UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





x
            Annual
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the fiscal year ended December 31,
2009





 ̈
            Transition
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the transition period from _____ to
  _____





Commission
file number: 1-31070





DERMA
SCIENCES, INC.


(Name of
Issuer in Its Charter)





Pennsylvania
              
              23-2328753(State
      or other jurisdiction of
              
              (I.R.S.
      Employerincorporation
      or organization)
              
              Identification
      No.)





214 Carnegie Center, Suite 300, 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 registeredCommon
      Stock, $.01 par value
              
              The
      NASDAQ Stock Market LLC





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





Title of
Class





Common
Stock, $.01 par value





Indicate by check mark if the
Registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.


Yes  ̈           No
x





Indicate by check mark if the
Registrant is not required to file reports pursuant to Section 13 or Section
15(d) of the Act.


Yes  ̈           No
x





Indicate by checkmark whether the
Registrant: (1) has filed all reports required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the Registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90
days.


Yes xNo  ̈





Indicate by check mark whether the
Registrant has submitted electronically and posted on its corporate Web site, if
any, every Interactive Data File required to be submitted and posted pursuant to
Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12
months (or for such shorter period that the Registrant was required to submit
and post such files).


Yes  ̈           No
 ̈





Indicate by checkmark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of the Registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K.x





Indicate by check mark whether the
Registrant is a large accelerated filer, an accelerated filer, a non-accelerated
filer, or a smaller reporting company. See the definitions of “large accelerated
filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





Large accelerated filer
                 ̈
                
                Accelerated
      filer
                 ̈Non-accelerated filer
                 ̈ (Do not check if a smaller
      reporting company)
                
                Smaller reporting company
                x





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


Yes  ̈           No
x





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 June 30, 2009, was approximately
$8,601,404.





The number of shares outstanding of the
issuer's common equity as of February 28, 2010 was 6,557,855.





Documents
Incorporated by Reference





Portions of the Registrant’s
definitive proxy statement for its 2010 annual meeting of shareholders are
incorporated by reference in Part III of this report.









Part I





Item
1. Description of Business





Overview





Derma
Sciences and its subsidiaries Sunshine Products, Derma Canada and Derma First
Aid Products, Inc. are referred to collectively as "We” and “Company.” Our
executive offices are located at 214 Carnegie Center, Suite 300 Princeton, New
Jersey.





We are a
specialty medical device/pharmaceutical company with a primary focus on wound
care. We engage in the manufacture, marketing and sale of three proprietary
dermatological related product lines: (1) wound care, (2) wound closure and
specialty securement devices, and (3) skin care. In addition, we have leveraged
our expanding manufacturing capabilities by building a growing private
label/original equipment manufacture (“OEM”) business. Our customers consist of
various health care agencies and institutions such as wound care centers,
long-term care facilities, hospitals, home healthcare agencies, physicians’
offices and closed door pharmacies. We also sell our products through retail
channels such as retail pharmacies, other retail outlets and first-aid kit
manufacturers. While we have our own direct selling organization, our products
are principally sold through medical products supply distributors. We currently
sell our products in the United States, Canada and select international markets.
Our principal U.S. distribution facilities are located in St. Louis, Missouri,
and Houston, Texas. In Canada, our products are distributed exclusively by a
third party distributor. Our principal manufacturing facility is located in
Toronto, Canada. We, through our subsidiary Derma Sciences Canada, have a light
manufacturing facility in Nantong, China producing low volume and/or labor
intensive wound care products.





The
markets we serve are large and growing. Our mission is to enhance shareholder
value by servicing a significant portion of these markets as a fully integrated
wound care product provider.





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 we acquired Genetic Laboratories Wound Care, Inc. (“Genetic
Labs”) by means of a tax-free reorganization whereby Genetic Labs became our
wholly-owned subsidiary. In December, 1999, pursuant to an Agreement and Plan of
Merger dated December 27, 1999, Genetic Labs was merged into Derma Sciences,
Inc. by means of a tax-free reorganization whereby the separate corporate
existence of Genetic Labs ceased. The Genetic Labs products constitute our wound
closure – specialty securement device product line.





In
November, 1998 we acquired the stock of Sunshine Products, Inc. (“Sunshine
Products”) in a cash transaction. As a result of the stock purchase, Sunshine
Products became our wholly-owned subsidiary. The Sunshine Products products
constitute our skin care product line.





In
September, 2002 we 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 our wholly-owned Canadian
subsidiary, Derma Sciences Canada Inc. (“Derma Canada”) f/k/a Dumex Medical
Canada Inc. The Dumex Medical products have been integrated into our wound care
product line.





In
January 2004, we acquired substantially all the assets of Kimberly-Clark
Corporation’s wound care segment. These assets have been integrated into both
our existing wound care and wound closure — specialty securement
device product lines.





In April
2006, we acquired certain assets and the business of Western Medical, Inc.
(“Western Medical”), a manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. These assets have
been integrated into our existing wound care product line.





In
November, 2007, we acquired certain assets and the business of Nutra Max
Products, Inc.’s first aid division (“FAD”). FAD is a leading manufacturer and
marketer of branded and private label adhesive strips and related first aid
products to the medical, industrial and retail markets. These assets have been
integrated into our existing wound care product line.


2





Products





Advanced/Active
Wound Care





Our
advanced/active wound care products include the following:





Medihoney is a line of novel,
patented dressings, comprised of a high percentage of Active Leptospermum Honey. This
unique type of honey has been shown to result in durable antimicrobial,
anti-inflammatory and immunomodulatory activities. Medihoney dressings are ideal
for the management of non-chronic and hard-to-heal wounds including chronic
ulcers, burns and post-operative wounds. The dressings are non-toxic and have
been shown in a large scale randomized controlled study to promote
healing.





Bioguard is a line of novel,
patented barrier dressings that contain an active antimicrobial compound. This
compound, a cationic biocide, is intrinsically bound to the dressing through a
proprietary process resulting in the inability for the compound to separate from
the dressing. These dressings are ideal for prophylactic use in the prevention
of hospital or community acquired infections through wound sites. The dressings
have been shown to kill 99.9% of virulent bacteria such as methicillin resistant
staphylococcus aureus
(MRSA) in less than 1 minute, and 99.999% of MRSA in less than 1 hour. Bioguard’s patented polymer
technology known as NIMBUS (novel intrinsically micro-biocidal utility
substrate) was licensed from QuickMed Technologies, Inc. in April,
2007.





Algicell Ag is a proprietary
antimicrobial dressing utilizing ionic silver as its active ingredient. The
dressing can absorb up to 20 times its weight in wound fluid. These dressings
compare favorably to the market leading dressings at a cost-effective price
point.





Xtrasorb is a novel,
proprietary dressing that utilizes a super absorbent polymer. While other
absorbing dressings currently on the market use open cell structures to capture
fluid, Xtrasorb
dressings convert fluid within the dressing to a gel thus locking the exudates
into the dressing. Xtrasorb dressings have a
distinct advantage over competitive dressings in that they absorb more fluid and
hold the fluid away from the wound thus avoiding further deterioration of the
wound.





TCC-EZ is a novel, patented
advanced dressing system for the management of diabetic foot ulcers. It is
considered a “next generation” total contact casting (TCC) system. TTC has been
shown in multiple randomized controlled studies to achieve 89% heal rates.
However, TTC is utilized in less than 2% of otherwise indicated cases due to
various factors such as long application times, frequency of application error
and patient dissatisfaction as a result of the heavy nature of the cast. TCC-EZ virtually eliminates
these issues as it can be applied in less than one third the time of a
traditional TCC, is a one-step process — so application errors are
uncommon — and the cast itself is significantly
lighter — due to its open weave pattern — than a traditional
TCC.





Other
advanced wound care products include a range of moist, occlusive dressings such
as hydrocolloids, foams, hydrogels, alginates, additional silver antimicrobial
dressings, cleansers and our proprietary Dermagran
products.





Traditional
Wound Care





Our
traditional wound care line consists of gauze sponges and bandages, non-adherent
impregnated dressings, retention devices, paste bandages and other compression
devices. We also manufacture and market a broad line of adhesive bandages and
related first aid products for the medical, industrial, private label and retail
markets.





Private
Label/OEM





We
manufacture private label wound care and adhesive bandages for a number of
United States and international customers.


3





Wound
Closure and Specialty Securement Devices





We market
a line of wound closure strips, nasal tube fasteners and a variety of catheter
fasteners to doctors, clinics, nursing homes, hospitals and other institutions.
Our specialty securement and closure device products incorporate our proprietary
polyamide fabrics in combination with a pressure sensitive skin-friendly
adhesive. These product combinations result in an ideal balance between
elasticity and adherence, making the products unique in their ability to safely
hold devices in place on the skin while assisting with the closure of sensitive
areas of the skin where a good cosmetic outcome is a priority. We also market a
line of traditional rigid wound closure strips.





Skin
Care





We market
general purpose and specialized skin care products to nursing homes, hospitals,
home healthcare agencies and other institutions. These products include barrier
creams and ointments, antibacterial cleansing foams and sprays, shampoos and
body washes, hand sanitizers, bath additives, body oils and
moisturizers





Product
Pipeline





We are
currently developing DSC127, an angiotensin analog licensed from the University
of Southern California in November, 2007, for use in wound healing and scar
reduction. The compound has shown activity in these areas in pre-clinical animal
model testing. The compound has successfully completed a phase I human trial and
is presently undergoing phase II human trials. This trial will assess safety and
efficacy of DSC127 on non-healing diabetic ulcers. We expect to receive the
results of the phase II trials in the third quarter, 2010. If the results are
favorable, we will ascertain whether it is in our best interests to conduct
phase III trials or license the rights to the product.





The
potential markets for DSC127 include: (1) the $10 billion chronic wound market,
(2) the $8 billion scar prevention/reduction market, (3) the $6 billion burn
market, and (4) the $6 billion radiation and other wound markets. The markets we
enter will depend on the results of the DSC127 clinical trials.





We
continue to evaluate certain products and technologies within the
advanced/active wound care market. Once products and technologies are located,
we may enter into licensing agreements or joint venture relationships with
owners of the products and technologies.





We have
several ongoing product development programs involving line-extensions of our
key brands including Medihoney , Bioguard and Xtrasorb . We anticipate new
line extensions to begin coming to market in the second quarter, 2010 and
continuing through the third quarter, 2011.





Sales and
Marketing





Sales in
the United States and Canada account for approximately 70% and 25%,
respectively, of our total sales with sales to Europe and Latin America
comprising the balance of 5%.





United
States





In the
United States, we employ a direct sales force and a number of national, regional
and local distributors (with their own sales forces) to sell our products. The
majority of our sales are made to distributors and large institutional customers
who sell the products to end users. Direct sales to end users are not a
significant part of our business.





Our
direct sales force consists of an executive vice president – sales, a
national director – sales, ten direct territory representatives and one clinical
resource specialist. Our sales employees receive a base salary together with
commissions based upon sales and gross profit achievement within their area of
responsibility.


4





Canada





In
Canada, we employ a sales manager, one direct sales representative in Ontario
and a manufacturer’s representative located in British Colombia. Our sales
representative receives a base salary together with commissions based upon
territory sales achievement. Our manufacturer’s representative is paid
commission based upon territory sales achievement and is reimbursed for
expenses. The majority of our 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 Centre’s (CCAC) agencies.





In May
2005, we entered into a five year agreement with a Canadian company to serve as
the exclusive distributor of our products in Canada. In November 2009, this
agreement was extended for one year through May, 2011. The distributor maintains
strategically located distribution centers and over 40 sales representatives
throughout Canada. We believe the agreement provides better service to our
customers throughout Canada and greater opportunity for sales
growth.





Other
Foreign Markets





Our
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 $2,448,342 in 2009 and
$2,743,388 in 2008.





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 us. 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
ours. 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, our basic wound care products compete in a commodity oriented
marketplace with Covidien, Medical Action and a number of others. In the
advanced wound care products marketplace, we compete principally with Convatec,
Smith & Nephew, MoInlycke and Systagenix (formerly Johnson & Johnson’s
wound care division) and Johnson & Johnson. Our adhesive bandage and related
first aid products compete with Medline, ASO and Dynerex in the medical market,
Medline and ASO in the industrial market, ASO, Medline and Liberty in the
private label market and Johnson & Johnson, 3M and Medline in the retail
market. 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. Our skin care products compete in a
commodity oriented marketplace with Medline, Provon and a number of
others.





In
Canada, our basic wound care products compete in a commodity-oriented
marketplace with Covidien, Medicom, Medical Mart and a number of others. In the
advanced wound care products marketplace, we compete principally with the same
competitors as we compete with in the United States together with a number of
domestic generic companies.





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


5





Product
Sourcing





We lease
manufacturing and warehousing facilities in Toronto, Canada, and Nantong, China,
and employ contract manufacturers in Mexico City, Mexico, and ZhongShan, China.
Approximately 60% of our products are manufactured at these four locations. The
remaining 40% of our products are manufactured by third party manufacturers in
the U.S., China and other countries.





Our four
manufacturing facilities are monitored and controlled by our management and
quality control teams. These teams oversee product production. Most of the
equipment in these facilities is owned by us and used exclusively by
us.





Our
76,399 square foot facility in Toronto manufactures our line of basic and
advanced wound care and wound closure-specialty securement device products. This
facility has the capability of liquid packaging, blister/vacuum packaging,
impregnation, die-cutting and steam sterilization. We also have research and
development laboratories on site. The Toronto facility is ISO 13485:2003, ISO
9001:2000, and Directive 93/42/EEC certified and SGS registered.





Our
11,388 square foot facility in Nantong manufactures our line of basic and some
advanced wound care products. This facility is primarily designed for production
of low volume and specialty products. The quality control team at Nantong has
the responsibility to oversee and inspect all products produced in China for us.
The Nantong facility is ISO 9002 certified and TUV registered.





Both our
Mexico City and ZhongShan facilities manufacture adhesive bandages and related
first aid products. The Mexico City facility is ISO 9001:2000 and ISO 13485:2004
certified and Aenor IQNET registered. The ZhongShan facility is ISO 13485:2003
certified and NQA registered.





A number
of basic and advanced wound care products are sourced in semi-finished and
finished form directly from suppliers. Derma Sciences Canada also serves in a
distributor capacity (sourcing finished products directly from suppliers) for a
number of medical device products in Canada.





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





We
require that all of our 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, Trademarks,
Proprietary and Non-Proprietary Technology





We own or
license the following trademarks: Derma Sciences, Dermagran, American White Cross, Dumex, Medihoney, Algicell, Xtrasorb, TCC-EZ and Bioguard. In addition, we own
or license over fifty United States patents, corresponding foreign patents and
patent applications. Most of our patents related to our DSC127 technology are
held under license agreements of indefinite duration. The license agreement
relative to our Bioguard technology expires
in June, 2014. We recently entered into an agreement extending our Medihoney license in
perpetuity. Subject to meeting minimum royalty and other specified conditions,
we expect to maintain these licenses indefinitely. We also have a number of
non-patented formulations and process technologies that, together with the
aforementioned patents, provide competitive advantages in the
marketplace.





We
believe our patents, proprietary and non-proprietary technology afford us
reasonable protection 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, or superior, to ours without
infringing upon our intellectual property.


6





Patent
law relating to the scope of claims with respect to wound care products is still
evolving and our 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 our 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 we 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 our
business.





Government
Regulation





United
States — Scope of Regulation





Agencies





The
manufacture, distribution and advertising of our 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 our 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 analagous to 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.





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 normally expensive to compile. Approval of Class
III devices may require several years.





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.


7





All of
the devices currently marketed by us, 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 and meet the performance standards
established by the FDA. Algicell Ag Dressings with
antimicrobial silver and Medihoney Wound & Burn
Dressings with Active Leptospermum Honey are
unclassified. We and our principal suppliers with respect to products sold to us
operate in accordance with GMP.





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.





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. We
believe all of the OTC products currently marketed by us have been deemed to be
generally recognized as safe and effective and not misbranded.





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.


8





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.





Drugs





The
Health Products and Food Branch Inspectorate of Health Canada regulates 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 last underwent an inspection
by the Health Products and Food Branch Inspectorate in August 2007 which
occasioned the renewal and subsequent annual renewal of its Drug Establishment
License.





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.





Registration
and Status of Derma Canada Products Sold in United States





Derma
Canada has passed inspection by the FDA.





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, we are 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.





We are
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 we are 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 us.





Third Party Reimbursement in
the United States





In the
United States, we sell our 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 our products are
purchased often are covered by medical insurance. Accordingly, our customers
routinely seek reimbursement for the cost of our 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 our 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.


9





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 our wound care and
fixation products are eligible for Medicare reimbursement.





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 and/or increases in
mandatory rebates for wound care products. As such, there is uncertainty as to
whether, and to what extent, reimbursements for our products will continue to be
available.





Employees





We
maintained 163 full-time and 11 part-time employees at December 31, 2009. Of
these employees, 67 are located in the United States, 67 in Canada and 40 in
China. We consider our employee relations to be satisfactory.





Item
1A. Risk Factors





We
have a history of losses and can offer no assurance of future
profitability.





We
incurred losses of $1,143,272 in 2009, $3,961,937 in 2008, $2,284,605 in 2007,
$1,099,990 in 2005, $2,338,693 in 2004, $2,581,337 in 2000 and $2,998,919 in
1999. At December 31, 2009, we had an accumulated deficit of $20,807,095. We
cannot offer any assurance that we will be able to generate sustained or
significant future earnings.





Our
liquidity may be dependent upon amounts available under our existing line of
credit or amounts available through additional debt or equity
financings.





We have a
history of operating losses and negative cash flow from operating activities. As
such, we have utilized funds from offerings of our equity securities and lines
of credit to fund our operations. We have taken steps to improve our overall
liquidity and believe we have sufficient liquidity to meet our needs for the
foreseeable future. However, in the event our cash flow from operating
activities is insufficient to meet our requirements, we may be forced either to
refinance our current line of credit or seek additional equity financing. The
sale of additional securities could result in additional dilution to our
shareholders. The incurrence of indebtedness would result in increased debt
service obligations and could result in operating and financing covenants that
would restrict our operations. There can be no assurance that such financing
would be available or, if available, that such financing could be obtained upon
terms acceptable to us.





Our
foreign operations are essential to our economic success and are subject to
various unique risks.





Our
future operations and earnings will depend to a large extent on the results of
our operations in Canada and our ability to maintain a continuous supply of
basic wound care products from our operations in China and suppliers in China
and Mexico. While we do not envision any adverse change to our operations in
Canada, China or Mexico, adverse changes to these operations, as a result of
political, governmental, regulatory, economic, exchange rate, labor, logistical
or other factors, could have an adverse effect on our future operating
results.





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





Sales of
several of our wound care products depend partly on the ability of our customers
to obtain reimbursement for the cost of our 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. Our ability to commercialize our products successfully will
depend in part on the extent to which reimbursement for the costs of such
products and related treatments will be available from government health
administration authorities, private health insurers and other third-party
payors. Significant uncertainty exists as to the reimbursement status of newly
approved medical products. The continuing efforts of the government, insurance
companies, managed care organizations and other payors of healthcare services to
contain or reduce costs of healthcare may adversely affect:


10




•      Our
ability to set a price we believe is fair for our products;


•      Our ability to generate revenues or
achieve or maintain profitability; and


•      The availability to us of
capital.





Payors
are increasingly attempting to contain healthcare costs by limiting both
coverage and the level of reimbursement, particularly for new therapeutic
products or where payors perceive that the target indication of the new product
is well-served by existing drugs or other treatments. Accordingly, even if
coverage and reimbursement are provided, market acceptance of our products would
be adversely affected if the amount of coverage and/or reimbursement available
for the use of our products proved to be unprofitable for healthcare providers
or less profitable than alternative treatments.





There
have been federal and state proposals to subject the pricing of healthcare goods
and services to government control and to make other changes to the U.S.
healthcare system. While we cannot predict the outcome of current or future
legislation, we anticipate, particularly given the recent enactment of
healthcare reform legislation, that Congress and state legislatures will
introduce initiatives directed at lowering the total cost of healthcare. In
addition, in certain foreign markets the pricing of drugs is subject to
government control and reimbursement may in some cases be unavailable or
insufficient. It is uncertain if future legislative proposals, whether domestic
or abroad, will be adopted that might affect our products. It is also uncertain
what actions federal, state or private payors for healthcare treatment and
services may take in response to any such healthcare reform proposals or
legislation. Any such healthcare reforms could have a material and adverse
effect on the marketability of any products for which we ultimately receive FDA
or other regulatory agency approval or for which we receive government sponsored
reimbursements.





Our
success may depend upon our ability to protect our patents and proprietary
technology.





We own
patents, both in the United States and abroad, for several of our products, and
rely upon the protection afforded by our patents and trade secrets to protect
our technology. Our future success, if any, may depend upon our ability to
protect our intellectual property. However, the enforcement of intellectual
property rights can be both expensive and time consuming. Therefore, we may not
be able to devote the resources necessary to prevent infringement of our
intellectual property. Also, our competitors may develop or acquire
substantially similar technologies without infringing our patents or trade
secrets. For these reasons, we cannot be certain that our patents and
proprietary technology will provide us with a competitive
advantage.





Government
regulation plays a significant role in our ability to acquire and market
products.





Government
regulation by the United States Food and Drug Administration and similar
agencies in other countries is a significant factor in the development,
manufacturing and marketing of many of our products and in our acquisition or
licensing of new products. Complying with government regulations is often time
consuming and expensive and may involve delays or actions adversely impacting
the marketing and sale of our current or future products.





Approximately
forty percent of our products are sourced from third parties.





Approximately
forty percent of our products are sourced in raw, semi-finished and finished
form directly from third party suppliers. None of these suppliers presently
account for more than ten percent of our sales. We maintain good relations with
our third party suppliers. There are several third party suppliers available for
each of our products. If a current supplier were unable or unwilling to continue
to supply our products, sale of the affected products could be delayed for the
period necessary to secure a replacement.




The
technology utilized in many of our advanced wound care products is licensed from
third parties and could become unavailable.
 
 Many of
our advanced wound care products utilize technology that we license on an
exclusive basis from third parties. These products include Medihoney dressings, Bioguard dressings and
MedEfficiency TM total
contact casts. The licensing agreements that we have with the owners of these
technologies are of limited duration (with the exception of Medihoneywhich is in
perpetuity) and renewals of the agreements are in the discretion of the
licensors. In addition, the maintenance of the license agreements requires that
we meet various minimum sales and/or minimum royalty requirements. If we fail to
meet the minimum sales or minimum royalty requirements of a given license
agreement, there is a possibility that the agreement will be cancelled or not
renewed or that our exclusivity under the license agreement will be withdrawn.
If any of these events were to occur, our ability to sell the products utilizing
the licensed technology could be lost or compromised and our revenues and
potential profits could be adversely affected.


11




Competitors
could invent products superior to ours and cause our products and technology to
become obsolete.





We
operate in an industry where technological developments occur at a rapid pace.
We compete with a large number of established companies and institutions many of
which have more capital, larger staffs and greater expertise than we do. We also
compete with a number of smaller companies. Our competitors currently
manufacture and distribute a variety of products that are in many respects
comparable to our products. While we have no specific knowledge of products
under development by our competitors, it is possible that these competitors may
develop technologies and products that are more effective than any we currently
have. If this occurs, any of our products and technology affected by these
developments could become obsolete.





Although
we are insured, any material product liability claims could adversely affect our
business.





We sell
over-the-counter products and medical devices and are exposed to the risk of
lawsuits claiming alleged injury caused by our products. Among the grounds for
potential claims against us are injuries due to alleged product inefficacy and
injuries resulting from infection due to allegedly non-sterile products.
Although we carry product liability insurance with limits of $1.0 million per
occurrence and $2.0 million aggregate with $10.0 million in umbrella coverage,
this insurance may not be adequate to reimburse us for all damages that we could
suffer as a result of successful product liability claims. No material product
liability claim has ever been made against us and we are not aware of any
pending product liability claims. However, a successful material product
liability suit could adversely affect our business.





The
potential increase in common shares due to the conversion, exercise or vesting
of outstanding dilutive securities may have a depressive effect upon the market
value of our shares.





Up to
3,111,348 shares of our common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock,
warrants and options (“dilutive securities”). The shares of common stock
potentially issuable upon conversion, exercise or vesting of dilutive securities
are substantial compared to the 6,557,855 shares of common stock currently
outstanding.





Earnings
per share of common stock may be substantially diluted by the existence of these
dilutive securities regardless of whether they are converted, exercised or
issued. This dilution of earnings per share could have a depressive effect upon
the market value of our common stock.





Our
stock price has been volatile and this volatility is likely to
continue.





Historically,
the market price of our common stock has been volatile. The high and low stock
prices (after reflecting the impact of the 1-for-8 reverse split) for the years
2004 through 2009 are set forth in the table below:





Derma
Sciences, Inc.


Trading
Range – Common Stock





Year
                          
                          Low
                          
                          High2004
                          
                          $
                          3.44
                          
                          
                          $
                          15.202005
                          
                          $
                          3.36
                          
                          
                          $
                          6.242006
                          
                          $
                          3.60
                          
                          
                          $
                          7.202007
                          
                          $
                          4.64
                          
                          
                          $
                          11.202008
                          
                          $
                          1.60
                          
                          
                          $
                          10.802009
                          
                          $
                          1.92
                          
                          
                          $
                          6.80





Events
that may affect our common stock price include:


12





•
            Quarter to quarter variations in
      our 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
industry;


•
            Fluctuations in stock market
      prices and trading volumes of similar
    companies;


•
            Discussion
      of us or our stock price by the financial and scientific press and in
      online investorcommunities;


•
            Additions or departures of key
      personnel;


•
            Changes in third party
      reimbursement
policies;


•
            The introduction of new products
      either by us or by our competitors;
  and


•
            The loss of a major
      customer.





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





We
have not paid, and we are unlikely to pay in the near future, cash dividends on
our securities.





We have
never paid any cash dividends on our common or preferred stock and do not
anticipate paying cash dividends in the foreseeable future. The payment of
dividends by us will depend on our future earnings, financial condition and such
other business and economic factors as our management may consider
relevant.





If
members of our management and their affiliates were to exercise all warrants and
options held by them, members of management and their affiliates could acquire
effective control of us.





The
executive officers and directors, together with institutions with which they are
affiliated, own substantial amounts of our common stock, together with
outstanding options and warrants to purchase our common stock. Depending upon
the warrants and options exercised by outside investors, if directors, executive
officers and affiliates were to exercise their options and warrants, members of
management and their affiliates could obtain effective control of us. As a
result, these officers, directors and affiliates would be in a position to
significantly influence our strategic direction, the composition of our board of
directors and the outcome of fundamental transactions requiring shareholder
approval.





Our
common stock does not have a vigorous trading market and you may not be able to
sell your securities when desired.





We have a
limited active public market for our common shares. We cannot assure you that a
more active public market will develop thereby allowing you to sell large
quantities of our shares. Consequently, you may not be able to readily liquidate
your investment.





Our
common stock may be delisted from the NASDAQ Capital Market which could
negatively impact the price of our common stock and our ability to access the
capital markets.





The
listing standards of the NASDAQ Capital Market (referred to as the “NASDAQ
Market”) provide that a company, in order to qualify for continued listing, must
maintain a minimum stock price of $1.00 and satisfy standards relative to
minimum shareholders’ equity, minimum market value of publicly held shares and
various additional requirements. If we fail to comply with all listing standards
applicable to issuers listed on the NASDAQ Market, our common stock may be
delisted. If our common stock is delisted, it could reduce the price of our
common stock and the levels of liquidity available to our shareholders. In
addition, the delisting of our common stock could materially adversely affect
our access to the capital markets and any limitation on liquidity or reduction
in the price of our common stock could materially adversely affect our ability
to raise capital. Delisting from the NASDAQ Market could also result in other
negative consequences, including the potential loss of confidence by suppliers,
customers and employees, the loss of institutional investor interest and fewer
business development opportunities.


13





The
liquidity of our common stock and market capitalization could be adversely
affected by our reverse stock split.





We
implemented a 1-for-8 reverse split of our common and preferred stock effective
February 1, 2010. A reverse stock split is often viewed negatively by the market
and, consequently, our reverse stock split could ultimately lead to a decrease
in our price per share and overall market capitalization.





Item
2. Properties





Our
headquarters are located in Princeton, New Jersey. In addition to the lease
relative to our headquarters, we have entered into leases for manufacturing,
warehousing and distribution facilities. Our facilities, locations, size,
monthly rent and lease expirations are set forth in the table
below:





Location
              
              Use
              
              Square
                Footage
              
              
              Base
                Monthly
                Rent
              
              Lease ExpirationPrinceton,
      New Jersey
              
              Headquarters
              
              
              8,024
              
              
              $
              19,726
              
              July,
      2012Fenton,
      Missouri
              
              Warehouse
              
              
              42,400
              
              
              $
              21,604
              
              March,
      2011Houston,
      Texas
              
              Warehouse
              
              
              52,770
              
              
              $
              18,206
              
              March,
      2012Toronto,
      Canada
              
              Manufacturing,
      Warehouse & Offices
              
              
              76,399
              
              
              $
              32,115
              
              August,
      2012Nantong,
      China
              
              Manufacturing
      & Offices
              
              
              11,388
              
              
              $
              1,546
              
              December,
      2013





We
believe that our facilities are adequate to meet our office, manufacturing and
distribution requirements for the foreseeable future.





Item
3. Legal Proceedings





We are not a party to any legal
proceedings that we believe will have a material adverse effect upon the conduct
of our business or our financial position.


14


Part II





Item 5.
            Market
      for Registrant’s Common Equity, Related Shareholder Matters and Issuer
      Purchases ofEquity
      Securities





Our
common stock is traded on the NASDAQ Capital Market under the symbol “DSCI.”
Until February 10, 2010 our common stock traded on the OTC Bulletin Board. The
following table sets forth the high and low bid prices for our common stock on
the OTC Bulletin Board during each of the indicated calendar
quarters:





Quarter Ended
                      
                      High
                      
                      
                      LowMarch
      31, 2009
                      
                      $
                      5.60
                      
                      
                      $
                      2.80June
      30, 2009
                      
                      $
                      4.40
                      
                      
                      $
                      1.92September
      30, 2009
                      
                      $
                      6.80
                      
                      
                      $
                      2.64December
      31, 2009
                      
                      $
                      6.16
                      
                      
                      $
                      4.32March
      31, 2008
                      
                      $
                      10.80
                      
                      
                      $
                      5.92June
      30, 2008
                      
                      $
                      8.40
                      
                      
                      $
                      6.40September
      30, 2008
                      
                      $
                      7.60
                      
                      
                      $
                      2.16December
      31, 2008
                      
                      $
                      5.60
                      
                      
                      $
                      1.60





The stock
prices reflect inter-dealer prices without retail mark-up, mark-down or
commission and may not necessarily represent actual transactions. The stock
prices also reflect a 1-for-8 reverse split of our common stock effective
February 1, 2010. There is no public market for our preferred stock. As of the
close of business on February 26, 2010 there were 1,167 holders of record of the
common stock.





15


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





Year
Ended December 31, 2009 Compared to Year Ended December 31, 2008





Overview





The
following table highlights the year ended December 31, 2009 versus 2008
operating results:





Year Ended December 31,
                                                    
                                                    
                                                    Variance2009
                                                    
                                                    
                                                    2008Gross
      Sales
                                                    
                                                    $
                                                    57,829,670
                                                    
                                                    
                                                    $
                                                    60,431,835
                                                    
                                                    
                                                    $
                                                    (2,602,165
                                                    )
                                                    
                                                    
                                                    (4.3
                                                    )%Sales
      adjustments
                                                    
                                                    
                                                    (9,303,512
                                                    )
                                                    
                                                    
                                                    (10,232,407
                                                    )
                                                    
                                                    
                                                    (928,895
                                                    )
                                                    
                                                    
                                                    (9.1
                                                    )%Net
      sales
                                                    
                                                    
                                                    48,526,158
                                                    
                                                    
                                                    
                                                    50,199,428
                                                    
                                                    
                                                    
                                                    (1,673,270
                                                    )
                                                    
                                                    
                                                    (3.3
                                                    )%Cost
      of sales
                                                    
                                                    
                                                    33,468,440
                                                    
                                                    
                                                    
                                                    35,289,684
                                                    
                                                    
                                                    
                                                    (1,821,244
                                                    )
                                                    
                                                    
                                                    (5.2
                                                    )%Gross
      profit
                                                    
                                                    
                                                    15,057,718
                                                    
                                                    
                                                    
                                                    14,909,744
                                                    
                                                    
                                                    
                                                    147,974
                                                    
                                                    
                                                    
                                                    0.1
                                                    %Selling,
      general and administrative expense
                                                    
                                                    
                                                    15,135,233
                                                    
                                                    
                                                    
                                                    17,196,863
                                                    
                                                    
                                                    
                                                    (2,061,630
                                                    )
                                                    
                                                    
                                                    (12.0
                                                    )%Research
      and development expense
                                                    
                                                    
                                                    399,558
                                                    
                                                    
                                                    
                                                    653,326
                                                    
                                                    
                                                    
                                                    (253,768
                                                    )
                                                    
                                                    
                                                    (38.8
                                                    )%Interest
      expense
                                                    
                                                    
                                                    842,132
                                                    
                                                    
                                                    
                                                    940,148
                                                    
                                                    
                                                    
                                                    (98,016
                                                    )
                                                    
                                                    
                                                    (10.4
                                                    )%Other
      (income) expense, net
                                                    
                                                    
                                                    (244,596
                                                    )
                                                    
                                                    
                                                    22,529
                                                    
                                                    
                                                    
                                                    (267,125
                                                    )Total
      expenses
                                                    
                                                    
                                                    16,132,327
                                                    
                                                    
                                                    
                                                    18,812,866
                                                    
                                                    
                                                    
                                                    (2,680,539
                                                    )
                                                    
                                                    
                                                    (14.3
                                                    )%Loss
      before income taxes
                                                    
                                                    
                                                    (1,074,609
                                                    )
                                                    
                                                    
                                                    (3,903,122
                                                    )
                                                    
                                                    
                                                    2,828,513
                                                    
                                                    
                                                    
                                                    72.5
                                                    %Provision
      for income taxes
                                                    
                                                    
                                                    68,663
                                                    
                                                    
                                                    
                                                    58,815
                                                    
                                                    
                                                    
                                                    9,848
                                                    
                                                    
                                                    
                                                    16.7
                                                    %Net
      loss
                                                    
                                                    $
                                                    (1,143,272
                                                    )
                                                    
                                                    $
                                                    (3,961,937
                                                    )
                                                    
                                                    $
                                                    2,818,665
                                                    
                                                    
                                                    
                                                    71.1
                                                    %





Gross
to Net Sales Adjustments





Gross to
net sales adjustments comprise the following:





Year Ended December 31,2009
                                            
                                            
                                            2008Gross Sales
                                            
                                            $
                                            57,829,670
                                            
                                            
                                            $
                                            60,431,835Trade rebates
                                            
                                            
                                            (6,822,694
                                            )
                                            
                                            
                                            (7,446,780
                                            )Distributor fees
                                            
                                            
                                            (1,022,311
                                            )
                                            
                                            
                                            (1,135,901
                                            )Sales incentives
                                            
                                            
                                            (561,653
                                            )
                                            
                                            
                                            (481,803
                                            )Returns and allowances
                                            
                                            
                                            (470,893
                                            )
                                            
                                            
                                            (694,765
                                            )Cash discounts
                                            
                                            
                                            (425,941
                                            )
                                            
                                            
                                            (473,158
                                            )Total adjustments
                                            
                                            
                                            (9,303,512
                                            )
                                            
                                            
                                            (10,232,407
                                            )Net sales
                                            
                                            $
                                            48,526,158
                                            
                                            
                                            $
                                            50,199,428





Trade
rebates decreased in 2009 versus 2008 due principally to lower Canadian sales
subject to rebate which, in turn, resulted from lower demand as a result of the
exclusive Canadian distributor reducing its inventory, unfavorable exchange and
a slight increase in sales not subject to rebate. U.S. rebates increased due to
an increase in regular sales subject to rebate, coupled with an increase in the
percentage of rebates to sales due to list price increases (without a
commensurate increase in contract pricing). This increase was partially offset
by the discontinuation of a significant private label customer rebate program
effective November 1, 2009. The decrease in distribution fee expense is
commensurate with the change in Canadian net sales upon which it is based,
coupled with a slight increase in sales not subject to the fee. The increase in
sales incentive expense relates principally to an expansion of the traditional
wound care and first aid products sales incentive programs. The sales returns
and allowances decrease is principally due to the non-recurrence of higher first
aid products integration related returns and allowances in 2008. The decrease in
cash discounts reflects lower U.S. sales subject to cash
discount.


16





Rebate
Reserve Roll Forward





A twelve
month roll forward of the trade rebate accruals at December 31, 2009 and 2008 is
outlined below:





Year Ended December 31,2009
                        
                        2008Beginning
      balance – January 1
                        
                        $
                        2,660,086
                        
                        
                        $
                        2,407,709Rebates
      paid
                        
                        
                        (6,989,548
                        )
                        
                        
                        (7,194,403
                        )Rebates
      accrued
                        
                        
                        6,822,694
                        
                        
                        
                        7,446,780Ending
      balance – December 31
                        
                        $
                        2,493,232
                        
                        
                        $
                        2,660,086





The
$166,854 decrease in the trade rebate reserve balance for the twelve months
ended December 31, 2009 reflects a reduction in the Canadian reserve due to
lower sales to the exclusive Canadian distributor in response to the
distributors’ plan to reduce its investment in inventory coupled with the timing
of payment of U.S. private label rebates and the decision of one significant
private label customer to discontinue its rebate program effective November 1,
2009. There has been no other discernable change in the nature of our business
in 2009 as it relates to the accrual and subsequent payment of
rebates.





Net
Sales and Gross Margin





The
following table highlights the December 31, 2009 versus 2008 product line net
sales and gross profit:





Year Ended December 31,
                                                    
                                                    
                                                    Variance2009
                                                    
                                                    
                                                    2008Net Sales
                                                    
                                                    $
                                                    48,526,158
                                                    
                                                    
                                                    $
                                                    50,199,428
                                                    
                                                    
                                                    $
                                                    (1,673,270
                                                    )
                                                    
                                                    
                                                    (3.3
                                                    )%Cost of sales
                                                    
                                                    
                                                    33,468,440
                                                    
                                                    
                                                    
                                                    35,289,684
                                                    
                                                    
                                                    
                                                    (1,821,244
                                                    )
                                                    
                                                    
                                                    (5.2
                                                    )%Gross Profit
                                                    
                                                    $
                                                    15,057,718
                                                    
                                                    
                                                    $
                                                    14,909,744
                                                    
                                                    
                                                    $
                                                    147,974
                                                    
                                                    
                                                    
                                                    0.1
                                                    %Gross Profit %
                                                    
                                                    
                                                    31.0
                                                    %
                                                    
                                                    
                                                    29.7
                                                    %





Consolidated
net sales decreased $1,673,270, or 3.3% (1.6% adjusted for exchange), in 2009
versus 2008. Canadian net sales decreased $826,206, or 6.8%, to $11,265,652 in
2009 from $12,091,858 in 2008. This decrease was driven by unfavorable exchange
of $880,834 associated with a 7.0% weakening of the Canadian dollar, partially
offset by sales growth of $54,628. Excluding exchange, inventory rationalization
on the part of our Company’s exclusive Canadian distributor is principally
responsible for the modest sales growth in 2009. Real growth as measured by
sales of our Company’s products reported by our exclusive distributor,
unadjusted for foreign exchange, approximated 6.3%. U.S. net sales decreased
$847,064, or 2.2%, to $37,260,507 in 2009 from $38,107,571 in 2008. The decrease
was driven by lower first aid product sales of $4,458,782, or 26.2%, and
traditional wound care sales of $446,842, or 6.6%, partially offset by higher
advanced wound care sales of $2,962,462, or 65.9%, and private label sales of
$1,251,965, or 18.3%. Specialty fixation, burn care and skin care and bathing
sales were down $33,867, or 1.3%, period to period. The lower first aid product
sales reflect the non-recurrence of higher sales in 2008 due to integration
related backorder fulfillment, lower demand and customers rationalizing their
inventory in 2009 in response to the economy and lost business. The lower
traditional wound care sales reflect the non-recurrence of a spot sale
(customer’s normal supplier was unable to supply) realized in 2008 and lower
demand. The higher advanced wound care sales reflect continued growth of Medihoney together with the
balance of the product line in response to our focused sales and marketing
effort. Gross U.S. Medihoney sales increased
$1,275,586, or 93.7%, to $2,637,210 in 2009 versus $1,361,624 in 2008. Bioguard, our new novel
anti-microbial advanced wound care product launched in June, recorded gross
sales of $634,922 in its first seven months. Algicell, Xtrasorb and MedEfficiency
have also exhibited strong growth in 2009. The increase in private label sales
reflects improved demand from a number of our core customers, coupled with some
modest new business. Excluding first aid products, U.S. sales increased
$3,733,718, or 18.1%.


17





Consolidated
gross profit increased $147,974, or 0.1%, in 2009 versus 2008, despite the
decrease in sales. The consolidated gross profit margin percentage increased to
31.0% in 2009 from 29.7% in 2008. Canadian gross profit decreased $760,501, or
19.3%, to $3,186,683 in 2009 from $3,947,184 in 2008. The Canadian gross profit
margin percentage decreased to 28.3% in 2009 from 32.6% in 2008. The decrease in
Canadian 2009 gross profit dollars reflects the lower sales and gross profit
margin percentage decrease. The change in Canadian gross profit margin
percentage principally reflects the adverse effect of price erosion coupled with
higher product costs, partially offset by the favorable impact of higher
production volumes on labor efficiency and overhead absorption and lower
overhead spending in 2009 versus 2008. U.S. gross profit increased $908,475, or
8.3%, to $11,871,034 in 2009 from $10,962,559 in 2008. The U.S. gross profit
margin percentage increased to 31.9% in 2009 from 28.8% in 2008. The increase in
U.S. gross profit dollars and margin principally reflects the increase in higher
margined advanced wound care sales, partially offset by the decrease in lower
margined first aid product sales. An improvement in first aid product margin due
to the discontinuation of higher cost domestic manufacturing in the fourth
quarter 2008 and lower freight costs, partially offset by higher other product
costs, also contributed. Excluding first aid products, favorable product mix
partially offset by higher product costs served to increase U.S. margin dollars
$1,711,276, or 24.7%, and the gross profit percentage to 35.4% from
33.5%.





Selling,
General and Administrative Expenses





The
following table highlights December 31, 2009 versus 2008 selling, general and
administrative expenses by type:





Year Ended December 31,
                                
                                
                                Variance2009
                                
                                
                                2008Distribution
                                
                                $
                                1,754,414
                                
                                
                                $
                                1,893,146
                                
                                
                                $
                                (138,732
                                )
                                
                                
                                (7.3
                                )%Marketing
                                
                                
                                1,544,862
                                
                                
                                
                                1,781,128
                                
                                
                                
                                (236,266
                                )
                                
                                
                                (13.3
                                )%Sales
                                
                                
                                5,093,252
                                
                                
                                
                                5,714,899
                                
                                
                                
                                (621,647
                                )
                                
                                
                                (10.9
                                )%General
      and administrative
                                
                                
                                6,742,705
                                
                                
                                
                                7,807,690
                                
                                
                                
                                (1,064,985
                                )
                                
                                
                                (13.6
                                )%Total
                                
                                $
                                15,135,233
                                
                                
                                $
                                17,196,863
                                
                                
                                $
                                (2,061,630
                                )
                                
                                
                                (12.0
                                )%





Selling,
general and administrative expenses decreased $2,061,630, or 12.0%, in 2009
versus 2008, including a decrease of $203,692 in Canadian selling, general and
administrative expenses attributable to exchange.





Distribution
expense decreased $138,732, or 7.3%, in 2009 versus 2008. Expenses in Canada
decreased $102,037 (including a $25,626 benefit related to exchange) while
expenses in the U.S decreased $36,695. The decrease in Canada was driven by the
non-recurrence of incremental expense related to the buy out of the former
distribution center lease in the second quarter 2008. The U.S. decrease was
driven by the non-recurrence of incremental first aid product related
integration expenses in Houston incurred in 2008, partially offset by higher
lease costs in Houston (relocated to new facility in April 2009) and St. Louis
(higher cost lease extension effective March 2009) together with higher
personnel and operating costs in St. Louis in support of the growing non-first
aid product business.





Marketing
expense decreased $236,266, or 13.3%, in 2009 versus 2008. The decrease is
attributable to a U.S. decrease of $210,421 coupled with a decrease in Canada of
$25,845 (including a $7,725 benefit related to exchange). The U.S. decrease
stems from a planned reduction in advanced wound care clinical personnel,
consulting, travel and trade show expenses in 2009, coupled with an increase in
first aid product related marketing expenses reflecting implementation of a full
marketing plan in 2009 versus a partial transition related plan in 2008. The
Canada expense decrease reflects lower advanced wound care promotion expense,
partially offset by higher product sampling expenses.


18


Sales
expense decreased $621,647, or 10.9%, in 2009 versus 2008. Expenses in Canada
decreased $106,170 (including a $55,718 benefit related to exchange) while
expenses in the U.S. decreased $515,477. Expenses in Canada decreased
principally due to lower 3rd party
sales commission due to a change in the sales commission program in 2009, lower
direct representative commissions due to lower sales and lower travel costs due
to cost reduction initiatives, partially offset by higher increased rate related
group purchasing organization fees. The U.S. decrease was attributable to lower
compensation and commission expenses associated with open (timing related) sales
representative positions, the elimination of three positions as a result of cost
reduction initiatives and the non-recurrence of incremental integration related
compensation expenses in customer service, lower first aid product broker
commissions due to lower sales, lower travel expenses due to cost reduction
initiatives, lower recruiting expenses (bulk of hiring took place in 2008)
together with the non-recurrence in 2009 of first aid product integration
related expenses. Offsetting these decreases were higher equity based
compensation, regional show and sales tracing expenses associated with the
implementation of a more structured sales tracing program in 2008.





General
and administrative expense decreased $1,064,985, or 13.6%, in 2009 versus 2008.
Expenses in Canada decreased $92,233 (including a $114,623 benefit related to
exchange) while expenses in the U.S. decreased $972,752. Adjusted for exchange,
the $22,390 increase in Canada reflects higher audit, insurance and equity based
compensation expense, partially offset by lower travel, recruiting and operating
expenses. The U.S. decrease principally reflects lower bad debt expense of
$392,900 due to the non-recurrence of a significant provision for bad debts in
2008, lower travel of $158,100 and investor relation expenses of $147,200 due to
cost reduction initiatives, non-recurring and lower legal expenses of $95,000,
non-recurring and lower amortization expense of $52,900 and non-recurring
recruiting expense of $45,700, together with lower other professional service
fees of $70,300 and other net operating costs of $10,652 due principally to
timing and cost saving initiatives.





Research
and Development Expense





Research
and development expense decreased $253,768 to $399,558 in 2009 from $653,326 in
2008. The decrease principally reflects the non-recurrence of a $320,000 payment
for the active compound to be used in the DSC127 Phase II trial in 2008 and
start up related consulting expense, partially offset by higher project
management (full year in 2009 versus eleven months in 2008), data management
(data management program implemented in second half of 2009) and ongoing patent
related legal expenses in 2009.





Interest
Expense





Interest
expense decreased $98,016 to $842,132 in 2009 from $940,148 in 2008. The
decrease is principally attributable to lower interest rates coupled with lower
line of credit and term loan borrowing levels, partially offset by higher loan
related fees and lower interest income in 2009 versus 2008.





Other
Income





Other
income increased $267,125 to income of $244,596 in 2009 from an expense of
$22,529 in 2008. The main drivers for the net year-to-year increase was an
exchange gain of $336,401 and a gain on miscellaneous asset sales principally
associated with the closure of the first aid product manufacturing operation of
$59,031, partially offset by non-income related taxes of $59,044, lower royalty
income $36,250 and other miscellaneous income of $33,013.





Income
Taxes





We
recorded a $68,663 tax provision for 2009 consisting of a $101,408 current
foreign tax provision and a $35,822 deferred foreign tax benefit based on our
Canadian subsidiary’s operating results and a $3,077 U.S. current tax provision
based on U.S. results. In 2008 a net foreign tax provision of $58,815 was
recorded.





Due to
uncertainties surrounding our ability to use our U.S. net operating loss carry
forwards and net deferred tax assets, a full valuation allowance for the U.S.
net deferred tax assets has been provided.





Net
Loss





We
generated a net loss of $1,143,272, or $0.23 per share (basic and diluted), in
2009 compared to a net loss of $3,961,937, or $0.82 per share (basic and
diluted), in 2008.


19





Liquidity and Capital
Resources





Cash
Flow and Working Capital





Quarterly
financial performance has improved steadily in 2009 culminating with net income
in the third and fourth quarters after losses in the first and second quarters.
We reported a cumulative net loss of $1,143,272 for 2009 versus a $3,961,937 net
loss in 2008. While sales are lower in 2009, gross profit dollars and margin
percentage increased due to a favorable sales mix (principally reflecting the
growth of the higher margined advanced wound care business), the elimination of
higher cost FAD domestic manufacturing in the fourth quarter 2008 and improved
manufacturing performance in Canada, partially offset by higher product costs.
Operating expenses were lower, as planned, to better align costs with
revenues.





The
launch of a number of new products bodes well for the future growth of our
higher-margined advanced wound care product line. While overall FAD sales
declined in 2009 versus 2008, we believe that the FAD product line continues to
represents a solid growth opportunity. Sales for the balance of our product
lines are expected to remain relatively stable. Further, we continue to actively
pursue distributors in several countries to increase our international
sales.





Improving
financial performance and other steps taken to improve cash management have
served to improve our liquidity. Operating cash flow has improved steadily in
2009 versus 2008. This is attributable to a significant reduction in net
operating assets and liabilities employed, together with a lower net loss. In
2008, we increased our investment in inventory by approximately $3,600,000. In
2009 the inventory level was reduced by approximately $1,000,000. Operating cash
flow is expected to continue to improve over the next twelve months given the
expected improvement in financial performance and continuation of our inventory
reduction initiative.





At
December 31, 2009 and December 31, 2008, we had cash and cash equivalents on
hand of $243,524 and $391,038, respectively. The $147,514 decrease in cash
reflects net cash provided by operating activities of $2,654,204 and cash
provided as a result of exchange rate changes of $169,972. These increases were
essentially offset by cash used in financing activities of $2,766,964 and cash
used in investing activities of $204,726.





Net cash
provided by operating activities of $2,654,204 stems from $2,952,580 cash
provided from operations (net loss plus non-cash items), together with $298,376
cash used from the net change in operating assets and liabilities. The increase
in cash provided from operations reflects the non-cash items, partially offset
by the operating loss. Lower accounts payable and accrued liabilities and higher
accounts receivable partially offset by lower inventory were the main drivers
behind the net change in operating assets and liabilities. The decrease in
accounts payable reflects a significant reduction in payables related to
inventory purchases (consistent with the plan to reduce inventory), lower
overall spending levels and timing. The decrease in accrued expenses and other
current liabilities principally reflects lower Canadian rebates due to lower
sales and timing related changes. The increase in accounts receivable reflects
higher fourth quarter sales. The reduced investment in inventory reflects our
plan to reduce inventory levels whenever possible, without compromising customer
service requirements.





Net cash
used in investing activities of $204,726 reflects capital expenditures of
$265,726, less receipt of $61,000 cash from the sale of assets associated with
the discontinuation of FAD domestic manufacturing. Capital expenditures are
lower in 2009 versus 2008.





Net cash
used in financing activities of $2,766,964 reflects regularly scheduled debt
payments of $1,298,208, pay down of outstanding line of credit borrowings of
$1,140,299, capitalization of equity raise expenses in anticipation of charging
them off to additional paid in capital upon completion of the planned equity
offering in 2010 of $305,715, an increase in restricted cash of $17,742 and
costs related to the issuance of stock from a previous offering of
$5,000.





Working
capital increased $51,950, or 0.8%, at December 31, 2009 to $6,791,601 from
$6,739,651 at December 31, 2008. Excluding the reclassification of the $500,000
promissory note from long term to current debt in the second quarter 2009,
working capital increased $551,950 in 2009 and increased by $126,457 in the
third quarter. Working capital of this magnitude is considered sufficient to
support ongoing operations.


20





Financing
Arrangements





With cash
on hand of $243,524, together with available revolver capacity of $2,099,055, we
have $2,342,579 of available liquidity at December 31, 2009, versus $2,125,840
at September 30, 2009.





On
February 22, 2010, we raised $4,537,497 (net of commission and other offering
expenses) from the sale in a secondary public offering of shares of our common
stock. These proceeds together with $2,032,818 of restricted cash from our
balance sheet were used to acquire the worldwide Medihoney licensing rights for
$2,250,000, pay off the outstanding U.S. term loan of $3,300,000 and pay off our
$500,000 promissory note due April 14, 2010, leaving $520,315 of the net
proceeds available for general working capital purposes. Payment of the
foregoing indebtedness will have a positive impact on cash flow going forward by
eliminating associated debt service. The $520,315 available for working capital
was applied to reduce our outstanding line of credit balance, thereby serving to
increase the availability of funds under the line.





On March
26, 2010, our U.S. lender modified the terms of our five year revolving credit
and security agreement to take into account the payment of the term loan. The
existing financial covenants were replaced with twelve month rolling fixed
charge coverage and total debt coverage covenants. The lender also reduced the
minimum 3 month LIBOR rate from 3.00% to 1.50% and authorized the payment of our
$500,000 unsecured promissory note.





The
equity raise and modification to our loan covenants in the first quarter 2010,
served to further improve our overall liquidity.





Prospective
Assessment





Our
strategic objective is to in-license, develop and launch novel higher margined
advanced wound care products while utilizing our core business (to the extent
possible) to fund this objective. In addition, we will continue to evaluate
external opportunities to leverage our core capabilities for growth. To the
extent we determine that we cannot finance our growth initiatives internally, we
will evaluate the feasibility of doing so via the sale of equity.





As a
result of these efforts, we launched Algicell in November 2006. We
launched our first Medihoney product in October
2007. This product represents the first of its kind and interest in the product
has been high. Sales have increased steadily and current indications are that
the planned Medihoney
based line of products could result in significant incremental sales. We
recently launched three new products to complement our existing advanced wound
care product line, the MedEfficiency line of Total Contact Cast systems (October
2008), Xtrasorb
(November 2008) and Bioguard, our novel
anti-microbial infection control product in June 2009. Bioguard, Xtrasorb and MedEfficiency
have been well received in the marketplace and have exhibited steady growth. We
continue to work on our pipeline and have identified several products that are
capable of contributing to future sales growth. We anticipate our overall core
business sales will grow modestly over the near term.





Our
strategy for growth going forward is:





1.
            Assuming the existing resources
      in place are generating the expected return, we will continue to expand
      our investment in sales and marketing resources in support of our advanced
      wound care products. We presently have ten direct sales representatives in
      place and our plan is to hire an additional ten in 2010 and increase the
      level of marketing and product development
  support.





2.
            The FAD business represents a
      growth opportunity. In addition to its core business opportunities, the
      FAD business will serve as a platform for introducing our existing
      advanced and traditional wound care products to new customers and markets,
      especially the retail market. The FAD continues to work on completion of a
      cost effective supply chain for its adhesive bandages and first aid
      related products. The supply chain is expected to be fully operational
      within the next nine months, at which time we expect to be able to further
      reduce our product costs and improve liquidity by reducing the level of
      inventory required to support the existing level of
      business.





3.
            In February 2010, we licensed the
      worldwide rights to Medihoney. This will serve as the catalyst for the
      expansion of our international business. Plans are in place to establish a
      direct presence in Europe immediately and in other areas of the world,
      employing a direct presence or distributor model as the basis for
      conducting business, as circumstances
  dictate.




21





4.
            We made a significant investment
      in DSC 127 beginning in December 2007. While the launch of DSC 127 is
      several years away, we believe the market potential for this product is
      considerable. The product began Phase II trials in early 2008 to achieve
      proof of principle in a human model. The Phase II trials are expected to
      be completed by the end of 2010. The projected cost to complete the Phase
      II trials is approximately $1,650,000, including $1,052,884 incurred
      through December 2009. We plan to continue with this investment and
      anticipate spending approximately $600,625 to complete the Phase II trial
      over the next twelve months.





The
results of the Phase II trial will determine the efficacy and safety of the
product and further refine its market potential. The cost of the Phase III trial
and bringing the product to market are expected to be significant. Should we
decide to proceed with the DSC 127 development plan after completion of Phase
II, we plan to fund the additional development costs out of available cash flow
or the sale of equity. Alternatively, we may determine to sublicense or sell the
rights to the compound.





With the
planned improvement in operations and expected working capital requirements,
together with the available cash on hand and available borrowing capacity as of
December 31, 2009, we anticipate having sufficient liquidity in place to meet
our operating needs and debt covenants for the foreseeable future.





Our
common stock is traded on the NASDAQ Capital Market under the symbol “DSCI.” We
have paid no cash dividends in respect of our common stock and do not intend to
pay cash dividends in the near future.





Additional Financial
Information





Forward
Looking Statements





Statements
that are not historical facts, including statements about our 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, sales incentives, 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 us, there may also be other
reasonable estimates or assumptions. We believe, 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 presented. Our most
critical accounting policies are described below.





Revenue
Recognition and Adjustments to Revenue





We sell
our products through our own direct sales force and through independent
distributors and manufacturers’ representatives. The primary end users of our
products are nursing homes, hospitals, clinics and home healthcare agencies. We
recognize revenue from the sale of our products when persuasive evidence of an
arrangement exists, delivery has occurred, the sales price is fixed and
determinable, and collectability is reasonably assured, which is generally at
the time of shipment or receipt by our customers, depending on the terms of the
related sales or distribution agreement. When we recognize revenue from the sale
of our products, we simultaneously adjust revenue for estimated trade rebates
and distribution fees (in Canada), and estimates of returns and allowances, cash
discounts and other sales incentives.


22





A trade
rebate represents the difference between the invoice price to the
wholesaler/distributor and the end user’s contract price. These rebates are
estimated monthly based on historical experience, distributor rebate submission
trends, estimated distributor inventory levels, and existing contract sales
terms with our distributors and end users. We have a contract with our exclusive
Canadian distributor and we pay a fixed fee based on sales subject to the fee
(as defined) for distribution services in Canada. Because the services performed
by the distributor cannot be separated from the purchase of our products by the
distributor, we treat this distribution fee as a reduction of revenue. The
distribution fee is accrued monthly based on net sales to the distributor
multiplied by the ratio of recent historical distributor fee expense to net
sales. The percentage of distributor fee expense to net sales is re-evaluated
quarterly for reasonableness.





Sales
incentives represent credits granted to specific customers based on attainment
of pre-determined sales objectives. Sales incentives are accrued monthly in
accordance with the terms of the underlying sales incentive agreement and actual
customer sales. Sales incentive agreements are generally for a period of one
year.





We
provide our customers certain limited return rights and we have a formal
returned goods policy that guides the disposition of returns with our customers.
We accrue for sales returns and allowances and cash discounts monthly based on
current sales and historical activity. We do not offer our customers price
protection rights or concessions. Returns were approximately 1% of gross sales
in both 2009 and 2008.





We
continually monitor the factors that influence rebates and fees, returns and
allowances, and other discounts and sales incentives and make adjustments as
necessary.





Goodwill





At
December 31, 2009, we had $7,119,726 of goodwill consisting of $4,679,684
relating to the FAD acquisition in November 2007 and $2,440,042 relating to the
Western Medical acquisition in April 2006. We assess the impairment of goodwill
annually in the fourth quarter or whenever events or changes in circumstances
indicate that the carrying value of goodwill may not be recoverable. The
assessment is performed using the two-step process required by FASB accounting
guidance relating to goodwill. The first step is a review for potential
impairment, while the second step measures the amount of the impairment, if any.
The first step of the goodwill impairment test compares the fair value of a
reporting unit with its carrying amount, including goodwill. For 2009 and 2008,
the first step of our goodwill impairment test reflected a fair value in excess
of the carrying value of our reporting units. Accordingly, we did not perform
the second step of this test during these periods.





The cash
generating unit level or reporting unit at which we test goodwill for impairment
is the operating segment level as that term is used in FASB accounting guidance
relating to segment reporting. We have three operating segments: wound care,
wound closure – specialty securement devices and skin care. Products are
allocated to each segment based on the nature and intended use of the product.
All of our goodwill has been allocated to the wound care segment as the business
acquisitions which gave rise to the goodwill were wound care
businesses.





For 2009
and 2008 and consistent with prior periods, we estimated the fair value of our
wound care segment, using the “income approach,” where we use a discounted cash
flow model (“DCF”) in preparing our goodwill impairment assessment. This
approach calculates fair value by estimating the after-tax cash flows
attributable to a reporting unit and then discounting these after-tax cash flows
to a present value using a risk-adjusted discount rate. We selected this method
as being the most meaningful in preparing our goodwill assessments because we
believe the income approach most appropriately measures our income producing
assets.





Significant
estimates used in the fair value calculation include: (i) estimates of future
revenue and expense growth, (ii) future estimated effective tax rates, (iii)
future estimated capital expenditures, (iv) future required investments in
working capital, (v) average cost of capital, and (vi) the terminal value of the
reporting unit.





The
amount and timing of future cash flows within our DCF analysis is based on our
five year forecast. Beyond our five year forecast we assumed a terminal value to
calculate the value of cash flows beyond the last projected period in our DCF
analysis. Annual revenue growth rates in our DCF model reflect expected growth
in our advanced wound care products as well as growth in the products which we
gained access to when we acquired FAD in November of 2007 as we introduce these
products across our existing customer base. The weighted average cost of capital
used to discount cash flows for the annual 2009 goodwill impairment test was
estimated to be 17%.


23





Over
time, our wound care segment has become an increasingly significant portion of
our overall business. For the year ended December 31, 2009, our wound care
segment accounted for approximately 95% of our consolidated revenue. Given the
significance of this segment to our overall results, we also look to our
publicly traded market value, which we may adjust in consideration of an
appropriate control premium, as an indicator of the fair value of our wound care
segment and the reasonableness of our DCF model.





There
have been no substantial changes to the methodology employed, significant
assumptions or calculations applied in the first step of the goodwill impairment
test over the past several years.





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.





Stock-Based
Compensation





We record compensation expense
associated with stock options and other equity-based compensation based on their
fair value at the grant date and recognized over the requisite service periods.
We estimate the fair value of stock options as of the date of grant using the
Black-Scholes for service and performance based awards or binomial/lattice
pricing model for market based awards and restricted stock based on the quoted
market price. Significant judgment and the use of estimates to value the
equity-based compensation, particularly surrounding Black-Scholes or
binomial/lattice pricing model assumptions such as stock price volatility and
expected option lives, as well as expected option forfeiturerates, are made by the
Company.




24




Item
8. Financial Statements and Supplementary Data





Index





Description
                  
                  PageReport
      of Independent Registered Public Accounting Firm
                  
                  26Consolidated
      Balance Sheets as of December 31, 2009 and 2008
                  
                  27Consolidated
      Statements of Operations for the Years Ended December 31, 2009 and
      2008
                  
                  28Consolidated
      Statements of Shareholders' Equity for the Years Ended December 31, 2009
      and 2008
                  
                  29Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2009 and
      2008
                  
                  30Notes
      to Consolidated Financial Statements
                  
                  31




25


Report
of Independent Registered Public Accounting Firm





To the
Shareholders and Board of Directors
 of Derma
Sciences, Inc.
 
 We have
audited the accompanying consolidated balance sheets of Derma Sciences, Inc. and
subsidiaries as of December 31, 2009 and 2008, and the related consolidated
statements of operations, shareholders' equity, and cash flows for each of the
two years in the period ended December 31, 2009.  These financial
statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. We were not engaged to perform an
audit of the Company's internal control over financial reporting. Our audits
included consideration of internal control over financial reporting as a basis
for designing audit procedures  that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the
Company's internal control over financial reporting.  Accordingly, we
express no such opinion. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
 
 In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Derma Sciences, Inc.
and subsidiaries at December 31, 2009 and 2008, and the consolidated results of
their operations and their cash flows for each of the two years in the period
ended December 31, 2009, in conformity with U.S. generally accepted accounting
principles.
  /s/ Ernst &
      Young LLP
  Philadelphia,
Pennsylvania
 March 31,
2010


26


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Consolidated
Balance Sheets





December 31,2009
                    
                    
                    2008ASSETSCurrent
      AssetsCash
      and cash equivalents
                    
                    $
                    243,524
                    
                    
                    $
                    391,038Accounts
      receivable, net
                    
                    
                    3,372,712
                    
                    
                    
                    3,892,523Inventories
                    
                    
                    11,489,724
                    
                    
                    
                    12,423,042Prepaid
      expenses and other current assets
                    
                    
                    456,675
                    
                    
                    
                    397,117Total
      current assets
                    
                    
                    15,562,635
                    
                    
                    
                    17,103,720Cash
      – restricted
                    
                    
                    2,032,164
                    
                    
                    
                    2,014,422Equipment
      and improvements, net
                    
                    
                    3,741,347
                    
                    
                    
                    3,977,853Goodwill
                    
                    
                    7,119,726
                    
                    
                    
                    7,119,726Other
      intangible assets, net
                    
                    
                    3,994,250
                    
                    
                    
                    5,310,129Other
      assets, net
                    
                    
                    849,753
                    
                    
                    
                    681,472Total
      Assets
                    
                    $
                    33,299,875
                    
                    
                    $
                    36,207,322LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      LiabilitiesLine
      of credit borrowings
                    
                    
                    2,306,306
                    
                    
                    
                    3,446,605Current
      maturities of long-term debt
                    
                    
                    1,759,185
                    
                    
                    
                    1,298,207Accounts
      payable
                    
                    
                    3,363,096
                    
                    
                    
                    3,614,764Accrued
      expenses and other current liabilities
                    
                    
                    1,342,467
                    
                    
                    
                    2,004,493Total
      current liabilities
                    
                    
                    8,771,054
                    
                    
                    
                    10,364,069Long-term
      debt
                    
                    
                    2,305,851
                    
                    
                    
                    4,065,036Other
      long-term liabilities
                    
                    
                    96,564
                    
                    
                    
                    44,848Deferred
      tax liability
                    
                    
                    355,349
                    
                    
                    
                    340,871Total
      Liabilities
                    
                    
                    11,528,818
                    
                    
                    
                    14,814,824Shareholders’
      EquityConvertible
      preferred stock, $.01 par value; 1,468,750 shares authorized; issued and
      outstanding: 285,051 (liquidation preference of $4,210,231 at December 31,
      2009)
                    
                    
                    2,851
                    
                    
                    
                    2,851Common
      stock, $.01 par value: 18,750,000 authorized ; issued andoutstanding
      shares: 5,039,468 at December 31, 2009 and 5,017,593 atDecember 31,
      2008
                    
                    
                    50,395
                    
                    
                    
                    50,176Additional
      paid-in capital
                    
                    
                    41,221,613
                    
                    
                    
                    40,398,829Accumulated
      other comprehensive income – cumulative translation
      adjustments
                    
                    
                    1,303,293
                    
                    
                    
                    604,465Accumulated
      deficit
                    
                    
                    (20,807,095
                    )
                    
                    
                    (19,663,823
                    )Total
      Shareholders’ Equity
                    
                    
                    21,771,057
                    
                    
                    
                    21,392,498Total
      Liabilities and Shareholders’ Equity
                    
                    $
                    33,299,875
                    
                    
                    $
                    36,207,322





See
accompanying consolidated notes.


27


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Consolidated
Statements of Operations





Year ended December 31,2009
                    
                    
                    2008Net
      Sales
                    
                    $
                    48,526,158
                    
                    
                    $
                    50,199,428Cost
      of sales
                    
                    
                    33,468,440
                    
                    
                    
                    35,289,684Gross
      Profit
                    
                    
                    15,057,718
                    
                    
                    
                    14,909,744Operating
      expensesSelling,
      general and administrative
                    
                    
                    15,135,233
                    
                    
                    
                    17,196,863Research
      and development
                    
                    
                    399,558
                    
                    
                    
                    653,326Total
      operating expenses
                    
                    
                    15,534,791
                    
                    
                    
                    17,850,189Operating
      loss
                    
                    
                    (477,073
                    )
                    
                    
                    (2,940,445
                    )Other
      expense, net:Interest
      expense
                    
                    
                    842,132
                    
                    
                    
                    940,148Other
      (income) expense, net
                    
                    
                    (244,596
                    )
                    
                    
                    22,529Total
      other expense, net
                    
                    
                    597,536
                    
                    
                    
                    962,677Loss
      before provision for income taxes
                    
                    
                    (1,074,609
                    )
                    
                    
                    (3,903,122
                    )Provision
      for income taxes
                    
                    
                    68,663
                    
                    
                    
                    58,815Net
      Loss
                    
                    $
                    (1,143,272
                    )
                    
                    $
                    (3,961,937
                    )Net
      loss per common share – basic and diluted
                    
                    $
                    (0.23
                    )
                    
                    $
                    (0.82
                    )Shares
      used in computing loss per common share – basic and
diluted
                    
                    
                    5,031,557
                    
                    
                    
                    4,825,847





See
accompanying consolidated notes.


28


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Consolidated
Statements of Shareholders’ Equity





Preferred
                          Shares
                          Issued
                        
                        
                        Convertible
                          Preferred
                          Stock
                        
                        
                        Common
                          Shares
                          Issued
                        
                        
                        Common
                          Stock
                        
                        
                        Additional
                          Paid-In
                          Capital
                        
                        
                        Accumulated
                          Other
                          Comprehensive
                          Income
      (Loss)
                        
                        
                        Accumulated
                          Deficit
                        
                        
                        Total
                          Shareholders’
                          EquityBalance,
      January 1, 2008
                        
                        
                        285,051
                        
                        
                        $
                        2,851
                        
                        
                        
                        4,228,719
                        
                        
                        $
                        42,287
                        
                        
                        $
                        33,856,916
                        
                        
                        $
                        1,854,787
                        
                        
                        $
                        (15,701,886
                        )
                        
                        $
                        20,054,955Net
      loss
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (3,961,937
                        )
                        
                        
                        (3,961,937
                        )Foreign
      currency translation adjustment
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,250,322
                        )
                        
                        
                        
                        
                        
                        
                        (1,250,322
                        )Comprehensive
      loss – total
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,212,259
                        )Issuance
      of common stock in private placement, net of issuance  costs of
      $389,079
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        762,500
                        
                        
                        
                        7,625
                        
                        
                        
                        5,603,246
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5,610,871Cashless
      exercise of warrants
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        11,399
                        
                        
                        
                        114
                        
                        
                        
                        (114
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Exercise
      of common stock warrants
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        12,500
                        
                        
                        
                        125
                        
                        
                        
                        104,875
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        105,000Exercise
      of common stock options
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2,475
                        
                        
                        
                        25
                        
                        
                        
                        12,350
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        12,375Stock
      based charges
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        821,556
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        821,556Balance,
      December 31, 2008
                        
                        
                        285,051
                        
                        
                        $
                        2,851
                        
                        
                        
                        5,017,593
                        
                        
                        $
                        50,176
                        
                        
                        $
                        40,398,829
                        
                        
                        $
                        604,465
                        
                        
                        $
                        (19,663,823
                        )
                        
                        $
                        21,392,498Net
      loss
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,143,272
                        )
                        
                        
                        (1,143,272
                        )Foreign
      currency translation adjustment
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        698,828
                        
                        
                        
                        
                        
                        
                        
                        698,828Comprehensive
      loss – total
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (444,444
                        )Issuance
      of common stock
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        21,875
                        
                        
                        
                        219
                        
                        
                        
                        (219
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Stock
      issuance costs
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,000
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,000
                        )Stock
      based charges
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        828,003
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        828,003Balance,
      December 31, 2009
                        
                        
                        285,051
                        
                        
                        $
                        2,851
                        
                        
                        
                        5,039,468
                        
                        
                        $
                        50,395
                        
                        
                        $
                        41,221,613
                        
                        
                        $
                        1,303,293
                        
                        
                        $
                        (20,807,095
                        )
                        
                        $
                        21,771,057





See
accompanying consolidated notes.


29


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Consolidated
Statements of Cash Flows





Year
      Ended December 31,2009
                        
                        
                        2008Operating
      ActivitiesNet
      loss
                        
                        $
                        (1,143,272
                        )
                        
                        $
                        (3,961,937
                        )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      of equipment and improvements
                        
                        
                        882,598
                        
                        
                        
                        855,609Amortization
      of intangible assets
                        
                        
                        1,315,879
                        
                        
                        
                        1,427,524Amortization
      of deferred financing costs
                        
                        
                        144,565
                        
                        
                        
                        129,519Provision
      for bad debts
                        
                        
                        (92,827
                        )
                        
                        
                        247,000Allowance
      for sales adjustments
                        
                        
                        702,999
                        
                        
                        
                        690,625Provision
      for inventory obsolescence
                        
                        
                        363,170
                        
                        
                        
                        349,303Gain
      on disposal of equipment
                        
                        
                        (59,031
                        )
                        
                        
                        –Deferred
      rent expense
                        
                        
                        46,318
                        
                        
                        
                        (60,115
                        )Compensation
      charge for employee stock options
                        
                        
                        800,945
                        
                        
                        
                        773,136Compensation
      charge for restricted stock
                        
                        
                        18,148
                        
                        
                        
                        48,420Interest
      charge for stock warrants
                        
                        
                        8,910
                        
                        
                        
                        –Deferred
      tax provision
                        
                        
                        (35,822
                        )
                        
                        
                        (5,008
                        )Changes
      in operating assets and liabilities:Accounts
      receivable
                        
                        
                        (151,126
                        )
                        
                        
                        (476,106
                        )Inventories
                        
                        
                        1,002,031
                        
                        
                        
                        (3,570,840
                        )Prepaid
      expenses and other current assets
                        
                        
                        19,203
                        
                        
                        
                        7,724Other
      assets
                        
                        
                        (440
                        )
                        
                        
                        (46,291
                        )Accounts
      payable
                        
                        
                        (367,404
                        )
                        
                        
                        (241,634
                        )Accrued
      expenses and other current liabilities
                        
                        
                        (800,640
                        )
                        
                        
                        (910,896
                        )Net
      cash provided by (used in) operating activities
                        
                        
                        2,654,204
                        
                        
                        
                        (4,743,967
                        )Investing
      ActivitiesCosts
      of acquiring businesses
                        
                        
                        –
                        
                        
                        
                        (120,484
                        )Refund
      of acquired business escrow funds
                        
                        
                        –
                        
                        
                        
                        1,193,187Purchase
      of equipment and improvements
                        
                        
                        (265,726
                        )
                        
                        
                        (471,357
                        )Proceeds
      from sale of equipment
                        
                        
                        61,000
                        
                        
                        
                        –Net
      cash(used in)
      provided by investing activities
                        
                        
                        (204,726
                        )
                        
                        
                        601,346Financing
      ActivitiesCash
      restricted
                        
                        
                        (17,742
                        )
                        
                        
                        (2,014,422
                        )Net
      change in bank line of credit
                        
                        
                        (1,140,299
                        )
                        
                        
                        2,227,408Deferred
      financing costs
                        
                        
                        –
                        
                        
                        
                        (269,235
                        )Deferred
      issuance costs
                        
                        
                        (305,715
                        )
                        
                        
                        –Long-term
      debt repayments
                        
                        
                        (1,298,208
                        )
                        
                        
                        (1,313,749
                        )Proceeds
      from issuance of common stock, net of costs
                        
                        
                        (5,000
                        )
                        
                        
                        5,728,246Net
      cash (used in) provided by financing activities
                        
                        
                        (2,766,964
                        )
                        
                        
                        4,358,248Effect
      of exchange rate changes on cash
                        
                        
                        169,972
                        
                        
                        
                        (401,684
                        )Net
      decrease in cash and cash equivalents
                        
                        
                        (147,514
                        )
                        
                        
                        (186,058
                        )Cash
      and cash equivalentsBeginning
      of year
                        
                        
                        391,038
                        
                        
                        
                        577,096End
      of year
                        
                        $
                        243,524
                        
                        
                        $
                        391,038Supplemental
      disclosures of cash flow information:Equipment
      obtained with capital leases
                        
                        $
                        -
                        
                        
                        $
                        96,324Cash
      paid during the year for:Interest
                        
                        $
                        723,339
                        
                        
                        $
                        809,808





See
accompanying consolidated notes.





30




DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Consolidated Financial Statements








1.
            Description
      of Business





Derma
Sciences, Inc. and its subsidiaries (the “Company”) is a full line provider of
wound care, wound closure and specialty securement devices 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 facilities are located in St. Louis, Missouri, and Houston,
Texas, while the Company’s Canadian distribution facility is located in Toronto.
The Company has manufacturing facilities in Toronto, Canada and Nantong,
China.





2.
            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.





Reverse Stock Split –The
accompanying financial statements reflect a 1-for-8 reverse split of the
Company’s common and preferred stock approved by the board of directors and
stockholders of the Company and made effective by an amendment to the Company’s
articles of incorporation on January 28, 2010. All share and per share
information herein that relates to the Company’s common and preferred stock has
been retroactively restated to reflect the reverse stock split.





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. 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 income of $84,423 and $128,470 for the years
ended December 31, 2009 and 2008 which is included in the consolidated statement
of operations as follows:





2009
                            
                            
                            2008Cost
      of sales
                            
                            $
                            152,853
                            
                            
                            $
                            (311,949
                            )Other
      (income) expense, net
                            
                            
                            (237,276
                            )
                            
                            
                            183,479$
                            (84,423
                            )
                            
                            $
                            (128,470
                            )





Exchange
rate fluctuations of foreign currency denominated assets and liabilities
associated with inventory are included in cost of sales.





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.


31


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Consolidated Financial Statements








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 $250,000.
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.





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 term nature. The fair value of the
Company's long-term debt approximates book value as the debt is 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 or fair value as determined as of the date of
acquisition. 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,
non-compete and other agreements are amortized over 4 to 13 years on a
straight-line basis.





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 tests
goodwill for impairment using a two-step process. 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. The Company performs its goodwill impairment test as of
December 31 of each year, or more frequently if impairment indicators are
present.





Stock-Based Compensation –
Financial Accounting Standards Board (FASB) guidance for stock compensation
requires that new, modified and unvested share-based payment transactions with
employees, such as grants of stock options and restricted stock, be recognized
in the financial statements based on their fair value at the grant date and
recognized as compensation expense over their requisite service periods. The
Company estimates the fair value of stock options as of the date of grant using
the Black-Scholes for service and performance based awards or binomial/lattice
pricing model for market based awards and restricted stock based on the quoted
market price.


32


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Consolidated Financial Statements







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.





The Company measures and recognizes the
tax implications of positions taken or expected to be taken in its tax returns
on an ongoing basis.  In 2009 and 2008, the Company had no
unrecognized tax benefits or liabilities, and no adjustment to its financial
position, results of operations or cash flows were required.  The
Company records interest and penalties related to tax matters within other
expense on the accompanying Consolidated Statements of
Operations.  These amounts are not material to the consolidated
financial statements for the periods presented.  The Company’s U.S.
tax returns are subject to examination by federal and state taxing
authorities.  Tax years prior to 2006 are no longer subject to federal
or state examination.  Tax years prior to 2006 are also no longer
subject to examination in Canada.





Revenue Recognition – The
Company operates in three segments: wound care, wound closure and specialty
securement devices and skin care.  Sales are recorded when product is
shipped or title passes to customers and collectability is reasonably
assured.  Gross sales are adjusted for cash discounts, returns and
allowances, trade rebates, distribution fees (in Canada) and other sales
deductions 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
$1,131,909 and $1,276,368 in 2009 and 2008, respectively.





Royalties –The Company
recognizesroyalty
expenses associated with the products sold at the time the related sale occurs
and records them as a component of cost of sales.  Royalty expense for
the years ended December 31, 2009 and 2008 was $447,291 and $346,260,
respectively.





Net Loss per Share– Net loss
per common share – basic is computed by dividing net loss by the weighted
average number of common shares outstanding for the period.  Net loss
per common share – diluted reflects the potential dilution of earnings by
including the effects of the assumed exercise, conversion or issuance of
potentially issuable shares of common stock (“potentially dilutive securities”),
including those attributable to stock options, warrants, convertible preferred
stock and restricted common stock in the weighted average number of common
shares outstanding for a period, if dilutive.  The effects of the
assumed exercise of warrants and stock options are determined using the treasury
stock method.  Potentially dilutive securities have not been included
in the computation of diluted loss per share for the years ended December 31,
2009 and 2008 as the effect would be anti-dilutive.





33




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Potentially
dilutive shares excluded as a result of the effects being anti-dilutive are as
follows:





Year Ended December 31,2009
                              
                              
                              2008Excluded
      dilutive shares:Preferred
      stock
                              
                              
                              285,051
                              
                              
                              
                              285,051Restricted
      common stock
                              
                              
                              -
                              
                              
                              
                              21,875Stock
      options
                              
                              
                              1,066,328
                              
                              
                              
                              1,002,828Warrants
                              
                              
                              1,099,407
                              
                              
                              
                              1,093,157Total
      dilutive shares
                              
                              
                              2,450,786
                              
                              
                              
                              2,402,911




Recently Issued Accounting
Pronouncements– Effective January 1, 2009, the Financial Accounting
Standards Board (“FASB”) issued new guidance related to assessing whether an
equity-linked financial instrument (or embedded feature) is indexed to an
entity’s own stock for the purposes of determining whether such equity-linked
financial instrument (or embedded feature) is subject to derivative
accounting.  We adopted this new guidance effective January 1,
2009 which had no impact on the consolidated financial statements.





In
April 2009, the FASB issued additional guidance requiring fair value
disclosures in both interim as well as annual financial statements in order to
provide more timely information about the effects of current market conditions
on financial instruments.  The guidance is effective for interim and
annual periods ending after June 15, 2009, and we adopted this guidance
commencing with our June 30, 2009 consolidated financial
statements.  The implementation of this standard did not have a
material impact on our consolidated balance sheet and operating
results.





In May 2009, the FASB issued new
guidance on the reporting of subsequent events which establishes general
standards of accounting for and disclosure of events that occur after the
balance sheet date but before financial statements are issued or are available
to be issued.  This statement sets forth the circumstances under which an
entity should recognize events or transactions occurring after the balance sheet
date in its financial statements.  We adopted this standard during the
quarter ended June 30, 2009.





On
July 1, 2009, the FASB issued the FASB Accounting Standards
Codification (the “Codification”).  The Codification became the single
source of authoritative nongovernmental U.S. GAAP, superseding existing
literature of the FASB, American Institute of Certified Public Accountants,
Emerging Issues Task Force and other sources.  The Codification was
effective for interim and annual periods ending after September 15,
2009.  We adopted the Codification for the quarter ended
September 30, 2009.  There was no impact on our consolidated
balance sheet and results of operations as this change is disclosure-only in
nature.




In
September 2009, the FASB issued amendments to the accounting and disclosure
for revenue recognition.  These amendments, effective for fiscal years
beginning on or after June 15, 2010 (early adoption is permitted), modify
the criteria for recognizing revenue in multiple element arrangements and the
scope of what constitutes a non-software deliverable.  The impact of
the adoption of these amendments will depend on the nature of the arrangements
that we enter into subsequent to the date we adopt the amendments.





34


DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




3.
            Accounts
      Receivable





Accounts
receivable include the following:





December 31,2009
                      
                      
                      2008Accounts
      receivable
                      
                      $
                      4,216,147
                      
                      
                      $
                      5,213,167Less:
      Allowance for doubtful accounts
                      
                      
                      (73,318
                      )
                      
                      
                      (370,000
                      )Allowance for trade rebates
                      
                      
                      (642,789
                      )
                      
                      
                      (709,244
                      )Allowance for cash discounts and returns
                      
                      
                      (127,328
                      )
                      
                      
                      (241,400
                      )Accounts
      receivable, net
                      
                      $
                      3,372,712
                      
                      
                      $
                      3,892,523





4.
            Inventories





Inventories
include the following:





December 31,2009
                              
                              
                              2008Finished
      goods
                              
                              $
                              7,804,339
                              
                              
                              $
                              9,001,269Work
      in process
                              
                              
                              466,365
                              
                              
                              
                              443,511Packaging
      materials
                              
                              
                              722,148
                              
                              
                              
                              700,948Raw
      materials
                              
                              
                              2,496,872
                              
                              
                              
                              2,277,314Total
      inventory
                              
                              $
                              11,489,724
                              
                              
                              $
                              12,423,042





5.
            Equipment
      and Improvements, net





Equipment
and improvements include the following:





December 31,2009
                                
                                
                                2008Machinery
      and equipment
                                
                                $
                                5,677,389
                                
                                
                                $
                                5,110,112Furniture
      and fixtures
                                
                                
                                609,694
                                
                                
                                
                                569,617Leasehold
      improvements
                                
                                
                                1,473,920
                                
                                
                                
                                1,229,168Gross
      equipment and improvements
                                
                                
                                7,761,003
                                
                                
                                
                                6,908,897Less:
      accumulated depreciation
                                
                                
                                (4,019,656
                                )
                                
                                
                                (2,931,044
                                )Total
      equipment and improvements, net
                                
                                $
                                3,741,347
                                
                                
                                $
                                3,977,853





Included in equipment and improvements
at December 31, 2009 were leased machinery and equipment with a cost of $161,381
and accumulated amortization of $92,795 and furniture and fixtures with a cost
of $260,069 and accumulated amortization of $118,315.  Amortization of
assets under capital leases is included in depreciation expense.




35




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




6.
            Other
      Intangible Assets, net





Other
intangible assets, net include the following:





December 31,2009
                              
                              
                              2008Patents
      and trademarks
                              
                              $
                              444,067
                              
                              
                              $
                              444,067Other
      intangible assets
                              
                              
                              7,842,797
                              
                              
                              
                              7,842,7978,286,864
                              
                              
                              
                              8,286,864Less
      accumulated amortization
                              
                              
                              (4,292,614
                              )
                              
                              
                              (2,976,735
                              )Other
      intangible assets, net
                              
                              $
                              3,994,250
                              
                              
                              $
                              5,310,129





In
connection with the acquisition of certain assets and assumption of trade
payables in 2007 and 2006, the Company allocated $7,500,000 to identifiable
intangible assets as outlined below:





Fair Value
                      
                      
                      Annual Amortization
                      
                      Amortization PeriodCustomer
      list
                      
                      $
                      3,300,000
                      
                      
                      $
                      600,000
                      
                      4-10
      yearsTrademarks
      and trade names
                      
                      
                      1,600,000
                      
                      
                      
                      135,000
                      
                      10-13
      yearsNon-compete
      agreement
                      
                      
                      1,200,000
                      
                      
                      
                      240,000
                      
                      5
      yearsOther
      agreements
                      
                      
                      1,200,000
                      
                      
                      
                      300,000
                      
                      4
      yearsCertification
      and product designs
                      
                      
                      200,000
                      
                      
                      
                      39,000
                      
                      5
      yearsTotal
                      
                      $
                      7,500,000
                      
                      
                      $
                      1,314,000





The
weighted average useful life of patent and trademarks and other intangibles as
of December 31, 2009 and 2008 is 3.0 and 3.8 years,
respectively.  Actual amortization expense for 2009 and 2008 and
estimated thereafter by year is outlined below:





Patents and
                                        Trademarks
                                      
                                      
                                      Other
                                        Intangibles
                                      
                                      
                                      TotalActual
      amortization expense for year ended December 31, 2009
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      1,315,879
                                      
                                      
                                      $
                                      1,315,879Actual
      amortization expense for year ended December 31, 2008
                                      
                                      $
                                      36,012
                                      
                                      
                                      $
                                      1,391,511
                                      
                                      
                                      $
                                      1,427,524Estimated
      amortization expense for years ending December 31,2010
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      1,314,000
                                      
                                      
                                      $
                                      1,314,0002011
                                      
                                      
                                      -
                                      
                                      
                                      
                                      1,050,375
                                      
                                      
                                      
                                      1,050,3752012
                                      
                                      
                                      -
                                      
                                      
                                      
                                      323,000
                                      
                                      
                                      
                                      323,0002013
                                      
                                      
                                      -
                                      
                                      
                                      
                                      285,000
                                      
                                      
                                      
                                      285,0002014
                                      
                                      
                                      -
                                      
                                      
                                      
                                      285,000
                                      
                                      
                                      
                                      285,000Thereafter
                                      
                                      
                                      -
                                      
                                      
                                      
                                      736,875
                                      
                                      
                                      
                                      736,875Total
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      3,994,250
                                      
                                      
                                      $
                                      3,994,250




36




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




7.
            Other
      Assets, net





Other
assets, net include the following:





December 31,2009
                            
                            
                            2008Deferred
      financing costs, net
                            
                            $
                            414,647
                            
                            
                            $
                            559,212Deferred
      issuance costs
                            
                            
                            305,715
                            
                            
                            
                            -Deposits
                            
                            
                            129,391
                            
                            
                            
                            122,260Total
      other assets, net
                            
                            $
                            849,753
                            
                            
                            $
                            681,472





Deferred financing costs related to the
U.S. credit facility are being amortized over the five-year term of the related
facility.  Costs incurred through December 31, 2009 in connection with
the February, 2010 equity raise (see note 15) are included in deferred issuance
costs and will be reclassified to additional paid in capital upon the close of
the equity offering.





8.
            Line
      of Credit Borrowings





In
November, 2007, the Company entered into a new five-year revolving credit
agreement providing for maximum borrowings of $8,000,000 with a U.S.
lender.  Advances under the revolving credit agreement may be drawn,
from time to time, up to the amount of 85% of eligible receivables (as defined)
and 44% of eligible inventory (as defined). Interest on outstanding advances
under the revolving credit agreement as amended is payable at the three
month LIBOR monthly rate (the “Base Rate”) plus 4.25% (the “Base Rate
Margin”) (6.00% at December 31, 2009).   In addition, the Company
pays a monthly unused line fee of 0.5% per annum on the difference between the
daily average amount of advances outstanding under the agreement and $8,000,000
together with a monthly collateral management fee of
$2,000.  Outstanding balances under the agreement are secured by all
of the Company’s and its subsidiaries’ existing and after-acquired tangible and
intangible assets located in the United States and Canada.  At
December 31, 2009 the Company had an outstanding balance of $2,306,306 under
this agreement.





The revolving credit agreement is
subject to financial covenants which require maintaining a minimum cumulative
EBITDA level and certain ratios of fixed charge coverage, senior debt leverage
and total debt leverage as defined in the agreement.  Additional
covenants governing permitted investments, indebtedness and liens, together with
payments of dividends and protection of collateral, are also included in the
agreement.  The revolving credit agreement contains a subjective
acceleration provision whereby the lender can declare a default upon a material
adverse change in the Company’s business operations.





On March
31, 2009, the Company’s U.S. lender agreed to amend the credit and security
agreement to allow the Company to enter into a forbearance agreement with
Western Medical to postpone payment of its promissory note due April 18, 2009
and to allow subsequent payments on the subordinated debt beginning in April
2010 provided the Company achieves predetermined liquidity and free cash flow
(as defined) objectives and provided Western Medical further extends for one
year the payment of the principal balance, if any, remaining on the promissory
note after giving effect to the April, 2010 payment.  In return for
the amendment, the Company agreed to change its base rate for interest charged
to a three month LIBOR rate from a one month LIBOR rate.  Further, the
base rate margin was increased 150 basis points on the revolving line of credit
from 2.75% to 4.25%, on the term loan from 4.25% to 5.75% and on the portion of
the term loan secured by restricted cash from 2.25% to 3.75%.  In
addition, the Company is obligated to increase the revolving loan availability
on its revolving line of credit to a minimum of $3,000,000 by December 31,
2009.  Failure to achieve the minimum revolving loan availability
amount will result in the base rate changing to the greater of 3.00% or the
actual rate in effect. The Company did not increase the availability of its
line of credit to a minimum of $3,000,000 by December 31, 2009. Accordingly,
effective January 1, 2010 the base rate changed from the three month LIBOR
rate to the greater of 3.00% or the actual rate in effect.




37


DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Effective
August 13, 2008, the Company’s lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge
coverage, senior debt leverage and total debt leverage covenants to allow the
Company to continue to implement its growth strategy in line with the lender’s
minimum liquidity terms.  Amendment of the covenants was predicated
upon the Company segregating $2,000,000 in a restricted account the use of which
is subject to the approval of the lender.  The Company’s maximum
revolver borrowing capacity remained unchanged.  The Company incurred
fees of $25,000 associated with the granting of the covenant
amendment.





Effective
March 28, 2008, the Company’s U.S. lender agreed to waive all prior financial
and reporting covenant defaults and amend the existing minimum EBITDA, fixed
charge coverage, senior debt leverage and total debt leverage covenants, to be
measured on a quarterly basis, to allow the Company to implement its growth
strategy.  Amendment of the covenants was predicated upon the
Company’s commitment to raise a minimum of $3,000,000 by May 1, 2008 from the
sale of equity and agreement to limit its maximum revolver borrowing to the
lesser of (a) the revolver loan commitment ($8,000,000) or (b) the borrowing
base (as defined), less $1,500,000.  Not less than $3,000,000 of the
equity infusion was required to be applied to the then existing revolver balance
which amount will be credited as a component of EBITDA for covenant compliance
purposes.  The Company incurred fees of $250,000 associated with the
granting of the covenant amendment, together with related expenses of $10,829
which are included as additions to deferred financing costs.  In
March, 2008 the equity infusion requirement was met (see Note 11).





9.
            Accrued
      Expenses and Other Current
Liabilities





Accrued
expenses and other current liabilities include the following:





December 31,2009
                      
                      
                      2008Accrued
      Canadian sales rebate, net (see note 15)
                      
                      $
                      369,197
                      
                      
                      $
                      1,257,273Accrued
      compensation and related taxes
                      
                      
                      317,230
                      
                      
                      
                      177,133Accrued
      sales incentives and administrative fees
                      
                      
                      260,985
                      
                      
                      
                      347,841Other
                      
                      
                      395,055
                      
                      
                      
                      222,246Total
      accrued expenses and other current liabilities
                      
                      $
                      1,342,467
                      
                      
                      $
                      2,004,493





At December 31, 2009 and 2008, the
value of the Canadian accrued sales rebate and other reserves exceeded the value
of the underlying trade receivables outstanding.  The net credit
balance in trade receivables was reclassified for financial reporting purposes
to accrued expense to recognize it as a net liability.




38




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




10.
            Long-Term
      Debt





Long-term debt and capital leases
includes the following:





December 31,2009
                              
                              
                              2008U.S.
      term loan
                              
                              $
                              3,500,000
                              
                              
                              $
                              4,700,000Promissory
      note
                              
                              
                              500,000
                              
                              
                              
                              500,000Capital
      lease obligations
                              
                              
                              65,036
                              
                              
                              
                              163,243Total
      debt
                              
                              
                              4,065,036
                              
                              
                              
                              5,363,243Less:
      current maturities
                              
                              
                              1,759,185
                              
                              
                              
                              1,298,207Long-term
      debt
                              
                              $
                              2,305,851
                              
                              
                              $
                              4,065,036





The following are term loan and
promissory note maturities over the next five years:





Year Ending
                                  December 31,
                                
                                Term Loan and
                                  Promissory Note2010
                                
                                $
                                1,700,0002011
                                
                                
                                1,200,0002012
                                
                                
                                1,100,0002013
                                
                                
                                -Total
      term loan obligations
                                
                                
                                4,000,000Less:
      current maturities
                                
                                
                                1,700,000Long-term
      loan obligations
                                
                                $
                                2,300,000





U.S. Term Loan





In
November, 2007, the Company entered into a five-year $6,000,000 term loan
agreement with a U.S. lender.  Interest on the term loan as amended is
payable at the three month LIBOR monthly rate plus 5.75%, (7.50% at December 31,
2009).  Monthly payments of principal in the amount of $100,000
together with interest are due under the agreement.  The agreement is
secured by all of the Company’s and its subsidiaries’ existing and
after-acquired tangible and intangible assets located in the United States and
Canada.





The term
loan agreement is subject to financial covenants which require maintaining a
minimum cumulative EBITDA level and certain ratios of fixed charge coverage,
senior debt leverage and total debt leverage as defined in the
agreement.  Additional covenants governing permitted investments,
indebtedness and liens, together with payments of dividends and protection of
collateral, are also included in the agreement.  The term loan
agreement contains a subjective acceleration provision whereby the lender can
declare a default upon a material adverse change in the Company’s business
operations.





Effective
March 31, 2009, August 13, 2008 and March 28, 2008, the foregoing financial
covenants were amended as described in the third, fourth and
fifth  paragraphs under the heading Line of Credit Borrowings (see
Note 8).





39


DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Promissory
Note





In connection with the acquisition of
Western Medical in April 2006, a portion of the purchase price was paid via a
three-year unsecured promissory note issued to the seller.  The
principal amount of the promissory note, together with simple interest of 12%,
is payable in 11 quarterly installments of interest only in the amount of
$15,000 and a final payment of accrued interest of $15,000 and the principal
balance of $500,000 on April 18, 2009.  The promissory note may be
prepaid in part or in full at any time without penalty.





On March 31, 2009, the Company entered
into a Forbearance Agreement (the “Agreement”) with Western Medical to postpone
payment of its $500,000 promissory note due April 18, 2009.  The
Company will continue to make interest payments when due and a final payment of
the principal plus accrued interest through the date of payment on April 14,
2010.  In consideration for the postponement, the Company granted
Western Medical warrants to purchase 6,250 shares of the Company’s common
stock at the market price on the date of execution of the Agreement and agreed
to pay Western Medical’s legal fees associated with the preparation and
subsequent enforcement of the Agreement.  In 2009 the Company recorded
an interest charge of $8,910 for the fair value of the warrants.





Capital Lease Obligations





The Company has two capital lease
obligations for office furniture totaling $65,036 as of December 31,
2009.  The capital lease obligations bear interest at annual rates
ranging from 6.8% to 9.6% expiring through February 2011.





The future minimum lease payments
required under the capital leases and the present value of the minimum lease
payments as of December 31, 2009 are as follows:





Year Ending
                                  December 31
                                
                                Capital Lease
                                  Obligations2010
                                
                                $
                                61,4632011
                                
                                
                                5,901Total
      minimum lease payments
                                
                                
                                67,364Less:
      Amount representing interest
                                
                                
                                2,328Present
      value of capital lease obligations
                                
                                
                                65,036Less:
      Current maturities of capital lease obligations
                                
                                
                                59,185Long-term
      capital lease obligations
                                
                                $
                                5,851





11.
            Shareholders’
      Equity





Preferred
Stock





There are
18,750 shares of series A convertible preferred stock outstanding at December
31, 2009.  The series A preferred stock is convertible into common
stock on a one-for-one basis, bears no dividend, maintains a liquidation
preference of $32.00 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
55,001 shares of series B convertible preferred stock outstanding at December
31, 2009.  The series B preferred stock is convertible into common
stock on a one-for-one basis, bears no dividend, maintains a liquidation
preference of $48.00 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.





40
 
  DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements


There are 77,382 shares of series C
convertible preferred stock outstanding at December 31, 2009.  The
series C preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $5.60 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 133,918 shares of series D
convertible preferred stock outstanding at December 31, 2009.  The
series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $4.00 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





Effective May 12, 2009 21,875 shares of
common stock were issued to outside directors upon vesting of compensatory
restricted stock granted on May 12, 2006.





In March
2008, the Company raised $5,605,871 (net of $494,129 in commission and other
offering expenses) from the private sale of 762,500 shares of common stock at a
price of $8.00 per share, together with 381,250 five-year warrants to purchase
one share of common stock at a price of $9.60 per share.  In addition,
the placement agent for the shares sold received 17,812 five-year warrants to
purchase one share of common stock at $9.60 per share.  The proceeds
were used to meet the minimum equity infusion requirements associated with the
Company’s March 28, 2008 amended bank covenants, support the Company’s strategic
growth initiatives and increase working capital.





In January 2008, the Company issued
26,374 shares of common stock as follows:  (a) 12,500 shares in
consideration of $105,000 upon exercise of series G warrants, (b) 2,475 shares
for consideration of $12,375 upon exercise of 2,475 stock options, and (c)
11,399 shares upon cashless exercise of 22,275 stock options.





Stock
Purchase Warrants





At December 31, 2009, the Company had
warrants outstanding to purchase 1,099,407 shares of the Company’s common stock
as outlined below:





Series
                          
                          
                          Number of Warrants
                          
                          
                          Exercise Price
                          
                          
                          Expiration DateH
                          
                          
                          
                          331,887
                          
                          
                          $
                          8.00
                          
                          
                          April
      30, 2011I
                          
                          
                          
                          94,351
                          
                          
                          $
                          5.76
                          
                          
                          April
      30, 2011J
                          
                          
                          
                          267,857
                          
                          
                          $
                          6.16
                          
                          
                          May
      31, 2013K
                          
                          
                          
                          399,062
                          
                          
                          $
                          9.60
                          
                          
                          April
      1, 2013L
                          
                          
                          
                          6,250
                          
                          
                          $
                          3.12
                          
                          
                          March
      31, 2014Total
                          
                          
                          
                          1,099,407





Stock
      Options





The
Company has a stock option plan under which options to purchase a maximum of
1,250,000 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.  Under the plan, service and performance based options
to purchase 184,375 and 45,000 shares of common stock were granted to officers,
directors, agents and employees in 2009 and 2008, respectively, with exercise
prices ranging from $2.88 to $8.88 per share.   In 2009 and 2008,
3,750 and 20,625 plan options were forfeited and 87,500 and 2,500 expired,
respectively.  In 2008, 24,750 options were exercised.  As
of December 31, 2009, options to purchase 859,328 shares of the Company’s common
stock were issued and outstanding under the plan.





41




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements


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, 2009, non-plan options to
purchase 207,000 shares of the Company’s common stock were issued and
outstanding.  In 2008 5,000 non-plan options were
forfeited.  In 2009 and 2008 29,625 and 17,232 non-plan options
expired, respectively.





For the years ended December 31, 2009
and 2008 the fair value of each service and performance based option award was
estimated at the date of grant using the Black-Scholes option pricing
model.  The weighted-average assumptions for the years ended December
31, 2009 and 2008 were as follows:





2009
                  
                  
                  2008Risk-free
      interest rate
                  
                  
                  2.32
                  %
                  
                  
                  3.08
                  %Volatility
      factor
                  
                  
                  92
                  %
                  
                  
                  118
                  %Dividend
      yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %Expected
      option life (years)
                  
                  
                  6.25
                  
                  
                  
                  6.25Contractual
      life (years)
                  
                  
                  10
                  
                  
                  
                  10





In both
2009 and 2008, the risk-free rate utilized represents the U.S. Treasury yield
curve rate which approximates the risk-free rate for the expected option life at
the time of grant.  In 2009 and 2008, the volatility factor was
calculated based on the seventy-five month-end closing prices of the Company’s
common stock preceding the month of stock option grant.  The Company
uses a seventy-five month volatility period to coincide with the expected stock
option life.  The dividend yield is 0% since the Company does not
anticipate paying dividends in the near future.  Based on the
Company’s historical experience of options that expired or are cancelled before
becoming fully vested, the Company has assumed an annualized forfeiture rate of
1.0% for all options.  The Company will record additional expense if
the actual forfeiture rate is lower than estimated, and will record a recovery
of prior expense if the actual forfeiture rate is higher than
estimated.





42




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements


A summary
of the Company’s stock option activity and related information for the years
ended December 31, 2009 and 2008 follows:





2009
                          
                          
                          2008Options
                          
                          
                          Weighted
                            Average
                            Exercise Price
                          
                          
                          Options
                          
                          
                          Weighted
                            Average
                            Exercise PriceOutstanding – beginning of year
                          
                          
                          1,002,828
                          
                          
                          $
                          5.60
                          
                          
                          
                          1,027,935
                          
                          
                          $
                          6.24Granted
                          
                          
                          184,375
                          
                          
                          $
                          3.07
                          
                          
                          
                          45,000
                          
                          
                          $
                          7.36Forfeited
                          
                          
                          (3,750
                          )
                          
                          $
                          5.31
                          
                          
                          
                          (25,625
                          )
                          
                          $
                          6.64Expired
                          
                          
                          (117,125
                          )
                          
                          $
                          5.83
                          
                          
                          
                          (19,732
                          )
                          
                          $
                          46.48Exercised
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (24,750
                          )
                          
                          $
                          5.04Outstanding
      – end of year
                          
                          
                          1,066,328
                          
                          
                          $
                          5.08
                          
                          
                          
                          1,002,828
                          
                          
                          $
                          5.60Exercisable
      at end of year
                          
                          
                          882,031
                          
                          
                          $
                          5.34
                          
                          
                          
                          795,328
                          
                          
                          $
                          5.60





The weighted average fair value per
share of options granted during 2009 and 2008 was $2.34 and $6.38,
respectively.  The fair value of options vested during 2009 and 2008
was $600,994 and $493,075, respectively.





The following table summarizes
information related to stock options outstanding and exercisable at December 31,
2009:





Options Outstanding
                            
                            
                            Options ExercisableRange of
                              Exercise Prices
                            
                            Number
                              Outstanding at
                              12/31/09
                            
                            
                            Weighted-Average
                              Remaining
                              Contractual Life
                            
                            
                            Weighted-Average
                              Exercise Price
                            
                            
                            Number
                              Exercisable at
                              12/31/09
                            
                            
                            Weighted-Average
                              Exercise Price$2.88
      - $4.00
                            
                            
                            453,890
                            
                            
                            
                            4.9
                            
                            
                            $
                            3.37
                            
                            
                            
                            319,280
                            
                            
                            $
                            3.60$4.01
      - $6.00
                            
                            
                            344,750
                            
                            
                            
                            6.7
                            
                            
                            $
                            5.09
                            
                            
                            
                            312,719
                            
                            
                            $
                            5.12$6.01
      - $10.00
                            
                            
                            225,000
                            
                            
                            
                            6.5
                            
                            
                            $
                            6.98
                            
                            
                            
                            207,344
                            
                            
                            $
                            7.04$10.01
      - $13.00
                            
                            
                            18,750
                            
                            
                            
                            4.8
                            
                            
                            $
                            12.40
                            
                            
                            
                            18,750
                            
                            
                            $
                            12.40$13.01
      - $13.60
                            
                            
                            23,938
                            
                            
                            
                            7.0
                            
                            
                            $
                            13.60
                            
                            
                            
                            23,938
                            
                            
                            $
                            13.601,066,328
                            
                            
                            
                            6.08
                            
                            
                            
                            
                            
                            
                            
                            882,031





For the years ended December 31, 2009
and 2008, no income tax benefit was recognized related to stock option
activity.





During the year ended December 31, 2009
and 2008, stock option compensation expense was recorded as
follows:





2009
                        
                        
                        2008Cost
      of sales
                        
                        $
                        97,091
                        
                        
                        $
                        65,428Selling,
      general and administrative expenses
                        
                        
                        703,854
                        
                        
                        
                        707,708Total stock option compensation
      expense
                        
                        $
                        800,945
                        
                        
                        $
                        773,136




43




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




As of
December 31, 2009, there was $464,390 of unrecognized compensation cost related
to nonvested service based awards granted under the plan.  This
expense is expected to be recognized over the options’ remaining weighted
average vesting period of 1.23 years.  The market based awards granted
in 2007 expired in 2009.





Restricted
Common Stock





On May 11, 2006, the Company adopted a
restricted common stock plan and reserved 312,500 shares of common stock for
issuance.





On May 12, 2006, 21,875 shares of
restricted common stock were granted to non-employee members of the Company’s
board of directors that vested three years from the date of the
grant.  The fair market value at the date of grant, determined by the
quoted market price, was $145,250 or $6.64 per share.  The fair market
value of the grant was recognized to compensation expense over the three-year
service period.  For the years ended December 31, 2009 and 2008,
$18,148 and $48,420, respectively, was recorded in selling, general and
administrative expense for these grants.





Shares
Reserved for Future Issuance





At December 31, 2009, the Company had
reserved the following shares of common stock for future issuance:





Convertible
      preferred shares (series A – D)
                  
                  
                  285,051Common
      stock options available for grant
                  
                  
                  390,672Common
      stock options outstanding
                  
                  
                  1,066,328Common
      stock warrants outstanding (series H – L)
                  
                  
                  1,099,407Restricted
      common stock available for grant
                  
                  
                  290,625Total common stock shares
      reserved
                  
                  
                  3,132,083





Securities
Registration Obligations





The Company consummated private
syndications of its securities on April 18, 2006, November 8, 2007 and April 2,
2008.  In connection with each such syndication, the Company agreed
with purchasers both to register the securities for public sale and to use its
best efforts to maintain the effectiveness of such registration statements until
the subject securities are sold or may be sold without
registration.  The Company has satisfied its obligations to register
the securities issued in each of the aforementioned syndications.





The
registration statement relative to the April, 2006 syndication has expired by
its terms.  Although the securities sold in this syndication are
eligible for sale under Rule 144(b(1)(i), the Company has accorded “piggyback”
registration rights to the subject purchasers for an indefinite
period.  The registration statements relative to November, 2007 and
April, 2008 syndications are currently effective and there has been no lapse in
their effectiveness.





The
securities registration provisions applicable to the November, 2007 and April,
2008 syndications require that if the Securities and Exchange Commission
suspends the effectiveness of the subject registration statements prior to all
registered securities either having been sold or becoming eligible for
unrestricted sale pursuant to Rule 144(b)(1)(i) under the Securities Act of
1933, an event not now anticipated, the Company must pay purchasers one
thirtieth of one percent of the purchase price of the securities for each day
the subject registration statement is not effective up to a maximum of ten
percent of the purchase price.





The
securities purchased in the November, 2007 and April, 2008 syndications are all
eligible for unrestricted sale under Rule 144(b)(1)(i) with the exception of
securities purchased by a single institutional investor in the total amount of
$6,500,000.  The Company’s maximum potential liability to the subject
investor under the foregoing registration provisions would be
$650,000.





44




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




The
Company consummated a public offering of its securities on February 22,
2010.  A portion of the underwriter’s compensation in this offering
consisted of warrants to purchase the Company’s common stock.  The
Company agreed to accord the underwriter a single demand registration right and
thereafter “piggyback” registration rights as to the common stock issuable upon
exercise of the underwriter’s stock purchase warrants.  However, the
Company, in lieu of providing the foregoing registration rights, has the
absolute right, in its discretion and without penalty, to satisfy the exercise
of the underwriter’s warrants with unregistered shares of common
stock.





12.
            Operating
      Segments





The
Company consists of three operating segments:  wound care, wound
closure and specialty securement devices and skin care.  Products in
the wound care segment consist of basic and advanced dressings, ointments and
sprays and adhesive bandages.  Wound closure and specialty securement
device products include wound closure strips, nasal tube fasteners and a variety
of catheter fasteners.  The skin care segment consists of
antibacterial skin cleansers, hair and body soaps, lotions and
moisturizers.





Products
in all three operating segments are marketed to long-term care facilities,
hospitals, physicians, clinics, home health care agencies and other healthcare
institutions.  Basic and advanced wound care products are manufactured
both internally and outsourced, while the manufacture of skin care products is
completely outsourced.  Wound closure-specialty securement devices are
significantly 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 2009 and 2008 are as
follows:





Year Ended December 31,
2009





Wound Care
              
              
              Wound Closure-
                Specialty
                Securement Devices
              
              
              Skin Care
              
              
              Other
              
              
              Total
                CompanyNet
      sales
              
              $
              46,017,618
              
              
              $
              1,769,742
              
              
              $
              738,978
              
              
              
              -
              
              
              $
              48,526,158Gross
      profit
              
              
              13,876,494
              
              
              
              985,917
              
              
              
              195,307
              
              
              
              -
              
              
              
              15,057,718Total
      expenses
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (16,200,990
              )Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (1,143,272
              )Net
      long-lived assets
              
              $
              3,242,422
              
              
              $
              132,165
              
              
              $
              -
              
              
              $
              366,760
              
              
              $
              3,741,347




45




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements





Year Ended December 31,
2008





Wound Care
              
              
              Wound Closure-
                Specialty
                Securement Devices
              
              
              Skin Care
              
              
              Other
              
              
              Total
                CompanyNet
      sales
              
              $
              47,641,194
              
              
              $
              1,799,256
              
              
              $
              758,978
              
              
              
              -
              
              
              $
              50,199,428Gross
      profit
              
              
              13,723,998
              
              
              
              968,230
              
              
              
              217,516
              
              
              
              -
              
              
              
              14,909,744Total
      expenses
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (18,871,681
              )Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (3,961,937
              )Net
      long-lived assets
              
              $
              3,293,499
              
              
              $
              130,729
              
              
              $
              41,463
              
              
              $
              512,162
              
              
              $
              3,977,853





Long-lived assets consist of equipment
and improvements.  Wound care long-lived assets consist principally of
Derma Sciences Canada Inc. equipment and improvements.  Corporate
headquarters and the Company’s U.S. distribution center based in Missouri’s
equipment and improvements are included in the Other column since they service
all three operating segments.





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





United States
                              
                              
                              Canada
                              
                              
                              Other
                              
                              
                              Total2009Net
      sales
                              
                              $
                              34,474,068
                              
                              
                              $
                              11,603,748
                              
                              
                              $
                              2,448,342
                              
                              
                              $
                              48,526,158Gross
      profit
                              
                              $
                              11,844,972
                              
                              
                              $
                              2,355,826
                              
                              
                              $
                              856,920
                              
                              
                              $
                              15,057,718Net
      long-lived assets
                              
                              $
                              577,378
                              
                              
                              $
                              2,526,904
                              
                              
                              $
                              637,065
                              
                              
                              $
                              3,741,3472008Net
      sales
                              
                              $
                              35,369,182
                              
                              
                              $
                              12,091,858
                              
                              
                              $
                              2,743,388
                              
                              
                              $
                              50,199,428Gross
      profit
                              
                              $
                              10,585,004
                              
                              
                              $
                              3,364,554
                              
                              
                              $
                              960,186
                              
                              
                              $
                              14,909,744Net
      long-lived assets
                              
                              $
                              893,383
                              
                              
                              $
                              2,627,922
                              
                              
                              $
                              456,548
                              
                              
                              $
                              3,977,853





Other sales and gross profit relate
principally to wound care and wound closure and specialty securement device
sales in Europe and Latin America.





For the year ended December 31, 2009,
the Company has a major U.S. customer comprising 14% of U.S. sales and 12% of
U.S. operations trade accounts receivable at December 31, 2009.  The
Company’s wholly owned Canadian subsidiary sells to one customer who serves as
its exclusive third party distributor and comprises 100% of Canada operations
trade accounts receivable at December 31, 2009.




46




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




13.
            Income
      Taxes





Income (loss) before provision for
income taxes consists of the following components:





2009
                      
                      
                      2008Domestic
                      
                      $
                      (1,240,845
                      )
                      
                      $
                      (4,060,199
                      )Foreign
                      
                      
                      166,236
                      
                      
                      
                      157,077Loss
      before provision for income taxes
                      
                      $
                      (1,074,609
                      )
                      
                      $
                      (3,903,122
                      )





The
components of the provision (benefit) for income taxes are as
follows:




2009
            
            
            2008Current:Federal
            
            $
            -
            
            
            $
            -State
            
            
            3,077
            
            
            
            -Foreign
            
            
            101,408
            
            
            
            63,823Total
      current
            
            
            104,485
            
            
            
            63,823Deferred:Federal
            
            
            -
            
            
            
            -State
            
            
            -
            
            
            
            -Foreign
            
            
            (35,822
            )
            
            
            (5,008
            )Total
      deferred
            
            
            (35,822
            )
            
            
            (5,008
            )Total
      provision for income taxes
            
            $
            68,663
            
            
            $
            58,815




47




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




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





December 31,2009
                                  
                                  
                                  2008Deferred
      tax liabilities:Prepaids
                                  
                                  $
                                  (25,207
                                  )
                                  
                                  $
                                  (28,915
                                  )Intangible
      amortization
                                  
                                  
                                  (464,865
                                  )
                                  
                                  
                                  (299,658
                                  )Deductible acquisition
      costs
                                  
                                  
                                  (110,779
                                  )
                                  
                                  
                                  (110,779
                                  )Depreciation
                                  
                                  
                                  (282,469
                                  )
                                  
                                  
                                  (280,089
                                  )Total deferred tax
      liabilities
                                  
                                  
                                  (883,320
                                  )
                                  
                                  
                                  (719,440
                                  )Deferred
      tax assets:Net operating loss carryforwards
      – U.S.
                                  
                                  
                                  3,752,540
                                  
                                  
                                  
                                  3,580,429Equity based
      compensation
                                  
                                  
                                  134,543
                                  
                                  
                                  
                                  127,564Allowance for sales
      deductions
                                  
                                  
                                  329,388
                                  
                                  
                                  
                                  512,306Amortization of
      intangibles
                                  
                                  
                                  1,213,067
                                  
                                  
                                  
                                  948,133Inventory
      adjustments
                                  
                                  
                                  467,175
                                  
                                  
                                  
                                  439,768Other
                                  
                                  
                                  91,369
                                  
                                  
                                  
                                  50,466Gross deferred tax
      assets
                                  
                                  
                                  5,988,082
                                  
                                  
                                  
                                  5,658,667Valuation
    allowance
                                  
                                  
                                  (5,455,065
                                  )
                                  
                                  
                                  (5,275,646
                                  )Total deferred tax
      assets
                                  
                                  
                                  533,017
                                  
                                  
                                  
                                  383,021Net
      deferred tax liabilities
                                  
                                  $
                                  (350,303
                                  )
                                  
                                  $
                                  (336,419
                                  )





The net
deferred tax liability relates to the Company’s Canadian operation and consists
of a deferred tax asset – current of $5,046 and a net deferred tax liability –
long term of $355,349 as of December 31, 2009.  The deferred tax asset
– current is included in prepaid expenses and other current assets in the
consolidated balance sheet.   The valuation allowance relates to
the U.S.  The timing in which the Company can utilize its U.S. 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 surrounding the Company’s ability
to use its U.S. net operating loss carryforwards and net deferred tax assets, a
full valuation allowance has been provided as of December 31, 2009 and
2008.





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





December 31,2009
                              
                              
                              2008Tax
      benefit at federal statutory rate
                              
                              $
                              (365,367
                              )
                              
                              $
                              (1,327,062
                              )State
      tax, net of federal benefit
                              
                              
                              (21,707
                              )
                              
                              
                              (146,334
                              )Nondeductible
      expenses
                              
                              
                              278,753
                              
                              
                              
                              298,277Other
                              
                              
                              (1,589
                              )
                              
                              
                              704,232Total
                              
                              
                              (109,910
                              )
                              
                              
                              (470,887
                              )Change
      in valuation allowance
                              
                              
                              178,573
                              
                              
                              
                              529,702Provision
      for income taxes
                              
                              $
                              68,663
                              
                              
                              $
                              58,815




48




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




At December 31, 2009, the Company has
net operating loss carryforwards of approximately $10,340,000 for federal income
tax purposes that begin to expire in years 2017 through 2029.  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
approximately $1,420,000 in New Jersey, the site of the Company’s
headquarters.  New Jersey currently allows the deduction of net
operating losses up to 100% 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 previous
limitations.  The New Jersey carryforwards begin to expire in years
2013 through 2017.





14.
            Retirement
      Benefits





The Company maintains a profit
sharing/401(k) plan for eligible full-time U.S.
employees.  Participants may contribute a fixed percentage 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, 2009 and 2008 were $58,546 and $53,270,
respectively.





The Company’s Canadian subsidiary
maintains a group retirement savings plan (Registered Retirement Savings Plan)
for eligible full time Canadian employees.  The Canadian subsidiary
makes a matching contribution of 50% of an employee’s contribution to a maximum
of 3% of annual gross earnings.  Employee contribution limits to the
group retirement savings plan are set by the Canada Customs and Revenue
Agency.  The Company’s Canadian subsidiary’s contributions to the plan
for the year ended December 31, 2009 and 2008 were $60,270 and $60,360,
respectively.





15.
            Commitments
      and Subsequent Events





Operating Leases





The
Company has operating lease agreements for its facilities and equipment expiring
in various years through 2013.  Rent expense under non-cancelable
operating agreements amounted to $1,402,092 and $1,468,289 in 2009 and 2008,
respectively.  The leases provide for increases in future minimum
annual rental payments based on specified conditions 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 on other properties.





Net
minimum future rental payments under these operating leases as of December 31,
2009 are:





Minimum Future Rental
    PaymentsYear Ending December 31,
                            
                            Amount2010
                            
                            $
                            1,549,5712011
                            
                            
                            1,326,6952012
                            
                            
                            645,0532013
                            
                            
                            24,405Thereafter
                            
                            
                            -Net
      minimum future rental payments
                            
                            $
                            3,545,724





The Company entered into a three year
lease agreement for a U.S. distribution center which became effective in April,
2009.  Payments under the amended terms of the lease agreement
commenced in August, 2009 and range from $18,206 during the first year of the
lease to $18,997 in year three of the lease term.  The Company is
recording lease expense monthly at $16,469, 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, 2009,
$57,190 of deferred rent expense was recorded.





49
 
  DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




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.  Under the Agreement, the Company received 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.) and non-exclusive rights within the consumer
marketplace.  Comvita retained 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 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.  In 2009 and
2008, the Company purchased $499,195 and $347,935 of active honey from Comvita
and had product sales of $88,274 and $84,406 to Comvita,
respectively.  The Company also incurred $210,110 and $113,203 of
royalties in 2009 and 2008 under the Agreement.





On
February 23, 2010, the Company entered into various agreements with Comvita in
which the Company principally received perpetual and exclusive worldwide
licensing rights for Medihoney® professional wound and skin care products
covering distribution and sales to all markets outside of the consumer
market.   In connection with the agreements the Company paid
$2,250,000 and issued Comvita 400,000 shares of its common stock valued at
$2,000,000, along with 133,333 warrants to purchase its common stock at an
exercise price of $5.50 per share, and 100,000 warrants to purchase its common
stock at a price of $6.25 per share.  The $4,250,000 cost of the
perpetual and worldwide licensing rights has been recorded as an intangible
asset and will be amortized over a preliminary estimated useful life of 10
years.





The
agreement calls for royalty payments on all sales and additional payments to
Comvita if certain Medihoney® net sales milestones are achieved over the course
of the license. The license rights may be terminated or rendered non-exclusive
by Comvita if the Company fails to meet certain minimum royalty
requirements.





Quick-Med Technologies, Inc. – License
Agreement





On March
23, 2007, the Company entered into a patent and technology license agreement
(the “Agreement”) with Quick-Med Technologies, Inc. (“QMT”) relating to QMT’s
proprietary anti-microbial technology (the “Technology”).  The Company
anticipates utilizing the Technology in a series of wound care products,
including conforming gauze, gauze sponges, gauze bandage rolls, gauze packing
strips, non woven sponges and island dressings.





The
initial term of the Agreement extends from March 23, 2007 (the “Effective Date”)
for a period of seven years.  Under the Agreement, QMT granted to the
Company an exclusive, royalty-bearing right and license to make, use and sell
products incorporating the Technology in the United States and Canada (with the
exception of sales to the United States government and agencies thereof in which
case the license will be non-exclusive).





In
consideration for the license to the Technology, the Company paid QMT a license
fee in the amount of $125,000.  The total non-refundable license and
advance royalty payments of $125,000 was expensed in 2007.  The
foregoing advance royalty payments of $75,000 were credited against
royalties that became due under the Agreement in 2009.





50




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Royalties
are payable upon the Company’s net sales of products utilizing the Technology
for sales within exclusive and non-exclusive territories at specified
rates.  The Agreement provides for escalating minimum royalty payments
for each contract year.  In the event for a given contract year the
Company fails to make the required minimum royalty payments, QMT’s exclusive
remedies (depending on the magnitude of the failure) would be either termination
of the Company’s exclusive rights to the Technology or termination of the
Agreement.





QMT
received clearance from the FDA for use of its Technology in February
2009.  The Company  launched its first products utilizing
this technology in June, 2009.





On
February 8, 2010 the parties amended the Agreement to clarify the field of
products included in the agreement and the annual minimum royalty payment
amounts.  The February amendment also extended the initial contract
term three years to June 22, 2017 provided the Company (i) executes a private
label agreement with a major U.S. distributor by March 1, 2010; (ii) the
distributor achieves first commercial sale of product incorporating the
Technology no later than 120 days after the private label agreement is executed;
and (iii) the Company meets 100% of its cumulative contract year 1 and 2 minimum
royalties by the end of contract year 2.  On February 8, 2010 the
Company signed a private label agreement with a major U.S. distributor
fulfilling the first condition for the three year extension.





USC
License Agreement





On
November 2, 2007, the Company entered into a license agreement (the “License
Agreement”) with the University of Southern California (“USC”) pursuant to which
the Company acquired exclusive rights to 49 United States and foreign patents
and non-exclusive rights to one patent, together with trade secrets and
know-how, related to an angiotensin analog (the patents, trade secrets and
know-how, collectively, the “Angiotensin Analog Technology”).  The
Angiotensin Analog Technology relates to a topical application for the treatment
of chronic wounds such as diabetic ulcers, leg ulcers associated with venous
insufficiency, pressure ulcers (bed sores), burns and surgical
scars.





The
Company paid to or on behalf of USC an initial license fee of $839,348 which it
expensed.    Additionally, the Company will pay USC
royalties relative to sales of products employing the Angiotensin Analog
Technology at specified rates in respect of revenues less than $100 million and
revenues equal to or greater than $100 million, respectively.  In
addition, the Company will make milestone payments to USC of up to $9,625,000
predicated upon obtaining approval of the FDA of various indications for the
Angiotensin Analog Products as well as the attainment of various sales
objectives.  Further, the Company is obligated to spend at least
$1,250,000 on direct marketing of the initial Angiotensin Analog Product within
twelve months of the FDA’s approval thereof.





The
compound employing the Angiotensin Analog Technology is classified as a “drug”
the sale of which is conditioned upon FDA approval.  The process of
obtaining FDA approval for the compound consists of subjecting the compound to a
series of pre-clinical and clinical studies, these latter known as phase I,
phase II and phase III studies.





The
compound has successfully undergone pre-clinical and phase I clinical
studies.  The phase II clinical studies commenced in 2008 and are
expected to be concluded by the end of 2010.  If the phase II clinical
studies are successful, phase III clinical studies are expected to begin shortly
thereafter and, barring unforeseen events, are expected to be completed by the
end of 2013.  In the event the phase III clinical studies are
successful, evaluation of the clinical studies by the FDA is expected to be
completed by the end of 2014.





The
Company’s costs incident to conducting phase II and phase III clinical studies
relative to the compound are expected to aggregate approximately $1.65 million
and $15 to $20 million, respectively.  The Company is under no
obligation to undertake or complete phase II or phase III
studies.  Should it elect not to do so, the Company may either
sublicense the Angiotensin Analog Technology to one or more pharmaceutical
concerns or release the Technology to USC.  In this latter event, USC
would reimburse the Company for certain of its costs incident to clinical
studies that have theretofore been performed.




51




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Canadian
      Distribution Agreement





The
Company has a five-year agreement with an original expiration date of 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 Company recognizes revenue under the agreement when
title and risk of loss pass to the distributor and collectability is reasonably
assured which is at the time product is shipped to the
distributor.  Payment terms from the distributor are 30
days.  The agreement automatically renews after five-years 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.  In November 2009, the agreement was automatically renewed for
an additional year through May 1, 2011.  Either party has the right to
terminate the agreement when an event of default (as defined) has occurred with
respect to the other party.  The distributor is entitled to continue
to sell or otherwise dispose of all inventory owned by it from and after the
date of contract expiration or termination.  If termination of the
agreement is not occasioned by breach by the distributor, the distributor will
be entitled on notice to the Company to return saleable inventory (as defined)
to the Company.  In the event sales returns are expected, they will be
reserved for at the time of sale.  Since the inception of the
agreement, sales returns have been minimal.





The
distributor assumes 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, 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 the end customer upon submission by the distributor of an agreed upon
rebate report.





Clinical
Services Agreement





In
January 2008, the Company entered into an agreement with a clinical services
company to provide phase II clinical studies for the angiotensin analog
technology compound licensed from USC in November 2007.  The Company
is presently negotiating an extension to the original agreement to account for
the delay in completion of the study.  The Company anticipates that a
preliminary efficacy report will be issued in the third quarter 2010, the
clinical study will be completed during the fourth quarter 2010, and the
definitive phase II study report will be submitted to the FDA in the first
quarter 2011.





Anticipated
costs under the agreement include services fees of $759,000 for the period from
February 2008 through December, 2010 and reimbursement of sterile manufacturing,
excess patient monitoring and statistician support services estimated in the
amount of $530,000.  The foregoing costs represent an estimate of the
Company’s costs under the agreement; however, actual costs could exceed these
estimates.  The agreement may be terminated upon termination of the
USC license agreement.  The Company incurred costs of $305,000 and
$572,083 in connection with this agreement in 2009 and 2008, respectively, which
amounts are included as a component of research and development
costs.





52




DERMA
SCIENCES, INC. AND SUBSIDIARIES
 
 Notes to
Consolidated Financial Statements




Sale
of Equity





In
February 2010, the Company raised $4,537,497 (net of $1,051,503 in commission
and other offering expenses) from the sale of 1,117,800 shares of common stock
at a price of $5.00 per share, together with 372,600 five-year warrants to
purchase common stock at $5.50 per share.  In addition, the placement
agent received 29,160 five-year warrants to purchase common stock at $6.25 per
share.  The proceeds along with restricted cash of $2,032,818 were
used to (i) acquire the perpetual worldwide licensing rights from Comvita; (ii)
pay off the outstanding U.S. term loan balance of $3,300,000 and the $500,000
promissory note; and (iii) support growth initiatives.





On March 26, 2010, our U.S. lender
modified the terms of our five year revolving credit and security agreement to
take into account the pay off of the term loan.  The existing
financial covenants were replaced with twelve month rolling fixed charge
coverage and total debt coverage covenants.  The lender also reduced
the minimum 3 month LIBOR rate from 3.00% to 1.50% and authorized the payment of
our $500,000 unsecured promissory note.





53




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





Item
9A.  Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





As of the
end of the year covered by this annual report, our president and chief executive
officer (our principal executive officer) and our vice president and chief
financial officer (our principal financial officer) performed an evaluation of
the effectiveness of our disclosure controls and procedures as defined in
Rules 13a-15(e) and 15d-15(e) of the Exchange Act.  Our
disclosure controls and procedures are designed to ensure that information
required to be disclosed in the reports we file or submit under the Exchange Act
is recorded, processed, summarized and reported within the time periods
specified in the SEC’s rules and forms and that such information is accumulated
and communicated to our management to allow timely decisions regarding required
disclosures.  Based on this evaluation, our president and chief
executive officer and our vice president and chief financial officer have
concluded that our disclosure controls and procedures were effective as of
December 31, 2009.





Management’s
Report on Internal Control Over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting (as defined in Exchange Act
Rules 13a-15(f) and 15d-15(f)) for our Company.  Internal control
over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with accounting
principles generally accepted in the United States.  Our management
conducted an assessment of the effectiveness of our internal control over
financial reporting as of December 31, 2009 based on criteria established
in Internal Control —
Integrated Frameworkissued by the Committee of Sponsoring Organizations
of the Treadway Commission.





Based on
this assessment, management believes that, as of December 31, 2009, our
internal control over financial reporting was effective.





This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.




Part III





Item
10.  Directors, Executive Officers and Corporate
Governance





Information
in response to this Item is incorporated herein by reference to our definitive
proxy statement for our 2010 annual meeting of shareholders to be filed with the
Securities and Exchange Commission not later than April 30, 2010.





Item
11.  Executive Compensation





Information in response to this Item is
incorporated herein by reference to our definitive proxy statement for our 2010
annual meeting of shareholders to be filed with the Securities and Exchange
Commission not later than April 30, 2010.





54




Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      StockholderMatters





Information in response to this Item is
incorporated herein by reference to our definitive proxy statement for our 2010
annual meeting of shareholders to be filed with the Securities and Exchange
Commission not later than April 30, 2010.





Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence





Information in response to this Item is
incorporated herein by reference to our definitive proxy statement for our 2010
annual meeting of shareholders to be filed with the Securities and Exchange
Commission not later than April 30, 2010.





Item
      14.
            Principal
      Accounting Fees and Services





Information in response to this Item is
incorporated herein by reference to our definitive proxy statement for our 2010
annual meeting of shareholders to be filed with the Securities and Exchange
Commission not later than April 30, 2010.





Part IV





Item
      15.
            Exhibits,
      Financial Statement Schedules





(a)
            Financial
      Statements





(1)
            Financial
      statements and related documents are listed in the Index under Item 8 of
      this report.





(2)
            All
      financial statement schedules are omitted because they are not applicable,
      not material or the required information is shown in the financial
      statements or notes thereto.





(b)
            Exhibits





Exhibit
                    Number
                  
                  Description3.01
                  
                  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).




55





3.06
              
              Amendment
      to the Articles of Incorporation effective December 28, 2007 (previously
      filed as Appendix A to the Company’s Proxy Statement filed November 21,
      2007 and incorporated herein by reference).3.07
              
              Amendment
      to the Articles of Incorporation effective February 1,
    2010.3.08
              
              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).3.09
              
              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).3.10
              
              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).3.11
              
              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).3.12
              
              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 31, 2009, between the Company and Edward J. Quilty
      (previously
      filed as Exhibit 10.01 to the Company’s Form 10-K filed March 31, 2009 and
      incorporated herein by reference).10.02*
              
              Employment
      Agreement, dated March 31, 2009, between the Company and John E.Yetter,
      CPA (previously filed as Exhibit 10.02 to the Company’s Form 10-K filed
      March 31, 2009 and incorporated herein by reference).10.03*
              
              Employment
      Agreement, dated March 31, 2009, between the Company and Robert C. Cole
      (previously filed as Exhibit 10.03 to the Company’s Form 10-K filed March
      31, 2009 and incorporated herein by reference).10.04*
              
              Employment
      Agreement, dated March 31, 2009, between the Company and Frederic Eigner
      (previously filed as Exhibit 10.04 to the Company’s Form 10-K filed March
      31, 2009 and incorporated herein by reference).10.05*
              
              Employment
      Agreement, dated March 31, 2009, between the Company and Barry J.
      Wolfenson (previously filed as Exhibit 10.05 to the Company’s Form 10-K
      filed March 31, 2009 and incorporated herein by
  reference).10.06*
              
              Employment
      Agreement, dated March 31, 2009, between the Company and Daniel Rivest
      (previously filed as Exhibit 10.06 to the Company’s Form 10-K filed March
      31, 2009 and incorporated herein by reference).10.07
              
              The
      Derma Sciences, Inc. Stock Option Plan, as amended November 29, 2007
      (previously filed as Exhibit 10.08 to the Company’s Form 10-KSB filed on
      April 1, 2008 and incorporated herein by reference).10.08
              
              Private
      Placement Memorandum with Amendments relative to the private placement of
      securities effected on April 18, 2006 (previously filed as Exhibit 10.01
      to the Company’s Form 8-K filed on April 24, 2006 and incorporated herein
      by reference).10.09
              
              Form
      of Purchase Agreement relative to the private placement of securities
      effected on April 18, 2006 (previously filed as Exhibit 10.02 to the
      Company’s Form 8-K filed on April 24, 2006 and incorporated herein by
      reference).10.10
              
              Form
      of Registration Rights Agreement relative to the private placement of
      securities effected on April 18, 2006 (previously filed as Exhibit 10.03
      to the Company’s Form 8-K filed on April 24, 2006 and incorporated herein
      by reference).10.11
              
              Warrant
      Agreement between the Company and StockTrans, Inc. relative to the private
      placement of securities effected on April 18, 2006 (previously filed as
      Exhibit 10.04 to the Company’s Form 8-K filed on April 24, 2006 and
      incorporated herein by reference).10.12
              
              Placement
      Agreement between the Company and Taglich Brothers, Inc. relative to the
      private placement of securities effected on April 18, 2006 (previously
      filed as Exhibit 10.05 to the Company’s Form 8-K filed on April 24, 2006
      and incorporated herein by
reference).




56





10.13
              
              Asset
      Purchase Agreement, dated January 26, 2006, relative to the Company’s
      purchase on April 18, 2006 of the assets of Western Medical, Inc.
      (previously filed as Exhibit 10.01 to the Company’s Form 8-K filed on
      April 24, 2006 and incorporated herein by reference).10.14
              
              Purchase
      Agreement, dated August 3, 2006, between the Company and Comvita New
      Zealand Limited relative to the private sale of securities (previously
      filed as Exhibit 10.01 to the Company’s Form 8-K filed on August 7, 2006
      and incorporated herein by reference).10.15
              
              Registration
      Rights Agreement, dated August 3, 2006, between the Company and Comvita
      New Zealand Limited relative to the private sale of securities (previously
      filed as Exhibit 10.03 to the Company’s Form 8-K filed on August 7, 2006
      and incorporated herein by reference).10.16
              
              Patent
      and Technology License Agreement, dated March 23, 2007,
      between the Company and Quick-Med Technologies, Inc. (previously filed as
      Exhibit 10.01 to the Company’s Form 8-K filed on March 29, 2007 and
      incorporated herein by reference).10.17
              
              Asset
      Purchase Agreement, dated November 8, 2007, between the Company and
      NutraMax Products, Inc. relative to the purchase by the Company’s
      subsidiary, Derma First Aid Products, Inc, of substantially all of the
      assets of the First Aid division of NutraMax (previously filed as Exhibit
      2.01 to the Company’s Form 8-K filed on November 15, 2007 and amended on
      January 15, 2008 and January 24, 2008 and incorporated herein by
      reference).10.18
              
              Form
      of Purchase Agreement relative to the private placement of common stock
      and series H and I warrants effected on November 8, 2007 (previously filed
      as Exhibit 10.01 and 10.02 to the Company’s Form 8-K filed on November 15,
      2007 and incorporated herein by reference).10.19
              
              License
      Agreement, dated November 2, 2007, between the Company and the University
      of Southern California (previously filed as Exhibit 10.01 to the Company’s
      Form 8-K filed on November 8, 2007 and incorporated herein by
      reference).10.20
              
              Patent
      and Technology License Agreement, dated March 23, 2007,
      between the Company and Quick-Med Technologies, Inc. (previously filed as
      Exhibit 10.01 to the Company’s Form 8-K filed on March 29, 2007 and
      incorporated herein by reference).10.21
              
              Credit
      and Security Agreement, dated November 8, 2007, between the Company and
      Merrill Lynch Capital (previously filed as Exhibit 10.01 to the Company’s
      Form 8-K filed on November 15, 2007 and incorporated herein by
      reference).10.22
              
              First
      Amendment to Credit and Security Agreement, dated March 28, 2008, between
      the Company and GE Business Financial Services, Inc. (previously filed as
      Exhibit 10.01 to the Company’s Form 8-K filed on April 2, 2008 and
      incorporated herein by reference).10.23
              
              Second
      Amendment to Credit and Security Agreement, dated August 13, 2008, between
      the Company and GE Business Financial Services, Inc. (previously filed as
      Exhibit 10.01 to the Company’s Form 8-K filed on August 19, 2008 and
      incorporated herein by reference).10.24
              
              Third
      Amendment to Credit and Security Agreement, dated March 31, 2009, between
      the Company and GE Business Financial Services, Inc. (previously filed as
      Exhibit 10.02 to the Company’s Form 8-K filed on April 6, 2009 and
      incorporated herein by reference).10.25
              
              Fourth
      Amendment to Credit and Security Agreement, dated February 26, 2010,
      between the Company and GE Business Financial Services, Inc. (previously
      filed as Exhibit 10.01 to the Company’s Form 8-K filed on March 1, 2010
      and incorporated herein by reference).10.26
              
              Clinical
      Services Agreement, dated January 22, 2008, between the Company and U.S.
      Biotest, Inc. (previously filed as Exhibit 10.01 to the Company’s Form 8-K
      filed on January 28, 2008 and incorporated herein by
      reference).




57


10.27
              
              Form
      of Purchase Agreement relative to the private placement of common stock
      and series K warrants effected on April 2, 2008 (previously filed as
      Exhibit 10.01 to the Company’s Form 8-K filed on April 7, 2008 and
      incorporated herein by reference).10.28
              
              License
      Agreement, dated February 23, 2010, between the Company and Comvita New
      Zealand Ltd. (previously filed as Exhibit 10.01 to the Company’s Form 8-K
      filed on March 1, 2010 and incorporated herein by
    reference).10.29
              
              Restraint
      Agreement, dated February 23, 2010, between the Company and Comvita New
      Zealand Ltd. (previously filed as Exhibit 10.02 to the Company’s Form 8-K
      filed on March 1, 2010 and incorporated herein by
    reference).10.30
              
              Collaborative
      Research and Development Agreement, dated February 23, 2010, between the
      Company and Comvita New Zealand Ltd. (previously filed as Exhibit 10.03 to
      the Company’s Form 8-K filed on March 1, 2010 and incorporated herein by
      reference).10.31
              
              Medical
      Honey Supply Agreement, dated February 23, 2010, between the Company and
      Comvita New Zealand Ltd. (previously filed as Exhibit 10.04 to the
      Company’s Form 8-K filed on March 1, 2010 and incorporated herein by
      reference).10.32
              
              Manufacturing
      Agreement, dated February 23, 2010, between the Company and Comvita New
      Zealand Ltd. (previously filed as Exhibit 10.05 to the Company’s Form 8-K
      filed on March 1, 2010 and incorporated herein by
    reference).10.33
              
              Nominating
      Agreement, dated February 18, 2010, between the Company and Comvita New
      Zealand Ltd. (previously filed as Exhibit 1.1 to the Company’s Form 8-K
      filed on February 24, 2010 and incorporated herein by
      reference).10.34
              
              Forbearance
      Agreement, dated March 31, 2009, between the Company and Western Medical,
      Inc. (previously filed as Exhibit 10.01 to the Company’s Form 8-K filed on
      April 6, 2009 and incorporated herein by reference).14.1
              
              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).21.1
              
              Information
      relative to subsidiaries.23.1
              
              Consent
      of Ernst & Young 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.




58


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
      31, 2010
                By:
                /s/ Edward J. QuiltyEdward
      J. QuiltyChairman,
      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 31, 2010.




Signatures:
                            
                            Title:/s/  Edward J.
    Quilty
                            
                            President,
      Chief Executive Officer andEdward
      J. Quilty
                            
                            Chairman of the Board of
      Directors(Principal Executive
      Officer)/s/  John E.
    Yetter
                            
                            Vice
      President and Chief Financial OfficerJohn
      E. Yetter, CPA
                            
                            (Principal Financial and
      Accounting Officer)/s/  Srini
      Conjeevaram
                            
                            DirectorSrini
      Conjeevaram/s/  Stephen T.
    Wills
                            
                            DirectorStephen
      T. Wills, CPA, MST/s/  James T.
    O’Brien
                            
                            DirectorJames
      T. O’Brien/s/  C. Richard Stafford,
      Esq.
                            
                            DirectorC.
      Richard Stafford, Esq./s/  Richard J.
    Keim
                            
                            DirectorRichard
      J. Keim/s/  Robert G.
    Moussa
                            
                            DirectorRobert
      G. Moussa/s/  Bruce F.
    Wesson
                            
                            DirectorBruce
      F. Wesson/s/  Brett
Hewlett
                            
                            DirectorBrett
      Hewlett




59