UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-KSB

|[ X ]  | Annual Report under Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the fiscal year ended December 31, 2005      
|------ | -------------------------------------------------------------------------------------------------------------------------------------
|       |                                                                                                                                      
|[    ] | Transition Report under Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the transition period from _____ to _____

Commission file number: 1-31070

DERMA SCIENCES, INC.(Name of small business issuer in its charter)

|Pennsylvania                                                        | 23-2328753                              
|------------------------------------------------------------------- | ----------------------------------------
|(State or other jurisdiction of
     incorporation or organization) | (I.R.S. EmployerIdentification
     No.)
|                                                                    |                                         
|214 Carnegie Center,
     Suite 100, Princeton, New Jersey          | 08540                                   
|(Address of principal executive
     offices)                       | (Zip code)                              

Registrant's telephone number: (609) 514-4744

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

|Title of each class               | Name of each exchange on which
     registered
|--------------------------------- | ----------------------------------------------
|                                  |                                               
|Common Stock, $.01 par
     value | Boston Stock Exchange                         
|Common Stock, $.01 par value      | Pacific Stock Exchange                        

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

Title of Class

Common Stock, $.01 par value

Check whether
the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange
Act.[    ]

Check whether the Registrant:
(1) filed all reports required to be filed by Sections 13 or 15(d) of the 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
past 90 days.

         YesX
     No

Check if there is no
disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part
III of this Form 10-KSB or any amendment to this Form 10-KSB. [    ]

Indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.

         Yes
     NoX

Issuers
revenues for its most recent fiscal year were $23,545,475.

The
aggregate market value of the common equity stock held by non-affiliates, computed by
reference to the average bid and asked prices of such stock as of February 28, 2006, was
approximately $5,481,685.

The
number of shares outstanding of the issuers common equity as of February 28, 2006
was 12,285,768.

Documents
incorporated by reference: None

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Part I

Item 1. Description of
Business

Overview

Derma
Sciences, Inc. (Derma Sciences) was incorporated under the laws of Colorado on
September 10, 1984. On June 3, 1996 Derma Sciences changed its state of domicile to
Pennsylvania.

In
September, 1998 Derma Sciences acquired Genetic Laboratories Wound Care, Inc.
(Genetic Labs) by means of a tax-free reorganization whereby Genetic Labs
became a wholly-owned subsidiary of Derma Sciences. In December, 1999, pursuant to an
Agreement and Plan of Merger dated December 27, 1999, Genetic Labs was merged into Derma
Sciences by means of a tax-free reorganization whereby the separate corporate existence of
Genetic Labs ceased.

In
November, 1998 Derma Sciences purchased the stock of Sunshine Products, Inc.
(Sunshine Products) in a cash transaction. As a result of the stock purchase,
Sunshine Products became a wholly-owned subsidiary of Derma Sciences.

In
August, 2002 Derma Sciences acquired the assets of Dumex Medical Inc., a leading
manufacturer and distributor of wound care and related medical devices to the Canadian
market. The acquisition was effected by Derma Sciences wholly-owned Canadian
subsidiary, Derma Sciences Canada Inc. (Derma Canada) f/k/a Dumex Medical
Canada Inc.

In
January 2004, Derma Sciences purchased substantially all the assets of the Kimberly-Clark
Corporations wound care assets. These assets have been integrated into the
Companys existing wound care and wound closure and fastener product lines.

Derma
Sciences and its subsidiaries Sunshine Products and Derma Canada are referred to
collectively as the Company. The Companys executive offices are located
at 214 Carnegie Center, Suite 100, Princeton, New Jersey.

The
Company engages in the manufacture, marketing and sale of three dermatological related
product lines: wound care, wound closure and fasteners and skin care. The Companys
customers consist of various health care agencies and institutions such as nursing homes,
hospitals, home healthcare agencies, physicians offices and retail and closed door
pharmacies. The Company sells its products principally through distributors servicing
these markets in the United States, Canada and select international markets. The
Companys principal distribution facilities are located in St. Louis, Missouri and
Toronto, Canada. The Companys principal manufacturing facility is located in
Toronto, Canada. The Company, through Derma Canada, also maintains a light manufacturing
facility in Nantong, China producing labor intensive wound care products.

The Companys Markets

Wound Care

The
Company markets a line of wound care and surgical products to doctors, clinics, nursing
homes, hospitals and other institutions. The Wound Care line consists of basic and
advanced dressings, ointments and sprays designed to manage and treat a wide range of skin
conditions from basic burns, skin tears, abrasions and incontinence related skin
impairment to chronic non-healing skin ulcerations such as pressure, diabetic and venous
ulcers, surgical incisions and serious burns. Many of the Companys chronic wound
care products seek to provide an environment conducive to wound healing by addressing, in
addition to healing factors such as protection and infection control, additional healing
factors such as vitamins, minerals, moisture, pH balance and nutrition.

Wound Closure and
Fasteners

The
Company markets a line of wound closure strips, nasal tube fasteners and a variety of
catheter fasteners to doctors, clinics, nursing homes, hospitals and other institutions.
The Companys wound closure strips eliminate the

1

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need for sutures on the surface of
many surgical wounds, decrease the incidence of scarring and infection and promote wound
healing. In contrast to the characteristics of surgical tapes, these wound closure strips
yield to the movement of the skin thereby reducing traction blisters at the wound site. In
addition, these wound closure strips provide excellent adherence, optimum surgical wound
security and protection from irritation and skin shearing.

The
Companys nasal tube and catheter fasteners facilitate attachment of suction tubes,
feeding tubes, urinary catheters, gastrostomy tubes, wound drainage systems, IVs and
chest tubes. These fasteners incorporate dynamic tape-to-skin adhesion which minimizes
irritation, blistering and skin shear. Further, the fasteners single piece
construction permits adoption of rapid and standardized attachment procedures.

Skin Care

The
Company markets general purpose and specialized skin care products to nursing homes,
hospitals, home healthcare agencies and other institutions. These products include bath
sponges, antibacterial skin cleansers, soaps, hair and body washes, lotions, body oil and
moisturizers. The Companys skin care products are designed to enable customers to
implement and maintain successful skin care/hygiene programs.

The Companys
Products

Descriptions
of the Companys principle products and their intended uses are set forth below:

Wound Care Product Line

|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                      |  | Primary Dressings - Wound Care                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® Ointment                   |  | Topical ointment with a lanolin odor, packaged in both jars
   and tubes. Active ingredient: aluminum hydroxide gel. Used to manage stage I pressure and venous ulcers, incisions, burns and
   other skin irritations.                                                                                                                                                                                                                                  
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® Spray                      |  | Colorless, odorless liquid, packaged in opaque plastic
   bottles with pump spray nozzles. Active ingredient: zinc acetate. Used to manage stage I pressure and venous ulcers,
   incisions, burns and other skin irritations.                                                                                                                                                                                                                           
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® Hydrophilic Wound Dressing |  | Advanced zinc hydrogel formulation impregnated in gauze pad.
   Used for the management of stages II through IV pressure sores, diabetic ulcers, venous stasis ulcerations, thermal burns,
   surgical incisions and superficial lacerations, cuts or abrasions. Also packaged in tubes and sold as Dermagran®-B
   Hydrophilic Wound Dressing.                                                                                                          
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                      |  | Primary Dressings - Hydrocolloid Dressings                                                                                                                                                                                                                                                                                                                                                                                                               
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Primacol Hydrocolloid Dressing        |  | Sterile, transparent, hydrocolloid dressing packaged in
   various sizes to accommodate different uses. Used to protect the wound from outside contamination such as bacteria, fecal
   matter, or urine. Available in the following configurations: Primacol Bordered Hydrocolloid Dressing, Primacol Thin
   Hydrocolloid Dressing, Primacol Specialty Hydrocolloid Dressing  Sacral and Primacol Specialty Hydrocolloid Dressing
    Heel and Elbow.
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                      |  | Primary Dressings - Calcium Alginate Dressings                                                                                                                                                                                                                                                                                                                                                                                                           
|                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Algicell Calcium Alginate Dressing    |  | Sterile dressing containing alginate ropes. Used for the
   absorption of moderate to large amounts of wound exudate and management of minor bleeding.                                                                                                                                                                                                                                                                                                   

2

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|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|------------------------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                 |  | Primary Dressings - Hydrogel Dressings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|AquaSite Amorphous Hydrogel Dressing             |  | Clear sterile gel packaged in bellows and tubes. Used for
   filling wounds, while keeping them moist, and absorbing small to moderate amounts of wound exudate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|AquaSite Impregnated Dressing                    |  | Sterile, gauze dressing (either non-woven or sponge)
   impregnated with absorbent hydrogel. Used for packing wounds and treating lightly exudating, partial or full thickness
   wounds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                 |  | Primary Dressings - Foam Dressings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|HydroCell Foam Dressing                          |  | Sterile polyurethane foam sheet with protective film. Used to protect
     the wound from outside contaminants. Available in adhesive and non-adhesive forms in the following configurations: HydroCell
     Adhesive Foam Dressing and HydroCell Thin Adhesive Foam Dressing.                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|SorbaCell Foam Dressing                          |  | Sterile foam dressing used to absorb exudate while cushioning
   and protecting the wound.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Petrolatum Gauze Non-Adhering Dressing           |  | Sterile, latex free petrolatum impregnated dressings are
   designed to provide non-adherent packing for full thickness wounds providing a moist environment conducive to wound healing.
   They are made of fine, soft, conformable gauze impregnated with white petrolatum. Being non-adherent, removal of these
   dressings causes minimal trauma to the wound bed and patient. Used for management of full thickness chronic wounds such as
   pressure ulcers (stages II-IV), tunneling wounds and non-infected wounds. The overwrap version of these dressings
   provides an additional layer of sterility for use in environments such as operating rooms.                                                     
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Xeroform Petrolatum Non-Adhering Dressing        |  | Sterile, latex free Xeroform petrolatum dressings are designed
   to provide non-adherent packing for wounds, providing a moist environment conducive to wound healing. They are made of fine,
   soft, conformable gauze impregnated with 3% bismuth tribromophonate. Being non-adherent, removal of these dressings causes
   minimal trauma to the wound bed and patient. They are the impregnated dressings of choice for applications where mild
   medication or deodorizing are required, such as post-operative applications, 1st and 2nd degree burns and skin grafts. The
   overwrap version of these dressings provides an additional layer of sterility for use in environments such as
   operating rooms.
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Shur-Conform® Oil Emulsion Non-Adhering Dressing |  | Sterile, latex free oil emulsion impregnated dressings are
   designed to provide non-adherent packing for wounds, providing a moist environment conducive to wound healing. They are made
   of a knitted cellulose acetate fabric coated with a formulated petrolatum emulsion. The knitted fabric allows wound fluid to
   move through the dressing and into a secondary absorbent dressing. Being non-adherent, removal of these dressings causes
   minimal trauma to the wound bed and patient. Used for the management of skin grafts, surgical sites, abrasions, lacerations
   dermal ulcers and cosmetic surgery sites.                                                                                        
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                 |  | Primary Dressings - Silver                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                 |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Silver Dressing                                  |  | Sterile, silver plated nylon fabric in a wide range
   of dressings for wound and burn care. Long lasting (up to 7 days) with superior anti-microbial properties.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

3

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|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                    |  | Primary Dressings - Gauze Dressings and Sponges                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|DuCare® Gauze Dressings/ Sponges  Non-Sterile and
   Sterile       |  | Woven sponges made from 100% USP cotton. Used for general use
   or for debriding, covering, and packing wounds. Also available as non-woven sponges/dressings (DuSoft Non-Woven
   Dressings/Sponges  Non-Sterile and Sterile) and pre-slit for use with tracheotomies.                                                                                                                                                                                                         
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Packing Strips                                                      |  | Sterile gauze strips used to fill or pack wounds and prevent
   premature wound closure. Strips are also available impregnated with Iodoform.                                                                                                                                                                                                                                                                                                                                     
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                    |  | Primary Dressings - Sponges                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Durlix® 100% Cotton 6 Ply Fluff Sponge  Non Sterile
   and Sterile |  | Gauze sponges made from 100% cotton. Used for absorbing wound
   exudate and packing wounds.                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                    |  | Secondary Dressings - Bandages                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Conforming Bandages                                                 |  | Stretch gauze bandages used as secondary dressing for
   wrapping legs and arms and to hold dressings in place. Available in the following configurations: Dutex® 100% Cotton 2
   Ply Conforming Bandage  Non-Sterile and Sterile, Durlex® Bandage Rolls  Non Sterile and Sterile, DuForm®
   Knitted Synthetic Conforming Bandage  Non-Sterile and Sterile, DuForm® Synthetic Conforming Bandage and DuFlex®
   Woven Synthetic Conforming Bandage  Non-Sterile and Sterile.
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Gazetex® Bandage Rolls  Non Sterile and Sterile                    |  | Washed low-linting woven gauze rolls. Used for wrapping or packing large and deep wounds.                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Compression Bandaging Systems                                       |  | Latex free systems of multiple layers used for graduated
   compression on venous leg ulcers. The Companys bandaging systems are available in the following configurations: DuBoot
   Two-Layer Paste Compression Bandaging System, TresFlex Three-Layer Compression Bandaging System and DuFore Four Layer
   Compression Bandaging System.                                                                                                                                     
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|UnnaPress® Paste Bandage                                            |  | Latex free bandage (with or without calamine lotion). Used
   for maintaining a moist wound environment, resisting edema formation, and protecting the wound from external contamination
   and mechanical disruption during the healing process.                                                                                                                                                                                                                                 
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|ElasTive Elastic Adhesive Bandage                                   |  | Latex free, non-allergenic, adhesive bandage made of 100% cotton. Used to conform to body contours
   without restriction.                                                                                                                                                                                                                                                                                                                                                        
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|DuSor Elastic Bandage Premium and Economy                           |  | Latex free, cotton-wrapped bandage with heat resistant rubber
   strands. Used for firm compression and vascular and muscle support. Available in premium and economy versions as well as with
   a velcro closure (PrimaCare Elastic Bandage with Velcro Closure).                                                                                                                                                                                                             
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                    |  | Operating Room Sponges                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|Laparotomy Sponges  Non-sterile and Sterile, X-Ray
   Detectable   |  | Pre-washed or non-washed low lint, X-Ray detectable sponges
   used to absorb blood and other fluids during surgery.                                                                                                                                                                                                                                                                                                                                                              
|                                                                    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|DuPaque Non-Sterile and Sterile X-Ray Detectable Gauze
   Sponges   |  | Opaque sponge made of 100% USP fine mesh absorbent cotton
   with folded edges. Used to absorb blood and other fluids during surgery. Includes an X-Ray detectable mono-filament thread.                                                                                                                                                                                                                                                                                          

4

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|                                                              |  |                                                                                                                                                                                
|------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                              |  | Secondary Dressings - Abdominal Pads                                                                                                                                           
|                                                              |  |                                                                                                                                                                                
|DuPad® Sealed-End Abdominal Pads  Non-Sterile and
   Sterile |  | Sealed-end, absorbent secondary dressing used to absorb and
   disperse wound exudate.                                                                                         
|                                                              |  |                                                                                                                                                                                
|                                                              |  | Secondary Dressings - Burn Dressings                                                                                                                                           
|                                                              |  |                                                                                                                                                                                
|DuPress Sterile Burn Dressing                                 |  | Gauze dressing filled with cellulose. Used to absorb large
   amounts of fluids and minimize trauma and adherence to the wound.                                                
|                                                              |  |                                                                                                                                                                                
|                                                              |  | Secondary Dressings - Wound Cleansing Products                                                                                                                                 
|                                                              |  |                                                                                                                                                                                
|Sterile Water or Saline                                       |  | Sterile water or saline packaged in plastic squirt bottles
   for use in wound cleansing.                                                                                      
|                                                              |  |                                                                                                                                                                                
|                                                              |  | Other                                                                                                                                                                          
|                                                              |  |                                                                                                                                                                                
|Enteral Feeding Systems                                       |  | Enteral feeding systems distributed by Derma Canada and sold
   exclusively in Canada. Used to administer nutrients to patients unable to feed themselves through normal means.

Wound Closure and Fastener Product Line

|                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                   
|---------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Suture Strip and Strip Plus® Wound Closure
   Strips |  | Latex-free, sterile, flexible, moisture resistant wound
   closure strips made of a macroporous non-woven polyamide and adhesive. Used in surgical and wound closure procedures.                                                                                                                                                                                                  
|                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                   
|Shur Strip® Wound Closure Strips                     |  | Shur Strips provide an alternative to our Suture Strips that
   are more similar to the market leading brand. Shur Strips are latex free sterile skin closure strips that are made of a
   porous, non-woven backing coated with a pressure-sensitive, hypoallergenic adhesive. These strips are rigid thereby keeping
   wound edges securely together to maximize wound healing.
|                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                   
|UC Strip® Catheter Tubing Fastener                   |  | Latex-free, flexible, moisture resistant, one-piece
   catheter/tubing fastener made of a macroporous non-woven polyamide with adhesive. Used to secure urinary and gastrostomy
   catheter tubing to the patient.                                                                                                                                                                
|                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                   
|Cath-Strip® Recloseable Catheter Fastener            |  | Latex-free, flexible, moisture resistant multi-use
   recloseable catheter fastener with adhesive. Used with urinary catheters, gastrostomy and jejunostomy tubes, wound drainage
   systems, central line catheters, and multi-port IVs.                                                                                                                                         
|                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                   

Skin Care Product Line

|                            |  |                                                                                                                                                         
|--------------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------
|                            |  | Skin Care and Personal Hygiene Products                                                                                                                 
|                            |  |                                                                                                                                                         
|Soft Wash Bathing Sponge    |  | Latex-free, no rinse, single use bath sponge impregnated with
   a gentle soap and moisturizers.                                                        
|                            |  |                                                                                                                                                         
|Optima Bath Additive        |  | Bath additive or after-bath moisturizer enhanced with
   acetylated lanolin alcohol. Used to lubricate and soften the skin.                             
|                            |  |                                                                                                                                                         
|Hydro-soft Skin Conditioner |  | Concentrated blend of skin emollients and gentle skin
   cleansers for moisturizing and conditioning the skin. Used in whirlpool and hydrotherapy units.

5

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|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|----------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Hair and Skin Cleansers and Washes                    |  | The Company has various hair and skin cleansers/washes: Swash
     Conditioning Shampoo and Body Wash, Therabath Hair and Skin Cleanser, Bathe Away® Hair and Skin Cleanser and
     ApriVera® Hair and Skin Cleanser with AloeVera, Primaderm® Anti-Dandruff Shampoo, Primaderm No Rinse Shampoo and Body
     Wash and fragrance free Primaderm Body and Hair Cleanser.
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|                                                      |  | Skin Conditioners and Moisturizers                                                                                                                                                                                                                                                                                                                                       
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Skin Care Lotion                                      |  | Lotion to moisturize and soften the skin.                                                                                                                                                                                                                                                                                                                                
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Primaderm® Skin Protectant Lotion with 3% Dimethicone |  | Greaseless and non-staining dry skin moisturizer designed to
   prevent and relieve chapped and cracked skin.                                                                                                                                                                                                                                                            
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|                                                      |  | Incontinence Products                                                                                                                                                                                                                                                                                                                                                    
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|In-Between® Perineal Spray Skin Cleanser              |  | An odor eliminating skin cleanser used to cleanse the entire
   perineal skin area.                                                                                                                                                                                                                                                                                      
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® 3-N-1                                      |  | High foaming, pH balanced all-over body cleanser. Used as a
   no rinse perineal/skin cleanser and shampoo. Contains cleansing agents designed to dissolve fecal soils resulting from
   incontinence. Enhanced with Aloe Vera and other emollients to soothe and moisturize delicate and fragile skin. Contains zinc
   and Vitamin B6 to optimize skin integrity.      
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® GP General Skin Protectant Ointment        |  | An ointment containing allantoin and aloe vera gel. Used as a
   moisture barrier on external skin areas where repeated exposure to body excrements and exudates may cause skin break down.
   May be used as skin barrier on friction points.                                                                                                                           
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® BC Perineal Protectant Ointment            |  | An ointment consisting of a non-greasy formulation based upon
   the Company's proprietary Zinc-Nutrient and balanced pH technology. Used as a protectant against minor skin irritations due
   to moisture, urine, feces and perspiration.                                                                                                                              
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|                                                      |  | Skin Protectants                                                                                                                                                                                                                                                                                                                                                         
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Dermagran® AF Antifungal Ointment                     |  | An ointment containing miconazole nitrate and the
   Companys Zinc-Nutrient and balanced pH technology. Used for maintaining healthy skin and providing a long-acting
   barrier against moisture. Miconazole nitrate is used to treat jock itch, ringworm and athletes foot.                                                                                          
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|                                                      |  | Sanitizing Products                                                                                                                                                                                                                                                                                                                                                      
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Mysotrol® No rinse Hand Sanitizer                     |  | Waterless, no rinse hand sanitizer containing ethyl alcohol.
   Provides germicidal and virucidal action and meets OSHA protocol for a healthcare personnel handwash while reducing the risk
   of nosocomial infections.                                                                                                                                                
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Antibacterial Soap                                    |  | An antibacterial soap containing chloroxylenol used to reduce
   nosocomial infections including both gram-positive and gram-negative organisms as well as yeast and fungus in institutional
   environments.                                                                                                                                                            
|                                                      |  |                                                                                                                                                                                                                                                                                                                                                                          
|Bacti-Guard Antibacterial Hand Soap                   |  | An antibacterial hand soap containing triclosan, aloe vera
   and glycerin. Used to reduce nosocomial infections including both gram-positive and gram-negative organisms, as well as yeast
   and fungus in institutional environments.                                                                                                                                 

6

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|                                              |  |                                                                                                                                                                                                                                                                        
|--------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                              |  |                                                                                                                                                                                                                                                                        
|Whirlpool/Hard Surface Detergent/Disinfectant |  | A detergent used specifically for cleaning hard surfaces and
   whirlpool units in nursing homes, hospitals and other institutions. Also effective as a bactericide, mildewstat, sanitizer,
   virucide and fungicide in the presence of organic soil (5% blood serum).
|                                              |  |                                                                                                                                                                                                                                                                        

Distribution and Sales

United States

In
the United States, the Company employs a direct sales force, manufacturers representatives
(when circumstances warrant) and a number of national, regional and local distributors
(with their own sales forces) to sell the Companys products. The majority of the
Companys sales are made to national, regional and local distributors and large
institutional customers who sell the products to end users. Direct sales to end users are
not a significant part of the Companys business.

The
Companys direct sales force consists of an Executive Vice President  Sales and
Marketing, a Vice President  Corporate Accounts and four Regional Sales Managers
together with varying numbers of manufacturers representatives as market opportunities
require. Company sales employees receive a base salary together with commissions based
upon sales and gross profit achievement within their area of responsibility. Manufacturers
representatives receive commissions based upon sales in their territory and market
segment.

Canada

In
Canada, the Company employs a Sales Manager, one direct sales representative in Ontario,
the most densely populated province, and a manufacturers representative located in British
Colombia. Company sales employees receive a base salary together with commissions based
upon sales and gross profit achievement within their areas of responsibility. The majority
of the Companys Canadian sales are to hospitals pursuant to tender contracts with
national, provincial and local buying groups. These institutional contracts are generally
exclusive in nature and are awarded for a term of 1 to 5 years. Nursing home, home
healthcare, physician office and retail sales are for the most part made through local
dealers and government sponsored Community Care Access Centres (CCAC) agencies.

In
May 2005, the Company entered into a five year agreement with a Canadian company to serve
as the exclusive distributor of its products in Canada. The distributor maintains
strategically located distribution centers and over 40 sales representatives throughout
Canada. The Company believes the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth.

Other Foreign Markets

The
Companys products are sold throughout the rest of the world through various
licensing and distribution agreements. Foreign sales are made principally to Europe and
Latin America. Sales made to other foreign markets totaled approximately $951,000 in 2005
and $963,000 in 2004.

Competition

The
wound and skin care sectors of the medical products industry are characterized by rapidly
evolving technology and intense competition. Many suppliers of competing products are
considerably larger and have much greater resources than the Company. In addition, many
specialized products companies have formed collaborations with large, established
companies to support research, development and commercialization of wound and skin care
products which may be competitive with those of the Company. Academic institutions,
government agencies and other public and private research organizations are also
conducting research activities and may commercialize wound and skin care products on their
own or through joint ventures.

In
the United States, the Companys basic wound care products compete in a very
competitive commodity oriented marketplace with Kendall Tyco, Medical Action and a number
of others. In the advanced wound care products marketplace, the Company competes
principally with Bristol-Myers Squibb  Convatec, Smith & Nephew

7

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and Johnson
& Johnson. The market for wound closure strips and catheter fasteners is characterized
by a wide range of generic competition. The most dominant competitor in the suture strip
market is 3M. The Companys skin care products compete in a commodity oriented
marketplace with Provon, Chester Laboratories, Calgon Vestal  Steris and a number of
others.

In
Canada, the Companys basic wound care products compete in a very competitive
commodity-oriented marketplace with Kendall Tyco, Medicom, Medical Mart, Johnson &
Johnson and a number of others. In the advanced wound care products marketplace, the
Company competes principally with the same competitors as it competes with in the United
States together with a number of domestic generic companies.

The
ability of the Company to remain competitive is based on its ability to provide its
customers with a broad range of quality products, at a competitive price with superior
customer service. The prospective ability to cost effectively develop and or acquire and
commercialize new products that provide superior value is an integral component of the
Companys ability to stay competitive. The Company believes that the breadth and
quality of its existing product lines, the infrastructure in place to cost effectively
source and market its products and the skill and dedication of its employees will allow
the Company to successfully compete.

Product Sourcing

The
Company maintains manufacturing facilities in Toronto, Canada, and Nantong, China. The
Toronto and Nantong facilities manufacture the Companys line of basic and advanced
wound care products. The Derma line of wound care, wound closure-fastener products, skin
care products and the patient bathing sponge are outsourced. A number of basic and
advanced wound care products are sourced in semi-finished and finished form directly from
suppliers. Derma Canada also serves in a distributor capacity (sourcing finished product
directly from suppliers) for a number of medical device products in Canada.

The
Company maintains a long-standing network of suppliers for its outsourced products. The
majority of the Companys outsourced products utilize readily available components.
Accordingly, there are numerous companies capable of manufacturing these products to
applicable regulatory standards. Given the ready availability of other suppliers, as well
as the Companys policy regarding maintenance of adequate safety stock levels, the
Company does not believe that a temporary interruption in supply or loss of one or more of
its suppliers would have a long-term detrimental impact on its operations.

The
Nantong facility is ISO 9002 certified. The Toronto facility is ISO 9001 2000/ISO 13485/EN
46001 certified. The Company requires that all of its suppliers conform to the standards
set forth in the Good Manufacturing Practice (GMP) regulations promulgated by
the United States FDA and local health agencies.

Patents, Proprietary and
Non-Proprietary Technology

Under
the title Two-Step Procedure for Indolent Wound Healing and Aqueous Medium and
Topical Ointment Used in Connection therewith, the Companys Dermagran Ointment
and Dermagran Spray incorporating a unique Zinc Nutrient formulation and balanced pH
technology have received patent protection in the United States and a number of foreign
countries.

Under
the title Topical Barrier Composition Containing Silicone and Bentonite, the
Companys Dermagran BC (barrier cream) has received patent protection in the United
States for its non-greasy formulation offering a long lasting barrier effect.

The
Company also has patents on its line of wound closure Suture Strips and line of catheter
and tube fasteners comprised of NG Strips, UC Strip and Cath-Strip in the United States
and United Kingdom incorporating an exclusive non woven material and skin friendly
adhesive designed to provide the superior performance of dynamic adherence.

The
Company has a trademark on the name Derma Sciences in the United States and
Dumex in the United States and Canada. A significant number of the
Companys products in the United States are trademarked. The

8

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Company possesses a
number of non-patented formulations and process technologies that provide competitive
advantages in the marketplace.

The
Company believes the aforementioned patents, proprietary and non-proprietary technology
affords reasonable protection to the Company against the unauthorized copying of the
technology embodied in the subject products. However, the specific means whereby these
products promote wound healing and skin care are unknown and the chemical and biological
processes bearing upon wound healing and skin care are highly complex and subject to a
wide variety of influences and stimuli. As such, it is possible that competitors will
develop products equal to or superior to those of the Company without infringing upon the
Companys intellectual property.

Patent
law relating to the scope of claims with respect to wound care pharmaceutical products is
still evolving and the Companys patent rights are subject to uncertainty.
Furthermore, the existence of patent rights does not provide absolute assurance against
infringement of these rights. The prosecution and defense of patent claims is both costly
and time consuming, regardless of the outcome.

An
important component of the Companys growth strategy is to acquire, by purchase or
license, both proprietary and non-proprietary wound and skin care technology. There can be
no assurance that the Company will be able to obtain such technology on acceptable terms,
if at all. Future inability to acquire or license wound and skin care technology could
have a material adverse effect on the Companys business.

Government Regulation

United States 
Scope of Regulation

The
manufacture, distribution and advertising of the Company and its products are subject to
regulation by numerous federal and state governmental agencies in the United States. The
United States Food and Drug Administration (FDA) is responsible for
enforcement of the Federal Food, Drug and Cosmetic Act, as amended, (FDC Act)
which regulates drugs and devices manufactured and distributed in interstate commerce.
Many of the Companys products are classified either as over-the-counter drugs or
medical devices pursuant to the FDC Act. The Federal Trade Commission (FTC)
administers the Federal Trade Commission Act (FTC Act) which regulates the
advertising of products including over-the-counter drugs and devices. All states have
individual laws that resemble the FDC Act and the FTC Act.

Medical
Devices

The
FDC Act requires that all devices for human use marketed in the United States prior to May
28, 1976 (Pre-amendment Devices) be classified by the FDA, based on
recommendations of expert panels, into one of three regulatory classes. Class I products
are subject only to the general controls which apply to all devices, irrespective of
class. General controls include the registration of manufacturers, record-keeping
requirements, labeling requirements, and Good Manufacturing Practice (GMP)
regulations.

The
following products are registered with the FDA as Class I devices pursuant to
the regulations under Section 510(k) of the FDC Act: Dermagran Zinc-Saline Dressing,
Dermagran Hydrogel Wound Dressing, Dermagran Hydrophilic Wound Dressing, Dermagran-B
Hydrophilic Wound Dressing, Dermagran Wound Cleanser, Suture Strip, NG Strip, Cath-Strip
and UC Strip.

Class
II devices are those for which general controls are not sufficient to ensure safety and
effectiveness, and for which enough information exists to develop a standard. These
devices are required to meet performance standards established by the FDA. Performance
standards may specify materials, construction components, ingredients, labeling and other
properties of the device. A standard may also provide for the testing of devices to ensure
that different lots of individual products conform to the requirements.

The
most restrictive controls are applied to devices placed in Class III. Class III devices
are required to have FDA approval for safety and effectiveness before they can be marketed
unless the FDA determines that pre-market approval is not necessary. Pre-market approval
necessitates the compilation of extensive safety and effectiveness data which is extremely
expensive to compile. Approval of Class III devices may require several years.

9

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Devices
marketed after May 28, 1976 are considered to be one of two kinds: those that are and
those that are not substantially the same as a Pre-amendment Device. Those that are
substantially equivalent to a Pre-amendment Device are given the same classification as
the equivalent Pre-amendment Device. New devices which are not substantially equivalent to
Pre-amendment Devices are automatically placed in Class III thereby requiring pre-market
approval.

All
manufacturers are required to give the FDA ninety days notice before they can introduce a
device on the market. During the ninety-day period, the FDA will determine whether the
device is or is not substantially equivalent to a Pre-amendment Device. If the FDA
determines that the device is not substantially equivalent to a Pre-amendment Device, it
is automatically placed in Class III and the manufacturer will have to provide the FDA
with a Premarket Approval Application (PMA) containing evidence that the
device is safe and effective before the device may be commercially distributed to the
public. However, the manufacturer may request that the FDA reclassify the device by filing
a reclassification petition. All of the devices currently marketed by the Company, with
the exceptions of Sterile Water and Sterile Saline, have been found by the FDA to be
substantially equivalent to a Pre-amendment Device and are, therefore, classified in Class
I. Sterile Water and Sterile Saline are classified in Class II.

Over-the-Counter
Drugs

Prescription
drugs may be dispensed only on the prescription of a licensed practitioner and must be
labeled: Caution: Federal law prohibits dispensing without prescription. In
general, a drug is restricted to the prescription class if it is not safe for use except
under professional supervision. All drugs having characteristics that do not require
prescription dispensing are considered to be over-the-counter (OTC) drugs.
Those of the Companys products which are classified as over-the-counter drugs
pursuant to the FDC Act are: Dermagran Spray, Dermagran Ointment, Mysotrol, Antibacterial
Soap, Dermagran AF, Dermagran BC, Dermagran GP, Primaderm Anti-Dandruff Shampoo and
Primaderm Skin Protectant Lotion with 3% Dimethicone.

In
1972, the FDA began a comprehensive review of the safety, efficacy, and labeling of all
OTC drugs for the purpose of establishing the conditions under which such drugs could be
generally recognized as safe, effective, and not misbranded. To facilitate the review,
these drug products were grouped into therapeutic classes, and advisory panels were
established to review each class. The panels completed their review in 1983, and it
remains for the FDA to complete the rulemaking process.

On
the basis of the recommendations submitted by the panels, the FDA issues monographs
setting forth the conditions under which OTC drugs in each class are deemed to be
generally recognized as safe, effective, and not misbranded. Generally, the administrative
process includes the publication of a Preliminary, Tentative
Final, and Final Monograph. During the rulemaking process, products are
placed into one of three categories describing whether a drug is deemed to be generally
recognized as safe and effective and not misbranded (Category I), to be not generally
recognized as safe and effective or misbranded (Category II), or to lack sufficient data
for categorization (Category III). Products that do not comply with general OTC
regulations or an applicable Final Monograph are subject to regulatory action. Any OTC
drug not in compliance with the content and labeling requirements of a Final Monograph is
subject to regulatory action unless it is the subject of an approved new drug application.
The FDA has issued a Compliance Policy Guide in which it determined that it would not
pursue regulatory action against OTC drugs prior to the adoption of a final regulation
unless failure to do so presents a potential public health hazard.

Dermagran
Spray, Dermagran Ointment, Dermagran AF, Dermagran BC, Dermagran GP, Primaderm
Anti-Dandruff Shampoo and Primaderm Skin Protectant Lotion with 3% Dimethicone are
currently being marketed as over-the-counter skin protectant drug products. Skin
protectant products are the subject of an ongoing FDA rule making procedure which has
resulted in the issuance of a final monograph specifying those active ingredients which
are permitted in, and defining labeling requirements for, such products. The FDA has
released its final monograph for skin protectant drug products for OTC human use which
became effective June 4, 2004.

10

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Canada  Scope of Regulation

Medical
Devices

The
Medical Devices Regulations have been established under the authority of the Food and
Drugs Act and apply to all medical devices imported and sold in Canada. The Medical
Devices Bureau of the Therapeutic Products Directorate is the national authority that
monitors and evaluates the safety, effectiveness and quality of diagnostic and therapeutic
medical devices in Canada.

On
July 1, 1998 the Medical Devices Regulations set forth the requirements governing the
sale, importation and advertisement of medical devices in Canada. Regulatory scrutiny is
applied in these areas based on risk management principles that classify medical devices
into four classes, with Class I representing the lowest risk and Class IV the highest.

Every
medical device imported or sold in Canada, with the exception of Class I medical devices,
is required to be licensed prior to being imported or sold. A device license will be
issued to the manufacturer of a device if it is determined that the device meets
applicable safety and effectiveness requirements. Although Class I devices do not require
a license, they are monitored through Establishment Licenses. An Establishment License
permits importers, distributors and manufacturers of Class I devices to operate in Canada
without using a licensed importer.

As
of January 1, 2003, manufacturers of Class II, III and IV devices are required to have a
quality system registered to ISO 13485 or ISO 13488 by a registrar recognized by Health
Canada. Proof of registration must be submitted with any new license application after
January 1, 2003 and with the renewal of existing licenses after November 1, 2003.

The
following Company products have been licensed as Class II products with the Therapeutic
Products Directorate: Cotton Gauze Packing  X Ray detectable, Packing strips 
Cotton, Dupaque X Ray Detectable Sponges, Bulb Syringe for irrigation, Tonsil Sponges, Eye
Spear, Hydrogel Wound Dressing, Surgical Sponges, Calcium Alginate Dressing, Sterile
Gastrostomy Tube, Foam Dressing, Composite Dressing, Laparotomy Sponges, Tracheostomy
Sponges, Hydrocolloid Dressing Sterile, Petrolatum Gauze Non-Adhering Dressing, Xeroform
Petrolatum Non-Adhering Dressing, Shur-Conform Oil Emulsion Non-Adhering Dressing and
Dermagran Hydrophilic Wound Dressing.

Drugs

The
Health Products and Food Branch Inspectorate of Health Canada is mandated to regulate
drugs and the processes used to manufacture drugs. A Drug Establishment License is
required for activities such as fabrication, packaging/labeling, importation,
distribution, wholesale and testing. Derma Canada underwent an inspection by Health
Products and Food Branch Inspectorate on September 28, 2004 which successfully resulted in
the renewal of its Drug Establishment License for 2005 and 2006.

Once
a drug has been approved, the Therapeutic Products Directorate issues a DIN (Drug
Identification Number) which permits the manufacturer to market the drug in Canada. A DIN
lets the user know that the product has undergone and passed a review of its formulation,
labeling and instructions for use. A drug product sold in Canada without a DIN is not in
compliance with Canadian Law. The Companys product, Iodoform Packing Strip 5% W/W,
has been assigned a DIN number by Health Canada.

Registration and Status
of Derma Canada Products Sold in United States

All
products manufactured at Derma Canada are Class I devices with the exception of Sterile
Water and Sterile Saline which are classified as Class II devices.

Derma
Canada has passed inspection by the United States Food and Drug Administration.

11

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Other Foreign Regulatory
Authorities

Whether
or not FDA approval has been obtained, approval of medical drugs and devices by regulatory
authorities in foreign countries must be obtained prior to marketing drugs and devices in
such countries. The requirements governing the conduct of clinical trials and product
approval vary widely from country to country and the time required for approval may be
longer or shorter than that required for FDA approval. Although there are procedures for
unified filings for certain European countries, most countries currently maintain their
own product approval procedures and requirements.

Other Regulatory
Requirements

In
addition to the regulatory framework for product approvals, the Company is subject to
regulation under state and federal law, including requirements regarding occupational
safety, laboratory practices, environmental protection and hazardous substance control,
and may be subject to other present and future local, state, federal and foreign
regulation.

The
Company is also subject to federal, state and foreign laws and regulations adopted for the
protection of the environment and the health and safety of employees. Management believes
that the Company is in compliance with all such laws, regulations and standards currently
in effect and that the cost of compliance with such laws, regulations and standards will
not have a material adverse effect on the Company.

Third Party Reimbursement

In
the United States, the Company sells its wound care products to nursing homes, hospitals,
home healthcare agencies, retail and closed door pharmacies and similar
institutions. The patients at these institutions for whose care the Companys
products are purchased often are covered by medical insurance. Accordingly, the
Companys customers routinely seek reimbursement for the cost of the Companys
wound care products from third party payors such as Medicare, Medicaid, health maintenance
organizations and private insurers. The availability of reimbursement from such third
party payors is a factor in the Companys sales of wound care products.

Medicaid
is a federally funded program administered by the states. Medicaid insurance is available
to individuals who have no Medicare or private health insurance or to individuals who have
exhausted their Medicare benefits. Included in the Medicaid insurance coverage are
in-patient stays in long term care facilities, hospitalization and drugs.

Medicaid
reimbursement of the Companys products is dependent upon Company paid rebates to
state Medicaid agencies. The Omnibus Budget Reconciliation Act of 1990 requires
pharmaceutical companies, as a condition of the eligibility of its products for Medicaid
reimbursement, to enter into a rebate agreement with the federal government. Only drugs of
the pharmaceutical companies having such rebate agreements are covered by state Medicaid
programs. Pharmaceutical companies participating in the Medicaid rebate program must remit
to state Medicaid agencies a formula-based rebate which varies from quarter to quarter in
accordance with the Companys quarterly net sales and the average manufacturer price
of the individual products. In 2005, Medicaid sales were 1% of total Company sales and 21%
of sales for products subject to Medicaid rebates. Medicaid rebates represent less than 1%
of net sales.

Medicare
is a federally funded program administered by private insurance companies. Medicare
insurance generally is available to individuals who have paid social security taxes and
are over the age of 65 years. Several of the Companys wound care and fixation
products are eligible for Medicare reimbursement.

The
Prospective Payment Systems (PPS) enacted by Congress as part of the Balanced Budget Act
of 1997 places per capita (per patient) limits on the amount of Medicare
payments for goods and services provided by skilled nursing facilities. PPS has generally
had a negative impact on the long-term care industry as well as suppliers to this
industry, including the Company.

Federal
and state governments, as well as private insurers, will continue their pursuit of
programs designed to control or reduce the cost of health care. These cost cutting
measures may include reductions in reimbursements

12

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and/or increases in mandatory rebates
for wound care products. As such, there is uncertainty as to whether, and to what extent,
reimbursements for the Companys products will continue to be available. Likewise,
there is uncertainty as to the future extent of the Companys rebate obligations.

Product Development

The
Companys strategy is to outsource product development through licensing and
purchasing products from R&D oriented niche manufacturers. The Companys internal
development resources are directed towards line extensions and coordinating and
implementing changes to product and packaging specifications. The Company relies heavily
on purchasing and licensing of products to expand its product lines.

Employees

The
Company maintained 131 full-time and 2 part-time employees at December 31, 2005. Of these
employees, 25 are located in the United States, 60 in Canada and 48 in China. The Company
considers its employee relations to be satisfactory.

Item 2. Description of
Property

The
Companys executive offices are located in Princeton, New Jersey. The Company leases
its executive office space, at a base rent of $10,421 per month, under a lease that
expires in August, 2007. The Company leases 24,000 square feet of office, light
manufacturing and warehouse space in St. Louis, Missouri, at a rate of $7,663 per month
under a lease that expires in January 2007. This facility has been unoccupied since
September 2005. It was previously used to manufacture the Companys skin care product
line which is now outsourced. In March 2004, the Company leased a 42,400 square foot
warehouse in Fenton, Missouri, at a rate of $15,160 per month, under a lease that expires
in March 2009. The Fenton, Missouri, facility serves as the United States distribution
center for the Companys products.

Derma
Canada leases 51,700 feet of executive office and manufacturing space, at a rate of
$35,400 per month, under a lease that expires in August, 2012 and leases a 20,400 square
foot distribution facility, at a rate of $10,680 per month, under a lease that expires in
August, 2009. Both of the foregoing facilities are located in Toronto, Canada. The 20,400
square foot facility formerly served as Derma Canadas product distribution facility,
a function outsourced commencing in June 2005. This facility is being sublet under a lease
that expires in June 2008. A subsidiary of Derma Canada also leases a 11,400 square foot
manufacturing facility in Nantong, China, at a rate of $1,035 per month, under a lease
that expires in June, 2008.

Management
believes that the Companys facilities are adequate to meet its executive office,
manufacturing and distribution requirements for the foreseeable future.

Item 3. Legal Proceedings

The
Company is not a party to any material litigation.

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

The Company
did not submit any matter to a vote of shareholders during the fourth quarter, 2005.

13

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Part II

Item 5. Market for Common Equity, Related Shareholder Matters
and Small Business Issuer Purchases of Equity Securities

The
Common Stock of the Company is traded on the OTC Bulletin Board under the symbol
DSCI.OB. The Common Stock is also traded on the Boston and Pacific Stock
Exchanges under the symbol DMS. The Companys Common Stock commenced
trading on May 13, 1994. The following table sets forth the high and low bid prices for
the Companys Common Stock:

`Quarter Ended                         High        Low
                    -------------                         ----        ---

                          2005
                          ----
                    March 31, 2005                        $0.70      $0.50
                    June 30, 2005                         $0.59      $0.42
                    September 30, 2005                    $0.78      $0.52
                    December 31, 2005                     $0.65      $0.43

                          2004
                          ----
                    March 31, 2004                        $1.90      $1.08
                    June 30, 2004                         $1.32      $0.56
                    September 30, 2004                    $0.75      $0.43
                    December 31, 2004                     $0.90      $0.47`

The
stock prices reflect inter-dealer prices without retail mark-up, mark-down or commission
and may not necessarily represent actual transactions. There is no public market for the
Companys preferred stock. As of the close of business on February 28, 2006, there
were 1,214 holders of record of the Common Stock. The Company has paid no cash dividends
in respect of its Common Stock and does not intend to pay cash dividends in the near
future.

Item 6. Management's Discussion and Analysis or Plan of
Operations

Reference to Consolidated
Financial Statements

Managements
Discussion and Analysis or Plan of Operations should be read in conjunction with the
Companys consolidated financial statements and notes to consolidated financial
statements set forth below under Item 7.

Results of Operations

Overview

The
2005 and 2004 operating results include Derma Sciences, Inc. and its subsidiaries. Unless
otherwise indicated by the context, the term Canadian operations is used throughout this
discussion in reference to the operations of Derma Sciences Canada Inc. and the term U.S.
is used throughout this discussion in reference to the Companys U.S. operations.

The
Company engages in the manufacture, marketing and sale of three dermatological product
lines consisting of wound care, wound closure and fasteners and skin care. The wound care
line is composed of basic and advanced wound care products. Basic wound care consists of
gauze dressings, packing strips, impregnated gauze dressings, abdominal pads, laparotomy
sponges, burn dressings and bandages. Advanced wound care products consist of ointments,
silver dressings, calcium alginate dressings, hydrogel dressings, hydrocolloid dressings
and foam dressings. The wound closure and fastener line consists of wound closure strips
and a variety of catheter fasteners. The skin care line consists of bath sponges, skin
cleansers, soaps, hair and body washes and moisturizers.

14

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The
following table highlights 2005 versus 2004 operating results:

`Year Ended December 31,
                                     -----------------------
                                      2005             2004               Variance
                                      ----             ----               --------

Gross Sales                      $27,205,522      $21,003,485      $ 6,202,037     29.5%
Total sales adjustments           (3,660,047)      (1,116,353)      (2,543,694)   227.9%
                                 ------------      -----------     ------------

Net sales                         23,545,475       19,887,132        3,658,343     18.4%
Cost of sales                     15,756,053       14,335,202        1,420,851      9.9%
                                 ------------      -----------     ------------
Gross profit                       7,789,422        5,551,930        2,237,492     40.3%
Gross profit percentage                 33.1%            27.9%
Operating expenses                 7,520,986        7,375,534          145,452      2.0%
Goodwill impairment loss             910,967             -             910,967      -
Interest expense, net                336,867          227,305          109,562     48.2%
Other (income) expense, net          (70,294)         287,784         (358,078)   124.4%
                                 ------------      -----------     ------------
Total expenses                     8,698,526        7,890,623          807,903     10.2%
Loss before income taxes            (909,104)      (2,338,693)       1,429,589     61.1%
Provision for income taxes              -                -                -         -
                                 ------------      -----------     ------------

Net loss                         $  (909,104)     $(2,338,693)     $ 1,429,589     61.1%
                                 ============     ============     ============`

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, Medicaid rebates, returns and allowances and cash
discounts to derive net sales. Trade rebates are trued-up monthly based upon an analysis
of historical sales subject to rebate and actual rebates received from distributors. The
normal rebate cycle is one month. Non-exclusive distributors generally carry one
months inventory. As distributor inventory is depleted via sales, it is replenished
via purchases from the Company. Rebates are processed and submitted for credit on a timely
basis consistent with distributor sales. If the normal rebate cycle were one-half month at
December 31, 2005, the trade rebate reserve would be overstated by approximately $138,000.
If the normal rebate cycle were two months at December 31, 2005, the trade rebate reserve
would be understated by approximately $276,000. To minimize its cash outflow invested in
rebates, distributors generally strive to optimize the rebate credit submission process.

Given
the nature of the Companys products and business, there is no external information
readily available to further validate the reasonableness of the trade rebate accrual
balance. Historical trends of sales subject to rebate and rebates received are evaluated
monthly, by distributor, on a 3 month, 6 month and 12 month rolling basis to update the
continued reasonableness of the assumptions used to quantify the trade rebate accrual
balance. Deviations in the trends resulting, among other causes, from distributors not
submitting their rebates on a timely basis are analyzed and factored in determining the
required accrual balance.

Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts have historically been accounted for as incurred.

15

---

Gross
to net sales adjustments comprise the following:

`Year Ended December 31,
                                     -----------------------
                                      2005             2004
                                      ----             ----

Gross Sales                      $27,205,522      $21,003,485

Trade rebates                     (3,410,742)        (859,095)
Medicaid rebates                     (29,256)         (44,221)
Returns and allowances               (65,731)         (57,782)
Cash discounts                      (154,318)        (155,255)
                                 ------------     ------------

Total adjustments                 (3,660,047)      (1,116,353)
                                 ------------     ------------

Net sales                        $23,545,475      $19,887,132
                                 ============     ============`

Trade rebates
increased $2,551,647 in 2005 versus 2004 due to the Companys implementing an
exclusive third party distribution agreement in the second quarter 2005 for its Canadian
operation, continuing growth of rebate intensive U.S. private label sales and a general
increase in the level of sales subject to rebate (contract business) in other
areas of the Companys business. Implementing the third party distribution agreement
was responsible for $2,358,985 of the increase as the majority of the Canadian sales
represent contract business subject to rebate. A continuing trend towards lower levels of
Medicaid reimbursed sales is responsible for the lower level of Medicaid rebates. Sales
returns and allowances were comparable period to period and on balance reflect a normal
level of activity. The slight decrease in cash discounts reflects the Companys
efforts to tighten its discount terms.

Rebate Reserve Roll
Forward

A
roll forward of the trade rebate accruals at December 31, 2005 and 2004 is outlined below:

`Year Ended December 31,
                                     -----------------------
                                      2005           2004
                                      ----           ----

Beginning balance - January 1    $   253,815      $ 212,000
Rebates paid                      (2,064,285)      (817,280)
Rebates accrued                    3,410,742        859,095
                                 ------------     ----------

Ending balance - December 31     $ 1,600,272      $ 253,815
                                 ===========      ==========`

The
$1,346,457 net increase in trade rebates in 2005 reflects a $1,157,490 incremental reserve
associated with implementing the third party distribution agreement in Canada during the
second quarter 2005 coupled with lower rebates paid due to extended rebate payment terms
with two large customers. There has been no other discernable change in the nature of the
Companys business as it relates to the accrual and subsequent payment of rebates,
nor has there been any material changes in estimates to the trade rebate accrual in 2005.
The $41,815 increase in the 2004 trade rebate accrual reflects the commencement of
extended rebate payment terms with two large customers during the first half of 2004
partially offset by the work down of a higher than normal beginning accrual balance due to
significant sales of product subject to rebate in December 2003 as part of a year end
sales promotion initiative. The December 31 ending balance consists of accrued rebates and
third party deductions accrued by and paid by the Company and recorded in accrued
liabilities. The ending balance at December 31, 2005 and 2004 consist of the following:

16

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`2005             2004
                                       ----             ----

Accrued rebates                    $1,404,290         $164,000
Third party deductions recorded
    in accrued liabilities            195,982           89,815
                                   ----------         --------

Total                              $1,600,272         $253,815
                                   ==========         ========`

Net Sales and Gross Profit

The
following table highlights the December 31, 2005 versus 2004 product line net sales and
gross profit:

`Year Ended December 31,
                                     -----------------------
                                      2005             2004               Variance
                                      ----             ----               --------
Product Line Net Sales
----------------------

Wound care                       $19,366,904      $14,609,033      $4,757,871       32.6%
Wound closure and fasteners        2,676,979        3,339,432        (662,453)     (19.8%)
Skin care                          1,501,592        1,938,667        (437,075)     (22.6%)
                                 ------------      -----------     ------------

    Total                        $23,545,475      $19,887,132      $3,658,343       18.4%
                                 ============     ============     ============


Product Line Gross Profit
-------------------------

Wound care                        $6,532,803       $3,507,263      $3,025,540       86.3%
Wound closure and fasteners        1,358,576        1,672,463        (313,887)     (18.8%)
Skin care                           (101,957)         372,204        (474,161)    (127.4%)
                                 ------------      -----------     ------------

    Total                         $7,789,422       $5,551,930      $2,237,492       40.3%
                                 ============     ============     ============`

Company
net sales increased $3,658,343, or 18.4%, to $23,545,475 in 2005 from $19,887,132 in 2004.
Canadian net sales increased $3,872,781, or 43.9%, to $12,699,991 in 2005 from $8,827,210
in 2004. This increase was driven by growth of $1,518,000, favorable exchange of $614,781
and the one-time benefit of approximately $1,740,000 related to the sale of inventory on
hand to a new distributor to fill its pipeline in connection with entering into a new
exclusive distributor agreement in 2005. U.S. net sales decreased $214,438, or 1.9%, to
$10,845,484 in 2005 from $11,059,922 in 2004. The decrease was driven by the loss of an
exclusive catheter fastener distribution agreement in 2004 coupled with continuing skin
care competitive pressure and a softening of demand for basic wound care and silver
dressings. Partially offsetting these decreases was the continued growth of the private
label business coupled with the stabilization of the Dermagran business.

Company
gross profit increased $2,237,492, or 40.3%, to $7,789,422 in 2005 from $5,551,930 in
2004. Canadian gross profit increased $2,242,377, or 114.5%, to $4,200,630 in 2005 from
$1,958,253 in 2004. Canadian gross profit margin percentage improved 10.9 points to 33.1%
in 2005 from 22.2% in 2004. The significant improvement in Canada in 2005 gross profit
dollars and margin percentage reflects the combined impact of higher sales, a significant
turnaround in operating performance, higher throughput, the benefit of lower negotiated
basic wound care costs and a one-time benefit of $600,000 related to the sale of inventory
to fill the new Canadian distributors pipeline. U.S. gross profit was essentially
flat at $3,588,792 in 2005 versus $3,593,677 in 2004. Gross profit margin percentage
increased to 33.1% in 2005 versus 32.5% in 2004. The change in gross profit dollars and
margin percentage reflects the combined effect of lower sales and adverse product mix as
2005 sales growth came from lower margined products, effectively being offset by the flow
through benefit of lower product costs sourced from Canada.

Wound
care sales increased $4,757,871, or 32.6%, to $19,366,904 in 2005 from $14,609,033 in
2004. The increase is principally attributable to a basic wound care increase of
$3,853,611, or 36.1%, to $14,522,860 in 2005

17

---

from $10,669,249 in 2004. This increase was
driven by a significant increase in Canadian basic wound care sales of $3,872,781,
comprised of growth of $3,258,000 and favorable exchange of $614,781 (reflecting a 6.5%
strengthening of the Canadian dollar), while U.S. basic wound care sales decreased
$19,170, or 1.0%. The Canadian sales growth was driven by a one-time benefit of
approximately $1,740,000 (excluding foreign exchange benefit) related to the sale of
inventory on hand to fill the distribution pipeline, in conjunction with the appointment
of an exclusive third party distributor for Canada in the second quarter 2005, coupled
with normal growth of $1,518,000, or 17.2%, due principally to improved contract
compliance and the improved market visibility afforded by the new exclusive distribution
agreement effective June 1, 2005. Advanced wound care sales increased $904,260, or 23.0%,
to $4,844,044 in 2005 from $3,939,784 in 2004. This increase was driven by continued
growth of the Companys private label business coupled with the stabilization of the
Dermagran business. Dermagran sales were up $51,325, or 3%, in 2005 versus a significant
decrease in 2004. Partially offsetting these increases were lower silver product sales
which, while improving in the second half of 2005, were $124,242, or 30.3%, less than in
2004.

Wound
care gross profit increased $3,025,540, or 86.3%, to $6,532,803 in 2005 from $3,507,263 in
2004. Gross profit margin increased to 33.7% in 2005 from 24.0% in 2004. Approximately
$600,000 of the increase in gross profit dollars relates to the one-time sale of inventory
to fill the new Canadian distributors pipeline. The balance of the gross profit
dollar increase and improved gross profit percentage is due to the increase in sales and
improved manufacturing efficiencies in 2005, coupled with the flow through of lower basic
wound care costs from China negotiated in 2004, the non-recurrence of one-time advanced
wound care private label manufacturing and Kimberly-Clark equipment transfer related
start-up and product validation costs incurred in 2004, lower advanced wound care costs
associated with the manufacture of the former Kimberly-Clark products in-house versus the
higher acquisition related negotiated costing used in much of 2004, lower silver dressing
costs associated with sourcing from a new supplier, and the non-recurrence of a one-time
$59,400 inventory write-off in the first quarter 2004.

Wound
closure and fastener sales decreased $662,453, or 19.8%, to $2,676,979 in 2005 from
$3,339,432 in 2004. A reduction of approximately $697,000 in sales of certain catheter
fasteners in 2005 versus 2004, associated with the loss of the Companys exclusive
distribution agreement for the sale of these products in August 2004, is primarily
responsible for the decrease. A $37,000, or 5.2%, decrease in catheter fastener sales due
to competitive pressure also contributed. These decreases were partially offset by a
$72,000, or 3.5%, increase in suture strip sales.

Wound
closure and fastener gross profit decreased $313,887, or 18.8%, to $1,358,576 in 2005 from
$1,672,463 in 2004. Gross profit margin increased to 50.8% in 2005 from 50.1% in 2004. The
decrease in margin dollars is consistent with the sales shortfall. The margin improvement
principally reflects the benefit of the loss of the exclusive catheter fastener business,
which was lower margined than the balance of the line.

Skin
care sales decreased $437,075, or 22.5%, to $1,501,592 in 2005 from $1,938,667 in 2004 due
to continuing competitive pressure and the loss of several key customers. Skin care gross
profit decreased $474,161 to a loss of $101,957 in 2005 from a profit of $372,204 in 2004.
The Company completed the closure of its skin care manufacturing operation on schedule in
August 2005 and commenced outsourcing the manufacture of its skin care products from a
third party supplier. Included in the 2005 loss are one-time costs of approximately
$169,000 associated with the closure of the facility and post closure ongoing lease and
maintenance costs of approximately $7,500 per month. Excluding these one-time costs, the
skin care line generated a positive gross profit of approximately $67,000 in 2005. Skin
care margins are expected to improve going forward as the Company works through its higher
cost inventory on hand. Further margin improvement will occur upon sub-leasing the former
manufacturing facility, which is under lease through January 2007, and eliminating the
costs associated therewith.

18

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Operating Expenses

The
following table highlights December 31, 2005 versus 2004 operating expenses by type:

`Year Ended December 31,
                                    -----------------------
                                     2005             2004                Variance
                                     ----             ----                --------

Distribution                     $1,564,512       $1,430,048       $134,464      9.4%
Marketing                           416,779          369,446         47,333     12.8%
Sales                             1,912,030        1,902,783          9,247      0.5%
General administrative            3,627,665        3,673,257        (45,592)    (1.2%)
                                 ----------       ----------       ---------

    Total                        $7,520,986       $7,375,534       $145,452      2.0%
                                 ==========       ==========       ========`

Operating
expenses increased $145,452, or 2.0%, to $7,520,986 in 2005 from $7,375,534 in 2004.
Operating expenses for 2005 include an increase of $193,603 related to foreign exchange
associated with a 6.5% strengthening of the Canadian dollar on the Canadian operations.
Excluding the impact of foreign exchange, operating expenses decreased $48,151, or 0.6%,
in 2005 versus 2004. Excluding exchange, operating expenses in Canada increased $49,974,
or 2.0%. U.S. operating expenses decreased $98,125, or 2.0%.

Distribution
expenses increased $134,464, or 9.4%, in 2005 versus 2004. Expenses in Canada increased
$297,518 (including $55,710 in expenses related to foreign exchange) while expenses in the
U.S. decreased $163,054. The increase in Canada was attributable to implementation of the
new distribution agreement. Effective June 2005, the new distributor assumed
responsibility for customer service, product delivery, inventory management and
warehousing while, to the extent feasible, the Company eliminated its internal cost for
these services. The distributor charges the Company a distribution fee each month based on
a fixed percentage of eligible distributor net sales of the Companys products to end
users. The $241,808 increase (excluding foreign exchange) is attributable to slightly
higher distributor fees versus the Companys previous internal charges and the impact
of higher sales and corresponding higher fees since inception of the agreement, together
with approximately $52,000 in one-time severance and other related costs associated with
the transition to the new agreement. In addition, the Company is incurring incremental
expense to maintain a temporary distribution warehouse in previously leased manufacturing
space adjacent to the main facility in Toronto (that it intended to sub-lease) until such
time that the activities conducted therein can be integrated into existing leased
manufacturing space in the main facility. The U.S. decrease principally reflects the
benefit of closing one of the Companys distribution facilities in April 2004 and the
non-recurrence in 2005 of approximately $60,000 of one-time costs to close the facility.
In addition, the Company incurred various incremental start up related expenses to open
the new U.S. distribution center in March 2004 that were not repeated in 2005. Partially
offsetting these expense reductions were higher lease, utility and depreciation expenses
associated with the new, larger, more well equipped U.S. distribution center.

Marketing
expenses increased $47,333, or 12.8%, in 2005 versus 2004. The increase is principally
attributable to higher promotion and product development expense in support of the
Companys growth initiatives.

Sales
expenses increased $9,247, or 0.5%, in 2005 versus 2004. Expenses in Canada increased
$39,555 (including $30,755 in expenses related to foreign exchange) while expenses in the
U.S. decreased $30,308. The $8,800 increase (excluding foreign exchange) in Canada is
attributable to a higher level of sales support activities consisting principally of
travel, convention attendance and sampling to expand market visibility and improve
contract compliance and one-time severance and travel costs associated with implementing
the new distribution agreement. Partially offsetting these increases were savings
associated with eliminating one territory sales representative position in connection with
implementing the new distribution agreement. The U.S. decrease was attributable to $56,000
associated with the elimination of a sales database consultant and related expenses in
early 2005, $39,000 associated with lower manufacturers representatives commissions
due to the decision to discontinue their use in the second quarter 2005, and lower sample
expense of $22,000. Partially offsetting these decreases were higher recruiting expenses
of $42,000, travel of $39,000 and compensation associated with hiring a new territory
representative in September 2005.

19

---

General
and administrative expenses decreased $45,592, or 1.2%, in 2005 versus 2004. Expenses in
Canada decreased $93,496 (net of $107,138 in expenses related to foreign exchange) while
expenses in the U.S. increased $47,904. The $200,634 decrease (excluding foreign exchange)
principally reflects the non-recurrence in 2005 of a $301,600 charge for employee
termination costs, partially offset by higher compensation costs associated with the
filling the new director of materials and logistics position in the second quarter 2005,
one-time costs of $41,700 for severance and other costs associated with implementing the
new distribution agreement, coupled with higher health benefit, travel, insurance, bank
and bad debt expenses. The increase in the U.S. reflects board of directors fees of
$69,000 initiated in 2005, higher compensation of $43,000 related to non management pay
increases, a full years expense for the new IT director hired in April 2004, a new
materials management position effective September 2005, incremental Sarbanes-Oxley related
fees of $30,000, and travel of $19,000, partially offset by the non-recurrence in 2005 of
a $42,600 bad debt write-off taken in the first quarter 2004 coupled with lower public
relations, legal and other miscellaneous expenses due to cost containment efforts.

Goodwill Impairment Loss

The Company conducted the
required annual goodwill impairment review in the fourth quarter 2005 and determined that the $1,110,967 carrying value of its
Sunshine Products, Inc. goodwill was impaired and recorded a $910,967 goodwill impairment charge on the Consolidated Statement of
Operations. In 2005, the Sunshine Product Line continued to experience competitive pressure leading to declining sales and gross
profit. Despite attempts to improve the financial performance of the line, the Company has been unable to overcome the sales and
marketing breadth and product cost advantage held by its larger competitors. Utilizing the Company's methodology for evaluating
goodwill impairment (see Note 1), the implied value of the Sunshine Product Line goodwill was determined to be $200,000. Excluding
goodwill, the Company believes the balance of the assets and liabilities related to the Sunshine Product Line are fairly valued
and recovery is reasonably assured. The Company has internally evaluated the prospective sale price of the Sunshine Product Line
and determined that in management's judgment it is comparable to the implied value of the goodwill.

Interest Expense

Interest
expense increased $109,562, or 48.2%, to $336,867 in 2005 from $227,305 in 2004. Interest
expense in Canada decreased $44,375 (net of $9,234 in expenses related to foreign
exchange) while interest expense in the U.S. increased $153,937. The $53,609 decrease in
Canada (excluding foreign exchange) reflects lower outstanding line of credit and term
loan balances in 2005, partially offset by slightly higher interest rates and fees.
Canadas outstanding line of credit balance was significantly reduced, beginning in
mid-May 2005, to zero by the end of June 2005 through the use of the initial one-time
positive cash flow generated by implementation of the new distribution agreement.
Canadas term loan was significantly reduced in January 2005 as a result of the pay
off of an outstanding irrevocable standby letter of credit issued by the U.S. lender in
the amount of $200,000 held by the Canadian lender as additional security for its credit
facility. The $200,000 payment was applied to the term loan as a permanent principal
reduction against the principal amount due in 2007. The increase in the U.S. is due to
higher outstanding line of credit balances, higher interest rates and higher line of
credit fees in 2005 versus 2004. In January 2005, the Company refinanced its U.S. line of
credit at a higher overall cost level. In addition, in 2004 the U.S. operation did not
move into a net borrowing position until June 2004.

Other Income/Expense

Other
income/expense improved $358,078 to $70,294 income in 2005 from $287,784 expense in 2004.
The 2005 net income was comprised of a gain plus interest of $179,000 related to a
one-time distribution agreement upset fee recorded in the first quarter 2005 and license
fee income of $15,000 less fixed asset write-offs of $72,000, unfavorable exchange of
$22,000 and miscellaneous net expenses of $30,000. The 2004 net expense was comprised of
fixed asset write-offs of $259,000, reversal of a prior year gain of $14,000 and
miscellaneous net expenses of $23,000, less license fee income of $8,000.

20

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Income Taxes

The
Company did not record any tax expense in 2005 or 2004 given its net operating losses in
2005 and 2004 and available net operating loss carry forwards.

Net Loss

The
Company incurred a net loss of $909,104, or $0.07 loss per share (basic and diluted), in
2005 compared to a $2,338,693 loss, or $0.25 loss per share (basic and diluted), in 2004.

Liquidity and Capital
Resources

Operational Overview

In
2005, overall sales growth did not meet Company expectations. While reported sales
increased 18.4% in 2005 over 2004, adjusted for one-time items, lost business and foreign
exchange, period to period sales growth was approximately 9%. Sales in Canada exceeded
expectations growing approximately 17%, as the Company has focused on contract compliance,
exploring opportunities in other market segments (other than its traditional strength in
the acute care segment) and working closely with its new exclusive distributor to leverage
sales growth opportunities presented by this new relationship. Sales in the U.S. increased
modestly at approximately 2% period to period. Growth in the private label area has
effectively been offset by softness in the skin care, basic wound care and silver areas.
Sales in the advanced wound care and wound closure-fasteners areas have remained
relatively stable.

As
expected, the Company realized the benefit of its manufacturing and sourcing initiatives
completed during 2004 and built on them throughout 2005. Notwithstanding the impact of
price and mix on margins, gross profit margin increased to 33.1% in 2005 from 27.9% in
2004 due principally to improved manufacturing efficiencies and lower product procurement
costs. In an effort to further enhance manufacturing efficiency and competitiveness, the
Company closed its underutilized skin care manufacturing facility in August 2005 and cost
effectively outsourced the manufacture of these products to a third party. Excluding
one-time and ongoing costs, the skin care line generated a modest gross profit in 2005.
Skin care margins are expected to improve going forward as the Company works through its
existing higher cost inventory and once it is able to offload ongoing lease and
maintenance costs of approximately $7,500 per month associated with the former
manufacturing facility.

Excluding
one-time costs, expense reclassifications and exchange, 2005 operating costs increased
approximately 4% versus 2004. Higher Canadian distribution costs related to the new
distribution agreement and marketing in support of the Companys growth initiatives
represented the major areas of increase. This modest increase reflects the Companys
continuing effort to restrain expenses to the extent possible without adversely affecting
the underlying infrastructure in place to support planned growth.

The
Company reported a net loss of $909,104 in 2005 versus a net loss of $2,338,693 in 2004.
While there were a number of one-time items affecting each years results, overall
2005s performance represents a distinct improvement over 2004. Notwithstanding this
improved performance, the Company will continue to focus on, and take the steps necessary
to accelerate, sales growth while properly aligning operating expenses with expected
revenues.

As
of December 31, 2005, the Board of Directors approved 461,875 stock options as part of the
Companys 2005 performance-based option plan as being earned by Company management.
In accordance with the terms of the performance based option plan, options earned are
immediately vested. In connection with the award of these options, the Company recorded a
non-cash charge of $23,094 to compensation expense.

On
December 30, 2005, the Board of Directors approved the acceleration of vesting of unvested
stock options held by officers, directors and employees of the Company. The vesting of
options to purchase 828,533 shares of common stock, with exercise prices ranging from
$0.37 to $1.70 per share and with a weighted average exercise price of $0.80 per share was
accelerated. Of the options whose vesting was accelerated, 116,250 options were in
the money when compared to a per share market price of $0.43, representing the
closing price of the Companys stock on December 29, 2005. In accordance with the
intrinsic value method of accounting under APB 25 used by the Company

21

---

through December 31,
2005, no charge was recorded for the vesting of the in the money options as, in the
opinion of Company management, all of these options would have ultimately vested pursuant
to the options original vesting schedule. The decision to accelerate the vesting of the
foregoing options was made primarily to reduce non-cash compensation expense of
approximately $422,000 that would otherwise have been recorded in future periods in
compliance with SFAS 123(R).

In
the fourth quarter 2005, the Company conducted its required annual goodwill
impairment review and determined that the $1,110,967 carrying value of its Sunshine Products, Inc.
goodwill was impaired. In December 2005, the Company recorded a $910,967 non-cash goodwill
impairment charge on the Consolidated Statement of Operations. The revised implied value
of the Sunshine Products, Inc. goodwill of $200,000 is comparable to the value derived using the
Companys discounted cash flow methodology and is deemed reasonable by management.

In
June 2005, in connection with implementation of the new distribution agreement, the
Company sub-leased its Canadian distribution center through June 2008 at its existing
rates and terms. The sub-lessee has the right to continue leasing the facility after June
2008 on a month-to-month basis with the Companys approval or extend the lease term
for up to two additional years. The Companys lease expires August 2009. Total
payments under the sub-lease agreement through June 2008 aggregate approximately $360,000.

In
June 2005, the Company announced its intention to close its skin care manufacturing
facility in St. Louis, Missouri and outsource the facilitys production with a view
to reducing overhead and improving cost competitiveness. The facility was closed on
schedule at the end of August 2005. Through year-end, one-time closure related and ongoing
costs of approximately $169,000 consisting of severance, lease costs, inventory
write-offs, fixed asset write-offs and post closing maintenance costs were incurred.
Ongoing estimated monthly lease and facility maintenance costs of $7,500, net of existing
committed lease cost and estimated sub-lease income through lease expiration on January
31, 2007, will be expensed as incurred.

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada.
Effective June 1, 2005 the distributor assumed responsibility for customer service,
product delivery and maintenance and warehousing of sufficient inventory to meet order
fulfillment requirements. With respect to sales made by the distributor to the
Companys contract customers in its capacity as a servicing agent, the Company will
pay the distributor a distribution fee and a specified incentive for growth (as achieved).
The Company will reimburse the distributor for the difference between the price paid by
the distributor and the Companys contract price with its customer upon submission by
the distributor of a rebate report. With respect to sales made by the distributor to its
customers, the distributors compensation will consist solely of the excess of the
proceeds over the cost of the product and the Company will not be responsible for payment
of any distribution fee. Further, the agreement requires the distributor to meet specified
minimum sales growth targets of 15%, 12%, 12% and 12% in the first four years, together
with private label product purchase targets, failing which the Company may cancel the
agreement. The Company believes that the agreement will provide better service to its
customers throughout Canada and greater opportunity for prospective sales and profit
growth.

In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand and all saleable finished product
it committed to manufacture prior to signing of the agreement for delivery by the Company
through September 2005 at the agreed upon prices to initially stock and maintain its
distribution pipeline. Other than the one-time sale in May and June 2005 of its existing
inventory on hand, which is estimated to represent two to two and one-half months sales,
prospective sales are expected to resume historical trends affected only by existing
market conditions and the growth opportunities inherent in the agreement. Given economic
order quantities and normal lead times associated with the products sold to the
distributor, it is expected that a two to three month safety stock will be required
prospectively by the distributor to maintain required customer service requirements. In
addition, the Company incurred one-time costs consisting of severance and other costs to
dismantle its distribution capabilities and sub-lease its distribution warehouse. A
summary of the estimated one-time benefit and costs of the agreement recognized in the
twelve months ended December 31, 2005 is outlined below:

22

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`Net Sales                 $1,840,000
                      Cost of Sales              1,240,000
                                                ----------

                      Gross Profit                 600,000
                      Expenses                     105,000

                      Pretax Income             $  495,000
                                                ----------`

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

In
2004, the Companys exclusive distribution agreement for certain catheter fasteners
expired and was not renewed by the manufacturer. In accordance with the Companys
distribution agreement with a major customer for the fasteners, if the customer
subsequently enters into an agreement with the manufacturer to distribute these products,
then the customer would be required to pay the Company an upset fee of $200,000 in
forty-eight monthly installments of $4,167. As of January 2005, the customer advised the
Company that it had entered into an agreement with the manufacturer to distribute the
catheter fasteners and that it was liable for payment of the upset fee. In January 2005,
the Company discounted the future cash flow stream associated with the payment of the
upset fee and recognized a gain of $164,300.

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering was initiated in December 2004. In 2004, the Company sold
1,555,000 units and received offering proceeds of $698,859, net of $78,641 in offering
expenses. In 2005, the Company sold 1,205,000 units and received offering proceeds of
$521,808, net of $80,692 in offering expenses.

In
2004, the Company entered into operating and capital leases totaling approximately
$4,222,000 in commitments through 2012, with terms ranging from three to five years,
relative to the following: extension of the Canada manufacturing facility lease in the
amount of $1,902,000, lease for the new U.S. distribution center in the amount of
$1,118,000, Canada distribution and U.S. manufacturing facility extensions in the amount
of $903,000 and U.S. distribution center equipment and upgrades to the Company-wide
telecommunications and information technology equipment in the amount of $299,000. No
further significant lease obligations are anticipated in the foreseeable future.

On
September 24, 2004, the Company settled litigation brought against it and its wholly owned
Canadian subsidiary by a former executive relative to the executives termination of
employment. Pursuant to the settlement, the Company agreed to pay the sum of $269,500 over
a period of seven months and extend the expiration date of previously granted options to
purchase 500,000 shares of the Companys common stock at $0.50 per share from May 9,
2004 to September 30, 2006. The settlement costs, together with estimated other costs
associated with the termination aggregating $301,600, were charged against the reserve
established in March 2004 to cover the estimated cost of the litigation. The balance due
the former employee was fully paid as of April 2005.

On
February 25, 2004, the Company closed a private offering of 2,057,145 shares of its common
stock at a price of $1.05 per share. Offering proceeds were used to fund the acquisition
of the Kimberly-Clark Corporation wound care business and for general working capital
purposes. Offering proceeds of $1,961,797, net of offering expenses of $198,203, were
received.

On
January 9, 2004, the Company purchased the Kimberly-Clark Corporation wound care business
for total consideration of $1,942,797. The consideration consisted of cash of $376,797 and
a seller financed, non-interest bearing promissory note due on or before December 31, 2004
of $1,566,000. The cash outlay consisted of $300,100 paid at closing and $76,697 for
acquisition related costs. The equipment purchased was installed in a newly renovated area
in the Companys manufacturing facility in Toronto, Canada that was completed in
August 2004. The cost to transfer, install and validate the equipment was approximately
$680,000. The promissory note was paid in full on December 30, 2004 using restricted cash
on deposit with the U.S. lender and available line capacity.

23

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Cash Flow

At
December 31, 2005 and 2004, the Company had cash and cash equivalents on hand of
$1,105,330 and $46,508, respectively. The $1,058,822 increase principally reflects a
timing difference that results from net cash provided by operating activities of
$2,956,051 partially offset by net cash used in financing activities of $1,723,089, net
cash used in investing activities of $238,670 and cash provided as a result of exchange
rate changes of $64,530. The timing difference reflected in net cash provided by operating
activities reflects receipt of a large Canadian receivable payment at year end. Subject to
constraints surrounding the movement of cash between legal entities, the Companys
objective has been to maintain minimum cash balances on hand while using available cash to
pay down its outstanding line of credit balances.

Net
cash provided by operating activities stems principally from an estimated $2,705,000
positive cash infusion associated with implementation of the Canadian distribution
agreement in the second quarter 2005 together with cash provided by ongoing operations of
approximately $299,000, cash provided of approximately $35,000 related to the one-time
distribution upset fee, less cash used of approximately $84,000 related to the one-time
cost to close the skin care manufacturing facility. Of the $299,000 of cash provided by
ongoing operations, approximately $742,000 represents cash provided by operations (net
loss plus non-cash charges) partially offset by approximately $443,000 of cash used
representing the net change in operating assets and liabilities. Higher inventory in
support of the 2005 sales growth and the pay down of accounts payable and accrued
liabilities afforded by the improved cash flow partially offset by lower receivables due
principally to timing were the drivers behind the net change in ongoing assets and
liabilities.

Net
cash used in financing activities principally reflects use of available cash generated
from operating activities to pay down the Companys outstanding line of credit
balance by $1,682,388. Other uses pertain to debt repayment of $445,919, including, in
addition to normal scheduled payments, a one-time payment of $200,000 in January 2005
related to the payoff of the outstanding standby letter of credit issued by the U.S.
lender in favor of the Companys Canadian lender as additional security for the
Companys Canadian credit facility and deferred financing costs of $116,590 related
to refinancing the U.S. line of credit in January 2005. Partially offsetting these cash
uses were net proceeds of $521,808 from the sale of common stock in the first quarter
2005.

Net
cash used in investing activities of $238,670 reflects capital investment of $223,754
principally in Canada to expand and improve manufacturing capability and efficiency,
$49,376 of capitalized business acquisition costs less $34,460 related to the sale of non
essential equipment.

Working Capital

Working
capital increased $505,197, or 17.7%, at December 31, 2005 to $3,354,793 from $2,849,596
at December 31, 2004. The increase reflects the net impact of the cash inflows and
outflows outlined in the Cash Flow section above.

Financing Arrangements
 United States

On
January 31, 2005, the Company entered into a three-year revolving credit facility
agreement (the New Agreement) with a new U.S. lender for a maximum principal
amount of $2,000,000. The New Agreement replaces a $2,000,000 revolving credit facility
that expired on January 31, 2005 with the previous U.S. lender. At January 31, 2005,
maximum potential advances under the New Agreement were approximately $1,700,000. On
January 31, 2005, the Company applied advances of approximately $1,300,000 under the New
Agreement in satisfaction of the prior U.S. lenders outstanding obligations. Future
advances will be utilized to fund strategic initiatives and general working capital
requirements. The Company incurred loan origination and legal fees of approximately
$147,300 in connection with the implementation of the New Agreement. These fees have been
deferred and are being amortized to interest expense over the three-year term of the New
Agreement.

24

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The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At December 31, 2005, the effective interest rate
was 9.75%. In addition, the Company pays a monthly collateral management fee at the rate
of 1.5% per annum upon the daily average amount of advances outstanding and a monthly
unused line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.

Maximum
potential advances under the New Agreement at December 31, 2005 were $1,800,000. Advances
outstanding against the line were $1,080,561 at December 31, 2005, leaving an additional
$719,439 available for borrowing.

Over
the term of the New Agreement, the Company has agreed to comply with the following
covenants as measured at the end of each month for the average of the three most recent
calendar months based upon its consolidated operating results: (a) maintain EBITDA
(earnings before interest, taxes, depreciation and amortization) in the range of negative
$300,000 (as of January 31, 2005) transitioning to positive $600,000 (post December 31,
2005) and (b) maintain its fixed charge ratio (EBITDA divided by the sum of debt service,
capital expenditures, income taxes and dividends) in the range of 1.0 to 1.0 (as of
January 31, 2005) to 1.25 to 1.0 (post December 31, 2005). In addition, at all times the
Companys cash on hand (including unused borrowing capacity under the New Agreement)
must not be less than $200,000. Additional covenants governing permitted indebtedness,
liens, payments of dividends and protection of collateral are included in the New
Agreement.

Based
upon consolidated operating results for March and April 2005, the Company was out of
compliance with its EBITDA and fixed charge ratio covenant under the New Agreement. The
U.S. lender agreed to waive these covenant violations. Effective June 30, 2005, the
Company and the U.S. lender agreed to prospectively amend the Companys monthly
minimum EBITDA and fixed charge ratio covenants to better align these covenants with
expected performance. The Company incurred fees of $10,000 associated with the granting of
the covenant amendments. Based upon consolidated operating results for September 2005, the
Company was out of compliance with its EBITDA covenant. The U.S. lender agreed to waive
the covenant violation for September 2005. Based upon consolidated operating results for
October 2005 through February 2006, the Company was out of compliance with its EBITDA and
fixed charge ratio covenants as amended effective June 30, 2005. The U.S. lender has
agreed to waive these covenant violations and to work with the Company to amend the
existing covenants going forward.

The
Company may terminate the New Agreement at any time by paying all outstanding indebtedness
and any other payments due the U.S. lender and paying the U.S. lender a yield maintenance
based early termination fee equal to the net present value (as defined) of the product of:
(a) the effective yield on the facility for the six months prior to termination (expressed
as an annual percentage rate), (b) $2,000,000, and (c) the quotient of the months
remaining in the original term of the New Agreement divided by 12.

On
January 13, 2005, in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the U.S. lender in the amount of $200,000 held by the Companys Canadian lender as
additional security for its credit facility. The $200,000 paid to the Canadian lender was
applied as a permanent principal reduction against the principal amount due in 2007
associated with the Companys outstanding term loan with the Canadian lender.
Subsequently, on January 31, 2005, the Canadian lender agreed as part of refinancing of
the U.S. line of credit to retain its second lien security interest and guarantee position
against the Companys U.S. assets and not to exercise its rights under its second
lien security interest and guarantee against the U.S. assets without the new U.S.
lenders approval.

On
December 30, 2004, the Company paid off the promissory note due Kimberly-Clark Corporation
in the amount of $1,566,000 using the restricted cash on deposit with the U.S. lender of
$1,000,000 and available line capacity. In addition, the irrevocable standby letter of
credit issued on behalf of the Kimberly-Clark Corporation in the amount of $1,566,000 was
cancelled. In connection with this transaction, the maximum principal amount of the line
was reduced from $4,000,000 to $2,000,000. All other terms of the prior agreement remained
in full force and effect.

25

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On
January 30, 2004, the Company entered into a modified one year line of credit agreement
with its previous U.S. lender (the prior agreement). The maximum principal
amount of the line increased to $4,000,000 from $3,000,000. In connection with entering
into this line of credit agreement, the Company deposited $1,000,000 of cash in a
restricted account with the U.S. lender and the U.S. lender issued an irrevocable standby
letter of credit on the Companys behalf for the benefit of Kimberly-Clark
Corporation in the amount of $1,566,000. Advances were used to fund strategic initiatives
and for general working capital purposes. Estimated maximum potential advances under the
prior agreement were equal to the lesser of (a) $4,000,000 or (b) the sum of (i) 80% of
eligible receivables (as defined), (ii) 50% of eligible inventory (as defined), (iii) an
amount equal to the immediate liquidation value of funds deposited with the U.S. lender in
a restricted account as security for any letters of credit extended by the lender on the
Companys behalf up to $1,000,000, less the aggregate amount of any outstanding
letters of credit issued by the U.S. lender.

Outstanding
advances were secured by all tangible and intangible assets of the Companys U.S.
operations. Over the term of the Agreement, the Company agreed to maintain its fixed
charge ratio (as defined) at not less than 1.25:1.0 as measured quarterly on a twelve
month trailing basis. Additional covenants governing permitted indebtedness, changes in
entity status, purchases of securities and protection of collateral were included in the
Agreement. Ongoing operating losses resulted in the Company being out of compliance with
certain of its U.S. line of credit covenants at March 31, June 30 and September 30, 2004.
In return for a commitment to secure alternative financing for its U.S. obligations prior
to the January 31, 2005 maturity date of the prior agreement, the U.S. lender agreed to
waive the Companys prior covenant violations and to maintain the line of credit
until maturity thereof. The Company incurred waiver fees of $7,500 and agreed to an
increase in the rate of interest payable under the line. All other terms of the prior
agreement were maintained in full force and effect.

Financing Arrangements
 Canada

In
November 2005, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $688,000 ($800,000
Canadian) with its Canadian lenders. In light of the favorable impact of the new
distribution agreement on the borrowing requirements of the Companys wholly owned
Canadian subsidiary, Derma Sciences Canada Inc., the maximum principal amount of the
credit facility was reduced in line with the subsidiarys prospective maximum
borrowing capacity. The next annual review is expected to be completed by May, 2006. Derma
Sciences Canada Inc., may request advances under the Canadian Agreement up to the value of
75% of eligible receivables (as defined) plus the lesser of $344,000 ($400,000 Canadian)
or 40% of eligible inventory (as defined), less priority claims. Interest on outstanding
advances is payable monthly in arrears at prime rate (as defined) plus 1.0%, or 6.00% for
Canadian dollar advances and 8.75% for U.S. dollar denominated advances at December 31,
2005. Outstanding advances are secured by all tangible and intangible assets of Derma
Sciences Canada Inc. In addition, the Company has accorded the Canadian lender its
guarantee of payment together with a second lien security interest in the Companys
assets located in the U.S.

Maximum
potential advances under the Canadian Agreement at December 31, 2005 were $235,000.
Advances outstanding against the Canadian Agreement were zero at December 31, 2005,
leaving $235,000 available for borrowing.

Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $430,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default.

26

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At
June 30, 2005, Derma Sciences Canada was out of compliance with its minimum working
capital covenant. The violation occurred due to the adverse impact on Derma Sciences
Canadas working capital associated with accelerating repayment of an inter company
loan and extending credit terms on regular inter company trade receivables to the U.S.
parent in June 2005 in an effort to optimize the use of the positive cash flow associated
with implementing the new distribution agreement in Canada. The violation has been
corrected and the Canadian lender agreed to waive the covenant violation at June 30, 2005.

Losses
principally associated with the write-off of obsolete equipment, employee termination
costs and a revamping of manufacturing operations in Toronto resulted in Derma Sciences
Canada being out of compliance with certain of its income based loan covenants that are
measured annually at December 31, 2004. The Canadian lender agreed to waive the covenant
violations at December 31, 2004. The Company incurred fees of $12,000 associated with the
granting of waivers in 2004.

Prospective Assessment

The
Companys objective is to continue to grow sales and gross profit and return to
profitability in 2006. Growth of the Companys existing private label business is
expected to accelerate in 2006 as existing business continues to grow and new customers
are brought on board. Plans are in place to better leverage existing opportunities in the
Companys basic and advanced wound care lines in the U.S. by working more closely
with several key existing and potential new customers to increase business. In Canada, the
exclusive distribution agreement represents an opportunity for sales growth in the near to
intermediate future. In 2005, the Company expanded its product development initiatives. As
a result of these efforts, the Company expects to launch two new products in 2006.

The
Company expects to build upon its success in 2005 in the area of product cost savings.
Higher throughput and improved operational efficiencies are expected to lower the
Companys overall internal cost of manufacturing going forward. Plans are in place to
bring the manufacture of the Companys wound closure and fastener line in house
during 2006 at a significant savings versus existing third party sourcing. The Company
expects to realize savings when it begins sterilizing its China source products in China
in 2006. Subject to commodity driven cotton prices and foreign exchange changes, which are
outside of the Companys control, the Company expects to continue building on its
successful relationships in China to keep its basic wound care costs competitive.

The
Company believes its existing infrastructure is adequate to support its growth plans for
the foreseeable future except in the area of information technology where the Company is
presently is in the midst of a two to three year program to upgrade its capabilities. In
addition, as a small business filer (as defined by the SEC), the Company is required to be
in compliance with Sarbanes-Oxley regulations as of December 31, 2007. The Company is
closely monitoring its requirements under Sarbanes-Oxley and expects to incur significant
one-time costs to comply beginning in the second half 2006 through the first quarter 2008
with modest ongoing incremental cost thereafter. Steps will continue to be taken to
monitor operating expenses and to limit spending in this area to that necessary to support
existing operations.

Going
forward, capital expenditures will continue to be limited to those projects capable of
generating an acceptable level of return and those necessary to support ongoing
operations. The Company plans to continue to closely monitor inventory levels with the
objective of properly balancing customer service requirements while minimizing its
investment in inventory wherever possible.

The
Company believes that available funds from expected improving operations and available
lines of credit will be sufficient to satisfy the Companys liquidity requirements
through at least December 31, 2006. In addition, the Company will continue to evaluate external
opportunities to leverage its core capabilities for growth.

The
Common Stock of the Company is traded on the OTC Bulletin Board under the symbol
DSCI.OB. The Common stock is also traded on the Boston and Pacific Stock
Exchanges under the symbol DMS. The Company has paid no cash dividends in
respect of its Common Stock and does not intend to pay cash dividends in the near future.

27

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Additional Financial
Information

Forward Looking Statements

Statements
that are not historical facts, including statements about the Companys confidence,
strategies, expectations about new or existing products, technologies, opportunities,
market demand or acceptance of new or existing products are forward-looking statements
that involve risks and uncertainties. These uncertainties include, but are not limited to,
product demand and market acceptance risk, impact of competitive products and prices,
product development, commercialization or technological delays or difficulties, and trade,
legal, social, financial and economic risks.

Critical Accounting
Policies

Estimates
and assumptions are required in the determination of sales deductions for trade rebates,
discounts and allowances. Significant estimates and assumptions are also required in
determining the appropriateness of

amortization periods for identifiable intangible
assets, the potential impairment of goodwill and the valuation of inventory. Some of these
judgments can be subjective and complex, and, consequently, actual results may differ from
these estimates. For any individual estimate or assumption made by the Company, there may
also be other reasonable estimates or assumptions. The Company believes, however, that
given current facts and circumstances, it is unlikely that applying any such other
reasonable judgment would cause a material adverse effect on the consolidated results of
operations, financial position or cash flows for the periods represented in this section.
The Companys most critical accounting policies are described below:

Revenue Recognition and
Adjustments to Revenue

Revenue
is recognized when product is shipped and title passes to the customer and collectability
is reasonably assured. When the Company recognizes revenue from the sale of products, the
Company simultaneously adjusts revenue for estimated trade rebates. A trade rebate
represents the difference between invoice price to the wholesaler and the indirect
customers contract price. These rebates are estimated based on historical
experience, estimated customer inventory levels, current contract sales terms with
customers and other competitive factors. If the assumptions used to calculate these
rebates do not appropriately reflect future activity, the Companys financial
position, results of operations and cash flows could be impacted. The Company continually
monitors the factors that influence these rebates and makes adjustments as necessary.

Goodwill

The
Company tests goodwill for impairment in the fourth quarter of each year or when
impairment indicators are present. The process of evaluating the potential impairment of
goodwill is highly subjective and requires significant judgments and assumptions in
estimating future cash flows to determine the fair value of the reporting unit. These
assumptions include future growth rates, discount factors, future tax rates and other
factors. The Companys cash flow forecasts are based on assumptions that are
consistent with the plans and estimates used to manage the underlying business. In
addition, the Company makes certain judgments about allocating shared assets to the
balance sheet for this segment. If the expected cash flows are not realized, impairment
losses may be recorded in the future. As discussed in Note 6 of the Companys
financial statements, in 2005 the Company recorded a goodwill impairment charge of
$910,967.

Inventory

The
Company writes down the value of inventory by the estimate of the difference between the
cost of the inventory and its net realizable value. The estimate takes into account
projected sales of the inventory on hand and the age of the inventory in stock. If actual
future demand or market conditions are less favorable than those projected by management,
additional inventory write-downs may be required. The provision for the write-down of
inventory is recorded in cost of sales.

28

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Recent Accounting
Pronouncements Affecting the Company

In
May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections  a replacement of APB Opinion No. 20 and FASB Statement No. 3
(SFAS 154). SFAS 154 changes the requirements of the accounting for and
reporting of a change in accounting principles. The provisions of SFAS 154 require, unless
impracticable, retrospective application to prior periods financial statements of
(1) all voluntary changes in accounting principles, and (2) changes required by a new
accounting pronouncement if a specific transaction is not provided. SFAS 154 also requires
that a change in depreciation, amortization or depletion method for long-lived,
non-financial assets be accounted for as a change in accounting estimate which requires
prospective application of the new method. SFAS 154 is effective for all accounting changes
made in fiscal years beginning after December 15, 2005. The Company does not expect the
adoption of SFAS 154 to have a material impact on its financial condition or results of
operations.

In
December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based
Payment (SFAS 123(R)). This statement revises SFAS No. 123,
Accounting for Stock-Based Compensation, which provided alternative methods of
disclosure for stock-based employee compensation. It also supercedes APB Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), and its related
implementation guidance. SFAS 123(R)

establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or services.
SFAS 123(R) requires a public entity to measure the cost of employee services received in
exchange for an award of equity instruments based on the grant-date fair value of the
award (with limited exceptions). That cost will be recognized over the period during which
an employee is required to provide service in exchange for the award  the requisite
service period (usually the vesting period). No compensation cost is recognized for equity
instruments for which employees do not render the requisite service. SFAS 123(R)
eliminates the alternative whereby the Company used APB 25s intrinsic value method
of accounting that was provided in SFAS 123 as originally issued. Under APB 25, issuing
stock options to employees generally resulted in recognition of no compensation cost. The
effective date for SFAS 123(R) was modified by the SEC in April 2005 and now is effective
for public entities as of the beginning of the next fiscal year that begins after December
15, 2005 and applies to all awards granted after the required effective date and to awards
modified, repurchased or cancelled after that date. The cumulative effect of initially
applying this statement, effective January 1, 2006, will be zero as all outstanding stock
options as of December 31, 2005 were fully vested. The Company used the intrinsic value
method through December 31, 2005 and, accordingly, the adoption of SFAS 123(R) will impact
the Companys results of operations based upon the grant of future options the
materiality of which will be determined by the amount and fair value of future stock
option grants. Notes 1 and 12 to the Companys financial statements contain
additional information on the Companys stock based compensation and stock options.

In
December 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB
No. 43B, Chapter 4 (SFAS 151). SFAS 151 retains the general principle of
ARB 43, Chapter 4, Inventory Pricing, that inventories are presumed to be stated at cost;
however, it amends ARB 43 to clarify that abnormal amounts of idle facilities, freight,
handling costs and spoilage should be recognized as charges of the current period and
allocation of fixed production facilities. SFAS 151 defines normal capacity as the
production expected to be achieved over a number of periods or seasons under normal
circumstances, taking into account the loss of capacity resulting from planned
maintenance. Accordingly, an entity will have to use judgment to determine when production
is outside the range of expected variation in production (either abnormally low or
abnormally high). In periods of abnormally low production, the amount of fixed overhead
allocated to each unit of production should not be increased. However, in periods of
abnormally high production, the amount of fixed overhead allocated to each unit of
production is decreased to assure inventories are not measured above cost. SFAS 151 is
effective for inventory costs incurred during fiscal years beginning after June 15, 2005
and should be applied prospectively. The Company does not expect the adoption of SFAS 151
to have a material impact on its financial condition or results of operations.

Factors Affecting Future
Prospects

The potential increase in common
shares due to the conversion or exercise of outstanding derivative securities may have a
depressive effect upon the market value of the Companys shares.

29

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As
of December 31, 2005, 12,123,128 shares of the Companys common stock were issuable
upon the conversion or exercise of outstanding convertible preferred stock, warrants and
options (derivative securities). The shares of common stock issuable upon
conversion or exercise of derivative securities are substantial compared to the 12,285,768
shares of common stock currently outstanding.

Earnings
per share relative to the Companys common stock, as and when generated, will be
calculated assuming the conversion or exercise of all dilutive derivative securities.
Earnings per share of common stock would be substantially diluted by the existence of
these derivative securities regardless of whether they are converted or exercised. This
dilution of earnings per share could have a depressive effect upon the market value of the
Companys common stock.

The Company has generated only
nominal income and it cannot guarantee future profitability.

The
Company earned net income of $22,241 in 2003, $61,368 in 2002 and $192,398 in 2001 and
incurred losses of $909,104 in 2005, $2,338,693 in 2004, $2,581,337 in 2000 and $2,998,919
in 1999. At December 31, 2005

the Company had an accumulated deficit of $13,895,134.
Although the Company achieved nominal profitability in 2003, 2002 and 2001, the Company
cannot offer any assurance that it will be able to generate sustained or significant
earnings.

The Companys stock price has
been volatile and this volatility is likely to continue.

Historically,
the market price of the Companys common stock has been volatile. The high and low
prices for the years 2001 through 2005 are set forth in the table below:

`Derma Sciences
                             Trading Range - Common Stock

                           Year           Low          High
                           ----           ---          ----

                           2001          $0.22        $0.80
                           2002          $0.35        $0.85
                           2003          $0.35        $2.30
                           2004          $0.43        $1.90
                           2005          $0.42        $0.78`

Events
that may affect the Companys stock price include:

|  |                                                                                   
|- | ----------------------------------------------------------------------------------
| | Quarter to quarter variations in its operating results;                           
| | Changes in earnings estimates by securities analysts;                             
| | Changes in interest rates or other general economic conditions;                   
| | Changes in market conditions in the wound care and skin care
     industries; and 
| | The introduction of new products either by the Company or by its
     competitors.

Although
all publicly traded securities are subject to price and volume fluctuations, it is likely
that the Companys common stock will experience these fluctuations to a greater
degree than the securities of more established and better capitalized organizations.

30

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The rate of reimbursement for the
purchase of the Companys products by government and private insurance is subject to
change.

Sales
of several of the Companys wound care and specialty fastener products depend partly
on the ability of its customers to obtain reimbursement for the cost of its products from
government health administration agencies such as Medicare and Medicaid. Both government
health administration agencies and private insurance firms continuously seek to reduce
healthcare costs. These cost reduction efforts may adversely affect both the eligibility
of the Companys products for reimbursement and the rate of reimbursement. Although
management believes that reimbursement policies relative to the Companys products
will remain stable for the foreseeable future, it can offer no assurance that the
Companys products will continue to be eligible for reimbursement indefinitely or
that the rate of reimbursement will not be reduced.

The Companys success may depend
upon its ability to protect its patents and proprietary technology.

The
Company owns patents, both in the United States and abroad, for several of its products,
and relies upon the protection afforded by its patents and trade secrets to protect its
technology. The Companys success may depend upon its ability to protect its
intellectual property. However, the enforcement of intellectual property rights can be
both expensive and time consuming. Therefore, the Company may not be able to devote the
resources necessary to prevent infringement of its intellectual property. Also, the
Companys competitors may develop or acquire substantially similar technologies
without infringing the Companys patents or trade secrets. For these reasons, the
Company cannot be certain that its patents and proprietary technology will provide it with
a competitive advantage.

Approximately half of the
Companys products are manufactured by third party manufacturers.

Approximately
one half of the Companys products are manufactured by third party manufacturers. One
manufacturer produces advanced wound care products which account for about ten percent of
the Companys sales. Another manufacturer produces wound closure strips and catheter
fasteners which account for about ten percent of the Companys sales. Each of the
Companys other manufacturers produces products that individually account for less
than ten percent of the Companys sales.

Management
considers the Companys relationships with its third party manufacturers to be
excellent. Although there are several manufacturers potentially available for each of the
Companys products, if a current manufacturer were unable or unwilling to continue to
manufacture the Companys products, distribution and sales of the affected products
could be delayed for the period necessary to secure a replacement.

Competitors could invent products
superior to those of the Company and cause its products and technology to become obsolete.

The
Company operates in an industry where technological developments occur at a rapid pace.
The Company competes with a large number of established companies and institutions many of
which have more capital, larger staffs and greater expertise than the Company. The
companies with which the Company competes include Bristol Myers Squibb-Convatec, Smith
& Nephew, Johnson & Johnson, 3M, Kendall, Hermitage, Medical Action, Cyprus,
DeRoyal, Provon, Calgon Vestal-Steris and Chester Laboratories, together with a number of
smaller companies. The Companys competitors currently manufacture and distribute a
variety of products that are in many respects comparable to those of the Company. While
management has no specific knowledge of products under development by the Companys
competitors, it is possible that these competitors may develop technologies and

31

---

products that are more effective than any the Company currently has. If this
occurs, any of the Companys products and technology affected by these developments could become obsolete.

Although the Company is insured, any
material product liability claims could adversely affect its business.

The
Company sells over-the-counter products and medical devices and is exposed to the risk of
lawsuits claiming alleged injury caused by its products. Among the grounds for potential
claims against the Company are injuries due to alleged product inefficacy and injuries
resulting from infection due to allegedly non-sterile products. Although the Company
carries product liability insurance with limits of $1.0 million per occurrence and $2.0
million aggregate with $5.0 million in umbrella coverage, this insurance may not be
adequate to reimburse the Company for all damages that it could suffer as a result of
successful product liability claims. No material product liability claim has ever been
made against the Company and management is not aware of any pending product liability
claims. However, a successful material product liability suit could adversely affect the
Companys business.

Item 7. Consolidated
Financial Statements

Index

|                                                                                                  |     
|------------------------------------------------------------------------------------------------- | ----
|Description                                                                                       | Page
|                                                                                                  |     
|Report of Independent Registered Public Accounting
   Firm                                        | 33  
|                                                                                                  |     
|Consolidated Balance Sheets as of December 31, 2005
   and 2004                                   | 34  
|                                                                                                  |     
|Consolidated Statements of Operations for the
   Years Ended December 31, 2005 and 2004           | 35  
|                                                                                                  |     
|Consolidated Statements of Shareholders'
   Equity for the Years Ended December 31, 2005 and 2004 | 36  
|                                                                                                  |     
|Consolidated Statements of Cash
   Flows for the Years Ended December 31, 2005 and 2004           | 37  
|                                                                                                  |     
|Notes to Consolidated Financial
   Statements                                                     | 38  
|                                                                                                  |     

32

---

Financial Index

Report of Independent
Registered Public Accounting Firm

To the Shareholders and
Board of DirectorsDerma Sciences, Inc.

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

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

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

/s/ J.H. Cohn LLP

Roseland, New JerseyFebruary 24, 2006

33

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Financial Index

DERMA SCIENCES, INC.Consolidated Balance Sheets

---

`--------------------------------------------------------------------------------------------------------
                                                                                   December 31,
ASSETS                                                                         2005            2004
------------------------------------------------------------------------------------------------------

Current Assets
  Cash and cash equivalents                                              $  1,105,330    $     46,508
  Accounts receivable, net                                                  1,225,639       2,601,092
  Inventories                                                               3,868,663       4,932,232
  Prepaid expenses and other current assets                                   210,288         181,201
------------------------------------------------------------------------------------------------------
Total current assets                                                        6,409,920       7,761,033
Equipment and improvements, net                                             3,385,862       3,662,557
Goodwill                                                                      200,000       1,110,967
Other intangible assets, net                                                  299,776         383,911
Other assets, net                                                             299,688         132,464
------------------------------------------------------------------------------------------------------
Total Assets                                                             $ 10,595,246     $13,050,932
------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------------------------------------------------------------------------
Current Liabilities
  Line of credit borrowings                                              $  1,080,561    $  2,820,284
  Current maturities of long-term debt                                        285,945         247,306
  Accounts payable                                                          1,197,062       1,249,409
  Accrued expenses and other current liabilities                              491,559         594,438
------------------------------------------------------------------------------------------------------
Total current liabilities                                                   3,055,127       4,911,437
Long-term debt                                                                388,473         867,539
Other long-term liabilities                                                    99,982          53,207
------------------------------------------------------------------------------------------------------
Total Liabilities                                                           3,543,582       5,832,183
------------------------------------------------------------------------------------------------------
Commitments
Shareholders' Equity
Convertible preferred stock, $.01 par value; 11,750,000 shares
  authorized; issued and outstanding: 2,280,407 at December 31, 2005
  and 2004 (liquidation preference of $4,210,231) at December 31, 2005
  and 2004                                                                     22,804          22,804
Common stock, $.01 par value, 30,000,000 shares authorized;
  issued and outstanding: 12,285,768 shares at December 31, 2005 and
  11,079,007 shares at December 31, 2004                                      122,858         110,790
Additional paid-in capital                                                 19,905,059      19,371,225
Accumulated other comprehensive income -
  cumulative translation adjustments                                          896,077         699,960
Accumulated deficit                                                       (13,895,134)    (12,986,030)
------------------------------------------------------------------------------------------------------
Total Shareholders' Equity                                                  7,051,664       7,218,749
------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity                               $ 10,595,246    $ 13,050,932
------------------------------------------------------------------------------------------------------`

See accompanying consolidated notes.

34

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Financial Index

DERMA SCIENCES, INC.Consolidated Statements of Operations

---

`-------------------------------------------------------------------------------------------------
                                                                         Year ended December 31,
                                                                          2005            2004
-------------------------------------------------------------------------------------------------

Net Sales                                                            $23,545,475     $19,887,132

Cost of sales                                                         15,756,053      14,335,202
-------------------------------------------------------------------------------------------------
Gross Profit                                                           7,789,422       5,551,930
-------------------------------------------------------------------------------------------------
Operating expenses                                                     7,520,986       7,375,534
Goodwill impairment loss                                                 910,967           -
Interest expense                                                         336,867         227,305
Other expense (income), net                                              (70,294)        287,784
-------------------------------------------------------------------------------------------------
Total Expenses                                                         8,698,526       7,890,623
-------------------------------------------------------------------------------------------------
Loss before provision for income taxes                                  (909,104)     (2,338,693)
Provision for income taxes                                                 -               -
-------------------------------------------------------------------------------------------------
Net Loss                                                             $  (909,104)    $(2,338,693)
-------------------------------------------------------------------------------------------------
Loss per common share - basic and diluted                            $     (0.07)    $    (0.25)
-------------------------------------------------------------------------------------------------
Shares used in computing loss per common share - basic and diluted    12,216,804       9,424,191
-------------------------------------------------------------------------------------------------`

See accompanying consolidated notes.

35

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Financial Index

DERMA SCIENCES,
INC.Consolidated Statements of Shareholders'
Equity

--------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                       Accumulated
                                           Preferred        Common     Convertible                    Additional          Other                           Total
                                             Shares         Shares      Preferred       Common         Paid-In        Comprehensive   Accumulated     Shareholders'
                                             Issued         Issued        Stock         Stock          Capital           Income         Deficit           Equity
--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 2003                   2,284,574   7,462,695         $22,846       $74,627      $16,746,690        $294,185     $(10,647,337)     $6,491,011

Net loss                                          -           -               -             -                -               -          (2,338,693)     (2,338,693)
Foreign currency translation adjustment           -           -               -             -                -            405,775             -            405,775
                                                                                                                                                        -----------
Comprehensive loss - total                        -           -               -             -                -               -                -         (1,932,918)
Issuance of common stock in
  private placement, net of issuance
  costs of $276,844                               -      3,612,145            -           36,121        2,624,535            -                -          2,660,656
Conversion of series B preferred stock          (4,167)      4,167             (42)          42             -                -                -               -
--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 2004                   2,280,407  11,079,007         $22,804      $110,790      $19,371,225        $699,960     $(12,986,030)     $7,218,749

Net loss                                          -           -               -             -                -                  -         (909,104)       (909,104)
Foreign currency translation adjustment           -           -               -             -                -            196,117             -            196,117
                                                                                                                                                         ----------
Comprehensive loss - total                        -           -               -             -                -               -                -           (712,987)
Issuance of common stock in
  private placement, net of issuance
  costs of $80,692                                -      1,205,000            -           12,050          509,758            -                -            521,808
Adjustment of shares issued and issuable
   in connection with acquisition                 -          1,761            -               18              (18)           -                -               -
Employee stock option expense                     -           -               -            -               24,094            -                -             24,094
--------------------------------------------------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 2005                   2,280,407  12,285,768         $22,804      $122,858      $19,905,059        $896,077     $(13,895,134)     $7,051,664
--------------------------------------------------------------------------------------------------------------------------------------------------------------------


See accompanying consolidated notes.

36

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Financial Index

DERMA SCIENCES, INC.Consolidated Statements of Cash Flows

`-----------------------------------------------------------------------------------------------------
                                                                            Year Ended December 31
                                                                            2005              2004
-----------------------------------------------------------------------------------------------------
Operating Activities
  Net loss                                                              $ (909,104)     $ (2,338,693)
  Adjustments to reconcile net loss to net
  cash provided by (used in) operating activities:
    Depreciation of equipment and improvements                             490,274           320,474
    Amortization of intangible assets                                       84,136           117,490
    Amortization of deferred financing costs                                71,598            88,483
    Provision for bad debts and rebates                                  1,196,504            15,233
    Provision for inventory obsolescence                                   289,946           196,837
    Goodwill impairment loss                                               910,967              -
    Loss on disposal of equipment and improvements                          65,753           273,263
    Deferred rent expense                                                   39,037            53,207
    Employee stock option expense                                           24,094              -
    Changes in operating assets and liabilities:
        Accounts receivable                                                159,162           163,501
        Inventories                                                        808,849          (910,904)
        Prepaid expenses and other current assets                          (11,412)          157,692
        Other assets                                                       (84,956)           11,276
        Accounts payable                                                   (67,945)          470,184
        Accrued expenses and other current liabilities                    (118,208)          257,574
        Other long-term liabilities                                          7,356              -
-----------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities                      2,956,051       (1,124,383)
-----------------------------------------------------------------------------------------------------
Investing Activities
  Business acquisition costs                                               (49,376)       (1,942,797)
  Purchase of equipment and improvements                                  (223,754)       (1,030,588)
  Proceeds from sale of equipment and improvements                          34,460              -
-----------------------------------------------------------------------------------------------------
Net cash used in investing activities                                     (238,670)       (2,973,385)
-----------------------------------------------------------------------------------------------------
Financing Activities
  Net change in bank line of credit                                     (1,682,388)        1,348,780
  Deferred financing costs                                                (116,590)          (91,409)
  Long-term debt repayments                                               (445,919)         (209,626)
  Proceeds from issuance of stock, net of issuance costs                   521,808         2,660,656
-----------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities                     (1,723,089)        3,708,401
-----------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash                                     64,530            (3,962)
-----------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                     1,058,822          (393,329)

Cash and cash equivalents
  Beginning of year                                                         46,508           439,837
-----------------------------------------------------------------------------------------------------
  End of year                                                         $  1,105,330    $       46,508
-----------------------------------------------------------------------------------------------------
Supplemental disclosures of cash flow information:
Cash paid during the year for:
  Interest                                                                $291,209          $172,663
Supplemental schedule of non cash investing and financing activities:
  Equipment obtained with capital leases                                      -             $228,518
-----------------------------------------------------------------------------------------------------`

See accompanying consolidated notes.

37

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

1.     Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) are full line providers of
wound care, wound closure and fasteners and skin care products. The Company markets its
products principally through independent distributors servicing the long-term care, home
health and acute care markets in the United States, Canada and other select international
markets. The Companys U.S. distribution facility is located in St. Louis, Missouri,
while the Companys Canadian distribution facility is located in Toronto. The Company
has manufacturing facilities in Toronto, Canada and Nantong, China.

Summary
of Significant Accounting Policies:

Principles
of Consolidation  The consolidated financial statements include the accounts of
Derma Sciences, Inc. and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.

Use
of Estimates  In conformity with accounting principles generally accepted in the
United States, the preparation of financial statements requires management to make
estimates and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Although these estimates are based on knowledge of current events and
actions which may be undertaken in the future, actual results may ultimately differ from
these estimates.

Foreign
Currency Translation  Assets and liabilities are translated using the exchange rates
in effect at the balance sheet date, while income and expenses are translated using
average rates. Translation adjustments are reported as a component of shareholders
equity in accumulated other comprehensive income (loss). For the Companys Canadian
subsidiary, whose functional currency is the Canadian dollar, exchange rate fluctuations
on foreign currency denominated assets and liabilities other than the functional currency
resulted in $22,414 of expense and $11,349 of income for the years ended December 31, 2005
and 2004, respectively.

Cash
and Cash Equivalents  The Company considers cash and cash equivalents as amounts on
hand, on deposit in financial institutions and highly liquid investments purchased with an
original maturity of three months or less.

Concentration
of Credit Risk  Financial instruments that subject the Company to a concentration of
credit risk consist principally of cash and cash equivalents and accounts receivable. The
Company maintains cash and cash equivalents with various financial institutions in amounts
which at times may exceed federally insured limits. Accounts are guaranteed by the Federal
Deposit Insurance Corporation (FDIC) up to $100,000. The Company has not experienced any
losses in such accounts. The Companys accounts receivable balance is net of an
allowance for doubtful accounts. The Company does not require collateral or other security
to support credit sales, but provides an allowance for doubtful accounts based on
historical experience and specifically identified risks. Accounts receivable are charged
off against the allowance for doubtful accounts when management determines that recovery
is unlikely and the Company ceases collection efforts.

Foreign
Operations Risk  The Companys future operations and earnings will depend to a
large extent on the results of its operations in Canada and its ability to continue to
maintain a continuous supply of basic wound care products from its own operation and/or
its suppliers in China. While the Company does not envision any adverse change to the
manner in which operations in Canada and China are presently being conducted, there can be
no assurance that the Company will be able to successfully conduct such operations in the
future, and a failure to do so may have a material adverse effect on the Companys
consolidated financial position, results of operations and cash flows. Also, the success
of the Companys operations will be subject to numerous contingencies, some of which
are beyond managements control. These contingencies include general and regional
economic conditions, prices for the Companys products, prices for materials and
products purchased from suppliers, competition and changes in regulations.

38

---

Financial Index

Inventories
 Inventories consist primarily of raw materials, packaging materials, work in
process and finished goods valued at the lower of cost or market. Cost is determined on
the basis of the first-in, first-out method.

Equipment
and improvements  Equipment and improvements are stated at cost and are depreciated
principally by the straight-line method over the estimated useful lives of the assets
ranging from three to ten years. Leasehold improvements are amortized over the lesser of
their useful lives or the remaining lease term.

Fair
Value of Financial Instruments  The carrying value of cash and cash equivalents,
accounts receivable, prepaid expenses and other current assets, accounts payable and
accrued expenses reported in the consolidated balance sheets equal or approximate fair
value due to their short maturities. The fair value of the Companys long-term debt
approximates book value as such notes are at market rates currently available to the
Company.

Other
Intangible Assets  Patents and trademarks and other intangible assets with definite
lives are stated on the basis of cost. Patent and trademarks are amortized over 12 to 17
years on a straight-line basis. Other intangible assets consisting of product rights,
formulations and specifications, regulatory approvals, customer lists and a non-compete
agreement are amortized over 5 years on a straight-line basis.

Long
Lived Assets  In accordance with Statement of Financial Accounting Standards No. 144
(SFAS 144), Accounting for Impairment or Disposal of Long Lived
Assets the Company reviews its long-lived assets with definitive lives whenever
events or changes in circumstances indicate that the carrying amount of such assets may
not be recoverable. If the carrying amount of the asset or group of assets exceeds its net
realizable value, the asset will be written down to its fair value.

Goodwill
 The Company adopted Statement of Financial Accounting Standards No. 142
Goodwill and Other Intangible Assets (SFAS 142) on January 1,
2002. Goodwill and certain other intangible assets having indefinite lives are no longer
amortized to earnings, but instead are subject to periodic (annual) testing for
impairment. The Company tests goodwill for impairment using the two-step process
prescribed by SFAS 142. The first step tests for potential impairment, while the
second step measures the amount of impairment, if any. The Company uses a discounted cash
flow analysis to complete the first step in this process. If the first step indicates an
impairment, i.e. when the carrying value exceeds the fair value, then the second step is
required to determine the implied fair value of goodwill. The implied fair value of
goodwill is calculated in the same manner that goodwill is calculated in a business
combination. The allocation is to be performed as if the reporting unit had just been
acquired and the fair value of the unit was the purchase price. The goodwill impairment
equals the carrying value of goodwill less the implied fair value of goodwill. As stated
in Note 6, in 2005 the Company recorded a goodwill impairment charge of $910,967.

Stock
Based Compensation  SFAS No. 123, Accounting for Stock-Based
Compensation, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure (SFAS 148), provides companies with a choice to follow
the provisions of SFAS No. 123 in the determination of stock-based employee compensation
expense based on the fair values of the options or to continue to use the intrinsic value
method pursuant to the provisions of Accounting for Stock Issued to Employees
APB 25 and related interpretations in accounting for stock-compensation plans. The Company
has elected to follow the provisions of APB 25. Under APB 25, if the exercise price of the
Companys stock options granted to employees equals or exceeds the market price of
the underlying common stock on the date of grant, generally no compensation expense is
recognized.

No
charge is recorded as of the date of grant for performance-based options. An evaluation is
conducted as of the end of each subsequent reporting period to determine the probability
of the performance criteria underlying the earning of the performance options being met.
If it is determined that achievement of the underlying performance criteria is not
probable as of the reporting date, no charge is recorded. If it is determined that
achievement of the performance criteria is probable, then a charge is recorded. The charge
represents the change in intrinsic value from the grant date through the reporting date.
The charge is remeasured and adjusted each subsequent reporting period until the final
determination as to the awarding of the performance-based options is made in accordance
with the terms of the original grant.

39

---

Financial Index

Pro forma information
regarding net income (loss) and earnings (loss) per share is required by SFAS 148, which also requires that the information be
determined as if the Company had accounted for stock options granted to employees under the fair value method of SFAS 123. The
fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following
weighted-average assumptions for 2005 and 2004:

`2005                 2004
                                            ----                 ----
         Risk-free interest rate

             First Quarter                  4.25%                4.00%
             Second Quarter                 3.90%                4.25%
             Third Quarter                  3.90%                 -
             Fourth Quarter                 4.40%                 -

         Volatility Factor

             First Quarter                  1.376                1.463
             Second Quarter                 1.353                1.448
             Third Quarter                  1.326                 -
             Fourth Quarter                 0.726                 -

         Dividend Yield                     0%                   0%

         Expected Option Life               5 Years              5 Years`

For
purposes of pro forma disclosures, the estimated fair value of stock options is amortized
to expense over the options vesting period. The Companys pro forma information
follows:

`2005            2004
                                                                       ----            ----

   Net loss - as reported                                        $  (909,104)    $(2,338,693)
   Add:    Stock-based employee compensation expense included
           in reported net loss                                       24,094            -
   Deduct: Total stock-based employee compensation expense
           determined under fair value method for all awards      (1,186,530)       (871,212)
                                                                 ------------    ------------

   Pro forma net loss                                            $(2,071,540)    $(3,209,905)
                                                                 ------------    ------------

   Loss per common share - basic and diluted
       As reported                                                   $(0.07)         $(0.25)
       Pro forma                                                     $(0.17)         $(0.34)`

As
of December 31, 2005, the board of directors approved 461,875 stock options as part of the
Companys 2005 performance-based option plan as being earned by Company management.
In accordance with the terms of the performance based option plan, options earned are
immediately vested. In connection with the award of these options, the Company recorded a
non-cash charge of $23,094 to compensation expense.

In
May 2005, the Company modified the terms of a retired employees stock option
agreement to provide for the continued vesting in accordance with the terms of the subject
stock option agreement to the same extent as if

40

---

Financial Index

the employees employment had
continued indefinitely. In connection with this modification, the Company recorded a
non-cash charge of $1,000 to compensation expense.

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R,
Share-Based Payment (SFAS 123R) which revises SFAS 123 and supercedes APB 25. SFAS
123R requires that new, modified and unvested share-based payment transactions with
employees, such as stock options and restricted stock, be recognized in the financial
statements based on their fair value and recognized as compensation expense over their
vesting periods.

On
December 30, 2005, the board of directors approved the acceleration of vesting of unvested
stock options held by officers, directors and employees of the Company. The vesting of
options to purchase 828,533 shares of common stock, with exercise prices ranging from
$0.37 to $1.70 per share and with a weighted average exercise price of $0.80 per share was
accelerated. Of the options whose vesting was accelerated, 116,250 options were in
the money when compared to a per share market price of $0.43, representing the
closing price of the Companys common stock on December 29, 2005. No charge was recorded for
the vesting of the in the money options as, in the opinion of management, all of these
options would have ultimately vested pursuant to the options original vesting
schedule. The decision to accelerate the vesting of the foregoing options was made
primarily to reduce non-cash compensation expense of approximately $422,000 that would
otherwise have been recorded in future periods in compliance with SFAS 123(R).

Income
Taxes  Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets, including tax loss and credit carryforwards, and liabilities are
measured using enacted tax rates expected to apply to taxable income in 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. Deferred income tax expense represents the
change during the period in the deferred tax assets and deferred tax liabilities. The
components of the deferred tax assets and liabilities are individually classified as
current and non-current based on their characteristics. Deferred tax assets are reduced by
a valuation allowance when, in the opinion of management, it is more likely than not that
some portion or all of the deferred tax assets will not be realized.

Revenue
Recognition  The Company operates in three segments: wound care, wound closure and
fasteners and skin care. Sales are recorded when product is shipped, title passes to
customers and collectability is reasonably assured. Gross sales are adjusted for cash
discounts, returns and allowances, Medicaid rebates and trade rebates in the same period
that the related sales are recorded. Freight costs billed to and reimbursed by customers
are recorded as a component of revenue. Freight costs to ship product to customers are
recorded as a component of cost of sales.

Advertising
and Promotion Costs  Advertising and promotion costs are expensed as incurred and
were $304,690 and $297,716 in 2005 and 2004, respectively.

Net
Income (Loss) per Share  Net income (loss) per common share  basic is computed
by dividing net income (loss) by the weighted average number of common shares outstanding
for the period. Net income (loss) per common share  diluted reflects the potential
dilution of earnings by including potentially issuable shares of common stock
(potentially dilutive securities), including those attributable to stock
options, warrants and convertible preferred stock in the weighted average number of common
shares outstanding for a period, if dilutive. Potential common stock has not been included
in the computation of diluted loss per share as the effect would be anti-dilutive.

41

---

Financial Index

Securities
that could potentially dilute basic earnings per share in the future were not included in
the computation of diluted earnings per share because to do so would have been
anti-dilutive for the periods presented. Those securities are as follows:

`December 31,
                                              --------------------
                                              2005            2004
                                              ----            ----
   Dilutive shares:
      Preferred stock                      2,280,407       2,280,407
      Warrants                             4,069,441       4,734,448
      Stock options                        5,773,280       4,464,655
                                          ----------      ----------

          Total dilutive shares           12,123,128      11,479,510
                                          ==========      ==========`

Reclassifications
 Certain reclassifications have been made to prior year reported amounts to conform
with the 2005 presentation.

2. Acquisition of
Kimberly-Clark Corporations Wound Care Assets

On
January 9, 2004, the Company purchased certain wound care assets from Kimberly-Clark
Corporation. The primary purpose of the acquisition was to obtain equipment to expand the
Companys in-house manufacturing capabilities and to broaden its product line. The
assets acquired consist of manufacturing equipment, product rights and other intangibles.
The purchase price for the assets was $1,942,797 and was paid as follows: (1) $300,100 at
closing; (2) $1,566,000 via a seller financed promissory note due December 31, 2004,
without interest; and (3) $76,697 incurred for transaction costs. The acquisition was
accounted for as a purchase of a business, effectively as of January 1, 2004, and the
purchase price was allocated to equipment in the amount of $1,600,000 and identifiable
intangible assets (see Note 7) in the amount of $342,797 based upon the estimated fair
values of the assets acquired. The promissory note was paid in full on December 30, 2004.

Kimberly-Clark
manufactured wound care products, for the account of the Company, at its facility through
April 9, 2004 to meet current customer demand and to build sufficient inventory to cover
the period during which production at the Kimberly-Clark facility was discontinued and the
equipment was transferred to the Companys facility in Toronto, Canada. Upon
cessation of manufacturing at Kimberly-Clarks facility, the Company purchased, in
accordance with a pre-determined formula, inventory consisting of raw and packaging
materials and up to four months supply of finished goods. The purchase price of this
inventory was approximately $550,000. Cash on hand and borrowings against available credit
lines were used to pay for this inventory.

The
Company completed the transfer, installation and validation of the equipment and commenced
manufacturing in Toronto, Canada in August 2004. The capital costs to transfer, install
and validate the equipment were approximately $680,000.

42

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Financial Index

3. Accounts Receivable

Accounts receivable include the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

   Trade accounts receivable                     $ 2,619,581     $2,774,293
   Less:  Allowance for doubtful accounts            (79,841)       (57,090)
          Allowance for trade rebates             (1,404,290)      (164,000)
                                                 ------------    -----------
        Net trade receivables                      1,135,450      2,553,203
   Other receivables                                  90,189         47,889
                                                 ------------    -----------

        Total receivables                        $ 1,225,639     $2,601,092
                                                 ============    ===========`

4. Inventories

Inventories include the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

   Finished goods                                $2,516,114      $3,531,095
   Work in process                                  144,390          71,423
   Packaging materials                              398,463         461,052
   Raw materials                                    809,696         868,662
                                                 ------------    -----------

        Total inventory                          $3,868,663      $4,932,232
                                                 ============    ===========`

5. Equipment and
Improvements, net

Equipment and improvements include the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

   Machinery and equipment                       $3,337,306      $3,407,073
   Furniture and fixtures                           245,357         196,506
   Leasehold improvements                           887,286         714,992
                                                 ------------    -----------
        Gross equipment and improvements          4,469,949       4,318,571
   Less:  accumulated depreciation               (1,084,087)       (656,014)
                                                 ------------    -----------

        Total equipment and improvements, net    $3,385,862      $3,662,557
                                                 ============    ===========`

Machinery
and equipment and leasehold improvements increased in the year ended December 31, 2004
principally due to the acquisition of the Kimberly-Clark Corporation wound care assets and
infrastructure improvements to the Companys Canadian manufacturing facilities
necessitated thereby. The Company incurred a charge of $273,263 for the year ended
December 31, 2004 related to the disposal of obsolete equipment.

Included
in equipment and improvements at December 31, 2005 was machinery and equipment with a cost
of $221,518 and accumulated amortization of $54,353 attributable to leased equipment.
Amortization of assets under capital leases is included in depreciation expense.

43

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Financial Index

6. Goodwill Impairment

In
connection with the acquisition of Sunshine Products, Inc. in 1998, the Company recorded
goodwill representing the excess of the purchase price over the fair value of the
identifiable assets acquired. The Sunshine products (the Product Line)
acquired in connection with this acquisition consist of hair and body soaps, lotions and
moisturizers and skin cleansers that comprise approximately 95% of the
Companys skin care segment. Prior to completion of the 2005 goodwill impairment test
in the fourth quarter 2005, the carrying value of this goodwill was $1,110,967.

In
2005, the Product Line continued to experience competitive pressure leading to declining
sales and gross profit. Despite various attempts to improve the financial performance of
the Product Line, the Company has been unable to overcome the sales and marketing breadth
and product cost advantage held by its larger competitors. Utilizing the Companys
methodology for evaluating goodwill impairment (see Note 1), the results of the 2005
goodwill impairment test is outlined below:

`Fair value of reporting unit with goodwill             $  624,000
    Less fair value of assets and liabilities,
        excluding goodwill, and including
        unrecognized intangible assets of $60,000             424,000
                                                           ----------
    Implied value of goodwill                                 200,000
    Carrying amount of goodwill                             1,110,967
                                                           ----------

    Goodwill impairment loss                               $  910,967
                                                           ==========`

Excluding
goodwill, the Company believes the balance of the assets and liabilities related to the
Product Line are fairly valued and recovery is reasonably assured. The Company has
internally evaluated the prospective sale price of the Product Line excluding the fair
value of any unrecorded intangible assets (customer lists, intellectual property etc.).
The sale value is comparable to the implied value of goodwill of $200,000 derived from the
discounted future cash flow methodology used in the impairment test and is deemed
reasonable by management.

The
goodwill impairment expense of $910,967 has been recorded as a separate line item within
Total Expense in the 2005 Consolidated Statement of Operations. Given the uncertainty
surrounding the Companys ability to use its available net operating loss
carryforwards (see Note 14), no tax benefit has been provided relative to the impairment
loss.

7. Other Intangible
Assets, net

Other
intangible assets, net include the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

Patents and trademarks                            $ 444,067      $ 444,067
Other intangible assets                             342,797        342,797
                                                  ----------     ----------

Gross other intangible assets                       786,864        786,864
Less accumulated amortization                      (487,088)      (402,953)
                                                  ----------     ----------

Other intangible assets, net                      $ 299,776      $ 383,911
                                                  ==========     ==========`

At
December 31, 2004, the Company recorded a $21,410 one-time charge to write-off the balance
of other intangible assets related to the Genesis ointment product rights. In connection
with the acquisition of the Kimberly-Clark Corporation wound care assets in January 2004,
the Company allocated $342,797 of the purchase price to intangible assets consisting of
product rights, formulations and specifications, regulatory approvals, customer lists and
a non-compete agreement.

44

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Financial Index

The
weighted average useful life of patent and trademarks and other intangibles is 5.9 years
and 3.0 years, respectively. Actual amortization expense for 2005 and 2004 and estimated
thereafter by year is outlined below:

`Patents and      Other
                                                                Trademarks   Intangibles      Total
                                                                ----------   -----------      -----

Actual amortization expense for year ended 12/31/05               $15,614      $ 68,522      $ 84,136
                                                                  =======      ========      ========

Actual amortization expense for year ended 12/31/04               $15,696      $101,794      $117,490
                                                                  =======      ========      ========

Estimated amortization expense for years ending December 31,

         2006                                                     $15,614      $ 68,522      $ 84,136
         2007                                                      15,614        68,522        84,136
         2008                                                      15,614        68,522        84,136
         2009                                                      15,614         1,849        17,463
         2010                                                      15,614           -          15,614
         Thereafter                                                14,291           -          14,291
                                                                  -------      --------      --------

              Total                                               $92,361      $207,415      $299,776
                                                                  =======      ========      ========`

8. Other Assets, net

Other
assets, net include the following:

`December 31,
                                                    -------------------
                                                    2005           2004
                                                    ----           ----

   Deferred financing costs, net                 $ 92,235        $ 60,728
   Deposits                                        67,777          71,736
   Long-term receivable                            90,300            -
   Other deferred costs                            49,376            -
                                                  -------        --------

        Total other assets, net                  $299,688        $132,464
                                                 ========        ========`

Deferred
financing costs related to the U.S. credit facility are being amortized over three years.
Deferred financing costs related to the Canadian credit facility are being amortized over
five years.

9. Line of Credit
Borrowings

Short-term
borrowings include the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

   U.S. line of credit                           $1,080,561      $1,312,756
   Canadian line of credit                             -          1,507,528
                                                 ----------      ----------

        Total line of credit borrowings          $1,080,561      $2,820,284
                                                 ==========      ==========`

45

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Financial Index

U.S.
Line of Credit

On
January 31, 2005, the Company entered into a three year revolving credit facility
agreement (the New Agreement) with a new U.S. lender for a maximum principal
amount of $2,000,000. The New Agreement replaces a $2,000,000 revolving credit facility
that expired on January 31, 2005. On January 31, 2005, the Company applied advances of
approximately $1,300,000 under the New Agreement in satisfaction of the prior U.S.
lenders outstanding obligations. Future advances will be utilized to fund strategic
initiatives and general working capital requirements. The Company incurred loan
origination and legal fees of $147,300 in connection with the implementation of the New
Agreement. These fees have been deferred and are being amortized to interest expense over
the three year term of the New Agreement.

The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At December 31, 2005 the effective interest rate
was 9.75%. In addition, the Company pays a monthly collateral management fee at the rate
of 1.5% per annum upon the daily average amount of advances outstanding and a monthly
unused line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.

Over
the term of the New Agreement, the Company has agreed to comply with the following
covenants as measured at the end of each month for the average of the three most recent
calendar months based upon its consolidated operating results: a) maintain EBITDA
(earnings before interest, taxes, depreciation and amortization) in the range of negative
$300,000 (as of January 31, 2005) transitioning to positive $600,000 (post December 31,
2005) and (b) maintain its fixed charge ratio (EBITDA divided by the sum of debt service,
capital expenditures, income taxes and dividends) in the range of 1.0 to 1.0 (as of
January 31, 2005) to 1.25 to 1.0 (post December 31, 2005). In addition, at all times the
Companys cash on hand (including unused borrowing capacity under the New Agreement)
must not be less than $200,000. Additional covenants governing permitted indebtedness,
liens, payments of dividends and protection of collateral are included in the New
Agreement.

Based
upon consolidated operating results for March and April 2005, the Company was out of
compliance with its EBITDA and fixed charge ratio covenants under the New Agreement. The
U.S. lender agreed to waive these covenant violations. Effective June 30, 2005 the Company
and the U.S. lender agreed to prospectively amend the Companys monthly minimum
EBITDA and fixed charge ratio covenants to better align these covenants with expected
performance. The Company incurred fees of $10,000 associated with the granting of the
covenant amendments. Based upon consolidated operating results for September 30, 2005, the
Company was out of compliance with its EBITDA covenant. The U.S. lender agreed to waive
the covenant violation for September 2005. Based upon consolidated operating results for
October, 2005 through February, 2006, the Company was out of compliance with its EBITDA
and fixed charge ratio covenants as amended effective June 30, 2005. The U.S. lender
agreed to waive these covenant violations and to work with the Company to amend the
existing covenants going forward. The Company expects to, but cannot assure that it will,
maintain compliance with all applicable loan covenants in the future.

The
Company may terminate the New Agreement at any time by paying all outstanding indebtedness
and any other payments due the new U.S. lender and paying the new U.S. lender a yield
maintenance based early termination fee equal to the net present value (as defined) of the
product of: (a) the effective yield on the facility for the six months prior to
termination (expressed as an annual percentage rate), (b) $2,000,000, and (c) the quotient
of the months remaining in the original term of the New Agreement divided by 12.

On
January 13, 2005 in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the former U.S. lender in the amount of

46

---

Financial Index

$200,000 held by the Companys Canadian
lender as additional security for its credit facility. The $200,000 paid to the Canadian
lender was applied as a permanent principal reduction against the principal amount due in
2007 associated with the Companys outstanding term loan with the Canadian lender
(see Note 11). Subsequently, on January 31, 2005 the Canadian lender agreed as part of
refinancing of the U.S. line of credit to retain its second lien security interest and
guarantee position against the Companys U.S. assets and not to exercise its rights
under its second lien security interest and guarantee against the U.S. assets without the
U.S. lenders approval.

Canadian
Line of Credit

In
November 2005, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $688,000 ($800,000
Canadian) with its Canadian lender. In light of the favorable impact of the new
distribution agreement (see Note 18) on the borrowing requirements of the Companys
wholly owned Canadian subsidiary, Derma Sciences Canada Inc., the maximum principal amount
of the credit facility was reduced in line with the subsidiarys prospective maximum
borrowing capacity. The next annual review is expected to be completed by May 1, 2006.
Derma Sciences Canada Inc. may request advances under the Canadian Agreement up to the
value of 75% of eligible receivables (as defined) plus the lesser of $344,000 ($400,000
Canadian) or 40% of eligible inventory (as defined), less priority claims. Interest on
outstanding advances is payable monthly in arrears at prime rate (as defined) plus 1.0%,
or 6.00% for Canadian dollar advances and 8.75% for U.S. dollar denominated advances at
December 31, 2005. Outstanding advances are secured by all tangible and intangible assets
of Derma Sciences Canada Inc. In addition, the Company has accorded the Canadian lender
its guarantee of payment together with a second lien security interest in the
Companys assets located in the U.S.

Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $430,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default.

10. Accrued Expenses and
Other Current Liabilities

Accrued
expenses and other current liabilities include the following:

`December 31,
                                                     -------------------
                                                     2005           2004
                                                     ----           ----
   Accrued compensation and related taxes         $124,718        $218,037
   Accrued sales, goods and services taxes          72,179         197,984
   Accrued administrative fees                     215,357         107,916
   Accrued closure costs                            26,348               -
   Other                                            52,957          70,501
                                                  --------        --------

      Total accrued expenses and other current
        liabilities                               $491,559        $594,438
                                                  ========        ========`

47

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Financial Index

11. Long-Term Debt

Long-term
debt includes the following:

`December 31,
                                                      -------------------
                                                      2005           2004
                                                      ----           ----

   Canadian term loan                             $533,809       $  916,805
   Capital lease obligations                       140,609          198,040
                                                  --------       ----------

        Total debt                                 674,418        1,114,845
   Less:  current maturities                       285,945          247,306
                                                  --------       ----------

        Long-term debt                            $388,473       $  867,539
                                                  ========       ==========`

The
following are the term loan maturities for the next 2 years:

`Year Ending
             December 31                                Term Loan
             -----------                                ---------

             2006                                        $233,878
             2007                                         299,931
                                                         --------

             Total term loan obligations                  533,809
             Less:  current maturities                    233,878
                                                         --------

             Long-term loan obligations                  $299,931
                                                         ========`

In
connection with the acquisition of substantially all the assets of Dumex Medical Inc., the
Company entered into a five-year term loan agreement with a Canadian Bank. The loan is
repayable in monthly payments consisting of principal and interest. Interest on the
outstanding principal balance is payable monthly at the banks prime rate (as
defined) plus 1.25%, or 6.25% at December 31, 2005. The term loan is secured by all
tangible and intangible assets of Derma Canada and is subject to the same financial
covenants applicable to the operating line of credit (see Note 9).

The
Company has three capital lease obligations for certain distribution equipment and
computer equipment totaling $140,609 as of December 31, 2005. The capital leases bear
interest at annual rates ranging from 3.9% to 10.2% with the longest lease term expiring
in April 2009.

The
future minimum lease payments required under the capital leases and the present value of
the minimum lease payments as of December 31, 2005 are as follows:

48

---

Financial Index

`Year Ending                                               Capital Lease
    December 31                                                Obligations
    -----------                                                -----------

          2006                                                   $ 60,535
          2007                                                     47,365
          2008                                                     38,925
          2009                                                      9,731
                                                                 --------

    Total minimum lease payments                                  156,556
    Less: Amount representing interest                             15,947
                                                                 --------

    Present value of capital lease obligations                    140,609
    Less: Current maturities of capital lease obligations          52,067
                                                                 --------

    Long-term capital lease obligations                          $ 88,542
                                                                 ========`

12. Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at December 31,
2005. The series A preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $4.00 per share, votes as
a class on matters affecting the series A preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at December 31,
2005. The series B preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $6.00 per share, votes as
a class on matters affecting the series B preferred stock and maintains voting rights
identical to the common stock on all other matters. During the year ended December 31,
2004, 4,167 series B preferred shares were converted into common stock.

There
are 619,055 shares of series C convertible preferred stock outstanding at December 31,
2005. The series C preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.70 per share,
votes as a class on matters affecting the series C preferred stock and maintains voting
rights identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at December 31,
2005. The series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.50 per share,
votes as a class on matters affecting the series D preferred stock and maintains voting
rights identical to the common stock on all other matters.

Common
Stock

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering commenced prior to December 31, 2004. During 2005, the
Company sold 1,205,000 units at $0.50 per unit and received total offering proceeds of
$521,808, net of $80,692 in offering expenses.

During
2004, the Company conducted two private common stock offerings. In February 2004, the
Company closed a private offering of 2,057,145 shares of its common stock at a price of
$1.05 per share. Total

49

---

Financial Index

offering proceeds of $1,961,797, net of $198,203 in offering
expenses, were used to fund strategic initiatives and for general working capital
purposes. As of December 31, 2004, the Company sold 1,555,000 units at $0.50 per unit,
each unit consisting of one share of the Companys common stock and one four-year
series G warrant to purchase one share of common stock at the price of $1.05 as part of a
new continuing offering. Total offering proceeds of $698,859, net of offering expenses of
$78,641, were received. In March 2004, 4,167 shares of series B preferred stock were
converted into 4,167 shares of common stock.

Stock
Purchase Warrants

At
December 31, 2005, the Company had warrants outstanding to purchase 4,069,441 shares of
the Companys common stock as outlined below:

`Series       Number of Warrants      Exercise Price    Expiration Date
    ------       ------------------      --------------    ---------------

       F              1,309,441               $0.57        January 6, 2007
       G              2,760,000               $1.05        December 31, 2008`

In
the first quarter of 2005, the Company issued 1,205,000 series G warrants in conjunction with
the private offering discussed above. The Companys 1,870,007 series E warrants
expired unexercised on July 18, 2005. As of December 31, 2004, the Company sold 1,555,000
units at $0.50 per unit, each unit consisting of one share of common stock and one
four-year series G warrant to purchase one share of common stock at the price of $1.05.

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 3,500,000
shares of common stock may be issued. The plan permits the granting of both incentive
stock options and nonqualified stock options to employees and directors of the Company and
certain outside consultants and advisors to the Company. The option exercise price may not
be less than the fair market value of the stock on the date of the grant of the option.
The duration of each option may not exceed 10 years from the date of grant. Options under
the plan to purchase 1,526,000 shares of common stock were granted to officers, directors,
agents and employees in 2005 with exercise prices ranging from $0.42 to $0.67 per share.
As of December 31, 2005, options to purchase 3,036,625 shares of the Companys common
stock were issued and outstanding under the plan. No options granted under the plan have
been exercised.

The
Company has previously granted nonqualified stock options to officers, directors, agents
and employees outside of the stock option plan (non-plan options). All
non-plan options were granted at the fair market value at the date of grant. As of
December 31, 2005, non-plan options to purchase 2,736,655 shares of the Companys
common stock were issued and outstanding.

50

---

Financial Index

A
summary of the Companys stock option activity and related information for the years
ended December 31, 2005 and 2004 follows:

`2005                          2004
                                     ------------------------------------------------------
                                                  Weighted                      Weighted
                                                  Average                       Average
                                     Options   Exercise Price      Options   Exercise Price
                                     -------   --------------      -------   --------------

Outstanding - beginning of year    4,464,655       $1.06         3,676,155       $1.09
    Granted                        1,526,000       $0.48         1,452,000       $1.20
    Forfeited                       (217,375)      $0.72          (663,500)      $1.55
                                   ----------                    ----------

Outstanding - end of year          5,773,280       $0.92         4,464,655       $1.06
                                   ==========                    ==========

Exercisable at end of year         5,773,280       $0.92         3,645,955       $1.08
                                   ==========      =====         ==========      =====`

The
weighted average fair value per share of options granted during 2005 and 2004 was $0.48
and $1.20, respectively.

The
following table summarizes information related to stock options outstanding and
exercisable at December 31, 2005:

`Options Outstanding and Exercisable
                    -------------------------------------------------------------------------

   Range of         Number Outstanding and          Weighted-Average          Weighted-Average
Exercise Prices     Exercisable at 12/31/05    Remaining Contractual Life      Exercise Price
---------------     -----------------------    --------------------------      --------------

$0.37 - $0.50              2,736,525                     6.7                        $0.46
$0.51 - $0.75              1,585,600                     6.5                        $0.61
$0.85 - $1.20                805,000                     6.6                        $0.93
$1.55 - $1.70                366,500                     7.7                        $1.64
$1.71 - $12.50               279,655                     2.4                        $6.20
                           ---------

                           5,773,280                     6.5
                           =========`

Shares
Reserved for Future Issuance

At
December 31, 2005, the Company has reserved the following shares of common stock for
future issuance:

`Convertible preferred shares (series A - D)            2,280,407
    Common stock options outstanding                       5,773,280
    Common stock options available for grant                 463,375
    Common stock warrants (series F - G)                   4,069,441
                                                          ----------

    Total common stock shares reserved                    12,586,503
                                                          ===========`

13. Operating Segments

The
Company consists of three operating segments: wound care, wound closure and fasteners and
skin care. Products in the wound care segment consist of basic and advanced dressings,
ointments and sprays designed to treat wounds. Wound closure and fasteners products
include wound closure strips, nasal tube fasteners, a variety of catheter fasteners and
net dressings. The skin care segment consists of bath sponges, antibacterial skin
cleansers,

51

---

Financial Index

hair and body soaps, lotions and moisturizers designed to enable customers to
implement and maintain successful skin care / hygiene programs.

Products in all three
operating segments are marketed to long-term care facilities, hospitals, physicians, clinics, home health care agencies and other
healthcare institutions. The manufacture of certain advanced wound care products (principally creams, ointments and other
specialty products), wound closure and fastener products are manufactured internally and outsourced and skin care products are
outsourced. Basic wound care products and the majority of advanced wound care products are manufactured in-house. Internally, the
segments are managed at the gross profit level. The aggregation or allocation of other costs by segment is not practical.

Segment
sales, gross profit and other related information for 2005 and 2004 are as follows:

`Year Ended December 31, 2005
                                                   ----------------------------

                                        Wound Closure-                                           Total
                           Wound Care     Fasteners         Skin Care          Other            Company
                           ----------     ---------         ---------          -----            -------

Net sales                 $19,366,904      $2,676,979      $1,501,592              -          $23,545,475

Gross profit (loss)         6,532,803       1,358,576        (101,957)             -            7,789,422
Total expenses                   -               -               -          $(8,698,526)       (8,698,526)
                                                                                              ------------

Net loss                                                                                      $  (909,104)
                                                                                              ============

Net long-lived assets     $ 3,311,128      $   58,450      $  200,000       $   316,060       $ 3,885,638



                                                   Year Ended December 31, 2004
                                                   ----------------------------

                                        Wound Closure-                                           Total
                           Wound Care     Fasteners         Skin Care          Other            Company
                           ----------     ---------         ---------          -----            -------

Net sales                 $14,609,033       $3,339,432      $1,938,667              -         $19,887,132

Gross profit                3,507,263        1,672,463         372,204              -           5,551,930
Total expenses                   -                -               -          $(7,890,623)      (7,890,623)
                                                                                              ------------

Net loss                                                                                      $(2,338,693)
                                                                                              ============

Net long-lived assets     $ 3,535,611             -         $1,352,059       $   269,765      $ 5,157,435
                                                                                              ============`

Long-lived
assets consist of equipment and improvements, other intangible assets and goodwill. Wound
care long-lived assets consist principally of Derma Sciences Canada Inc. equipment and
improvements and other intangible assets. Wound closure and fastener products are both
outsourced and manufactured internally starting in the second half of 2005. Skin care
long-lived assets consist of goodwill associated with the acquisition of Sunshine
Products, Inc. In 2005, the Company closed its skin care manufacturing facility and
outsourced the facilitys production with a view to reducing overhead and improving
cost competitiveness. In connection with the closure, the Company sold or transferred the
long-lived assets (excluding goodwill) associated with the skin care segment. In addition,
the Company determined that the Sunshine goodwill was impaired and recorded a charge of
$910,967 (see Note 6) in the fourth quarter 2005. Corporate headquarters and the
Companys U.S. distribution center equipment and improvements are included in the
Other column since they service all three business segments.

52

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Financial Index

A
geographical breakdown of the Companys sales, gross profit and long-lived assets is
outlined below:

`United States     Canada         Other        Total
                         -------------     ------         -----        -----
2005
----

Net sales                 $ 9,893,704    $12,699,991    $951,780    $23,545,745
                          -----------    -----------    --------    -----------
Gross profit              $ 3,611,738    $ 3,844,561    $333,123    $ 7,789,422
                          -----------    -----------    --------    -----------
Net long-lived assets     $   816,318    $ 3,031,311    $ 38,009    $ 3,885,638
                          -----------    -----------    --------    -----------

2004
----

Net sales                 $10,096,492    $ 8,827,210    $963,430    $19,887,132
                          -----------    -----------    --------    -----------
Gross profit              $ 3,500,215    $ 1,714,514    $337,201    $ 5,551,930
                          -----------    -----------    --------    -----------
Net long-lived assets     $ 2,020,946    $ 3,115,293    $ 21,196    $ 5,157,435
                          -----------    -----------    --------    -----------`

Other
sales and gross profit relate principally to wound closure and fastener sales in Europe.
Other long-lived assets relate to the Companys manufacturing facility in China.

14. Income Taxes

Loss before income taxes consists of the following components:

`2005               2004
                                            ----               ----

   Domestic                            $(1,591,173)       $(1,431,001)
   Foreign                                 682,069           (907,692)
                                       -----------        ------------

   Total loss before income taxes      $  (909,104)       $(2,338,693)
                                       ============       ============`

Significant
components of the Companys deferred tax assets and liabilities are as follows:

`December 31,
                                                          ------------
                                                      2005             2004
                                                      ----             ----
    Deferred tax liabilities:
       Prepaid insurance                         $   (10,499)     $   (10,215)
       Patent amortization                           (37,492)         (51,127)
       Deferred financing costs                         -             (14,033)
       Depreciation                                  (14,837)            -
                                                  -----------      -----------

         Total deferred tax liabilities              (62,828)         (75,375)
                                                  -----------      -----------`

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Financial Index

`Deferred tax assets:
       Net operating loss carryforwards - U.S.     3,341,339        3,300,395
       Net operating loss - foreign                  130,007          361,911
       Depreciation                                        -           24,442
       Amortization of intangibles                    69,932           86,702
       Accrued expenses                               16,895           51,277
       Inventory obsolescence reserve                 60,890           93,365
       Allowance for trade rebates                   100,185           66,573
       Allowance for doubtful accounts                17,049           18,886
       Stock compensation                             33,081                -
       Deferred rent                                  37,445                -
       Other                                               -           23,301
                                                  -----------      -----------

         Gross deferred tax assets                 3,806,823        4,026,852
       Valuation allowance                        (3,743,995)      (3,951,477)
                                                  -----------      -----------

         Total deferred tax assets                    62,828           75,375
                                                  -----------      -----------

    Net deferred tax assets                       $     -         $      -
                                                  ===========     ============`

The
majority of the valuation allowance relates to net operating loss carryforwards for which
realization is not assured.

The
reconciliation of income tax computed at the U.S. federal statutory tax rates to income
tax expense is:

`December 31,
                                                         ------------
                                                     2005           2004
                                                     ----           ----

    Tax expense at federal statutory rate        $(309,095)     $(795,156)
    State tax, net of federal benefit             (104,858)      (154,120)
    Expiration of state tax operating loss
        carryforwards                              270,108           -
    Differential in foreign taxes                  (40,924)        54,461
    Goodwill impairment loss                       369,762           -
    Nondeductible expenses                          22,489         16,417
                                                 ----------     ----------

         Total                                     207,482       (878,398)
    Change in valuation allowance                 (207,482)       878,398
                                                 ----------     ----------

    Provision for income taxes                   $    -         $    -
                                                 ==========     ==========`

At
December 31, 2005, the Company has net operating loss carryforwards of approximately
$8,900,000 for federal income tax purposes that begin to expire in years 2012 through
2025. For state income tax purposes, the Company has net operating loss carryforwards in a
number of jurisdictions in varying amounts and with varying expiration dates. The most
significant state net operating loss carryforward is in New Jersey, site of the
Companys headquarters and is approximately $4,800,000. New Jersey currently allows
the deduction of net operating losses up to 50% of net income. The state has a seven year
carryforward period but such period is extended where an otherwise deductible net
operating loss was disallowed in full or in part because of such limitations. The New
Jersey carry forwards begin to expire in years 2006 through 2012. As of December 31, 2005,
the Company has foreign net operating loss carryforwards of approximately $382,000 which
begin to expire in 2009. The timing in which the Company can utilize its federal net
operating loss carryforwards in any year or in total may be limited under the Internal
Revenue Code section 382 regarding changes in ownership of corporations. Due to
uncertainties

54

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Financial Index

surrounding the Companys ability to use its net operating loss
carryforwards, a valuation allowance has been provided as of December 31, 2005.

15. Operating Leases

The
Company has operating lease agreements for its facilities and equipment expiring in
various years through 2012. Expense under these agreements amounted to $1,014,029 and
$997,060 in 2005 and 2004, respectively. In 2004, the Company entered into a five year
lease for its new U.S. distribution center in St. Louis, extended the lease on its Toronto
manufacturing facility five years through 2012 in connection with the installation of the
Kimberly-Clark Corporation equipment there, renewed its Canadian distribution center lease
for an additional five years through 2009 and renewed its St. Louis manufacturing facility
lease for three years through 2007. The leases provide for increases in future minimum
annual rental payments based on agreed upon terms over the life of the lease and/or annual
inflationary increases tied to a published price index. The leases provide for renewal
options consistent with the terms of the current lease. It is expected that these leases
will be renewed or replaced by leases in other properties.

Net
minimum future rental payments under non-cancelable operating leases as of December 31,
2005 are:

`Minimum Future Rental Payments
    --------------------------------------------------------
    Year Ending December 31,                          Amount
    ------------------------                          ------

       2006                                       $1,029,140
       2007                                          924,359
       2008                                          811,253
       2009                                          529,227
       2010                                          396,903
       Thereafter                                    668,445
                                                  -----------

    Total minimum future rental payments          $4,359,327
    Sublease income                                 (328,933)
                                                  -----------

    Net minimum future rental payments            $4,030,394
                                                  ===========`

Minimum
rental payments associated with the U.S. distribution lease range from $11,000 per month
in year one to $21,600 in year five of the lease term. The Company is recording lease
expense monthly at $16,300, the weighted average monthly lease expense over the life of
the lease. The difference between the monthly lease expense being recorded and the amount
paid is being recorded as deferred rent expense on the balance sheet. At December 31,
2005, $92,244 of deferred rent expense was recorded.

16. Retirement Benefits

The
Company maintains a profit sharing/401(k) plan for eligible full-time U.S. employees.
Participants may contribute up to 12% of their salary to the plan, subject to IRS
limitations. The Company makes a matching contribution of 50% on the first 6% of each
participants annual earnings contributed to the plan. Company contributions to the
plan for the years ended December 31, 2005 and 2004 were $39,346 and $39,945,
respectively.

17. Related Party
Transactions

The
Company has a consulting agreement with its founder, former president and former director.
In 2005 and 2004 compensation and reimbursed expenses under this agreement were $26,087
and $28,643, respectively.

A
director of the Company is a general partner in the firm that holds a significant equity
ownership in the Company. In 2004, the firm was paid a $45,000 private equity fund raising
commission.

55

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Financial Index

18. Appointment of
Canadian Distributor

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada. The
agreement also appoints the distributor as the Companys servicing agent to fulfill
supply contracts held directly by the Company. The agreement automatically renews
thereafter for consecutive periods of one year each on the same terms and conditions
unless either party gives notice of its intent not to renew 180 days prior to expiry.
Either party shall have the right to terminate the agreement when an event of default (as
defined) has occurred with respect to the other party.

Effective
June 1, 2005 the distributor assumed responsibility for customer service, product delivery
and maintenance and warehousing of sufficient inventory to meet agreed upon order
fulfillment requirements. On an ongoing basis, the distributor will place inventory
replenishment orders with the Company at agreed upon prices, 120 days in advance of
scheduled delivery. Unless amended, each order becomes non-cancelable 90 days in advance
of scheduled delivery.

With
respect to sales made by the distributor to the Companys contract customers in its
capacity as a servicing agent, the Company will pay the distributor an agreed upon
distribution fee and a specified incentive for growth (as achieved). The Company will
reimburse the distributor for the difference between the price paid by the distributor and
the Companys contract price with its customer upon submission by the distributor of
an agreed upon rebate report. With respect to sales made by the distributor to its
customers, the distributors compensation will consist solely of the excess of the
proceeds over the cost of the product and the Company will not be responsible for payment
of any distribution fee. Further, the agreement requires the distributor to meet specified
minimum sales growth targets of 15%, 12%, 12% and 12% in the first four years and private
label product purchase targets failing which the Company may cancel the agreement. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth.

In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand and all saleable finished product
it committed to manufacture prior to signing of the agreement for delivery by the Company
through September 2005 at the agreed upon prices to initially stock and maintain its
distribution pipeline. Other than the one-time sale in May and June 2005 of its existing
inventory on hand which is estimated to represent two to two and one-half months sales,
prospective sales are expected to resume historical trends affected only by existing
market conditions and the growth opportunities inherent in the agreement. Given economic
order quantities and normal lead times associated with the products sold to the
distributor, it is expected that a two to three month safety stock will be required
prospectively by the distributor to maintain required customer service requirements. In
addition, the Company incurred one-time costs consisting of severance and other costs to
dismantle its distribution capabilities and sub-lease its distribution warehouse. A
summary of the estimated one-time benefit and cost of the agreement recognized in the
twelve months ended December 31, 2005 is outlined below:

`Net Sales                 $1,840,000
         Cost of Sales              1,240,000
                                   ----------

         Gross Profit                 600,000
         Expenses                     105,000
                                   ----------

         Pretax Income             $  495,000
                                   ==========`

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

56

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Financial Index

19. Distribution
Agreement Upset Fee

In
August 2004, the Companys exclusive distribution agreement for certain catheter
fasteners expired and was not renewed by the manufacturer. Sales and gross profit of these
catheter fasteners for the twelve months ended December 31, 2005 and 2004 were as follows:

`Twelve Months Ended
                                -------------------
                                    December 31,
                                    ------------
                                2005            2004
                                ----            ----

         Sales                $117,000        $826,000
         Gross profit          $58,000        $378,000`

In
accordance with the Companys distribution agreement with a major customer for these
catheter fasteners, if the customer subsequently entered into an agreement with the
manufacturer to distribute these products, then the customer shall pay the Company an
upset fee of $200,000 payable in forty-eight monthly installments of $4,167. As of January
2005, the customer advised the Company that it had entered into an agreement with the
manufacturer to distribute the catheter fasteners and that it was liable for payment of
the upset fee. In January 2005, the Company discounted the future cash flow stream
associated with the payment of the upset fee and recognized a gain of $164,300 in other
income. At December 31, 2005 payments were current and the outstanding receivable balance
was $129,140. The current portion of the receivable has been recorded in accounts
receivable and the long-term portion in other assets in the balance sheet.

20. Employee Termination
Costs

On
March 9, 2004 the Company terminated the employment of its Executive Vice President and
President of its Derma Sciences Canada Inc. subsidiary. Thereupon, the former employee
initiated litigation against the Company for wrongful termination. The Company recorded an
estimated charge of $450,000 representing severance, benefits and other costs potentially
recoverable by the employee. The charge was recorded against general administrative
expense in the statement of operations.

On
September 24, 2004, the Company settled the subject litigation. In accordance with the
settlement, the Company extended the expiration date of previously granted options to
purchase 500,000 shares of the Companys common stock at $0.50 per share from May 9,
2004 to September 30, 2006. The settlement costs, and other costs associated with the
termination and modification of the previously granted options, totaling $301,600 were
recorded in general and administrative expense in the 2004 consolidated statement of
operations.

21. Subsequent Events

Comvita Licensing,
Manufacturing and Sales Agreement

On
February 13, 2006 the Company entered into an exclusive five year licensing, manufacturing
and sales agreement (the Agreement) with Comvita New Zealand Limited, whereby
the Company will manufacture and sell a line of Manuka Honey based wound care products
developed by Comvita. These products are supported by proprietary intellectual property
that will serve to provide a competitive advantage in the market place. Access to this
technology and these products represents a significant milestone in the Companys
strategy to build a larger presence in the advanced wound care market segment. Under the
Agreement, the Company receives exclusive rights to manufacture and sell its branded
products throughout North and South America within the professional medical-surgical
marketplace (i.e. extended care, acute care, home care, etc). Comvita retains the right to
these products in the consumer marketplace and has the option to purchase its branded
consumer product requirements from the Company at agreed upon pricing.

In
accordance with the Agreement, the Company will purchase its requirements for active honey
from Comvita at agreed upon pricing. As consideration for the grant of the license, the
Company will pay Comvita a

57

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Financial Index

royalty based on sales. The Agreement calls for the Company to
spend a minimum of either $200,000 or 8% of sales per year on Advertising and Promotion in
support of these products. Further, the Agreement calls for minimum sales achievement
targets beginning in the second year of the Agreement and each year thereafter to maintain exclusivity.

58

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Item 8A. Controls and
Procedures

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of December 31, 2005. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures were effective as of that date for
gathering, analyzing and disclosing the information the Company is required to disclose in
the reports it files under the Securities Exchange Act of 1934, within the time periods
specified in the SECs rules and forms.

During
the three months ended December 31, 2005, there was no change in the Companys
internal controls over financial reporting that materially affected, or is reasonably
likely to materially affect, the Companys internal controls over financial
reporting.

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Part III

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

Directors and Executive
Officers

The
directors and executive officers of the Company are:

| |                                     |     |  |                                                    
| | ----------------------------------- | --- |  | ---------------------------------------------------
| | Name                                | Age |  | Position held with the Company                     
| |                                     |     |  |                                                    
| | Edward J. Quilty (1)(2)             | 55  |  | Chairman, President and Chief Executive Officer    
| | John E. Yetter, CPA                 | 53  |  | Vice President and Chief Financial Officer         
| | Robert C. Cole                      | 53  |  | Executive Vice President - Sales                   
| | Frederic Eigner                     | 56  |  | Executive Vice President - Operations              
| | Barry J. Wolfenson                  | 39  |  | Vice President - Marketing and Business Development
| | Srini Conjeevaram (1)(2)(3)         | 47  |  | Director                                           
| | Stephen T. Wills, CPA, MST (2)(3)   | 49  |  | Director                                           
| | James T. O'Brien (2)(3)             | 67  |  | Director                                           
| | C. Richard Stafford, Esq. (1)(2)(3) | 70  |  | Director                                           
| | Richard J. Keim (2)(3)              | 70  |  | Director                                           
| | Robert G. Moussa (2)(3)             | 70  |  | Director                                           

_______________ 
(1)   Member of the Nominating Committee. (2)   Member of the Compensation Committee. (3)  
Member of the Audit Committee.

All
members of the board of directors are independent directors as defined in
Nasdaq Marketplace Rule 4200 with the exception of Edward J. Quilty.

Information Relative to
Directors and Executive Officers

Edward
J. Quilty has served as Chief Executive Officer of the Company since November, 1996,
Chairman of the Board since May, 1996 and as a director of the Company since March, 1996.
Mr. Quilty was the Chairman of the Board of Palatin Technologies, Inc., a publicly traded
biopharmaceutical company specializing in peptide drug design for diagnostic and
therapeutic agents from November, 1995 until May, 2000. During the period November, 1996
through May, 2000 Mr. Quilty held the Chief Executive Officer positions at both the
Company and Palatin Technologies, Inc. From July, 1994 through November, 1995, he was
President and Chief Executive Officer of MedChem Products, Inc., a publicly traded
developer and manufacturer of specialty medical products which was acquired by C. R. Bard
in November, 1995. From March, 1992 through July, 1994 Mr. Quilty served as President and
Chief Executive Officer of Life Medical Sciences, Inc., a publicly traded developer and
manufacturer of specialty medical products including wound healing agents. The assets of
Life Medical Sciences were purchased by MedChem Products, Inc. During the period January,
1987 through September, 1991 Mr. Quilty served as Vice President  Sales and
Marketing and later as Executive Vice President (in which capacity he shared the office of
the President) with McGaw Laboratories, a pharmaceutical and medical device company.
Previously, he served from 1974 in a variety of sales, marketing and management positions
with Baxter/American Hospital Supply Corporation. Mr. Quilty has over 30 years of
experience in the healthcare industry primarily in strategic planning, management and
sales and marketing. Mr. Quilty is director of the MedTech Group, a privately held medical
products company. He earned a Bachelor of Science degree from Southwest Missouri State
University, Springfield, Missouri in 1973 and a Master of Business Administration degree
from Ohio University, Athens, Ohio in 1987.

John
E. Yetter, CPA has served as Vice President and Chief Financial Officer of the Company
since August, 2000. Prior to joining the Company, Mr. Yetter held a variety of senior
financial positions with Bristol-Myers Squibb Company. Before his association with
Bristol-Myers Squibb, he held several supervisory financial positions with Cooper
Industries, Inc., Price Waterhouse and Hulse Manufacturing Company. Mr. Yetter is a member
of the American Institute of Certified Public Accountants and the New York Society of
Certified Public

60

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Accountants. He earned a Bachelor of Science in Accounting, magna cum
laude, from Boston College School of Management, Boston, Massachusetts in 1975.

Robert
C. Cole recently assumed the office of Executive Vice President for Sales of the Company.
Previously, he served as the Companys Vice President  Sales and Marketing
since January, 2003. Prior to joining the Company, Mr. Cole held a variety of executive
sales positions with B. Braun Medical and predecessor firms beginning in 1974, most
recently as Vice President, Sales, Eastern Zone. Mr. Cole earned his Bachelor of Science
degree in Biology, cum laude, from St. Vincents College, Latrobe, Pennsylvania, in
1974.

Frederic
Eigner has served as Executive Vice President for Operations of the Company and General
Manager of the Companys Canadian subsidiary, Derma Sciences Canada Inc., since
March, 2005. Previously he served as Vice President for Operations of Derma Sciences
Canada Inc. since August, 2002. Prior to its acquisition by the Company, he held several
positions with Dumex Medical Inc. during the period 1992 until August of 2002, most
recently as Executive Vice President. Prior to his association with Dumex Medical, Mr.
Eigner held a variety of executive manufacturing positions with The Kendall Company during
the period 1980 through 1992, most recently as Director of Manufacturing. He earned a
Bachelor of Science degree in Industrial Engineering from the High Technical school of
Kranj, Slovenia, in 1975, a Master of Science in Chemical Engineering from the University
of Maribor, Slovenia, in 1980, and a Master of Business Administration from the University
of Toronto, Ontario, Canada, in 2000.

Barry
J. Wolfenson currently serves as Vice President for Marketing and Business Development of
the Company. Previously, he served as the Companys Director of Marketing during the
period February 2004 through February 2006. Prior to joining the Company, Mr. Wolfenson
held a variety of sales and marketing positions with Bristol-Myers Squibb beginning in
2001, most recently as Marketing Manager with the Bristol-Myers Squibb Conva-Tec division.
Before his association with Bristol-Myers Squibb, he operated a successful entrepreneurial
venture and served as an account executive with Anderson Consulting. Mr. Wolfenson earned
a Bachelor of Science in Economics from Franklin and Marshall College, Lancaster,
Pennsylvania, in 1989 and a Master of Business Administration, cum laude (Phi Beta Kappa)
from the University of Michigan, Ann Arbor, Michigan, in 2001.

Srini
Conjeevaram has served as director of the Company since May, 1998. Mr. Conjeevaram is
Managing Director of SC Capital Management, LLC pursuing opportunities in the private
equity arena. From 1991 through March 2006, he was with Galen Associates, a healthcare
venture capital firm, becoming a General Partner in 1996. Prior to his affiliation with
Galen Associates, he was an Associate in Corporate Finance at Smith Barney from 1989 to
1990 and a Senior Project Engineer for General Motors Corporation from 1982 to 1987. He
earned a Bachelor of Science degree in Mechanical Engineering from Madras University,
Madras, India, a Master of Science degree in Mechanical Engineering from Stanford
University, Stanford, California, and a Master of Business Administration in Finance from
Indiana University, Bloomington, Indiana.

Stephen
T. Wills, CPA, MST has served as a director of the Company since May, 2000. He also served
as Chief Financial Officer of the Company from July, 1997 and Vice President from
November, 1997 until his resignation from these positions in July, 2000. Mr. Wills
currently serves as Executive Vice President  Operations and Chief Financial Officer
of Palatin Technologies, Inc., a publicly traded biopharmaceutical company. Mr. Wills is a
member of the American Institute of Certified Public Accountants, New Jersey Society of
Certified Public Accountants and Pennsylvania Institute of Certified Public Accountants.
He earned a Bachelor of Science degree in Accounting from West Chester University, West
Chester, Pennsylvania in 1979 and a Master of Science in Taxation from Temple University,
Philadelphia, Pennsylvania in 1994.

James
T. OBrien has served as a director of the Company since May, 2001. He currently
serves as a consultant to the pharmaceutical and healthcare industries. Most recently, he
served as President of OBrien Marketing & Communications. Previously, Mr.
OBrien served from 1989 to 1991 as President and Chief Operating Officer for Elan
Corporation (NYSE: ELN), a multi-national medical products and pharmaceutical company. In
1986, Mr. OBrien founded OBrien Pharmaceuticals and served as its President
and Chief Executive Officer until the acquisition of this company by Elan Corporation.
During the period 1980 to 1986, Mr. OBrien held several division presidencies with
the Revlon Health Care Group. Prior to his association with Revlon, he

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served for
seventeen years with Sandoz Pharmaceuticals, Inc., most recently as Vice President of U.S.
Marketing and Sales. Mr. OBrien serves on the board of directors of Pharmaquest,
Inc. and serves as chairman of the board of directors of Benedictine College. He earned a
Bachelor of Science in Business Administration from Benedictine College, Atchison, Kansas,
in 1960 and attended the Harvard University Advanced Management Program in 1974.

C. Richard Stafford,
Esq. has served as a director of the Company since May, 2002. Mr. Stafford is a consultant to the pharmaceutical industry.
Previously, he was Vice President for Corporate Development and a member of the operating committee of Carter-Wallace, Inc., a
multinational manufacturer of pharmaceutical, toiletry and diagnostic products. Prior to joining Carter-Wallace, Inc. in 1977, Mr.
Stafford was President of Caithness Corporation, a natural resources development firm, and an adjunct professor of law at New York
Law School. Mr. Stafford earned his Bachelor of Arts, cum laude, from Harvard College, his Bachelor of Laws from Harvard Law
School and his Master of Laws from New York University Law School.

Richard
J. Keim has served as a director of the Company since May, 2002 and serves as a consultant
to various industries. He is the founder and Managing Director of Kensington Management
Group, LLC, a portfolio manager with assets in excess of $90 million. Prior to organizing
Kensington in 1986, Mr. Keim founded and served as Executive Vice President of the
Buckingham Research Group Incorporated, a registered broker-dealer, from 1982 through 1993
and Executive Vice President and Chief Investment Officer of Buckingham Capital Management
from 1985 until 1993. Mr. Keim received his Bachelor of Arts in Business Administration
from the University of Wisconsin and his Master of Business Administration from the
University of Chicago. He is a Senior Security Analyst, a Chartered Financial Analyst, and
a member of the New York Society of Security Analysts and the Financial Analyst
Federation.

Robert
G. Moussa has served as a director of the Company since May, 2005. Mr. Moussa is the
owner, President and Chief Executive Officer of Robert Moussa & Associates, a
consulting firm serving the pharmaceutical, biotechnology and healthcare industries. Prior
to founding this firm, he served in a variety of executive positions with Mallinckrodt,
Inc., St. Louis, Missouri, a $2.4 billion healthcare and chemical company. Mr.
Moussas most recent assignment at Mallinckrodt was President  International, a
position he held from 1995 through 1997. Previously he served from 1992 to 1996 as
President and Chief Executive Officer of Mallinckrodt Medical, Inc., Mallinckrodts
largest business unit with over one billion dollars in revenues. Before joining
Mallinckrodt Medical, Mr. Moussa served during the period 1978 through 1992 as
Mallinckrodt, Inc.s Group Vice President  International Medical Products, Vice
President and General Manager  Medical Products Europe, General Manager 
Critical Care, Director of Business Operations and General Sales Manager. Prior to joining
Mallinckrodt, Mr. Moussa held a number of positions during the period 1969 through 1976
with Sherwood Medical, United Kingdom, most recently as Director of Marketing. Mr. Moussa
received his Baccalaureate from the Collège du Sacre-Cur, Beirut, Lebanon, in
1966 and his Bachelor of Science in Business Administration from Ealing University,
London, England, in 1969. He has also completed executive seminars at the University of
California at Berkley, the Aspen Institute, the Wharton Executive School and the Center
for Creative Leadership.

Compliance with Section
16(a) of the Exchange Act

Section
16(a) of the Securities Exchange Act of 1934 (the Exchange Act) requires the
Companys directors and executive officers, and persons who own more than ten percent
of a registered class of the Companys equity securities, to file with the Securities
and Exchange Commission (the Commission) initial reports of ownership and
reports of changes in ownership of common stock and other equity securities of the
Company. Officers, directors and greater than ten percent shareholders are required by
Commission regulation to furnish the Company with copies of all Section 16(a) forms they
file.

To
the Companys knowledge, based solely on a review of the copies of such reports
furnished to the Company, all reports under Section 16(a) required to be filed by its
officers, directors and greater than ten-percent beneficial owners were timely filed with
the exception of Form 3  Initial Statement of Beneficial Ownership of Securities by
Voyager Partners the filing of which has not been made and Form 4  Statement of
Changes in Beneficial Ownership of Securities by Srini Conjeevaram the filing of which was
untimely.

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Information Relative to
Audit Committee

The
Company has established an audit committee in accordance with section 3(a)(58)(A) of the
Securities Exchange Act of 1934. Members of the audit committee are designated in the
table under the heading Directors and Executive Officers above. Stephen T. Wills, CPA,
MST, chairman of the audit committee, is the audit committee financial expert and is
independent as that term is used in Nasdaq Marketplace Rule 4200.

Item 10. Executive
Compensation

Compensation of Outside
Directors

Upon
election or appointment, outside directors receive options to purchase 20,000 shares of
the Companys Common Stock at a price per share equal to the fair market value of the
Common Stock on the date of the option grant. These options vest at the rate of 5,000 on
the date of grant and 5,000 per year thereafter. For each year of service, outside
directors receive options to purchase 70,000 shares of the Companys Common Stock at
a price per share equal to the fair market value of the Common Stock on the date of the
option grant. These options vest at the rate of 55,000 on the date of grant and 5,000 per
year thereafter. Effective January 1, 2005 each outside Director receives a $12,000 cash
payment, payable quarterly, for each year of service on the board of directors. All
directors are reimbursed for expenses incurred in connection with each board and committee
meeting attended. Inside directors receive no compensation for their services as
directors.

Compensation of Executive
Officers

Summary Compensation Table

The
following table shows all compensation paid by the Company in the years 2003, 2004 and
2005 to its Chief Executive Officer, four individuals who served as the Companys
officers or directors on December 31, 2005 whose compensation exceeded $100,000 for their
services (in all capacities) and up to two individuals who would have been disclosed
herein under the foregoing criteria if they had been officers on December 31, 2005:

`Annual Compensation
                                                      -------------------      # of Options      All Other
Name and Principal Position                Year       Salary         Bonus        Granted      Compensation
---------------------------                ----       ------         -----        -------      ------------

Edward J. Quilty                           2005      $295,000          --         193,750        $11,045
Chairman, President and                    2004      $287,499       $40,000        50,000        $11,245
Chief Executive Officer                    2003      $250,000          --          75,000        $10,745

John E. Yetter, CPA                        2005      $195,000          --         116,250         $4,875
Vice President and                         2004      $193,333       $30,000        25,000         $6,500
Chief Financial Officer                    2003      $182,500       $25,000        40,000         $6,000
                                                                       --
Robert C. Cole                             2005      $170,000          --         116,250        $11,450
Vice President - Sales                     2004      $167,500       $25,000        25,000        $11,100
                                           2003      $155,000          --            --           $7,200

Frederic Eigner                            2005      $126,861          --         121,875           $303
Executive Vice President - Operations      2004      $108,280       $19,215        30,000           $303
and General Manager, Derma Sciences        2003       $96,181          --          20,000           $282
Canada Inc.

Barry J. Wolfenson                         2005      $114,167          --          50,000         $1,294
Vice President - Marketing and             2004      $106,250 (1)      --          70,000           --
Business Development                       2003          --            --            --             --`

_____________________________

(1)     Represents compensation earned during the period
February through December, 2004.

63

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Option Grants Table

The
following table sets forth information regarding grants of stock options to the following
named executive officers and directors during the year ended December 31, 2005:

`Percent of Total
                                               Options Granted to    Exercise
                              # of Options       Employees and        Price
              Name               Granted       Directors in 2004    ($/Share)   Expiration Date
              ----            -------------    -----------------    ---------   ---------------

Edward J. Quilty              250,000 (1)            17.30%           $0.50      March 1, 2015
John E. Yetter, CPA           150,000 (2)            10.38%           $0.50      March 1, 2015
Robert C. Cole                150,000 (2)            10.38%           $0.50      March 1, 2015
Frederic Eigner               150,000 (3)            10.38%           $0.50      March 1, 2015
Barry J. Wolfenson             50,000 (4)             3.46%           $0.50      March 1, 2015
Stephen T. Wills, CPA, MST     70,000 (5)             4.84%           $0.42      May 12, 2015
Srini Conjeevaram              70,000 (5)             4.84%           $0.42      May 12, 2015
James T. O'Brien               70,000 (5)             4.84%           $0.42      May 12, 2015
Richard J. Keim                70,000 (5)             4.84%           $0.42      May 12, 2015
C. Richard Stafford, Esq.      70,000 (5)             4.84%           $0.42      May 12, 2015
Robert G. Moussa               90,000 (6)             6.23%           $0.42      May 12, 2015`

_________________

|(1) | Upon grant, these options were scheduled to vest as follows: (i) to the extent
          of 62,500 thereof, at the rate of 15,625 upon grant and 15,625 annually
          (periodic vesting options); and (ii) to the extent of 187,500 thereof, upon the
          attainment of certain performance objectives (performance based options). The
          periodic vesting options were declared vested effective December 30, 2005. Of
          the performance based options, 131,250 vested and 56,250 lapsed effective
          December 30, 2005.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Upon grant, these options were scheduled to vest as follows: (i) to the extent
          of 37,500 thereof, at the rate of 9,375 upon grant and 9,375 annually (periodic
          vesting options); and (ii) to the extent of 112,500 thereof, upon the attainment
          of certain performance objectives (performance based options). The periodic
          vesting options were declared vested effective December 30, 2005. Of the
          performance based options, 78,750 vested and 33,750 lapsed effective December
          30, 2005.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Upon grant, these options were scheduled to vest as follows: (i) to the extent
          of 37,500 thereof, at the rate of 9,375 upon grant and 9,375 annually (periodic
          vesting options); and (ii) to the extent of 112,500 thereof, upon the attainment
          of certain performance objectives (performance based options). The periodic
          vesting options were declared vested effective December 30, 2005. Of the
          performance based options, 84,375 vested and 28,125 lapsed effective December
          30, 2005.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Upon grant, these options were scheduled to vest as follows: (i) to the extent
          of 25,000 thereof, at the rate of 6,250 upon grant and 6,250 annually (periodic
          vesting options); and (ii) to the extent of 25,000 thereof, upon the attainment
          of certain performance objectives (performance based options). The periodic
          vesting options and performance based options were declared vested effective
          December 30, 2005.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Upon grant, these options were scheduled to vest at the rate of 55,000 upon
          grant and 5,000 annually. These options were declared vested effective December
          30, 2005.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Upon grant, these options were scheduled to vest at the rate of 60,000 upon
          grant and 10,000 annually. These options were declared vested effective December
          30, 2005.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

64

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Aggregate Year End Option
Value Table

The
following table sets forth information regarding the aggregate number and value of options
to purchase Common Stock held by the named executive officers as of December 31, 2005. No
options have been exercised:

`Number of Shares                $ Value of Unexercised
                             Underlying Unexercised              In-The-Money Options
                          Options at December 31, 2004         At December 31, 2004 (1)
                        -------------------------------     ------------------------------
   Name                          Exercisable                         Exercisable
   ----                          -----------                         -----------
   Edward J. Quilty                709,805                             $56,938
   John E. Yetter, CPA             361,250                             $28,013
   Robert C. Cole                  316,250                             $14,563
   Frederic Eigner                 221,875                              $6,094
   Barry Wolfenson                 120,000                              $2,500`

_________________

|(1) | Determined based on the fair market value
          for the Companys Common Stock at December 31, 2005 of $0.55 per share.
|--- | ---------------------------------------------------------------------------------------------------------------------------

Employment Arrangements

Edward J. Quilty

The
Company employs Edward J. Quilty, its Chairman, President and Chief Executive Officer,
pursuant to a two-year employment agreement, effective March 1, 2006, providing for base
compensation in the amount of $315,000 per year and incentive compensation in the
discretion of the Companys board of directors. The agreement further provides for
the payment of severance compensation in the amount of two-years base salary upon
failure of the Company to renew the agreement for successive two-year terms or for
termination of Mr. Quiltys employment other than for cause. In addition,
upon a change in control of the Company, Mr. Quilty may, within six-months of the change
in control, tender his resignation and receive two-years severance compensation.

John E. Yetter, CPA

The
Company employs John E. Yetter, CPA, its Vice President and Chief Financial Officer,
pursuant to a one-year employment agreement, renewed effective March 1, 2006, providing
for base compensation in the amount of $204,750 per year and incentive compensation in the
discretion of the Companys board of directors. The agreement further provides for
the payment of severance compensation in the amount of one-years base salary upon
failure of the Company to renew the agreement for successive one-year terms or for
termination of Mr. Yetters employment other than for cause. In addition,
upon a change in control of the Company, Mr. Yetter may, within six-months of the change
in control, tender his resignation and receive one-years severance compensation.

Robert C. Cole

The
Company employs Robert C. Cole, its Vice President for Sales and Marketing, pursuant to a
one-year employment agreement, renewed effective March 1, 2006, providing for base
compensation in the amount of $183,000 per year and incentive compensation in the
discretion of the Companys board of directors. The agreement further provides for
the payment of severance compensation in the amount of one-years base salary upon
failure of the Company to renew the agreement for successive one-year terms or for
termination of Mr. Coles employment other than for cause. In addition,
upon a change in control of the Company, Mr. Cole may, within six-months of the change in
control, tender his resignation and receive one-years severance compensation.

Frederic Eigner

The
Company employs Frederic Eigner, its Vice President and Executive Vice President 
Operations and General Manager of Derma Sciences Canada Inc., pursuant to a one-year
employment agreement, renewed effective March 1, 2006, providing for base compensation in
the amount of $151,163 ($174,960 Canadian) per year and

65

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incentive compensation in the
discretion of the Companys board of directors. The agreement further provides for
the payment of severance compensation in the amount of one-years base salary upon
failure of the Company to renew the agreement for successive one-year terms or for
termination of Mr. Eigners employment other than for cause. In addition,
upon a change in control of the Company, Mr. Eigner may, within six-months of the change
in control, tender his resignation and receive one-years severance compensation.

Barry J. Wolfenson

The
Company employs Barry J. Wolfenson, its Vice President for Marketing and Business
Development, pursuant to a one-year employment agreement, effective March 1, 2006,
providing for base compensation in the amount of $145,000 per year and incentive
compensation in the discretion of the Companys board of directors. The agreement
further provides for the payment of severance compensation in the amount of
one-years base salary upon failure of the Company to renew the agreement for
successive one-year terms or for termination of Mr. Wolfensons employment other than
for cause. In addition, upon a change in control of the Company, Mr. Wolfenson
may, within six-months of the change in control, tender his resignation and receive
one-years severance compensation.

Stock Option Plan

The
Company adopted the Stock Option Plan (the Plan) July 18, 1991 and amended the
Plan January 14, 1994, May 22, 1996, July 14, 1998, February 6, 2003 and February 24,
2004. The number of shares of Common Stock reserved for issuance pursuant to the Plan is
3,500,000 shares. The Plan authorizes the Company to grant two types of equity incentives:
(i) options intended to qualify as incentive stock options (ISOs)
as defined in Section 422 of the Internal Revenue Code of 1986, as amended, and (ii)
nonqualified stock options (NQSOs). The Plan authorizes options to be granted
to directors, officers, key employees and consultants of the Company, except that ISOs may
be granted only to employees. The Plan is administered by a committee of disinterested
directors designated by the Board of Directors (the Compensation Committee).
Subject to the provisions of the Plan, the Compensation Committee determines who is
eligible to receive stock options, together with the nature, amount, timing, exercise
price, vesting schedule and all other terms and conditions of the options to be granted.

Under
the Plan, ISOs and NQSOs may have a term of up to ten years. Stock options are not
assignable or transferable except by will or the laws of descent and distribution. Stock
options granted under the Plan which have lapsed or terminated revert to the status of
unissued and become available for reissuance.

At
December 31, 2005, options to purchase 3,036,625 shares of the Companys Common Stock
at prices in the range of $0.37 to $5.00 per share were issued and outstanding under the
Plan.

Equity Compensation Plan
Information

The
following table provides information concerning the Companys equity compensation
plans or individual arrangements that were approved by shareholders and those that were
not approved by shareholders as of December 31, 2005.

66

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`Number of Securities
                                                                               Remaining Available for
                             Number of Securities                               for Future Issuance
                               to be Issued Upon        Weighted-Average            Under Equity
                                  Exercise of          Exercise Price of         Compensation Plans
                              Outstanding Options,     Outstanding Options,    (Excluding Securities
Plan Category                 Warrants and Rights      Warrants and Rights      Reflected in Column 1)
-------------                 -------------------      -------------------      ----------------------

Equity Compensation Plans
Approved by Shareholders
                                 3,036,625 (1)                  $0.77                 463,375
Equity Compensation Plans
Not Approved by
Shareholders                     2,736,655 (2)                  $1.08                       0
                                 ---------                      -----                 -------

Total                            5,773,280                      $0.92                 463,375
                                 =========                      =====                 =======`

|(1) | The securities consist of Incentive Stock Options and Nonqualified Stock Options
          granted to officers, directors, employees and consultants in 1997, 1998, 2003,
          2004 and 2005 pursuant to the Companys Stock Option Plan. The per share
          exercise price of the options is in the range of $0.37 to $5.00. The shares of
          Common Stock underlying the options have not been registered under the
          Securities Act of 1933.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The securities consist of Nonqualified Stock Options granted to officers,
          directors, employees and consultants of the Company during the period 1995
          through 2002. These options were effected pursuant to employment agreements or
          stock option agreements recommended by the Compensation Committee of the
          Companys Board of Directors and approved by its Board of Directors. The
          per share exercise price of the options is in the range of $0.40 to $12.50. The
          shares of Common Stock underlying the options have not been registered under the
          Securities Act of 1933.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Code of Ethics

The
Company has adopted a code of ethics that applies to its principal executive officer,
principal financial officer, principal accounting officer (controller) and persons
performing similar functions. The Company has filed a copy of its code of ethics as
Exhibit 10.42 to its Form 10-KSB filed on March 31, 2003.

Item 11. Security Ownership of Certain Beneficial Owners and
Management and Related Shareholder Matters

The
following table sets forth as of March 31, 2006 certain information regarding the
beneficial ownership of shares of the Companys Common Stock by: (i) each person
known by the Company to own beneficially more than 5% of the outstanding shares of Common
Stock, (ii) each director of the Company, (iii) each officer of the Company, and (iv) all
directors and officers of the Company as a group:

67

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`Number of Shares               Percent
Name and Address of Beneficial Owner (1)                 Beneficially Owned (18)    Beneficially Owned (18)
----------------------------------------                 -----------------------    -----------------------

Galen III Partnerships (2).............................          5,675,513                35.04%
Kensington Management Group, LLC (3)...................          1,475,000                11.72%
Voyager Partners (4)...................................          1,428,572                11.63%
Edward J. Quilty (5)...................................          1,145,489                 8.78%
Hambrecht & Quist California (6).......................            624,167                 5.08%
Norman H. Pessin (7)...................................          1,003,000                 7.91%
Bushido Capital Master Fund (8)........................          1,000,000                 7.82%
William R. Grant (9)...................................            900,000                 7.21%
Endeavor Asset Management (10).........................            800,000                 6.31%
Stephen T. Wills, CPA, MST (11)........................            531,668                 4.19%
James T. O'Brien (12)..................................            446,600                 3.53%
C. Richard Stafford, Esq. (13).........................            370,000                 2.93%
John E. Yetter, CPA (14)...............................            401,250                 3.17%
Robert C. Cole (15)....................................            356,250                 2.82%
Frederic Eigner (16) ..................................            221,875                 1.77%
All directors and officers as a group (9 persons) (17)          10,623,645                73.95%`

_________________

|(1) | Except as otherwise noted, the address of each of the persons listed is: 214
          Carnegie Center, Suite 100, Princeton, New Jersey 08540.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Galen III Partnerships can be reached at: 610 Fifth Avenue, Fifth Floor, New
          York, New York 10020. Includes shares owned by Galen Partners III, L.P., Galen
          Partners International III, L.P. and Galen Employee Fund III, L.P. Ownership
          consists of: 1,762,000 shares of Common Stock, 125,003 shares of Class A
          Convertible Preferred Stock (Class A Preferred), 416,668 shares of
          Class B Convertible Preferred Stock (Class B Preferred), 619,055
          shares of Class C Convertible Preferred Stock (Class C Preferred),
          1,071,346 shares of Class D Convertible Preferred Stock (Class D
          Preferred), 1,309,441 warrants to purchase common stock exercisable at
          $0.50 per share (Class F Warrants) and exercisable options to
          purchase 372,000 shares of Common Stock. No additional options to purchase
          Common Stock will become exercisable within 60 days of March 31, 2006. Srini
          Conjeevaram, a director of the Company, is a former General Partner of the Galen
          III Partnerships.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Kensington Management Group, LLC can be reached at: 200 Park Avenue, New York,
          New York 10016. Includes shares owned by Kensington Partners L.P., Kensington
          Partners II L.P., Bald Eagle Fund Ltd., Peter Orthwein Managed Account and Peter
          Orthwein Family Trust. Ownership consists of: 1,175,500 shares of Common Stock,
          440,000 Class E Warrants and exercisable options to purchase 300,000 shares of
          Common Stock. No additional options to purchase Common Stock will become
          exercisable within 60 days of March 31, 2006. Richard J. Keim, a director of the
          Company, is a Managing Director of Kensington Management Group, LLC.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Voyager Partners can be reached at: Oakmont Corporation, 865 South Figueroa
          Street, Suite 700, Los Angeles, California 90017. Ownership consists of:
          1,428,572 shares of Common Stock.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Edward J. Quiltys ownership consists of: 385,684 shares of Common Stock,
          220,001 Class E Warrants, 50,000 Class G Warrants and exercisable options to
          purchase 709,805 shares of Common Stock. No additional options to purchase
          Common Stock will become exercisable within 60 days of March 31, 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Hambrecht & Quist California can be reached at: One Bush Street, San
          Francisco, California 94104. Ownership consists of: 624,167 shares of Common
          Stock and 440,000 Class E Warrants.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Norman H. Pessin can be reached at 455 East 57th Street, New York, New York.
          Ownership consists of 603,000 shares of Common Stock and 400,000 Class G
          Warrants.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Bushido Capital Master Fund can be reached at 275 Seventh Avenue, Suite 2000,
          New York, New York 10001. Ownership consists of 500,000 shares of Common Stock
          and 500,000 warrants to purchase Common Stock at $1.05 per share (Class G
          Warrants).
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | William R. Grant can be reached at 30 Sutton Place # 7B, New York, New York
          10022. Ownership consists of: 700,000 shares of Common Stock and 200,000 Class G
          Warrants.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

68

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|(10) | Endeavor Asset Management can be reached at 29 Broadway, Room 1125, New York,
          New York 10006. Ownership consists of: 400,000 shares of Common Stock and
          400,000 Class G Warrants.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Stephen T. Wills ownership consists of: 119,668 shares of Common Stock,
          58,668 Class E Warrants and exercisable options to purchase 412,000 shares of
          Common Stock. No additional options to purchase Common Stock will become
          exercisable within 60 days of March 31, 2006.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | James T. OBriens ownership consists of: 81,600 shares of Common
          Stock and exercisable options to purchase 325,000 shares of Common Stock. No
          additional options to purchase Common Stock will become exercisable within 60
          days of March 31, 2006.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | C. Richard Staffords ownership consists of: 35,000 shares of Common Stock,
          35,000 Class G Warrants and exercisable options to purchase 300,000 shares of
          Common Stock. No additional options to purchase Common Stock will become
          exercisable within 60 days of March 31, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) | John E. Yetters ownership consists of: 40,000 shares of Common Stock and
          exercisable options to purchase 361,250 shares of Common Stock. No additional
          options to purchase Common Stock will become exercisable within 60 days of March
          31, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) | Robert C. Coles ownership consists of: 25,000 shares of Common Stock and
          exercisable options to purchase 316,250 shares of Common Stock. No additional
          options to purchase Common Stock will become exercisable within 60 days of March
          31, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(16) | Frederic Eigners ownership consists of: exercisable options to purchase
          221,875 shares of Common Stock. No additional options to purchase Common Stock
          will become exercisable within 60 days of March 31, 2006.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(17) | Ownership consists of: Common Stock, Class A Preferred, Class B Preferred, Class
          C Preferred, Class D Preferred, Class E Warrants, Class F Warrants, Class G
          Warrants and options currently exercisable and exercisable within 60 days of
          March 31, 2006 to purchase shares of Common Stock.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) | The number of shares beneficially owned and the percent beneficially owned by
          each entity or individual assume the exercise of all exercisable options
          (including those that would be exercisable within 60 days of March 31, 2006),
          the exercise of all warrants and the conversion into Common Stock of all
          Convertible Preferred Stock owned by such entity or individual. The percent
          beneficially owned is a fraction the numerator of which is the number of shares
          of Common Stock beneficially owned by each entity or individual and the
          denominator of which is the number of outstanding shares of Common Stock plus
          the number of shares of Common Stock which would be issued upon exercise by the
          subject entity or individual of its/his/her own options and warrants and the
          conversion into Common Stock of its/his/her own Convertible Preferred Stock.
          This method of computing the percent beneficially owned results in the aggregate
          ownership percentages of all owners exceeding 100%.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Item 12. Certain
Relationships and Related Transactions

The
Company has a consulting agreement with its founder, former president and former director.
In 2005 and 2004 compensation and reimbursed expenses under this agreement were $26,087
and $28,643, respectively.

A
director of the Company was formerly a general partner in the firm that holds a
significant equity ownership of the Company. In 2004, the firm was paid a $45,000 private
equity fund raising commission.

Item 13. Exhibits

(a) Exhibits

`Exhibit
Number                                                   Description
------                                                   -----------

3.01                 Articles of Incorporation effective June 3, 1996 (previously filed as Exhibit B to the
                        Company's Proxy Statement filed on April 23, 1996 and incorporated herein by
                        reference).
3.02                 Amendment to the Articles of Incorporation effective February 10, 1998 (previously
                        filed as Exhibit A to the Company's Proxy Statement filed on December 22, 1997 and
                        incorporated herein by reference).
3.03                 Amendment to the Articles of Incorporation effective October 20, 1998 (previously filed
                        as Exhibit A to the Company's Proxy Statement filed on August 14, 1998 and
                        incorporated herein by reference).`

69

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`3.04                 Amendment to the Articles of Incorporation effective May 26, 1999 (previously filed as
                        Exhibit A to the Company's Proxy Statement filed on April 13, 1999 and incorporated
                        herein by reference).
3.05                 Amendment to the Articles of Incorporation effective August 2, 1999 (previously filed
                        as Exhibit 3 to the Company's Form 8-K filed on August 6, 1999 and incorporated
                        herein by reference).
3.06                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series A Convertible Preferred
                        Stock (previously filed as Exhibit 10.03 to the Company's Form 8-K filed on November
                        24, 1997 and incorporated herein by reference).
3.07                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series B Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on July 9,
                        1998 and incorporated herein by reference).
3.08                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series C Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on August
                        20, 1999 and incorporated herein by reference).
3.09                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series D Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on January
                        10, 2000 and incorporated herein by reference).
3.10                 Bylaws effective May 14, 1997 (previously filed as Exhibit 3.1 to the Company's Form
                        10-QSB filed on August 15, 1997 and incorporated herein by reference).
10.01*               Employment Agreement, dated March 1, 2004, between the Company and Edward J. Quilty
                        (previously filed as Exhibit 10.01 to the Company's Form 10-KSB filed on March 30,
                        2004 and incorporated herein by reference).
10.02*               Senior Management Stock Option Agreement, dated April 30, 1997, between the Company and
                        Edward J. Quilty (previously filed as Exhibit 10.05 to the Company's Form 8-K filed
                        on May 6, 1997 and incorporated herein by reference).
10.03*               Employment Agreement, dated March 1, 2004, between the Company and John E.
                        Yetter, CPA (previously filed as Exhibit 10.06 to the Company's Form 10-KSB filed on
                        March 30, 2004 and incorporated herein by reference).
10.04*               Employment Agreement, dated March 1, 2004, between the Company and Robert C. Cole
                        (previously filed as Exhibit 10.11 to the Company's Form 10-KSB filed on March 30,
                        2004 and incorporated herein by reference).
10.05*               Employment Agreement, dated March 1, 2005, between the Company and Frederic Eigner
                        (previously filed as Exhibit 10.42 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
10.06*+              Employment Agreement, dated March 1, 2006, between the Company and Barry J. Wolfenson.
10.07                Agreement and Plan of Merger dated December 27, 1999 by and among Derma Sciences, Inc.
                        and Genetic Laboratories Wound Care, Inc. (previously filed as Exhibit 10.01 to the
                        Company's Form 8-K filed on January 10, 2000 and incorporated herein by reference).
10.08                Asset Purchase Agreement and amendments thereto, dated June 28, 2002, July 12, 2002 and
                        July 18, 2002, by and between Derma Sciences, Inc. and Dumex Medical, Inc.
                        (previously filed as Exhibits 2.01, 2.02 and 2.03 to the Company's Form 8-K filed on
                        September 10, 2002 and incorporated herein by reference).
10.09                The Derma Sciences, Inc. Stock Option Plan, as amended February 24, 2004 (previously
                        filed as Appendix C to the Company's Proxy Statement filed April 5, 2004 and
                        incorporated herein by reference).
10.10                Purchase Agreement, dated February 28, 2002 relative to the private placement of
                        securities (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on
                        March 6, 2002 and incorporated herein by reference).`

70

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`10.11                Registration Rights Agreement, dated February 28, 2002 relative to the private
                        placement of securities (previously filed as Exhibit 10.02 to the Company's Form 8-K
                        filed on March 6, 2002 and incorporated herein by reference).

10.12                Offer of Finance dated July 23, 2002 relative to financing by the Company of the
                        purchase of the assets of Dumex Medical Inc. through the Laurentian Bank of Canada
                        (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on September 10,
                        2002 and incorporated herein by reference).
10.13                Guarantee of the Company dated on or about August 26, 2002 of indebtedness of Dumex
                        Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit
                        10.03 to the Company's Form 8-K filed on September 10, 2002 and incorporated herein
                        by reference).
10.14                Guarantee of the subsidiary of the Company, Sunshine Products, Inc., dated on or about
                        August 26, 2002 of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank
                        of Canada (previously filed as Exhibit 10.04 to the Company's Form 8-K filed on
                        September 10, 2002 and incorporated herein by reference).
10.15                Security Agreement of the Company dated on or about August 26, 2002 pledging collateral
                        to secure its guarantee of indebtedness of Dumex Medical Canada Inc. to the
                        Laurentian Bank of Canada (previously filed as Exhibit 10.05 to the Company's Form
                        8-K filed on September 10, 2002 and incorporated herein by reference).
10.16                Security Agreement of the subsidiary of the Company, Sunshine Products, Inc., dated on
                        or about August 26, 2002 pledging collateral to secure its guarantee of indebtedness
                        of Dumex Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as
                        Exhibit 10.06 to the Company's Form 8-K filed on September 10, 2002 and incorporated
                        herein by reference).
10.17                Bond Conversion Agreement, dated January 7, 2002, between the Company and Galen
                        Partners III, Galen Partners International III, Galen Employee Fund III (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on March 7, 2002 and
                        incorporated herein by reference).
10.18                Code of ethics applicable to the Company's principal executive officer, principal
                        financial officer and principal accounting officer (previously filed as Exhibit
                        10.42 to the Company's Form 10-KSB filed on March 31, 2003 and incorporated herein
                        by reference).
10.19                Form of Purchase Agreement relative to private placement of securities (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on June 12, 2003 and
                        incorporated herein by reference).
10.20                Form of Registration Rights Agreement relative to private placement of securities
                        (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on June 12, 2003
                        and incorporated herein by reference).
10.21                Asset Purchase Agreement, dated August 6, 2003, between the Company and GeriCare
                        Providers, Inc. (previously filed as Exhibit 10.01 to the Company's Form 8-K filed
                        on August 29, 2003 and incorporated herein by reference).
10.22                Purchase Agreement, dated January 9, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 2.01 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.23                Security Agreement dated January 9, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.24                Lease Agreement, dated January 9, 2003 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.25                Supply Agreement dated January , 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.03 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.26                Trademark License Agreement dated January , 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.04 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).`

71

---

`10.27                Trademark Assignment dated January, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.28                Amendment to Purchase Agreement, dated as of January 9, 2004 between the Company and
                        Kimberly-Clark Corporation (previously filed as Exhibit 2.01 to the Company's Form
                        8-K/A-2 filed on February 6, 2004 and incorporated herein by reference).
10.29                Form of Purchase Agreement relative to private placement of common stock (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on March 8, 2004 and
                        incorporated herein by reference).
10.30                Form of Registration Rights Agreement relative to private placement of common stock
                        (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on March 8, 2004
                        and incorporated herein by reference).
10.31                Form of Purchase Agreement relative to private placement of common stock and series G
                        warrants (previously filed as Exhibit 10.40 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
10.32                Form of Registration Rights Agreement relative to private placement of common stock and
                        series G warrants (previously filed as Exhibit 10.41 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
16.1                 Letter from previous certifying accountants concurring with the Company's statements
                        relative to this firm in the Company's report concerning its change of certifying
                        accountants (previously filed as Exhibit 16.1 to the Company's Form 8-K filed
                        October 4, 2004 and incorporated herein by reference).
21+                  Information relative to subsidiaries.
23.1+                Consent of J.H. Cohn LLP.
31.1+                Certification of the Principal Executive Officer pursuant to Section 302 of the
                        Sarbanes-Oxley act of 2002.
31.2+                Certification of the Principal Financial Officer pursuant to Section 302 of the
                        Sarbanes-Oxley act of 2002.
32.1+                Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as
                        adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2+                Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as
                        adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.`

_________________

* Management contract or compensatory
plan.

+ Exhibit filed with this report.

Item 14. Principal
Accountant Fees and Services

Independent Registered
Public Accounting Firm Fees

Fees
for professional services provided by the Companys Independent Registered Public
Accounting Firms, J.H. Cohn LLP for the year ended December 31, 2005, J.H. Cohn LLP
(effective September 29, 2004) and Ernst & Young LLP (prior to September 29, 2004) for
the year ended December 31, 2004, are as follows:

`2005                 2004
                                     ----                 ----

    Audit fees                     $196,775             $188,645
    Audit related fees                    -               16,985
    Tax fees                         14,540               26,265
                                   --------             --------

    Totals                         $211,315             $231,895
                                   ========             ========`

Audit Fees

Audit
fees consist of fees relative to the audit of the Companys year-end financial
statements and review of the Companys quarterly reports on Form 10-QSB.

72

---

Audit Related Fees

The
2004 audit related fees principally relate to the Form 8-K in connection with the
Kimberly-Clark Corporation wound care acquisition.

Tax Fees

Tax
fees consist of fees relative to preparation of the Companys consolidated United
States federal, state and local and Canadian tax returns in 2005 and 2004.

Audit Committee
Pre-Approval Policy

It
is the policy of the Companys audit committee to approve all engagements of the
Companys independent auditors to render audit or non-audit services prior to the
initiation of such services.

73

---

SIGNATURES

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

|               | DERMA SCIENCES, INC.                                
|-------------- | ----------------------------------------------------
|               |                                                     
|               |                                                     
|March 30, 2006 | By: /s/ Edward J. Quilty                            
|               | Edward J.
     Quilty                               
|               | Chairman,
     President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following
persons on behalf of the Registrant and in the capacities indicated on March 30, 2006.

| | Signatures: |  |  | Title: | 
| | ----------- |  |  | ------ | 

|/s/ Edward J. Quilty       | President, Chief Executive Officer and Chairman of the Board
|-------------------------- | ------------------------------------------------------------
|Edward J. Quilty           | of Directors (Principal Executive
     Officer)             
|                           |                                                             
|/s/ John E. Yetter         | Vice President and Chief Financial Officer                  
|John E. Yetter, CPA        | (Principal Financial and Accounting
     Officer)           
|                           |                                                             
|/s/ Srini Conjeevaram      | Director                                                    
|Srini Conjeevaram          |                                                             
|                           |                                                             
|/s/ Stephen T. Wills       | Director                                                    
|Stephen T. Wills, CPA, MST |                                                             
|                           |                                                             
|/s/ James T. O'Brien       | Director                                                    
|James T. O'Brien           |                                                             
|                           |                                                             
|/s/ C. Richard Stafford    | Director                                                    
|C. Richard Stafford, Esq.  |                                                             
|                           |                                                             
|/s/ Richard J. Keim        | Director                                                    
|Richard J. Keim            |                                                             
|                           |                                                             
|/s/ Robert G. Moussa       | Director                                                    
|Robert G. Moussa           |                                                             

74

---

`EXHIBIT INDEX
-------------


Exhibit
Number                                                   Description
------                                                   -----------

3.01                 Articles of Incorporation effective June 3, 1996 (previously filed as Exhibit B to the
                        Company's Proxy Statement filed on April 23, 1996 and incorporated herein by
                        reference).
3.02                 Amendment to the Articles of Incorporation effective February 10, 1998 (previously
                        filed as Exhibit A to the Company's Proxy Statement filed on December 22, 1997 and
                        incorporated herein by reference).
3.03                 Amendment to the Articles of Incorporation effective October 20, 1998 (previously filed
                        as Exhibit A to the Company's Proxy Statement filed on August 14, 1998 and
                        incorporated herein by reference).
3.04                 Amendment to the Articles of Incorporation effective May 26, 1999 (previously filed as
                        Exhibit A to the Company's Proxy Statement filed on April 13, 1999 and incorporated
                        herein by reference).
3.05                 Amendment to the Articles of Incorporation effective August 2, 1999 (previously filed
                        as Exhibit 3 to the Company's Form 8-K filed on August 6, 1999 and incorporated
                        herein by reference).
3.06                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series A Convertible Preferred
                        Stock (previously filed as Exhibit 10.03 to the Company's Form 8-K filed on November
                        24, 1997 and incorporated herein by reference).
3.07                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series B Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on July 9,
                        1998 and incorporated herein by reference).
3.08                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series C Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on August
                        20, 1999 and incorporated herein by reference).
3.09                 Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
                        Preferred Stock of Derma Sciences, Inc. Designated Series D Convertible Preferred
                        Stock (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on January
                        10, 2000 and incorporated herein by reference).
3.10                 Bylaws effective May 14, 1997 (previously filed as Exhibit 3.1 to the Company's Form
                        10-QSB filed on August 15, 1997 and incorporated herein by reference).
10.01*               Employment Agreement, dated March 1, 2004, between the Company and Edward J. Quilty
                        (previously filed as Exhibit 10.01 to the Company's Form 10-KSB filed on March 30,
                        2004 and incorporated herein by reference).
10.02*               Senior Management Stock Option Agreement, dated April 30, 1997, between the Company and
                        Edward J. Quilty (previously filed as Exhibit 10.05 to the Company's Form 8-K filed
                        on May 6, 1997 and incorporated herein by reference).
10.03*               Employment Agreement, dated March 1, 2004, between the Company and John E.
                        Yetter, CPA (previously filed as Exhibit 10.06 to the Company's Form 10-KSB filed on
                        March 30, 2004 and incorporated herein by reference).
10.04*               Employment Agreement, dated March 1, 2004, between the Company and Robert C. Cole
                        (previously filed as Exhibit 10.11 to the Company's Form 10-KSB filed on March 30,
                        2004 and incorporated herein by reference).
10.05*               Employment Agreement, dated March 1, 2005, between the Company and Frederic Eigner
                        (previously filed as Exhibit 10.42 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
10.06*+              Employment Agreement, dated March 1, 2006, between the Company and Barry J. Wolfenson.
10.07                Agreement and Plan of Merger dated December 27, 1999 by and among Derma Sciences, Inc.
                        and Genetic Laboratories Wound Care, Inc. (previously filed as Exhibit 10.01 to the
                        Company's Form 8-K filed on January 10, 2000 and incorporated herein by reference).
10.08                Asset Purchase Agreement and amendments thereto, dated June 28, 2002, July 12, 2002 and
                        July 18, 2002, by and between Derma Sciences, Inc. and Dumex Medical, Inc.
                        (previously filed as Exhibits 2.01, 2.02 and 2.03 to the Company's Form 8-K filed on
                        September 10, 2002 and incorporated herein by reference).
10.09                The Derma Sciences, Inc. Stock Option Plan, as amended February 24, 2004 (previously
                        filed as Appendix C to the Company's Proxy Statement filed April 5, 2004 and
                        incorporated herein by reference).
10.10                Purchase Agreement, dated February 28, 2002 relative to the private placement of
                        securities (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on
                        March 6, 2002 and incorporated herein by reference).
10.11                Registration Rights Agreement, dated February 28, 2002 relative to the private
                        placement of securities (previously filed as Exhibit 10.02 to the Company's Form 8-K
                        filed on March 6, 2002 and incorporated herein by reference).
10.12                Offer of Finance dated July 23, 2002 relative to financing by the Company of the
                        purchase of the assets of Dumex Medical Inc. through the Laurentian Bank of Canada
                        (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on September 10,
                        2002 and incorporated herein by reference).
10.13                Guarantee of the Company dated on or about August 26, 2002 of indebtedness of Dumex
                        Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit
                        10.03 to the Company's Form 8-K filed on September 10, 2002 and incorporated herein
                        by reference).
10.14                Guarantee of the subsidiary of the Company, Sunshine Products, Inc., dated on or about
                        August 26, 2002 of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank
                        of Canada (previously filed as Exhibit 10.04 to the Company's Form 8-K filed on
                        September 10, 2002 and incorporated herein by reference).
10.15                Security Agreement of the Company dated on or about August 26, 2002 pledging collateral
                        to secure its guarantee of indebtedness of Dumex Medical Canada Inc. to the
                        Laurentian Bank of Canada (previously filed as Exhibit 10.05 to the Company's Form
                        8-K filed on September 10, 2002 and incorporated herein by reference).
10.16                Security Agreement of the subsidiary of the Company, Sunshine Products, Inc., dated on
                        or about August 26, 2002 pledging collateral to secure its guarantee of indebtedness
                        of Dumex Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as
                        Exhibit 10.06 to the Company's Form 8-K filed on September 10, 2002 and incorporated
                        herein by reference).
10.17                Bond Conversion Agreement, dated January 7, 2002, between the Company and Galen
                        Partners III, Galen Partners International III, Galen Employee Fund III (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on March 7, 2002 and
                        incorporated herein by reference).
10.18                Code of ethics applicable to the Company's principal executive officer, principal
                        financial officer and principal accounting officer (previously filed as Exhibit
                        10.42 to the Company's Form 10-KSB filed on March 31, 2003 and incorporated herein
                        by reference).
10.19                Form of Purchase Agreement relative to private placement of securities (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on June 12, 2003 and
                        incorporated herein by reference).
10.20                Form of Registration Rights Agreement relative to private placement of securities
                        (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on June 12, 2003
                        and incorporated herein by reference).
10.21                Asset Purchase Agreement, dated August 6, 2003, between the Company and GeriCare
                        Providers, Inc. (previously filed as Exhibit 10.01 to the Company's Form 8-K filed
                        on August 29, 2003 and incorporated herein by reference).
10.22                Purchase Agreement, dated January 9, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 2.01 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.23                Security Agreement dated January 9, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.01 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.24                Lease Agreement, dated January 9, 2003 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.25                Supply Agreement dated January , 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.03 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.26                Trademark License Agreement dated January , 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.04 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.27                Trademark Assignment dated January, 2004 between the Company and Kimberly-Clark
                        Corporation (previously filed as Exhibit 10.05 to the Company's Form 8-K filed on
                        January 23, 2004 and incorporated herein by reference).
10.28                Amendment to Purchase Agreement, dated as of January 9, 2004 between the Company and
                        Kimberly-Clark Corporation (previously filed as Exhibit 2.01 to the Company's Form
                        8-K/A-2 filed on February 6, 2004 and incorporated herein by reference).
10.29                Form of Purchase Agreement relative to private placement of common stock (previously
                        filed as Exhibit 10.01 to the Company's Form 8-K filed on March 8, 2004 and
                        incorporated herein by reference).
10.30                Form of Registration Rights Agreement relative to private placement of common stock
                        (previously filed as Exhibit 10.02 to the Company's Form 8-K filed on March 8, 2004
                        and incorporated herein by reference).
10.31                Form of Purchase Agreement relative to private placement of common stock and series G
                        warrants (previously filed as Exhibit 10.40 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
10.32                Form of Registration Rights Agreement relative to private placement of common stock and
                        series G warrants (previously filed as Exhibit 10.41 to the Company's Form 10-KSB filed on March 31,
                        2005 and incorporated herein by reference).
16.1                 Letter from previous certifying accountants concurring with the Company's statements
                        relative to this firm in the Company's report concerning its change of certifying
                        accountants (previously filed as Exhibit 16.1 to the Company's Form 8-K filed
                        October 4, 2004 and incorporated herein by reference).
21+                  Information relative to subsidiaries.
23.1+                Consent of J.H. Cohn LLP.
31.1+                Certification of the Principal Executive Officer pursuant to Section 302 of the
                        Sarbanes-Oxley act of 2002.
31.2+                Certification of the Principal Financial Officer pursuant to Section 302 of the
                        Sarbanes-Oxley act of 2002.
32.1+                Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as
                        adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2+                Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as
                        adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.`

_________________

* Management contract or compensatory
plan.

+ Exhibit filed with this report.