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




or





 ̈       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:                      001-09727





PATIENT
SAFETY TECHNOLOGIES, INC.


(Exact
name of registrant as specified in its charter)





Delaware
                
                13-3419202(State  or
      other jurisdiction of incorporation or organization)
                
                (I.R.S.
      Employer Identification
No.)





5
Caufield Place, Suite 102, Newtown, PA 18940


(Address
of principal executive offices) (Zip Code)





Registrant’s
telephone number, including area code: (215) 579-7789





Securities registered pursuant to
Section 12(b) of the Act:None





Securities
registered pursuant to Section 12(g) of the Act:





Title of each class
                  Common
      Stock, par value $0.33 per share
                Name of each exchange on which
      registered
                  OTC
      Bulletin Board





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 check mark 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 x
    No    ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, 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 check mark, if disclosure of delinquent filers in response to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.   ̈




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, 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 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 registrant’s common stock held by non-affiliates
of the registrant based on the last reported sale price of the common stock as
reported on the OTC.BB on June 30, 2009 was approximately $18.0
million.




The
number of outstanding shares of the registrant’s common stock, par value $0.33
per share, as of March 29, 2010 was 23,456,063.




DOCUMENTS
INCORPORATED BY REFERENCE




The
Registrant has incorporated by reference in Part III of this report on Form 10-K
portions of its definitive Proxy Statement for the 2010 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission within 120
days after the end of the Registrant’s fiscal year.





PATIENT
SAFETY TECHNOLOGIES, INC.





FORM
10-K FOR THE FISCAL YEAR


ENDED
DECEMBER 31, 2009





TABLE
OF CONTENTS





PageCAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS
                                                iiHELPFUL
      INFORMATION
                                                iiPART
      I
                                                2ITEM
      1.BUSINESS
                                                2ITEM
      1A. RISK FACTORS
                                                9ITEM
      1B. UNRESOLVED STAFF COMMENTS
                                                17ITEM
      2. PROPERTIES
                                                17ITEM
      3. LEGAL PROCEEDINGS
                                                17ITEM
      4. (REMOVED AND RESERVED)
                                                18PART
      II
                                                18ITEM
      5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
      ISSUER PURCHASES OF EQUITY SECURITIES
                                                18ITEM
      6. SELECTED FINANCIAL DATA
                                                19ITEM
      7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF OPERATIONS
                                                19ITEM
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK
                                                29ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
                                                30ITEM
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
      FINANCIAL DISCLOSURE
                                                62ITEM
      9A(T). CONTROLS AND PROCEDURES
                                                62ITEM
      9B. OTHER INFORMATION
                                                63PART
      III
                                                63ITEM
      10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
                                                63ITEM
      11. EXECUTIVE COMPENSATION
                                                64ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
      RELATED STOCKHOLDER MATTERS
                                                64ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
                                                64ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
                                                64PART
      IV
                                                64ITEM
      15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
                                                64SIGNATURES
                                                65EXHIBIT
      INDEX
                                                66





CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS




Some of
the statements in this annual report on Form 10-K are forward-looking
statements.  You can sometimes identify forward-looking statements by
our use of forward-looking words like “may,” “should,” “expects,” “intends,”
“plans,” “anticipates,” “believes,” “estimates,” “seeks,” “predicts,”
“potential,” or “continue” or the negative of these terms and other similar
expressions.




Although
we believe that the plans, objectives, expectations and intentions reflected in
or suggested by our forward-looking statements are reasonable, those statements
are based only on the current beliefs and assumptions of our management and on
information currently available to us and, therefore, they involve uncertainties
and risks as to what may happen in the future.  Accordingly, we cannot
guarantee that our plans, objectives, expectations or intentions will be
achieved.  Our actual results, performance (financial or operating) or
achievements could differ from those expressed in or implied by any
forward-looking statement in this report as a result of many known and unknown
factors, many of which are beyond our ability to predict or
control.  These factors include, but are not limited to, those
described under the caption “Risk Factors” in this annual report on Form 10-K,
including without limitation the following:





·
            our
      need for additional financing to support our
  business;





·
            the
      early stage of adoption of our Safety-Sponge® System and the need to
      expand adoption of our Safety-Sponge®
System;





·
            any
      failure of our new management team to operate
  effectively;





·
            our
      reliance on third-party manufacturers, some of whom are sole-source
      suppliers, and on our exclusive distributor;
and





·
            any
      inability to successfully protect our intellectual property
      portfolio





All
written and oral forward-looking statements attributable to us are expressly
qualified in their entirety by these cautionary statements.




Our
forward-looking statements speak only as of the date they are made and should
not be relied upon as representing our plans, objectives, expectations and
intentions as of any subsequent date.  Although we may elect to update
or revise forward-looking statements at some time in the future, we specifically
disclaim any obligation to do so, even if our plans, objectives, expectations or
intentions change.





HELPFUL
INFORMATION





As used
throughout this annual report on Form 10-K, the terms the “Company,” “the
registrant,” “we,” “us,” and “our” mean Patient Safety Technologies, Inc., a
Delaware corporation, together with its consolidated subsidiary, SurgiCount
Medical Inc., a California Corporation, unless the context otherwise
requires.





Unless
otherwise indicated, all statements presented in this annual report on Form 10-K
regarding the medical patient safety market, the market for surgical sponges,
our market share, the cumulative number of surgical sponges used and number of
procedures are internal estimates only.





Safety-Sponge®,
SurgiCounterTM and CitadelTM, among others, are registered or unregistered
trademarks of Patient Safety Technologies, Inc. (including its
subsidiary).


ii


PART
I




ITEM
1.  BUSINESS





Overview





We focus
on the development, marketing and sales of products and services in the medical
patient safety markets.  Our proprietary Safety-Sponge® System is a
patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications integrated to form a comprehensive counting and
documentation system.  This system is designed to eliminate the
possibility of retained surgical sponges being unintentionally left inside of
patients during surgical procedures by allowing faster and more accurate
counting of surgical sponges.  We sell our Safety-Sponge® System to
hospitals through our direct sales force, but rely on an exclusive distributor
for the ongoing supply of our proprietary surgical sponge products to hospitals
that have adopted our system.  Our business model consists of selling
our unique surgical sponge products, which are manufactured for us by an
exclusive supplier, on a recurring basis to those hospitals that have adopted
our Safety-Sponge® System. One of the ways in which we differentiate our
products from other competing products is by working closely with hospital
personnel through education and implementation services. We currently sell our
Safety-Sponge® System only in the United States and we had revenues of
$4,503,535 and $2,779,871 in the years ended December 31, 2009 and 2008,
respectively, and at December 31, 2009 we reached a milestone of having had a
cumulative total of an estimated 25,000,000 sponges used in 1,000,000 procedures
without a single sponge unintentionally left inside a surgical
patient.





Organizational
History





Patient
Safety Technologies, Inc. is a Delaware corporation that currently conducts its
operations through a wholly-owned subsidiary, SurgiCount Medical, Inc., a
California corporation.  We were incorporated on March 31, 1987 and
from July 1987 through March 2005, operated as an investment company registered
pursuant to the Investment Company Act of 1940, as amended.  In
February 2005, we began operations in our current field, the medical patient
safety market, through our acquisition of SurgiCount Medical, Inc., the
developer of our proprietary Safety-Sponge® System, and in April 2005 changed
our name from Franklin Capital Corporation to Patient Safety Technologies,
Inc.  From July 2005 through August 2007, we also operated an express
car wash business through a wholly-owned subsidiary, Automotive Services Group,
Inc., a Delaware corporation, which held our investment in Automotive Services
Group, LLC, or ASG.  During 2007, all assets of Automotive Services
Group, Inc., including our investment in ASG, were sold.  Since the
2007 divestitures, we have focused solely on the medical patient safety
market.





Patient
Safety Industry





The U.S.
medical patient safety market is a multi-billion dollar annual market, which
includes a significant range of medical devices, technologies and other
equipment, all geared towards addressing patient safety.  We estimate
that the current U.S. market for surgical sponges alone is $400 million annually
and that there is significant opportunity for us to expand our share of this
specific market through expansion of adoption of our Safety-Sponge®
System.





We
believe that the healthcare system is highly receptive to cost-effective medical
solutions that can help providers quickly lower costs, reduce potential
liability and eliminate preventable errors.  Increased litigation and
a renewed focus on patient safety by regulators are also spurring demand for
medical device solutions that address these issues, such as our Safety-Sponge®
System.  We believe that our Safety-Sponge® System is attractive to
healthcare professionals because it has proven effective at both eliminating
retained foreign object events, or RFO events, and reducing the costs associated
with RFO events (such as the reoperative costs, insurance costs, litigation and
arbitration expenses and settlement costs).


2


Our Safety-Sponge®System





Our
proprietary Safety-Sponge® System is designed to eliminate retained sponges and
towels unintentionally left in patients during surgical procedures by allowing
accurate tracking of surgical sponges and towels.  Our proprietary
Safety-Sponge®System
is a patented system of bar-coded surgical sponges and towels, SurgiCounterTM
scanners, and CitadelTM, our proprietary file management system, integrated to
form a comprehensive counting and documentation system.  We sell our
Safety-Sponge® System to hospitals through our direct sales force, but rely on
an exclusive distributor for the ongoing supply of our proprietary surgical
sponge and towel products to hospitals that have adopted our
system.  Our business model consists of selling our unique bar-coded
surgical sponge and towel products on a recurring basis to those hospitals that
have adopted our Safety-Sponge® System, and working closely with hospital
personnel and distributors to differentiate our product from other competing
products.  We currently sell our Safety-Sponge® System only in the
United States.





Our
Safety-Sponge® System works much like a supermarket scanning checkout system:
every surgical sponge and towel used during a surgical procedure must be
“scanned in” prior to use and “scanned out” once the procedure is
completed.   Each of our Safety-Sponge® surgical sponge or towel
products is affixed with a unique inseparable two-dimensional data matrix bar
code.  These individual bar coded Safety-Sponge® products are grouped
together and banded into a pack.  Each pack is then affixed with a
unique code (Master Tag) that contains the data for the bar-coded products
grouped in that pack.  As the banded packs of our Safety-Sponge®
products are opened for use during a surgical procedure, operating room staff
use our SurgiCounterTM scanner to scan the tag on each pack of surgical sponge or
towel products.  This quick and simple process records the individual
code of each product contained within the packs, thereby recording the beginning
count.  Similarly, at the end of a procedure, the SurgiCounterTM
scanner is used to scan the bar code on each product at the final
count.  Our SurgiCounterTM scanner will not allow the same
Safety-Sponge® sponge or towel to be counted more than one time.  This
prevents double-counting or missed counting and helps accurately track all
surgical sponges and towels used in a procedure.  When Safety-Sponge®
sponge and towel counts are completed at the end of a surgical procedure; the
CitadelTM software used in our Safety-Sponge® System stores an electronic record
of the initial and final counts (including the unique bar codes of the sponges
and towels used) and transfers the information to the hospital records system.
The system has been designed with future applications in mind, and our goal is
to apply the scanning and information management technology to other patient
safety and workflow management areas within the operating room
environment.





The
software installed in the SurgiCounterTM scanners controls the individual sponge
counts with easy-to-learn and easy-to-use touch screen. Our proprietary
file management system, CitadelTM, typically resides in a PC environment and is
used to consolidate individual sponge reports from the SurgiCounterTM scanner
software in a central database.  This database can then be used to
generate not only reports following a procedure, but also departmental
statistics, documented outcome records and output to patient electronic records
systems (such as electronic medical records (also called EMRs) or personal
health records (also called PHRs)).





Customers
and Distribution





We
currently target our sales efforts to hospitals in the United States that
perform surgery in multiple operating rooms, OB/GYN departments and other
surgical locations.  Our sales process involves making contact with
multiple stakeholders within a hospital.  These include executives,
surgeons, medical and nursing personnel, and risk management.  We
believe it is important that all of these stakeholders evaluate not only the
economics, but also the effectiveness of our Safety-Sponge®
System.  As part of the sales process, we conduct a product evaluation
event in which a subset of hospital clinicians are educated on the use
of our system on a suitable number of cases in order to gain an
understanding of the functionality and integration requirements of our
Safety-Sponge® System.




Although
sometimes customers will have entered into an agreement to adopt our
Safety-Sponge® System prior to the evaluation event, we generally sign up
new hospital customers following a successful evaluation event.  Once a
customer has agreed to adopt our Safety-Sponge® System by executing a
purchase contract, we then provide the hardware used in our system to the
hospital and make numerous visits to provide technical support for our
hardware and systems integration, as well as clinical training of operating room
staff on the proper use of our Safety-Sponge® System (see “Sales and Clinical
Support” below).   Following this intensive transition and clinical
training process, use of our Safety-Sponge® System is implemented hospital-wide,
and hospitals then begin placing purchase orders for products used in our
Safety-Sponge® System.  We estimate that the entire process ranges between
five to eight months from initial presentation before implementation and use of
our Safety-Sponge® System.


3


Cardinal
Health – Exclusive U.S. Distributor





In
November 2006, we began an exclusive distribution relationship with Cardinal
Health for the supply to hospitals that had adopted our Safety-Sponge®
System.  This original agreement had a term of 36 months, and
automatically renewed for successive 12 month periods unless terminated early in
accordance with its terms.





In
November 2009, we renewed our distribution relationship with Cardinal Health
through the execution of a new Supply and Distribution
Agreement.  This new agreement has a five-year term and names Cardinal
Heath as the exclusive distributor in the United States, Puerto Rico, and Canada
of current products used in our proprietary Safety-Sponge® System.





In
connection with the execution of the new agreement, Cardinal Health issued a
$10,000,000 purchase order for products used in our Safety-Sponge® System that
called for deliveries over the 12-month period ending November
2010.  Cardinal Health paid us $8,000,000 as partial pre-payment of
the purchase order, and agreed to pay $2,000,000 directly to A Plus
International Inc., our exclusive supplier (see “—Manufacturing” below), when
invoiced for delivery of product under the purchase order.  Cardinal
Health also agreed to place an additional $5,000,000 purchase order prior to the
end of the third quarter of 2010, if we have achieved a minimum target sales
threshold for sales of our Safety-Sponge® products.  Cardinal Health
also agreed to maintain, for a period of time, its current ordering pattern and
volume and that the Safety-Sponge® products delivered under the $10,000,000 and
$5,000,000 purchase orders would be added to its customary inventory
levels.  For a discussion of the effects that this agreement is
expected to have on our financial condition and results of operations, see
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Factors Affecting Future Results—Cardinal Health Supply
Agreement.”





In
addition, we agreed to provide Cardinal Health a discount on pricing terms if we
fail to meet delivery commitments, as well as minimum gross margins on the sale
of our surgical sponge products.  These guaranteed minimums vary
depending on the product sold (Single Sterile or Bulk Non-Sterile) and how it is
sold (directly by Cardinal Health, through sub-distributors or to convenience
kit-packers). In addition, for Bulk Non-Sterile products included in Cardinal
Health product kits, the guaranteed minimum gross margins are based on a formula
that varies depending on sales performance criteria for specific time
periods.





The new
supply and distribution agreement terminates November 19, 2014 unless terminated
earlier in accordance with its terms.  Under the new supply and
distribution agreement, either we or Cardinal Health may terminate upon written
notice to the other (with a 30-day cure period) in the event of bankruptcy or
insolvency, or material breach, or in the event either fails to maintain the
agreed fill rates (with a 60-day cure period). In addition, Cardinal Health may
terminate its obligation to distribute certain products if such products
infringe upon third-party proprietary rights.





We also
agreed to first negotiate with Cardinal Health if we intend to use a distributor
to sell our products outside the territory for which Cardinal Health acts as our
exclusive distributor.  We also granted Cardinal Health a limited
right of first negotiation in the event we decide to undertake certain
fundamental corporate transactions (such as the sale of all our assets to a
third party or a merger or other reorganization that would result in a change in
control).





In
connection with the new supply agreement described above, we entered into a
Warrant Purchase Agreement, dated effective November 19, 2009, pursuant to which
we issued Cardinal Health warrants to purchase 1,250,000 shares of our common
stock at $2 per share and 625,000 shares of our common stock at $4 per
share.  The warrants each have a term of five-years, but are subject
to early expiration in certain circumstances, and grant the holder a right of
first refusal for the initial year of the term with respect to certain issuances
of common stock.  We also granted Cardinal Health certain registration
rights with respect to the shares of our common stock issuable upon exercise of
the warrants pursuant to a Registration Rights Agreement dated November 19,
2009.





Manufacturing





In 2005,
we entered into an exclusive supply agreement for the manufacture of surgical
products used in our Safety-Sponge® System with A Plus International Inc., or A
Plus.  Wenchen Lin, a member of our Board of Directors, is a founder
and significant beneficial owner of A Plus (see “Management’s Discussion and
Analysis of Financial Condition and Results of Operations—Related Party
Transactions” below).


4


In
January 2007, we entered into a successor supply agreement and, in May 2008, we
entered into our current exclusive supply agreement with A Plus.  The
current supply agreement grants A Plus the exclusive, world-wide license to
manufacture and import the surgical products used in our Safety-Sponge® System,
including the right to sublicense to the extent necessary. A Plus manufactures
our products in its FDA approved facilities in China, which are subject to
periodic site inspections by the FDA.  In addition to manufacturing
our products, A Plus provides packaging, sterilization, logistics and all
related quality and regulatory compliance. A Plus has agreed not to manufacture,
import or otherwise supply any bar coded surgical products for any other third
party. Under the current supply agreement, we agreed to negotiate the pricing
schedule annually to reflect manufacturing costs, taking into account changes in
cotton prices and exchange rates. While we believe the manufacturing capacity of
A Plus is sufficient to meet our expected demand, in the event A Plus cannot
meet our requirements, the agreement allows us to retain additional
manufacturers as needed.  The successor agreement has an initial term
of ten years and will expire in May 2018 unless terminated early in accordance
with its terms.





In
conjunction with the execution of the January 2007 successor supply agreement,
we entered into a subscription agreement with A Plus, pursuant to which we sold
A Plus 800,000 shares of our common stock and warrants to purchase 300,000
shares of our common stock at an exercise price of $2.00 per share, which have a
term of five years.  We received gross proceeds of $500,000 in cash
and a $500,000 deposit against future shipments (which has been fully
utilized).  A Plus was also granted the right to participate in future
financings and was granted certain director designation rights, pursuant to
which Wenchen Lin, currently a member of our board was proposed for this
role.  In addition, we agreed not to undertake certain transactions
(such as incurring certain indebtedness or engaging in certain transactions with
respect to our intellectual property) without such A Plus designated director’s
approval.





We do not
engage in any manufacture of the hardware used in our Safety-Sponge® System
(such as our SurgiCounterTM scanners) but purchase these items from third-party
vendors on a purchase order basis.  We also utilize third party
developers to create, document and test our proprietary software that operates
in our SurgiCounterTM scanners and interfaces with our proprietary CitadelTM file
management system.





Sales
and Clinical Support





As of
December 31, 2009, our sales organization consisted of seven full-time sales
personnel and one full-time administrative employee. Our sales organization
provides consultation and assistance to our customers on the effective use of
our Safety-Sponge® System, both prior to implementation and after
adoption.  We believe that maintaining this consultative effort allows
us to develop a long-term relationship with our customers.





The time
between identifying a customer for our Safety-Sponge® System and such customer
adopting and implementing our system can vary substantially from customer to
customer, particularly given the validation and training we provide (see
“Customers and Distribution” above).   Our sales organization
works closely with each customer throughout this process.




In
addition to our sales organization, we have a team of clinical support
specialists, which included one full-time employee and 20 outside nursing
consultants at December 31, 2009. Our clinical support specialists all have
nursing backgrounds and not only train our customers in the utilization of our
Safety-Sponge® System and products, but also provide clinical consultation
regarding safety and clinical protocols.





Indemnification
Program





In the
third quarter of 2009, we launched an indemnification program to provide our
customers with added assurance regarding the reliability of our Safety-Sponge®
System.  Under the program, we indemnify customers who properly use
our Safety-Sponge® System in conjunction with our proprietary file
management system, CitadelTM, up to $1 million per RFO event.  We
maintain insurance to cover the potential liability we may have under this
program.  We implemented this indemnification program to provide an
additional level of security for our customers, not only because we believe that
it has the potential to increase interest in, and accelerate adoption of, our
Safety-Sponge®System, but also because
we are confident in the overall effectiveness and reliability of our
Safety-Sponge® System.


5


Research
and Development





Research
and development activities are a critical component of our business. We use
contract firms with suitable expertise for much of the research and development
activities related to maintaining or improving our Safety-Sponge® System and
products used therein. We incurred costs of $321,116, and $270,858,
respectively, during the fiscal years ended December 31, 2009 and 2008 for
research and development activities.





In 2005,
we entered into a clinical trial agreement with Brigham and Women’s Hospital,
the teaching affiliate of Harvard Medical School, relating to our Safety-Sponge®
System.  Under terms of the agreement, Brigham and Women’s Hospital
collected data on how our Safety-Sponge®System
saves time, reduces costs and increases patient safety in the operating room.
The clinical study also was intended to provide clear guidance and instruction
to hospitals on techniques to easily integrate our Safety-Sponge®System
into operating room protocols.  In connection with the study, which
included a research grant, we provided Brigham and Women’s Hospital a
non-exclusive license to use our Safety-Sponge® System, and we retained rights
to all technical innovations and other intellectual properties derived from the
study.





Researchers
at Brigham and Women’s Hospital found that using bar-code technology to augment
the physical counting of surgical sponges during surgery enhances the detection
rate of miscounted and/or misplaced sponges.  Previous studies have
shown that counts are falsely reported as correct in the majority of cases of
retained sponges, resulting in the surgical team believing that all the sponges
are accounted for.  In this study, researchers compared the
traditional counting protocol with and without augmentation by the bar-code
technology in 300 general surgery operations. The researchers found that our
technology can reduce the incidence of retained surgical sponges at a materially
lower cost than the combined legal and medical costs of an RFO
event.





Intellectual
Property





Patents,
trademarks and other proprietary rights are an important element of our
business. Our policy is to file patent applications and trademark registrations
and to protect technology, inventions and improvements to inventions that are
commercially important to the development of our business, in particular, as
pertains to the technology used in our proprietary Safety-Sponge® System,
including our SurgiCounterTM scanners and CitadelTM file management system. We
also rely on trademark registrations, trade secrets, employee and third-party
nondisclosure agreements and other protective measures to protect our
intellectual property rights pertaining to our products and
technology.





We
currently hold patents in the United States and Europe related to our
Safety-Sponge®System,
which will expire in August 2019 and March 2017, respectively.  We
also own a number of registered and unregistered trademarks, including
Safety-Sponge®, SurgiCounterTM and CitadelTM.





Competition





We face
competition in a number of ways.  Our Safety-Sponge® System faces
competition from other products in the marketplace for adoption as a solution by
hospitals to lower costs and reduce medical errors.  RF Surgical
Systems, Inc. and ClearCount Medical Solutions, Inc, provide products using
radio frequency identification technology to identify surgical sponges with
embedded chips.  In addition, as a growing business, we continue to
face competition for financial resources, technology and personnel.





Government
Regulation




Our
products and research and development activities are regulated by numerous
governmental authorities, principally the U.S Food and Drug Administration, or
FDA, and corresponding state and foreign regulatory agencies. Any device
manufactured or distributed by us is subject to continuing regulation by the
FDA.  The Food, Drug and Cosmetics Act, or FDC Act, and other federal
and state laws and regulations govern the clinical testing, design, manufacture,
use and promotion of medical devices, such as our Safety-Sponge®System.


6


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




Under the
FDC Act, most medical devices must receive FDA clearance through the
Section 510(k) notification process, or the more lengthy premarket approval
process (commonly referred to as PMA).  Class I and II devices also
have subsets of “exempt devices” that are exempt from the PMA requirement
subject to certain limitations.  Our Safety-Sponge® System is within a
defined device group that is specifically denoted as “exempt” from the PMA
process.  As such, on our Safety-Sponge® System received FDA clearance
through the 510(k) notification process.





The FDA’s
quality system regulations also require companies to adhere to current good
manufacturing practices requirements, which include testing, quality control,
storage, and documentation procedures. Compliance with applicable regulatory
requirements is monitored through periodic site inspections by the
FDA.  Our exclusive manufacturer, A Plus manufactures our products in
FDA approved facilities and is subject to such periodic site
inspections.  In addition, we are required to comply with FDA
requirements for labeling and promotion. The Federal Trade Commission also
regulates medical device advertising for appropriate claims of effectiveness. We
are also subject to the Safe Medical Devices Act of 1990, which imposes certain
reporting requirements on distributors in the event of an incident involving
serious illness, injury or death caused by a medical device.





Given the
state of the new healthcare legislation it’s far too early to evaluate its
impact on our business and on our customers. Changes in regulations and
healthcare policy occur frequently and may impact our results, growth potential
and the profitability of products we sell. There can be no assurance that
changes to governmental reimbursement programs will not have a material adverse
effect on our business, results of operations or financial
condition.





Investments





Because
of our legacy business as an investment company, we have an investment portfolio
of non-core assets.  As of the date of this annual report on Form
10-K, our investment portfolio is comprised solely of our continued ownership of
shares of Series F Convertible Preferred Stock of Alacra Corporation, which we
acquired in April, 2000.  The Series F Convertible Preferred Stock
gives us the right, subject to Alacra having the available cash from operations,
to have it redeemed by Alacra over a period of three years for face value plus
accrued dividends beginning on December 31, 2006, if any.  We notified
Alacra of our exercise of this right in December 2006 and Alacra completed the
redemption of one-third of our preferred stock in December
2007.  Since that time, Alacra has not redeemed any more of our Series
F Convertible Preferred Stock.  Based on discussions with Alacra
management, we currently anticipate redemption and subsequent receipt of funds
for all of our remaining shares of Alacra Series F Convertible Preferred Stock
(50% in each of the fourth quarters of 2010 and 2011,
respectively).  Following the eventual redemption of this stock by
Alacra, we do not anticipate undertaking any investments in non-core
assets.  For more information, see Note 8 to our Consolidated
Financial Statements, appearing elsewhere in this annual report on Form
10-K





Employees




As of
December 31, 2009, we had 16 full-time employees, which consisted of two
executive officers, three senior managers, six sales managers, one clinical
support employee, one customer-field engineer, one quality assurance employee,
one finance employee and one sales administrative staff member.  We
also regularly use the services of outside consultants on an as needed basis for
sales, finance and clinical support staff. We intend to hire additional
personnel as the development of our business makes such action
appropriate.  Our employees are not represented by a labor union nor
covered by a collective bargaining agreement. We believe that our relations with
our employees are good.


7


Executive
Officers





The
following is a list of our executive officers as of the date of this annual
report on Form 10-K:





Name
            
            Age
            
            Position
            
            Served as an
              Officer SinceSteven
      H. Kane
            
            57
            
            President
      and Chief Executive Officer
            
            2009Marc
      L. Rose
            
            44
            
            Vice
      President of Finance, Chief Financial Officer, Treasurer and Corporate
      Secretary
            
            2009





Steven H. Kane, age 57, has
served as our President and Chief Executive Officer since May 2009, and has
served as a Director since November 26, 2007 (and acted as Chairman from
February 7, 2008 through January 26, 2010).  Mr. Kane has over 30
years experience in the health care industry.  Before joining our
company, from 2002 to 2009 he was the President, Chief Executive Officer and
Director of Protalex, Inc. (OTCBB: PRTX).  From April 1997 to August
2000, Mr. Kane served as Vice President of North American Sales & Field
Operations for Aspect Medical. While at Aspect, he helped guide the company to a
successful initial public offering in January 2000. Prior to Aspect, Mr. Kane
was Eastern Area Vice President for Pyxis Corporation, where he was instrumental
in positioning the company for its successful initial public offering in 1992.
Pyxis later was acquired by Cardinal Health for $1 billion. Prior to that, Mr.
Kane worked in sales management with Eli-Lilly and Becton
Dickinson.





Marc L. Rose,age 44, has
served as our Vice President of Finance, Chief Financial Officer, Treasurer and
Corporate Secretary since November 2009. From November 2004 to November 2009,
Mr. Rose served as the Vice President of Finance, Chief Financial Officer,
Treasurer and Corporate Secretary of Protalex, Inc. (OTCBB:
PRTX).  From March 2001 to November 2004, Mr. Rose served as Vice
President and Chief Financial Officer of the DentalEZ Group, a privately held
manufacturer of dental equipment and dental handpieces located in Malvern,
PA.  From January 1998 to March 2001, Mr. Rose was Practice Manager of
Oracle Consulting Services for Oracle Corporation responsible for designing and
implementing Oracle financial and project applications.  From
September 1990 to January 1998, Mr. Rose held several positions with the
controllership organization of Waste Management, Inc and from June 1988 to
September 1990, was an auditor with Ernst & Young in
Philadelphia.  Mr. Rose is a Certified Public Accountant in the
Commonwealth of Pennsylvania and received his BA in Accounting/Finance from
Drexel University.





Code
of Business Conduct and Ethics





Each of
our executive officers and directors, as well as all of our employees, are
subject to our Code of Business Conduct and Ethics, which was adopted by our
Board of Directors on November 11, 2004 and is incorporated by reference as an
Exhibit to this annual report on Form 10-K.  Our Code of Business
Conduct and Ethics encompasses our “code of ethics” applicable to our Chief
Executive Officer, principal financial officer, and principal accounting officer
and controller and persons performing similar functions. We intend to make any
required disclosures regarding any amendments of our Code of Business Conduct
and Ethics or waivers granted to any of our directors or executive officers
under our Code of Business Conduct and Ethics on Form 8-K.





Printed
copies of our Code of Business Conduct and Ethics; the Charters of each of the
Audit, Compensation, and Nominating  and Governance Committees of the
Board of Directors materials are also available upon written request to the
Corporate Secretary, Patient Safety Technologies, Inc., c/o Corporate Secretary,
5 Caufield Place, Suite 102, Newtown, Pennsylvania 18940.





Available
Information





Our
periodic and current reports, including our annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments
to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available
free of charge on our website as soon as reasonably practicable after such
material is electronically filed with, or furnished to, the Securities and
Exchange Commission.


8


Other
Information





Our
principal executive offices are located at 5 Caufield Place, Suite 102, Newtown,
Pennsylvania 18940 and our telephone number is (215) 579-7789. Our website is
www.surgicountmedical.com. Our website and the information contained therein or
connected thereto are not intended to be incorporated into this annual report on
Form 10-K.  The inclusion of our website address in this report does
not include or incorporate by reference into this report any information on our
website.





ITEM
1A. RISK FACTORS





In
addition to the other information contained in this annual report on
Form 10-K, we have identified the following risks and uncertainties that
may have a material adverse effect on our business, financial condition or
results of operations. Investors should carefully consider the risks described
below before making an investment decision. The trading price of our common
stock could decline due to any of these risks, and investors may lose all or
part of their investment.





Risks
Related to Our Business





We have a history
of losses, expect future losses and cannot assure you that we will become
profitable and generate sufficient cash from operations.




Historically,
we have incurred significant losses and have had negative cash flows from our
operations. To date, we have dedicated most of our financial resources to
selling, general and administrative expenses. As of December 31, 2009, our
accumulated deficit was $58,418,330.  Our future success depends
significantly upon continued expansion of adoption of our Safety-Sponge®System
and our ability to obtain financing.  Although the sale of products
used in our Safety-Sponge® System generates revenues, those revenues are
presently insufficient to generate consistent, positive cash flows from our
operations.  In addition, as we work to expand adoption of our
Safety-Sponge® System, because of how our sales cycle works (see
“Business—Customers and Distribution”) we expect that our cash needs will
increase before we begin to generate cash from such efforts.  During
the years ended December 31, 2009 and 2008, we had revenues of $4,503,535 and
$2,779,871, respectively.  If we are not successful in generating
sufficient revenues from sales of products used in our Safety-Sponge® System and
we are unable to obtain sufficient capital to fund our efforts to expand
adoption of our Safety-Sponge® System, there can be no assurance that we will be
able to maintain adequate liquidity to allow us to continue to operate our
business or prevent the possible impairment of our assets.  If this
were to occur, you might lose all or part of your investment in our
company.





Our
auditors’ opinion includes a going concern explanatory paragraph, which could
have a negative effect on the price of our common stock and our ability to
obtain financing.





The
report of our independent registered public accounting firm dated March 31, 2010
for the years ended December 31, 2009 and 2008 includes a going concern
explanatory paragraph, which states that our significant operating losses and
working capital deficit cause substantial doubt about our ability to continue as
a going concern.  This may have a negative effect on the trading price
of our common stock and adversely impact our ability to obtain
financing.  If we are not able to continue as a going concern, you
might lose all or part or your investment.





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




Because
revenues from sales of products used in our Safety-Sponge® System are presently
insufficient to generate consistent, positive cash flows from our operations, we
have historically financed our activities through additional cash proceeds from
the private placement of debt and equity securities.  We believe that
our existing working capital and expected future cash flows from operating
activities will only be sufficient to meet our operating and capital
requirements into the second quarter of 2010.  Accordingly, we will
need to raise additional capital.


9


If
additional debt financing is raised in the future, we may be required to grant
lenders a security interest in all or a portion of our assets and issue warrants
to acquire our equity securities, resulting in dilution to our stockholders. In
addition, any such debt financing may involve restrictive covenants, including
limitations on our ability to incur additional debt, limitations on our ability
to acquire or assign intellectual property rights and other operating
restrictions that could adversely impact our ability to conduct our
business.  If additional equity financing is raised in the future, it
will dilute your current investment in our company.





Future
additional funding may not be available on acceptable terms, or at all. If we
are unable to raise additional capital when required or on acceptable terms,
there can be no assurance that we will be able to maintain adequate liquidity to
allow us to continue to operate our business, or prevent the possible impairment
of our assets.  If this were to occur, you might lose all or part of
your investment in our company.





Growth
of our business is critical to our success.  However, failure to
properly manage our potential growth would be detrimental to our
business.




We need
to grow our business and expand adoption of our Safety-Sponge® System to
succeed.  However, any growth in our operations will place a
significant strain on our existing resources and increase demands on our
management, our operational and administrative systems and
controls.  In addition, because of how our sales cycle works (see
“Business—Customers and Distribution”), any growth in our customer base will
require the investment of a significant amount of resources prior to generating
any cash from such customers.  There can be no assurance that our
existing personnel, systems, procedures or controls or available financial
resources will be adequate to support our operations in the future or that we
will be able to successfully implement appropriate measures consistent with our
growth strategy.  We need to implement new operational and financial
systems, procedures and controls to expand, train and manage our employee
base.  We will also need to continue to attract, retain and integrate
additional personnel in all aspects of our operations. We cannot guarantee that
we will be able to do so, or that if we are able to do so, we will be able to
effectively integrate them into our existing organization.  Failure to
manage our growth effectively could have a material adverse effect on our
financial condition and results of operations.





We
may incur significant costs to comply with Section 404 of the Sarbanes-Oxley Act
of 2002.





Section
404 of the Sarbanes-Oxley Act of 2002 requires us to document and test the
effectiveness of our internal control over financial reporting in accordance
with an established internal control framework and to report on our management’s
conclusion as to the effectiveness of this internal control over financial
reporting.  Based on the current Securities and Exchange Commission,
or SEC rules, we will be required to have our independent registered public
accounting firm perform an audit and report on the effectiveness of our internal
control over financial reporting as of December 31, 2010 and subsequent
years.  We expect to incur significant costs to comply with this
requirement.  In connection with our assessment of internal control
over financial reporting included in our Form 10-K for the periods ended
December 31, 2009 and 2008, we identified certain material weaknesses in our
internal control over financial reporting.  Even if we are successful
in remedying these material weaknesses, we may in the future discover other
areas of our internal control over financial reporting that need
improvement.  There can be no assurance that the recent remedial
measures we implemented to address prior and current material weaknesses will
result in adequate internal control over financial reporting in the
future.  Any failure to implement our improved controls, or
difficulties encountered in the future, could cause us to fail to meet our
reporting obligations.  If we are unable to conclude that we have
effective internal control over financial reporting, or if our auditors are
unable to provide an unqualified report regarding the effectiveness of internal
control over financial reporting when required by applicable rules and
regulations of the SEC, investors may lose confidence in the reliability of our
financial statements, which could result in a decrease in the value of our
securities and negatively affect our efforts to obtain necessary
financing.  In addition, failure to comply with Section 404 could
potentially subject us to sanctions or investigation by the SEC or other
regulatory authorities.  This could have a material adverse effect on
our financial condition and results of operations.





Cost containment
measures implemented by hospitals could adversely affect our ability to
successfully market our Safety-Sponge® System, which would have a material
adverse effect on our business.




The
economic downturn in the United States at the end of 2008 has increased the
focus of many of our current and potential customers on implementing cost
containment measures.  Cost containment measures instituted by
healthcare providers and insurers could negatively affect our efforts to expand
adoption of our Safety-Sponge® System, which would have a have a material
adverse effect on our business, prospects, financial condition and results of
operations.


10


The effects of
general healthcare reform on our industry are uncertain, and there is a risk
that it could adversely affect our ability to market our Safety-Sponge® System,
which would have a material adverse effect on our business.




General
healthcare reform is the subject of ongoing debate in the United
States.  There is uncertainty regarding the legislation recently
signed into law and how it will affect our industry and our business
prospects.  We cannot predict the effect such healthcare reform
legislation might have on demand for our Safety-Sponge® System.  If
such healthcare reform has a negative effect on our efforts to expand adoption
of our Safety-Sponge® System, it would have a have a material adverse effect on
our business, prospects, financial condition and results of
operations.





The
volatility of our stock price can have a material adverse effect on our reported
profit or loss.





At
December 31, 2009, we had a warrant derivative liability of $3,666,336, which
represented just over 22% of our current liabilities at such
date.  Under applicable accounting rules, we are required to “mark to
market” this liability each reporting period and record changes in the fair
value associated with this liability in our consolidated statement of operations
(see “Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Critical Accounting Policies—Warrant Derivative
Liability”).  As such, when our stock price increases, the fair value
of this liability increases, and we recognize an expense associated with this
change.  Similarly, when our stock price decreases, the fair value of
this liability decreases, and we recognize a gain associated with this change in
fair value.  As such, the volatility of our stock price (which ranged
from a high of $2.25 to a low of $0.47 in the year ended December 31, 2009) has
a direct impact on our reported profit or loss.





Our future
financial results could be adversely impacted by asset impairments or other
charges.





As of
December 31, 2009, we had goodwill of $1,832,027 and other intangible assets of
$3,114,025 (or 15.9% and 27.0%, respectively of our total assets).  We
are required to test goodwill and other intangible assets determined to have
indefinite lives for impairment on an annual, or on an interim basis if certain
events occur or circumstances change that would reduce the fair value of a
reporting unit below its carrying value or if the fair value of intangible
assets with indefinite lives falls below their carrying value (see “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations—Critical Accounting Policies” below). If circumstances change such
that we are required to take an impairment charge, the amount of any such annual
or interim impairment charge could be significant.  If so, this could
have a material adverse effect on our financial condition and results of
operations.





We have limited
marketing experience, and our failure to build and manage our sales force or to
market our products effectively would negatively affect our ability to implement
our growth strategy.




Currently,
we do not have an in-house marketing team, nor have we retained a third party to
perform the function. If we do not build an in-house marketing capability or
hire a third party provider, it could have a material adverse effect on our
financial condition and results of operations.





While we
currently employee a seven person sales team, no assurance can be given that we
will be able to hire additional qualified sales personnel with the necessary
skills and experience to sell and market our Safety-Sponge® System effectively.
Even if we are able to hire well qualified sales personnel, if we do not provide
adequate training in the use and benefits of our products, it could have a
material adverse effect on our financial condition and results of
operations.





As all
sales personnel are employees at will, no assurance can be given that some or
all of them will not seek employment on better terms for themselves elsewhere
or, in such event, that we will be able to retain additional sales personnel
with appropriate skills and experience. Our failure to retain our current sales
personnel could have a material adverse effect on our financial condition and
results of operations.


11


No
assurance can be given that any particular marketing program which we may adopt
or acquire, itself, will be effective in building sales.  If we are
unable to develop or acquire an effective marketing program, it could have a
material adverse effect on our financial condition and results of
operations.





Any failure in
our customer education efforts could negatively affect our efforts to expand
adoption of our Safety-Sponge® System.





It is
important to the success of our sales efforts that our clinical support staff
properly educates operating room nurses in the techniques of using our
Safety-Sponge®System.  Such
training is a key component of our sales process (see “Business—Sales and
Clinical Support” above).  Positive results using our Safety-Sponge®
System are highly dependent upon proper technique. If our Safety-Sponge®System
is used suboptimally or improperly, such use may contribute to unsatisfactory
patient outcomes or fail to prevent an RFO event.  This could give
rise to negative publicity or lawsuits against us, any of which could have a
material adverse effect on our reputation as a medical device company, and on
our financial condition or results of operations.





Our
reliance on third parties for the supply and distribution of, and on proper
training of hospital personnel in the use of, the surgical sponge and towel
products used in our Safety-Sponge® System exposes us to risk of lack of quality
control, which could harm our reputation and have a material adverse effect on
our reputation as a medical device company, and on our financial condition or
results of operations.





Our
Safety-Sponge® System is highly dependent on proper technique, including the
proper handling and use of the surgical sponge and towel products used
therein.  There are a number of third parties that handle such
products in our supply and distribution chain, as well as at the hospitals who
have adopted our system, over which and whom we have no
control.  Although we have put in place contractual arrangements to
ensure quality control in the supply and distribution chain, and although we
engage in extensive training and provide clinical support to ensure proper
technique and use at our hospital customers, we cannot guarantee that such third
parties will not mishandle or misuse the surgical sponge and towel products used
in our Safety-Sponge® System.  Because we are not directly involved in
the supply and distribution chain, we might not be aware of quality control
issues that arise.  Moreover, we might not be aware of improper
handling techniques at our hospital customers.  If such quality
control issues arise and we are not able to promptly remedy them, it could harm
our reputation and have a material adverse effect on our financial condition or
results of operations.





We rely on a sole
supplier for manufacture of the surgical sponges and towels used in our
Safety-Sponge® System.




We have
an exclusive supply arrangement with A Plus for the manufacture of the surgical
sponge and towel products used in our Safety-Sponge® System (see
“Business—Manufacturing” above).  While our relationship with A Plus
is on good terms, we cannot assure you that we will be able to maintain our
relationship with A Plus or that A Plus will be able to manufacture an adequate
supply of our products.  While we believe that we could find
alternative suppliers, in the event that A Plus fails to meet our needs, a
change in suppliers or any significant delay in our ability to have access to
product for resale would have a material adverse effect on our delivery
schedules, which could have a material adverse effect on our financial condition
and results of operations.





We
rely on a number of third parties in the execution of our business
plan.  If such third parties do not perform as agreed, it could harm
our reputation and disrupt our business, which could have a material and adverse
effect on our financial condition and results of operations.





We rely
on a number of third parties in the execution of our business
plan.  For example, we use third party developers to maintain and
improve the technological elements of our Safety-Sponge® System; we have an
exclusive manufacturing arrangement with A Plus (see above) and have an
exclusive distribution arrangement with Cardinal Health for the distribution of
products used in our Safety-Sponge® System (see “Business—Customers and
Distribution—Cardinal Health – Exclusive U.S. Distributor”
above).  Although we believe that our relationships with these
third-parties are good, if such third parties fail to honor their contract
obligations, it could lead to disruptions in our business while we negotiate
replacement agreements and find other suppliers or distributors for our
products.  In addition, there is no guarantee that we would be able to
negotiate a distribution agreement with a contract party comparable to Cardinal
Health, or be able to obtain comparable contract provisions in terms of pricing
and quality control.  These disruptions, or inability to effectively
distribute our products, could harm our reputation and customer relationships,
which could have a material adverse effect on our financial condition and
results of operations.


12


We depend on our
executive officers and key personnel to implement our business strategy and
could be harmed by the loss of their services.  In addition,
competition for qualified personnel is intense.




We
believe that our growth and future success will depend in large part upon the
skills of our management team. In particular, our success depends in part upon
the continued service and performance of: Steven H. Kane, our President and
Chief Executive Officer, and Marc L. Rose, our Chief Financial
Officer.  Although we have employment agreements with Mr. Kane, and
Mr. Rose, the loss of the services of one or both of these executive officers
could adversely affect our ability to implement our growth
strategy.




The
competition for qualified personnel is intense, and we cannot assure you that we
will be able to retain our existing key personnel or to attract additional
qualified personnel. In addition, we do not have key-person life insurance on
any of our employees. The loss of our key personnel or an inability to continue
to attract, retain and motivate key personnel could adversely affect our
business.





We have
experienced turnover in our chief executive officer position and if we continue
with frequent executive turnover we may have difficulty implementing our
business strategy.




In
January 2007, Milton “Todd” Ault, III resigned as our Chief Executive Officer
and Chairman, and our Board of Directors appointed William B. Horne as Chief
Executive Officer. In April 2008, our Board of Directors appointed William
Adams, as our President and Chief Executive Officer.  In January 2009,
Mr. Adams resigned, and our Board of Directors appointed David I. Bruce as our
President and Chief Executive Officer.  Mr. Bruce resigned in May 2009
and our Board of Directors appointed Steven H. Kane as our President and Chief
Executive Officer.  If we are not able to attain stability of our
Chief Executive Officer position, we may have difficulty implementing our
business strategy.





Risks
Related to Our Industry





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




Our
success depends, in part, on our ability to maintain and defend our patents
protecting the technology in our proprietary Safety-Sponge® System. However, we
cannot guarantee that the technologies and processes covered by our patents will
not be found to be obvious or substantially similar to prior work, which could
render these patents unenforceable.  If we are not able to
successfully protect and defend our intellectual property, it could have a
material adverse effect on our business, financial condition and results of
operations.




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




We cannot
be sure that the products and technologies used in our business do not or will
not infringe valid patents, trademarks, copyrights or other intellectual
property rights held by third parties. We may be subject in the ordinary course
of our business to legal proceedings and claims relating to the intellectual
property or derivative rights of others. Any legal action against us claiming
damages or seeking to enjoin commercial activities relating to the affected
products or our methods or processes could:





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





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


13


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





·
            result
      in litigation or administrative proceedings that may be costly or not
      covered by our insurance policies, whether we win or
  lose.





If any of
the foregoing were to occur, it could have a material adverse effect on our
financial condition and results of operations.





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





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





Our failure to
respond to rapid changes in technology and its applications and intense
competition in the medical devices industry could make our system
obsolete.




The
medical devices industry is subject to rapid and substantial technological
development and product innovations. To be successful, we must respond to new
developments in technology and new applications of our existing
technology.  Our limited resources may limit our ability to innovate
and respond to such developments.   In addition, we compete
against several companies offering alternative systems, some of which could have
greater financial, marketing and technical resources than us.  If our
products fail to compete favorably against competing products, or if we fail to
be responsive on a timely and effective basis to competitors’ new devices,
applications, or price strategies, it would have a material adverse effect on
our financial condition and results of operations.





The nature of our
business exposes us to potential product liability risks, among others,
which may
not be covered by insurance.




The
nature of our business exposes us to potential product liability risks, which
are inherent in the design, manufacture and distribution of medical products and
systems, as well as the clinical use, manufacturing, marketing and use of our
Safety-Sponge® System.  Although we maintain liability insurance,
insurance coverage may not be adequate to cover all risks and continuing
insurance coverage may not be available at an acceptable cost, if at
all.  In addition, we are exposed to the risks under our
indemnification program if our Safety-Sponge® System is used properly but does
not prevent an RFO.  If we are required to indemnify customers for a
significant number of events, our insurance may not cover the entire cost.
Regardless of merit or eventual outcome, product liability claims or a high
number of indemnifiable RFO events may result in decreased demand for our
products, injury to our reputation and loss of revenues.  As a result,
regardless of whether we are insured or are required to indemnify a significant
number of customers, a product liability claim or product recall may result in
losses that could have a material adverse effect upon our financial condition
and results of operations.





Our business is
subject to extensive regulation and we need FDA clearances and approval to
distribute and market our products.




Our
Safety-Sponge® System is considered a medical device and is subject to extensive
regulation.  Although we believe that we are in compliance with all
material applicable regulations, current regulations depend heavily on
administrative interpretation. We are also subject to periodic inspections by
the FDA and other third party regulatory groups, as is our exclusive
manufacturer, A Plus.  Future interpretations made by the FDA or other
regulatory bodies, with possible retroactive effect, may vary from current
interpretations and may adversely affect our business.


14


Laws and
regulations regarding the manufacture and sale of medical devices are subject to
future changes, as are administrative interpretations of regulatory
requirements.  Failure to comply with applicable laws or regulations
could subject us to enforcement actions, including, but not limited to, product
seizures, injunctions, recalls, possible withdrawal of product clearances, civil
penalties and criminal prosecutions, and of which could have a material adverse
effect on our financial condition and results of operations.





Risks
Related to our Investments




We have an
investment in non-marketable investment securities, which may subject us to
significant impairment charges.




We have
investments in illiquid non-marketable equity securities acquired in private
transactions as a result of our legacy business (see “Business—Organizational
History” above and Note 8 to our Consolidated Financial Statements appearing
elsewhere in this annual report on Form 10-K). At December 31, 2009, 5.8% of our
consolidated assets were comprised of investment securities, which are illiquid
investments.  Investments in illiquid, or non-marketable, securities
are inherently risky and difficult to value. We account for our investments in
non-marketable investment securities on a cost basis.  We review our
investment in non-marketable securities on a quarterly basis for indicators of
impairment, however, for non-marketable equity securities; the impairment
analysis requires significant judgment to identify events or circumstances that
would likely have a material adverse effect on the fair value of the investment.
Because a significant amount of our assets are comprised of non-marketable
investment securities, any future impairment charges from the write down in
value of these securities will most likely have a material adverse affect on our
financial condition.





Risks
Related to Our Common Stock





Our stock price
is expected to continue to be volatile, and the market price of our common stock
could drop significantly.





In the
year ended December 31, 2009, our stock price ranged from a high of $2.25 to a
low of $0.47 per share.  Stock markets in general have experienced
substantial volatility that has often been unrelated to the operating
performance of individual companies.  Our stock price volatility is
attributable, in part, to our very low average daily trading
volumes.  These broad market fluctuations may also adversely affect
the trading price of our common stock.





Future sales of
our common stock could adversely affect its price and our future capital-raising
activities could involve the issuance of equity securities, which would dilute
your investment and could result in a decline in the trading price of our common
stock.





We may
sell securities in the public or private equity markets if and when conditions
are favorable.  Sales of substantial amounts of common stock, or the
perception that such sales could occur, could adversely affect the prevailing
market price of our common stock and our ability to raise capital.  We
may issue additional common stock in future financing transactions or as
incentive compensation for our management team and other key personnel,
consultants and advisors. Issuing any equity securities would be dilutive to the
equity interests represented by our then-outstanding shares of common stock. The
market price for our common stock could decrease as the market takes into
account the dilutive effect of any of these issuances. Furthermore, we may enter
into financing transactions at prices that represent a substantial discount to
the market price of our common stock. A negative reaction by investors and
securities analysts to any discounted sale of our equity securities could result
in a decline in the trading price of our common stock.





Our common stock
is quoted on the OTC Bulletin Board, which may have an unfavorable impact on our
stock price and liquidity.





Our
common stock is quoted on the OTC Bulletin Board. The OTC Bulletin Board is a
significantly more limited market than the New York Stock Exchange, NASDAQ
system, or our former trading market, the American Stock Exchange. The quotation
of our shares on the OTC Bulletin Board may result in a less liquid market
available for existing and potential stockholders to trade shares of our common
stock, could depress the trading price of our common stock and could have a
long-term adverse impact on our ability to raise capital in the
future.  Because of the limited trading market for our common stock,
and because of the significant price volatility, you may not be able to sell
your shares of common stock when you desire to do so. In the year ended December
31, 2009, our stock price ranged from a high of $2.25 to a low of $0.47 per
share. The inability to sell your shares in a rapidly declining market may
substantially increase your risk of loss as a result of such illiquidity and
because the price for our common stock may suffer greater declines due to its
price volatility.


15


We have never
paid dividends on our common stock, and we do not anticipate paying any cash
dividends in the foreseeable future.





We have
never paid cash dividends on our common stock and we currently intend to retain
our future earnings, if any, to fund the development and growth of our business.
In addition, the terms of any future debt or credit facility, and the terms of
our Series A Preferred Stock, may preclude us from paying these dividends. As a
result, capital appreciation, if any, of our common stock will be your sole
source of gain for the foreseeable future.  Investors seeking cash
dividends should not invest in our common stock.





Common
stockholders may not be able to elect a majority of our Board of
Directors.





The terms
of our Series A Preferred Stock provide that if at any time dividends on the
Series A Preferred Stock shall be unpaid in an amount equal to two full years’
dividends, until such time as all dividends in arrears have been paid, such
holders shall have the right to elect a majority of our Board of
Directors.  If we are not able to obtain financing, we may not be able
continue to pay dividends on our preferred stock.   If this were
to occur, holders of our common stock would lose their ability to control our
Board of Directors as the holders of the Series A Preferred Stock would have the
right to elect a majority of our Board of Directors.





We are subject to
penny stock regulations and restrictions, which could make it difficult for
stockholders to sell their shares of our stock.





SEC
regulations generally define “penny stocks” as equity securities that have a
market price of less than $5.00 per share or an exercise price of less than
$5.00 per share, subject to certain exemptions. As of March 29, 2010, the last
sale price for our common stock was $1.04 per share.  For transactions
in securities that are not exempt from the “penny stock” definition, the SEC has
adopted rules and regulations that impose additional sales practice requirements
on broker-dealers prior to selling penny stocks, which may make it burdensome to
conduct transactions in our shares. Because our shares are subject to these
rules, it may be difficult to sell shares of our stock, and because it may be
difficult to find quotations for shares of our stock, it may be impossible to
accurately price an investment in our shares. In addition, the SEC has the
authority to restrict any person from participating in a distribution of a penny
stock if the SEC determines that such a restriction would be in the public
interest.





The Financial Industry Regulatory
Authority, or FINRA, sales practice requirements may also limit a stockholder's
ability to buy and sell our stock.





In
addition to the penny stock rules described above, the FINRA has adopted rules
that require that in recommending an investment to a customer, a broker-dealer
must have reasonable grounds for believing that the investment is suitable for
that customer. Prior to recommending speculative low priced securities to their
non-institutional customers, broker-dealers must make reasonable efforts to
obtain information about the customer's financial status, tax status, investment
objectives and other information. Under interpretations of these rules, the
FINRA believes that there is a high probability that speculative low priced
securities will not be suitable for at least some customers. The FINRA
requirements make it more difficult for broker-dealers to recommend that their
customers buy our common stock, which may limit your ability to buy and sell our
stock and have an adverse effect on the market for our shares.


16


Provisions in our amended and
restated certificate of incorporation and amended and restated bylaws and
applicable Delaware law may prevent or discourage third parties or our
stockholders from attempting to replace our management or influencing
significant decisions.




Provisions
in our amended and restated certificate of incorporation and amended and
restated bylaws may have the effect of delaying or preventing a change in
control of our company or our management, even if doing so would be beneficial
to our stockholders. These provisions include:




·
            authorizing
      our Board of Directors to issue preferred stock without stockholder
      approval;




·
            limiting
      the persons who may call special meetings of
  stockholders;




·
            prohibiting
      our stockholders from making certain changes to our certificate of
      incorporation or bylaws except with 662⁄3% stockholder approval;
      and




·
            requiring
      advance notice for raising business matters or nominating directors at
      stockholders’ meetings.




We are
also subject to provisions of the Delaware corporation law that, in general,
prohibit any business combination with a beneficial owner of 15% or more of our
common stock for five years unless the holder’s acquisition of our stock was
approved in advance by our Board of Directors. Together, these charter and
statutory provisions could make the removal of management more difficult and may
discourage transactions that otherwise could involve payment of a premium over
prevailing market prices for our common stock.




ITEM
1B. UNRESOLVED STAFF COMMENTS





Not
applicable.





ITEM
2. PROPERTIES





We do not
own any real estate or other physical properties materially important to our
operations.  In January 2010, we relocated our headquarters to 5
Caufield Place, Suite 102, Newtown, PA 18940, upon effectiveness of a sublease
entered into on December 31, 2009 for 5,670 square feet of office
space.  We continue to maintain our approximate 4,000 square feet of
office space at our former headquarters located at 43460 Ridge Park Drive, Suite
140, Temecula, CA 92590, pursuant to a lease signed on November 7, 2007 that
terminates December 31, 2010.  We are responsible for paying $11,576
per month in rent for our new Pennsylvania headquarters and expect to continue
to pay $9,757 per month in rent for our California office space until
termination of the lease.





ITEM
3. LEGAL PROCEEDINGS





On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit against our company, Sunshine Wireless, LLC, and four other
defendants affiliated with Winstar Communications, Inc.  This lawsuit
alleged that the Winstar defendants conspired to commit fraud and breached their
fiduciary duty to the plaintiffs in connection with the acquisition of the
plaintiff's radio production and distribution business.  The complaint
further alleged that our company and Sunshine joined the alleged
conspiracy.  On February 25, 2003, the case against our company and
Sunshine was dismissed.  However, on October 19, 2004, Jeffrey A. Leve
and Jeffrey Leve Family Partnership, L.P. exercised their right to
appeal.  On June 1, 2005, the United States Court of Appeals for the
Second Circuit affirmed the February 25, 2003 judgment of the district court
dismissing the claims against us.


On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed
another lawsuit against our company, Sunshine and four other defendants
affiliated with Winstar.  That lawsuit attempted to collect a federal
default judgment of $5 million entered against two entities, Winstar Radio
Networks, LLC and Winstar Global Media, Inc., by attempting to enforce the
judgment against our company and others under the doctrine of de factomerger.  The action was tried before a Los Angeles County
Superior Court judge, without a jury, in 2008.  On August 5, 2009, the
Superior Court issued a statement of decision in our favor, and on October 8,
2009, the Superior Court entered judgment in our favor, and judged plaintiffs’
responsible for $2,708.70 of ourcourt
costs.  On November 6, 2009, the plaintiffs filed a notice of appeal
in the Superior Court of the State of California, County of Los Angeles Central
District.  We have engaged appellate counsel, believe the plaintiff’s
case to be without merit and intend to continue to defend the case
vigorously.





17




ITEM
4. (REMOVED AND RESERVED)





Not
applicable.





PART
II





ITEM
5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES





Market
Information





Since
February 16, 2007 our common stock has been quoted on the OTC Bulletin Board
under the symbol “PSTX.OB.” Prior to such time, our stock was listed on the
American Stock Exchange under the symbol “PST.”





The
following table sets forth the high and low sales prices for our common stock
for the periods indicated below, as reported by the OTC Bulletin
Board.  Such over-the-counter market quotations reflect inter-dealer
prices, without retail mark-up, mark-down, or commission and may not necessarily
represent actual transactions in our common stock.





High
                      
                      
                      LowYear
      Ended December 31, 2009First
      Quarter
                      
                      $
                      1.20
                      
                      
                      $
                      0.47Second
      Quarter
                      
                      
                      1.10
                      
                      
                      
                      0.60Third
      Quarter
                      
                      
                      1.40
                      
                      
                      
                      0.70Fourth
      Quarter
                      
                      
                      2.25
                      
                      
                      
                      1.06Year
      Ended December 31, 2008First
      Quarter
                      
                      $
                      0.96
                      
                      
                      $
                      0.33Second
      Quarter
                      
                      
                      1.25
                      
                      
                      
                      0.50Third
      Quarter
                      
                      
                      1.49
                      
                      
                      
                      0.95Fourth
      Quarter
                      
                      
                      1.50
                      
                      
                      
                      0.85





Stockholders





As of
March 29, 2010, there were 622 holders of record of our common stock. We have
100,000,000 shares of common stock authorized, of which 23,456,063 were issued
and outstanding at March 29, 2010.  We have 1,000,000 shares of
authorized convertible preferred stock, of which 10,950 shares were issued and
outstanding at March 29, 2010.





Dividends





We paid
$95,812 and $76,650 in dividends to holders of our Series A Preferred Stock
during 2009 and 2008, respectively, and have not paid any dividends to common
stockholders.  Dividends to our preferred stockholders are cumulative
and paid at the rate of 7% per annum. We currently have no intention of paying
dividends on our common stock, and the terms of our Series A Preferred Stock may
limit our ability to pay any such dividends.


18


Recent
Sales of Unregistered Securities





On
November 19, 2009, in connection with the execution of our new supply and
distribution agreement with Cardinal Health (see “Business—Customers and
Distribution—Cardinal Health – Exclusive U.S. Distributor,” above), we issued
Cardinal Health warrants to purchase 1,250,000 shares of our common stock at $2
per share and 625,000 shares of our common stock at $4 per share pursuant to a
Warrant Purchase Agreement dated effective November 19, 2009.  The
warrants have a term of five-years, but are subject to early expiration in
certain circumstances, and grant the holder a right of first refusal for the
initial year of the term with respect to certain issuances of common
stock.  We also granted Cardinal Health certain mandatory and
“piggyback” registration rights, which require us to register the shares
issuable upon exercise of the warrants under the Securities Act in certain
circumstances pursuant to a Registration Rights Agreement dated November 19,
2009.  The warrants (and shares issuable upon exercise of the
warrants) have not been registered under the Securities Act or state securities
laws and may not be offered or sold in the United States absent registration
with the SEC or an applicable exemption from the registration
requirements.





We relied
on the exemption from the registration requirements of the Securities Act,
provided by Section 4(2) thereof and the rules and regulations promulgated
thereunder, including Regulation D, in connection with the issuance of the
warrants. The offer, sale and issuance of the warrants were made without general
solicitation or advertising. The warrants were offered and issued only to
“accredited investors” as such term is defined in Rule 501 under the Securities
Act.





Issuer
Repurchases of Equity Securities





Not
applicable.





ITEM
6. SELECTED FINANCIAL DATA





Not
applicable.





ITEM
7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our audited consolidated financial
statements and the related notes thereto and the description of our business
appearing elsewhere in this annual report on Form 10-K.  This
discussion contains forward-looking statements that involve risks and
uncertainties. See “Cautionary Note Regarding Forward-Looking
Statements.”  Known and unknown risks, uncertainties and other factors
could cause our actual results to differ materially from those projected in any
forward-looking statements.  In evaluating these statements, you
should specifically consider various factors, including, but not limited to,
those set forth under the caption “Risk Factors” in Item 1.A of this annual
report on Form 10-K.




Overview




We focus
on the development, marketing and sales of products and services in the medical
patient safety markets.  Our proprietary Safety-Sponge® System is a
patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications integrated to form a comprehensive counting and
documentation system.  This system is designed to eliminate the
possibility of retained surgical sponges being unintentionally left inside of
patients during surgical procedures by allowing faster and more accurate
counting of surgical sponges.  We sell our Safety-Sponge® System to
hospitals through our direct sales force, but rely on an exclusive distributor
for the ongoing supply of our proprietary surgical sponge products to hospitals
that have adopted our system.  Our business model consists of selling
our unique surgical sponge products, which are manufactured for us by an
exclusive supplier, on a recurring basis to those hospitals that have adopted
our Safety-Sponge® System. One of the ways in which we differentiate our
products from other competing products is by working closely with hospital
personnel through education and implementation services. We currently sell our
Safety-Sponge® System only in the United States and we had revenues of
$4,503,535 and $2,779,871 in the years ended December 31, 2009 and 2008,
respectively, and at December 31, 2009 we reached a milestone of having had a
cumulative total of an estimated 25,000,000 sponges used in 1,000,000 procedures
without a single sponge unintentionally left inside a surgical
patient.


19


Sources
of Revenues and Expenses




Revenues




Surgical Sponge
Revenues.  We generate revenues primarily from the sale of
surgical sponges used in our Safety-Sponge® System to our exclusive distributor,
who then sells directly and through sub-distributors to hospitals that have
adopted our Safety-Sponge® System.  We expect hospitals that adopt our
Safety-Sponge® System to commit to its use and thus provide a recurring source
of revenues from ongoing sales of surgical sponges and other products used in
our system. We recognize revenues from the sale of surgical sponges upon
shipment to our distributor because most of our surgical sponge sales are to our
distributor, FOB shipping point.  Note that because of the way our
sales cycle works (see “Business—Customers and Distribution”), there is a gap
between the time we begin incurring costs associated with our new customer
arrangements and when we begin generating revenues from such
arrangements.




Hardware, Software and Maintenance
Agreement Revenues.  We also generate revenues from the sale of
related hardware and software to hospitals that have adopted our Safety-Sponge®
System.  The sale of our Safety-Sponge® System includes hardware (the
SurgiCounterTM scanners), our proprietary file management software (CitadelTM) and
an initial one-year maintenance agreement (which may be renewed).  All
of these items are considered to be separate deliverables within a
multiple-element arrangement and, accordingly, we allocate the total price of
this arrangement among each respective deliverable, and recognize revenue as
each element is delivered.  For the hardware and software elements of
our Safety-Sponge® System, we recognize revenues on delivery, which is the time
of shipment (if terms are FOB shipping point) or upon receipt by the customer
(if terms are FOB destination).  Delivery with respect to our initial
one-year maintenance agreements is considered to occur on a monthly basis over
the term of the one-year period; we recognize revenues related to this element
on a pro-rata basis during this period.  Because of the change in our
business model discussed below under “—Factors Affecting Future Results,” we do
not expect these sales to represent a significant portion of our revenues going
forward.





Prior to
the third quarter of 2009, our business model included the sale of our
SurgiCounterTM scanners and related software used in our Safety-Sponge® System to
most hospitals that adopted our system.  Beginning with the third
quarter of 2009, we modified our business model and began to provide our
SurgiCounterTM scanners and related software to all hospitals at no cost when
they adopt our Safety-Sponge® System.  Because we no longer engage
in direct SurgiCounterTM scanner sales and generally
anticipate only recognizing revenues associated with our SurgiCounterTM scanners
in connection with reimbursement arrangements under the our agreement with
Cardinal Health. Therefore, we do not expect that our SurgiCounterTM
scanners will represent a sizable source of future revenues for us.
Deferred scanner revenue associated with the reimbursement from Cardinal Health,
will be recognized over the life of the specific hospital contract.





Cost
of revenues




Our cost
of revenues consists primarily of our direct product costs for surgical sponges
and products from our exclusive third-party manufacturer.  We also
include a reserve expense for obsolete and slow moving inventory in cost of
revenues.  In addition, when we provide scanners to hospitals for
their use (rather than sell), we include only the depreciation expense of the
scanners in cost of revenues (not the full product cost).  We estimate
the useful life of the scanners to be three years. However, should we sell
the scanners to hospitals, our cost of revenue include the full product cost
when shipped.





Research
and development expenses




Our
research and development expenses consist of costs associated with the design,
development, testing and enhancement of our products.  We also include
salaries and related employee benefits, research-related overhead expenses and
fees paid to external service providers in our research and development
expenses.


20


Sales
and marketing expenses




Our sales
and marketing expenses consist primarily of salaries and related employee
benefits, sales commissions and support costs, professional service fees,
travel, education, trade show and marketing costs.




General
and administrative expenses




Our
general and administrative expenses consist primarily of salaries and related
employee benefits, professional service fees, expenses related to being a public
entity, and depreciation and amortization expense.




Total
other income (expense)




Our total
other income (expense) primarily reflects changes in the fair value of warrants
classified as derivative liabilities.  Under applicable accounting
rules (discussed below under “—Critical Accounting Policies—Warrant Derivative
Liability”), we are required to make estimates of the fair value of our warrants
each quarter, and to record the change in fair value each period in our
statement of operations.  As a result, changes in our stock price from
period to period result in other income (when our stock price decreases) or
other expense (when our stock price increases) on our income
statement.




Critical
Accounting Policies and Estimates




The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires the use of estimates and assumptions that affect
the reported amounts of assets and liabilities, revenues and expenses, and
related disclosures in the financial statements.  Critical accounting
policies are those accounting policies that may be material due to the levels of
subjectivity and judgment necessary to account for highly uncertain matters or
the susceptibility of such matters to change, and that have a material impact on
financial condition or operating performance. While we base our estimates and
judgments on our experience and on various other factors that we believe to be
reasonable under the circumstances, actual results may differ from these
estimates under different assumptions or conditions.  We believe the
following critical accounting policies used in the preparation of our financial
statements require significant judgments and estimates.  For
additional information relating to these and other accounting policies, see Note
3 to our audited consolidated financial statements, appearing elsewhere in this
annual report on Form 10-K.




Warrant
Derivative Liability




Under
applicable accounting guidance, an evaluation of outstanding warrants is made to
determine whether warrants issued are required to be classified as either equity
or a liability. Because certain warrants we have issued in connection with past
financings contain certain provisions that may result in an adjustment to their
exercise price, we classify them as derivative liabilities, and accordingly, we
are then required to estimate the fair value of such warrants, at the end of
each fiscal quarter.  We use the Black-Scholes option pricing model to
estimate such fair value, which requires the use of numerous assumptions,
including, among others, expected life (turnover), volatility of the underlying
equity security, a risk-free interest rate and expected dividends. The use of
different values by management in connection with these assumptions in the Black
Scholes option pricing model could produce substantially different
results.  Because we record changes in the fair value of warrants
classified as derivative liabilities in total other income (expense), materially
different results could have a material effect on our results of
operations.


21


Goodwill





Our
goodwill represents the excess of the purchase price over the estimated fair
values of the net tangible and intangible assets of SurgiCount Medical, Inc.,
which we acquired in February 2005. We review goodwill for impairment at least
annually in the fourth quarter, as well as whenever events or changes in
circumstances indicate its carrying value may not be recoverable.  We
are required to perform a two-step impairment test on goodwill. In the first
step, we will compare the fair value to its carrying value.  If the
fair value exceeds the carrying value, goodwill will not be considered impaired
and we are not required to perform further testing.  If the carrying
value exceeds the fair value, then we must perform the second step of the
impairment test in order to determine the implied fair value of goodwill and
record an impairment loss equal to the difference. Determining the implied fair
value involves the use of significant estimates and assumptions. These estimates
and assumptions include revenue growth rates and operating margins used to
calculate projected future cash flows, risk-adjusted discount rates, future
economic and market conditions and determination of appropriate market
comparables. We base our fair value estimates on assumptions we believe to be
reasonable but that are unpredictable and inherently uncertain. Actual future
results may differ from those estimates. To the extent additional events or
changes in circumstances occur, we may conclude that a non-cash goodwill
impairment charge against earnings is required, which could have an adverse
effect on our financial condition and results of operations.




Stock-Based
Compensation




We
recognize compensation expense in an amount equal to the estimated grant date
fair value of each option grant, or stock award over the estimated period of
service and vesting.  This estimation of the fair value of each
stock-based grant or issuance on the date of grant involves numerous assumptions
by management. Although we calculate the fair value under the Black Scholes
option pricing model, which is a standard option pricing model, this model still
requires the use of numerous assumptions, including, among others, the expected
life (turnover), volatility of the underlying equity security, a risk free
interest rate and expected dividends. The model and assumptions also attempt to
account for changing employee behavior as the stock price changes and capture
the observed pattern of increasing rates of exercise as the stock price
increases.  The use of different values by management in connection
with these assumptions in the Black Scholes option pricing model could produce
substantially different results.




Impairment
of Long-Lived Assets




Our
management reviews our long-lived assets with finite useful lives for impairment
whenever events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable. We recognize an impairment loss when the sum
of the future undiscounted net cash flows expected to be realized from the asset
is less than its carrying amount. If an asset is considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the asset exceeds its fair value. Considerable judgment is necessary
to estimate the fair value of the assets and accordingly, actual results could
vary significantly from such estimates. Our most significant estimates and
judgments relating to the long-lived asset impairments include the timing and
amount of projected future cash flows.




Accounting
for Income Taxes




Deferred
income taxes result primarily from temporary differences between financial and
tax reporting. Deferred tax assets and liabilities are determined based on the
difference between the financial statement basis and tax basis of assets and
liabilities using enacted tax rates. Future tax benefits are subject to a
valuation allowance when management is unable to conclude that our deferred tax
assets will more-likely-than-not be realized from the results of operations. Our
estimate for the valuation allowance for deferred tax assets requires management
to make significant estimates and judgments about projected future operating
results. If actual results differ from these projections or if management’s
expectations of future results change, it may be necessary to adjust the
valuation allowance.




Since
January 1, 2007, we have measured and recorded uncertain tax positions in
accordance with rules that took effect on such date that prescribe a threshold
for the financial statement recognition and measurement of a tax position taken
or expected to be taken in a tax return.  Accordingly, we now only
recognize (or continue to recognize) tax positions meeting the
more-likely-than-not recognition threshold (or that met such threshold on the
effective date).  Accounting for uncertainties in income tax positions
involves significant judgments by management.  If actual results
differ from management’s estimates, we may need to adjust the provision for
income taxes.





Recent
Accounting Pronouncements




On July
1, 2009, the Financial Accounting Standards Board, or FASB, released the FASB
Accounting Standards CodificationTM, sometimes referred to as the “Codification”
or “ASC.”  The Codification does not change how we account for our
transactions or the nature of related disclosures made, and was made effective
for periods ending on or after September 15, 2009,  Accordingly, we
have updated references in this annual report on Form 10-K to reflect the
Codification Topics as applicable.


22


In June
2008, the FASB ratified guidance regarding accounting treatment for contracts
that are to be settled in an entity’s own equity, which guidance is effective
for financial statements issued for fiscal years beginning after December 15,
2008, and interim periods within those fiscal years.  Early
application was not permitted.  Under this guidance, a contract that
would otherwise meet the definition of a derivative but is both (a) indexed to
an entity’s own stock and (b) classified in stockholders’ equity in the
statement of financial position would not be considered a derivative financial
instrument.   The guidance provided a new two-step model to
determine whether a financial instrument or an embedded feature is indexed to an
entity’s own stock and thus able to qualify for an exception.  When we
adopted this guidance effective January 1, 2009, we identified certain warrants
we had issued contained provisions that could result in an adjustment to their
exercise price, making them ineligible for classification in stockholders’
equity. Accordingly, we reclassified these warrants as liabilities upon the
effective date of the guidance, and now measure them at fair value on each
balance sheet date and recognize changes in fair value in our income statement.
We recognized the cumulative effect of the change in accounting for these
warrants as an adjustment to our opening balance of accumulated deficit at
January 1, 2009, which amount was based on the difference between the amounts
recognized in the consolidated balance sheet before the initial adoption and the
amounts recognized in the consolidated balance sheet as a result of the initial
application of this guidance.





In
October 2009, the FASB updated its guidance regarding accounting for multiple
deliverable arrangements in order to enable vendors to account for products and
services (deliverables) separately rather than as a combined
unit.  These changes are effective prospectively for revenue
arrangements entered into or materially modified in the fiscal years beginning
on or after June 15, 2010 and early adoption is permitted.  We have
not yet evaluated the effects of this accounting update on our financial
statements.





In
October 2009, the FASB changed the accounting model for revenue arrangements
that include both tangible products and software elements that are “essential to
the functionality,” and carves these products out of current software revenue
guidance. The new guidance will include factors to help companies determine what
software elements are considered “essential to the functionality.” These changes
are effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010 and early
adoption is permitted. We have not yet evaluated the effects of this accounting
update on our financial statements.





In
January 2010, the FASB issued guidance designed to improve disclosures about
fair value measurements as well as disclosures related to significant transfers
between each level and additional information about Level 3
activity.  This guidance begins phasing in the first fiscal period
after December 15, 2009, and we are currently assessing the effects on our
financial statements.





For
additional discussion regarding these, and other recent accounting
pronouncements, see Note 4 to our audited consolidated financial statements,
appearing elsewhere in this annual report on Form 10-K.





Internal
Control Over Financial Reporting




In
connection with our assessment of the effectiveness of internal control over
financial reporting as of December 31, 2009 and 2008, we identified certain
material weaknesses in our internal control over financial
reporting.





The
material weaknesses identified in connection with our assessment at December 31,
2008 included an ineffective general control environment, ineffective risk
assessment processes, and ineffective internal control policies and procedures
relating to equity transactions and share-based payments, the proper reporting
of income and accounting for payroll taxes, and the integrity of spreadsheets
and other “off system” work papers used in the financial reporting
process.  In part, to address the weaknesses identified in our general
control environment, our board of directors hired a new Chief Executive Officer
and restructured the board to include two independent directors, one of whom
meets the requirements of an audit committee financial expert, and both of whom
have significant corporate governance experience. To address the weaknesses
identified relating to equity transactions, we implemented a new software
program specifically designed to track and account for share-based payments and
equity transactions.  In addition, we engaged an internal control
specialist to design and help implement effective risk assessment
processes.  Although we implemented these remedial actions, we
nevertheless still continued to have material weaknesses in our internal control
over financial reporting as of December 31, 2009.


23


In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:





·
            Ineffective
      control environment due to the following identified
      weaknesses:


o
            Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.


o
            Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.


·
            Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.


·
            Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.





To remedy
these material weaknesses, we have implemented policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.




For
information regarding our evaluation of the effectiveness of our disclosure
controls and procedures, our evaluation of our internal control over financial
reporting, as well as any changes in our internal control over financial
reporting, see “Controls and Procedures” below.





Factors
Affecting Future Results




Cardinal Health Supply
Agreement.   On November 19, 2009 we entered into a new
exclusive Supply and Distribution Agreement with Cardinal
Health.  Cardinal Health is the exclusive distributor of current
products used in our proprietary Safety-Sponge® System in the United States,
Puerto Rico and Canada.  In connection with the execution of the new
supply and distribution agreement, Cardinal Health issued a $10,000,000 purchase
order, paid us $8,000,000 in cash as a partial prepayment and agreed to pay
$2,000,000 directly to A Plus, our exclusive manufacturer, upon delivery of
product to Cardinal Health.  Because we did not ship any product
pursuant to this purchase order in 2009, all $10,000,000 of incremental revenue
from this purchase order is expected to be recognized in 2010.  In
addition, Cardinal Health agreed to issue a $5,000,000 purchase order before the
end of the third quarter 2010 if certain milestones are achieved.  If
the second purchase order is issued, Cardinal Health will pay us $4,000,000 in
cash as a partial prepayment and pay $1,000,000 directly to A Plus upon delivery
of product to Cardinal Health.  Assuming the second purchase order is
issued and we can meet our delivery requirements, we expect to have minimum
incremental revenue of $10,500,000 in 2010, with the remaining $4,500,000 from
the second purchase order recognized when product is shipped in 2011 in
accordance with the agreement.  Because of this arrangement, we expect
that our reported revenues for 2010 will be at a significantly higher level than
that which would be reflected based on sales by our exclusive distributors’ to
its end-user hospital customers.  In contrast, we anticipate that our
revenues for 2011 and 2012 will be at levels below actual sales by our exclusive
distributors’ to its end-user hospital customers because we anticipate that
Cardinal Health will satisfy customer demand, in part, by working down this
inventory.  For more information relating to our distribution and
other arrangements with Cardinal Health, see “Business—Customers and
Distribution—Cardinal Health-Exclusive U.S. Distributor” above.




Effect of Stocking Sales and Backlog
on Revenues.  Our revenues reflect primarily the sale of
surgical sponges to our main distributor.  Because we recognize
revenues when we ship product, the timing of orders by our main distributor and
the management of its inventory may affect the comparability of revenues between
periods. Additionally, because we primarily recognize revenues when we ship our
products to our main distributor, to the extent there is a backlog in receipt of
products from our exclusive supplier of our surgical sponges, we may not always
be able to recognize revenues in the same period in which a product order is
received. In addition, our main distributor may be required to sell down its
inventory more than it anticipated, which could result in a larger than normal
product order.   Thus, certain changes in our revenues between
periods are not necessarily reflective of actual hospital demand for our
surgical sponge products.


24


Reduction in Hardware Sales – Effect
on Revenues and Cost of Revenues.  Prior to the third quarter
of 2009, our business model included the sale of our SurgiCounterTM scanners and
related software used in our Safety-Sponge® System to most hospitals that
adopted our system.  Beginning with the third quarter of 2009, we
modified our business model and began to provide our SurgiCounterTM scanners and
related software to all hospitals at no cost when they adopt our Safety-Sponge®
System.  Because we no longer engage
in direct SurgiCounterTM scanner sales and generally
anticipate only to recognize revenues associated with our SurgiCounterTM scanners
in connection with reimbursement arrangements under our agreement with Cardinal
Health, we do not expect our SurgiCounterTM scanners to continue to
represent a sizable source of revenues for our company. Notably, in 2009,
surgical sponge sales accounted for 94.0% of our revenues, and sales of hardware
accounted for 6.0%, compared to 86.5% and 13.5% for the same period in 2008,
respectively.  In addition to its effect on our revenue, this change
in our business model also affected our costs of revenues because rather than
recognizing the full product cost for all SurgiCounterTM scanners at the time of
shipment in our cost of revenues, we now recognize only the depreciation expense
for those SurgiCounterTM scanners that we have provided to certain hospitals for
their use at no cost.  This business model change led to
a significant improvement in our gross margin in the year ended December
31, 2009 based on the shift in product mix resulting in a significantly higher
percentage of surgical sponge sales, which are sold at a higher margin than our
SurgiCounterTM scanners included in our cost of revenue.  Going
forward, we anticipate that the shift in product mix and
anticipated increase in volume of surgical sponge sales will more than
offset the effects of including depreciation expense for the scanners in
cost of revenue without generating the corresponding revenue from the sale
of the scanner.





Results
of Operations




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




Revenues




We had
revenues of $4,503,535 for the year ended December 31, 2009, an increase of
62.0% compared to $2,779,871 for the same period in 2008.  In the year
ended December 31, 2009, surgical sponge sales accounted for 94.0% of revenues,
and sales of hardware accounted for 6.0%, compared to 86.5% and 13.5% for the
same period in 2008, respectively.  The primary reason for the
increase in revenues was an increase in sales of surgical sponges used in our
Safety-Sponge® System. The increase in sales activity was attributable to an
upgraded sales force and changes made in our sales program, including the
indemnification program (See “Business – Indemnification Program”) and providing
scanners and associated software at no additional cost to our end-user hospital
customers.




Cost
of revenues




Cost of
revenues increased by $902,524 or 50.1%, to $2,703,931 for the year ended
December 31, 2009 from $1,801,871 for the same period in
2008.  The primary reason for the increase in costs was an increase in
sales of our products used in our Safety-Sponge® System, reflecting an increase
in the number of hospitals that have adopted and implemented our
system.  The increase in costs associated with the increase in sales
of products more than offset the decrease in costs that resulted from the change
in our business model with respect to the provision of our SurgiCounterTM
scanners, which resulted in approximately $395,000 of cost now being depreciated
and recognized over the life of the hardware.




Gross
profit




We had
gross profit of $1,799,604 for the year ended December 31, 2009, an increase of
$821,604, or 84.0%, compared to $978,000 in the same period in
2008.  The primary reason for the increase in gross profit during
2009 was the higher revenue growth achieved, combined
with the shift in product mix, resulting in a significantly higher
percentage of surgical sponge sales, which are sold at a higher margin
than our SurgiCounterTM scanners.  We had gross margin of 40.0%
for the year ended December 31, 2009, compared to 35.2% for the same period
in 2008, which improvement is primarily attributable to our change in business
model, and only partially offset by the increase in inventory reserves and
customer rebates.


25


Operating
expenses




We had
total operating expenses of $12,604,717 for the year ended December 31, 2009, an
increase of $4,611,240, or 57.7%, compared to $7,993,477 in the same period in
2008.  The primary reason for the increase in operating expenses was
the significant increase in our general and administrative expenses, which
increased as a result of increased personnel-related expenses and warrant and
stock based compensation expenses.





Research
and development expenses





We had
research and development expenses of $321,116 for the year ended December 31,
2009, an increase of $50,258, or 18.5%, compared to $270,858 in the same period
in 2008.  The primary reason for the increase in research and
development expenses was an increase in personnel and associated compensation
costs.





Sales
and marketing expenses





We had
sales and marketing expenses of $1,926,580 for the year ended December 31, 2009,
a decrease of $589,465, or 23.4%, compared to $2,516,045 in the same period in
2008.  The primary reason for the decrease in sales and marketing
expenses was a decrease in travel and trade show related expenses.




General
and administrative expenses




We had
general and administrative expenses of $10,357,021 for the year ended December
31, 2009, an increase of $5,150,447, or 98.9%, compared to $5,206,574 in the
same period in 2008.  The primary reason for the increase is
$2,429,242 relating to the warrants associated with the Cardinal Health supply
agreement, (see “Business—Customers and Distribution—Cardinal Health-Exclusive
U.S. Distributor” above).  Personnel related expenses, such as
salaries, benefits, severance, travel and equity based compensation expenses,
also accounted for a portion of the increase.




Total
other income (expense)




We had
total other expense of $6,904,539 for the year ended December 31, 2009, compared
to total other income of $2,202,524 in the same period in 2008.  The
primary reason for the change was a significant increase in the fair value of
our warrant derivative liability, which resulted in expense of $5,564,125 in the
year ended December 31, 2009, compared to income of $2,582,043 in the same
period in 2008.  This liability, and the related expense, increases
and decreases as a direct result of fluctuations in the price of our common
stock, which trades on the over the counter market.  In addition, for
the year ended December 31, 2009 we had $588,374 of amortization of debt
discount and $537,919 loss on extinguishment of debt compared to nil in 2008 due
to our December 2009 payment in full of the senior secured notes issued in
January 2009. Because we repaid the notes in full, we had to accelerate the
amortization of the debt discount we recorded in January 2009 at the time of
issuance of the notes and warrants, rather than over the two-year life of the
notes.




Net
loss




For the
foregoing reasons, we had a net loss of $17,531,255 for the year ended December
31, 2009 compared to a net loss of $4,373,524 for the year ended December 31,
2008.





Financial
Condition, Liquidity and Capital Resources




We had
cash and cash equivalents of $3,446,726 at December 31, 2009 compared to
$296,185 at December 31, 2008, and total current liabilities of $16,495,410 at
December 31, 2009 compared to $6,791,397 at December 31, 2008. As of December
31, 2009 we had a working capital deficit of approximately $11,369,127, of which
$8,000,000 and $3,666,336, respectively, are associated with deferred revenue
relating to the partial prepayment from Cardinal Health and the warrant
derivative liability.


26


Our
principal sources of cash have included the issuance of equity and debt
securities. We expect that as our revenues grow, our operating expenses will
continue to grow and, as a result, we will need to generate significant
additional net revenues to achieve profitability.  Because of the way
our sales cycle works (see “Business—Customers and Distribution”), we often
begin to incur significant expenses in advance of the time we generate revenues
from our new customer arrangements.  Thus, as our business grows and
we expand our customer base, our cash needs will increase prior to the time we
generate cash from such new customer arrangements.  As such, we do not
believe that our current cash and cash equivalents will be adequate to fund our
projected operating requirements for the next 12 months.  Although we
engaged in a financing transaction in July 2009 that resulted in the receipt of
$1,706,143 in cash in the third quarter of 2009, and repaid a significant amount
of indebtedness in December 2009 following receipt of $8,000,000 in cash in
November 2009 from Cardinal Health in connection with its prepayment of a
$10,000,000 purchase order (see “—Factors Affecting Future Results—Cardinal
Health Supply Agreement” above), we must still obtain additional financing and
achieve profitable operations in order to provide a sufficient source of
operating capital.  If we are unable to obtain this additional
financing, the absence of capital will have a material adverse impact on our
business and operations during 2010.





Operating
activities




We
generated $3,105,638 of net cash from operating activities in the year ended
December 31, 2009.  Non-cash adjustments to reconcile net loss to net
cash provided by operating activities plus changes in operating assets and
liabilities provided $20,636,893 of cash in the year ended December 31,
2009.  These significant non-cash adjustments primarily reflect the
increase in deferred revenue as a result of the $8,000,000 proceeds from the
November 2009 renewal of our agreement with Cardinal Health order (see “—Factors
Affecting Future Results—Cardinal Health Supply Agreement” above), as well as
significant non-cash adjustments to reflect stock and warrant based compensation
to employees and directors and adjustments to reflect the change in fair value
of our warrant derivative liability.




Investing
activities




We used
$411,388 of net cash in investing activities for the year ended December 31,
2009, primarily for the purchase of scanners and related hardware used in our
Safety Sponge® System.




Financing
activities




We
generated $456,291 of net cash from financing activities during the year ended
December 31, 2009, primarily from the issuance of common stock and warrants,
offset by the December 2009 repayment of a significant amount of our outstanding
indebtedness.




Description
of Indebtedness




At
December 31, 2009, we had aggregate indebtedness of $1,424,558 pertaining to the
Ault Glazer Capital Partners LLC note as described below.





December
2009 Debt Reduction





In
December 2009, following receipt of the $8,000,000 payment from Cardinal Health
in connection with its $10,000,000 purchase order (see “Factors Affecting Future
Results—Cardinal Health Supply Agreement” above), we used approximately
$3,422,000 to repay in full the principal and related accrued interest of senior
secured notes issued in January 2009, the two outstanding promissory notes
issued in favor of the Herbert Langsam Irrevocable Trust and the discount
convertible debenture issued to David Spiegel.  During the year ended
December 31, 2009, we incurred interest expense of $219,384 on the senior
secured notes, and during the years ended December 31, 2009 and 2008, we
incurred interest expense of $68,682 and $48,395, respectively, on the Langsam
promissory notes, and interest expense and amortization of the debt discount of
$15,113 and $1,337, respectively, on the Spiegel debenture.  For more
information relating to these debt instruments, see Note 9 to our Consolidated
Financial Statements appearing elsewhere in this annual report on Form
10-K.


27


Ault
Glazer Capital Partners, LLC




On
September 5, 2008, we entered into an Amendment and Early Conversion of Secured
Convertible Promissory Note or Amendment, with Ault Glazer Capital
Partners, LLC, or Ault Glazer, to modify the terms of our outstanding
$2,530,558 convertible secured promissory note (issued to Ault Glazer
effective as of June 1, 2007). This convertible secured note was to have matured
on December 31, 2010, bore interest at a rate of 7% per annum, was convertible
into shares of our common stock at $2.50 per share in certain circumstances, and
was secured by all of our assets.  Under the amendment, we agreed
to pay Ault Glazer $450,000 in cash and, contingent upon satisfaction of certain
conditions by Ault Glazer, convert the remaining balance of the convertible
secured note into 1,300,000 shares of our common stock.  Notably, one
condition was that Ault Glazer transfers certain leases from our name into its
name.  On September 12, 2008, we entered into an Agreement for the
Advancement of Common Stock Prior to Close of the Amendment and Early Conversion
of Secured Convertible Promissory Note or Advancement, whereby we agreed to
issue shares of our common stock to Ault Glazer in advance
of its satisfaction of the conditions for the conversion of the
convertible secured note that were set out in the amendment
agreement. As of the date of this annual report on Form 10-K, we have paid
Ault Glazer $450,000 in cash and issued Ault Glazer an aggregate 800,0000 shares
of our common stock, valued at $656,000 in settlement of the note in advance of
conversion of the note.  Ault Glazer has not yet satisfied the
conditions set out in the amendment and the issuance of the remaining
shares of our common stock to Ault Glazer remains contingent upon its
satisfaction of such conditions.  In light of the Amendment
agreement and issuance of shares pursuant to the Advancement, we are no longer
incurring interest expense on this convertible secured promissory note.  As
of December 31, 2009, the outstanding principal balance on this note was
$1,424,558.  For further information relating to this note, see
Note 9 to our Consolidated Financial Statements appearing elsewhere in this
annual report on Form 10-K.




Ault
Glazer is controlled by Milton “Todd” Ault III, our former Chairman and Chief
Executive Officer, and Louis Glazer, M.D. Ph.G, a Director of our company. Dr.
Glazer currently has a significant beneficial ownership interest in our common
and preferred stock.





Investment
Portfolio





At
December 31, 2009 and 2008, we had an investment in preferred stock of Alacra
Corporation, with a carrying value of $666,667, which represented 5.8% and 8.4%
of our total assets at December 31, 2009 and 2008, respectively.  In
December 2007, we received proceeds of $333,000 from the redemption of one-third
of our initial $1,000,000 investment.  In accordance with the terms of
our investment, we have exercised our right to put back our remaining preferred
stock to Alacra, and based on discussions with Alacra management, we anticipate
redemption and subsequent receipt of funds in the fourth quarters of 2010 and
2011, respectively. As there is no readily determinable fair value of the Alacra
preferred stock, we account for this investment under the cost
method.  For additional information relating to this investment, see
“Business—Investment Portfolio” and Note 8 to our Consolidated Financial
Statements appearing elsewhere in this annual report on Form 10-K.





Related
Party Transactions




Herbert
Langsam is a member of our Board of Directors.  As described above
under “—Description of Indebtedness—December 2009 Debt Reduction,” Mr. Langsam
provided financing to our company in exchange for equity and interest payments
and a security interest in our assets.




Ault
Glazer Capital Partners, LLC is controlled by Milton “Todd” Ault III, our former
Chairman and Chief Executive Officer, and Louis Glazer, M.D. Ph.G. Dr. Glazer is
a member of our Board of Directors and currently has a significant beneficial
ownership interest in our common and preferred stock.




Catalysis
Offshore Ltd and Catalysis Partners, LLC (collectively, “Catalysis”), which are
controlled by Francis Capital Management, LLC, participated in the January 2009
Senior Secured Note Offering described above under “Description of
Indebtedness—December 2009 Debt Reduction,” and received interest payments and a
security interest in our assets.  In addition, Catalysis and Francis
Capital Management, LLC, have participated in other equity financings of our
company.  John P. Francis, a member of our Board of Directors, is
President of Francis Capital Management, LLC, which is the managing partner of
Catalysis.


28


We have
an exclusive supply agreement for surgical sponges used in our Safety-Sponge®
System with A Plus International Inc (see “Business—Manufacturing” above).
Wenchen Lin, a member of our Board of Directors, is a founder and significant
beneficial owner of A Plus.  In addition, Mr. Lin has participated in
equity financings of our company.  During the years ended December 31,
2009 and 2008, our cost of revenue included $2,049,426 and $1,382,164,
respectively, in connection with this supply arrangement, and our accounts
payable included $1,683,080 and $164,341 at December 31, 2009 and 2008,
respectively, payable to A Plus under this supply agreement.





From time
to time, we may use the services of an aircraft owning partnership principally
owned by Steven H. Kane, our Chief Executive Officer, for air
travel.  During the years ended December 31, 2009 and 2008, we
incurred $15,800 and $0 respectively, of expenses related to the use such air
travel services.





For
additional information relating to these and other related party transactions,
see Note 16 to our Consolidated Financial Statements appearing elsewhere in this
annual report on Form 10-K.




Off-Balance
Sheet Arrangements




As of
December 31, 2009, we had no off-balance sheet arrangements.





Commitments
and Contingencies




As of
December 31, 2009, other than our office leases and employment agreements with
key executive officers, we had no material commitments other than the
liabilities reflected in our consolidated financial statements.





ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not
applicable.


29


ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





PATIENT
SAFETY TECHNOLOGIES, INC.


INDEX
TO FINANCIAL STATEMENTS





Report
      of Squar, Milner, Peterson, Miranda & Williamson, LLP
              31Consolidated
      Balance Sheets as of December 31, 2009 and 2008
              32Consolidated
      Statements of Operations for the years ended December 31, 2009 and
      2008
              33Consolidated
      Statements of Stockholders’ (Deficit) Equity for the years ended December
      31, 2009 and 2008
              34Consolidated
      Statements of Cash Flows for the years ended December 31, 2009 and
      2008
              35Notes
      to Financial Statements
              36


30


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Stockholders


Patient
Safety Technologies, Inc.




We have
audited the accompanying consolidated balance sheets of Patient Safety
Technologies, Inc. as of December 31, 2009 and 2008, and the related
consolidated statements of operations, stockholders’ equity, and cash flows for
the years then ended. These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on the
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. The Company was not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that were
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, as well as evaluating the overall
presentation of the financial statements. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Patient Safety Technologies, Inc.
as of December 31, 2009 and 2008, and the results of their operations and their
cash flows for the years then ended, in conformity with accounting principles
generally accepted in the United States of America.




The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 2 to the consolidated
financial statements, the Company has incurred significant recurring
net losses through December 31, 2009 and has a significant working capital
deficit as of December 31, 2009. These factors raise substantial doubt about the
Company’s ability to continue as a going concern. Management’s plans as to these
matters are described in Note 2. The accompanying financial statements do not
include any adjustments that might result from the outcome of this
uncertainty.





As
discussed in Note 3 to the consolidated financial statements, effective January
1, 2009, the Company changed the way certain financial instruments that are
settled in the Company’s common stock are accounted for.





Squar,
Milner, Peterson, Miranda & Williamson, LLP





San
Diego, California


March 31,
2010


31


PATIENT
SAFETY TECHNOLOGIES, INC.





Consolidated
Balance Sheets





For the Year Ended December 31,2009
                    
                    
                    2008AssetsCurrent
      assets:Cash
      and cash equivalents
                    
                    $
                    3,446,726
                    
                    
                    $
                    296,185Accounts
      receivable
                    
                    
                    906,136
                    
                    
                    
                    418,525Inventories,
      net
                    
                    
                    565,823
                    
                    
                    
                    199,909Prepaid
      expenses
                    
                    
                    207,598
                    
                    
                    
                    187,551Total
      current assets
                    
                    
                    5,126,283
                    
                    
                    
                    1,102,170Restricted
      certificate of deposit
                    
                    
                    —
                    
                    
                    
                    93,630Notes
      receivable
                    
                    
                    —
                    
                    
                    
                    121,065Property
      and equipment, net
                    
                    
                    744,646
                    
                    
                    
                    622,410Goodwill
                    
                    
                    1,832,027
                    
                    
                    
                    1,832,027Patents,
      net
                    
                    
                    3,114,025
                    
                    
                    
                    3,438,966Long-term
      investment
                    
                    
                    666,667
                    
                    
                    
                    666,667Other
      assets
                    
                    
                    43,246
                    
                    
                    
                    37,481Total
      assets
                    
                    $
                    11,526,894
                    
                    
                    $
                    7,914,416Liabilities
      and Stockholders’ (Deficit) EquityCurrent
      liabilitiesAccounts
      payable
                    
                    $
                    2,043,166
                    
                    
                    $
                    909,333Current
      portion of convertible note
                    
                    
                    1,424,558
                    
                    
                    
                    1,424,558Current
      portion of notes payable
                    
                    
                    —
                    
                    
                    
                    1,100,000Current
      portion of capital lease
                    
                    
                    19,330
                    
                    
                    
                    —Warrant
      derivative liability
                    
                    
                    3,666,336
                    
                    
                    
                    1,761,878Deferred
      revenue
                    
                    
                    8,099,144
                    
                    
                    
                    —Accrued
      liabilities
                    
                    
                    1,242,876
                    
                    
                    
                    1,595,628Total
      current liabilities
                    
                    
                    16,495,410
                    
                    
                    
                    6,791,397Long-term
      convertible notes, less current portion
                    
                    
                    —
                    
                    
                    
                    51,377Long-term
      capital lease, less current portion
                    
                    
                    58,274
                    
                    
                    
                    —Deferred
      tax liability
                    
                    
                    805,768
                    
                    
                    
                    1,042,400Total
      liabilities
                    
                    
                    17,359,452
                    
                    
                    
                    7,885,174Commitments
      and contingencies (Note 18)Stockholders’
      (deficit) equity:Series
      A preferred stock, $1.00 par value, cumulative 7% dividend: 1,000,000
      shares authorized; 10,950 issued and outstanding at December 31,2009 and
      December 31, 2008; (Liquidation preference of $1.2 million at December 31,
      2009 and December 31, 2008)
                    
                    
                    10,950
                    
                    
                    
                    10,950Common
      stock, $0.33 par value: 100,000,000 shares authorized; 23,456,063 shares
      issued and outstanding at December 31, 2009; 17,197,511 shares issued and
      outstanding at December 31, 2008
                    
                    
                    7,740,501
                    
                    
                    
                    5,675,298Additional
      paid-in capital
                    
                    
                    44,834,321
                    
                    
                    
                    36,033,542Accumulated
      deficit
                    
                    
                    (58,418,330
                    )
                    
                    
                    (41,690,548
                    )Total
      stockholders’ (deficit) equity
                    
                    
                    (5,832,558
                    )
                    
                    
                    29,242Total
      liabilities and stockholders’ (deficit) equity
                    
                    $
                    11,526,894
                    
                    
                    $
                    7,914,416





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


32


PATIENT
SAFETY TECHNOLOGIES, INC.




Consolidated
Statements of Operations





For the Year Ended December 31,2009
                      
                      
                      2008Revenues
                      
                      $
                      4,503,535
                      
                      
                      $
                      2,779,871Cost
      of revenue
                      
                      
                      2,703,931
                      
                      
                      
                      1,801,871Gross
      profit
                      
                      
                      1,799,604
                      
                      
                      
                      978,000Operating
      expenses:Research
      and development
                      
                      
                      321,116
                      
                      
                      
                      270,858Sales
      and marketing
                      
                      
                      1,926,580
                      
                      
                      
                      2,516,045General
      and administrative
                      
                      
                      10,357,021
                      
                      
                      
                      5,206,574Total
      operating expenses
                      
                      
                      12,604,717
                      
                      
                      
                      7,993,477Operating
      loss
                      
                      
                      (10,805,113
                      )
                      
                      
                      (7,015,477
                      )Other
      income (expenses)Loss
      on extinguishment of debt
                      
                      
                      (537,919
                      )
                      
                      
                      —Interest
      expense
                      
                      
                      (383,485
                      )
                      
                      
                      (332,755
                      )Loss
      (gain) on change in fair value of warrant derivative
    liability
                      
                      
                      (5,564,125
                      )
                      
                      
                      2,582,043Amortization
      of debt discount
                      
                      
                      (588,374
                      )
                      
                      
                      —Realize
      loss on sale of assets, net
                      
                      
                      —
                      
                      
                      
                      (90,564
                      )Gain
      on warrant exchange
                      
                      
                      164,226
                      
                      
                      
                      —Other
      income
                      
                      
                      5,138
                      
                      
                      
                      43,800Total
      other income (expense)
                      
                      
                      (6,904,539
                      )
                      
                      
                      2,202,524Loss
      before income taxes
                      
                      
                      (17,709,652
                      )
                      
                      
                      (4,812,953
                      )Income
      tax benefit
                      
                      
                      178,397
                      
                      
                      
                      439,429Net
      loss
                      
                      
                      (17,531,255
                      )
                      
                      
                      (4,373,524
                      )Preferred
      dividends
                      
                      
                      (76,650
                      )
                      
                      
                      (76,650
                      )Net
      loss applicable to common shareholders
                      
                      $
                      (17,607,905
                      )
                      
                      $
                      (4,450,174
                      )Net
      loss per common share – basic and diluted
                      
                      $
                      (0.90
                      )
                      
                      $
                      (0.31
                      )Weighted
      average common shares outstanding:Basic
      and diluted
                      
                      
                      19,537,938
                      
                      
                      
                      14,451,582





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


33


PATIENT
SAFETY TECHNOLOGIES, INC.





Consolidated
Statements of Stockholder's (Deficit) Equity





Preferred Stock
                            
                            
                            Common Stock Issued
                            
                            
                            Paid – In
                            
                            
                            Accumulated
                            
                            
                            Total
                              StockholdersShares
                            
                            
                            Amount
                            
                            
                            Shares
                            
                            
                            Amount
                            
                            
                            Capital
                            
                            
                            Deficit
                            
                            
                            EquityBALANCES,
      December 31, 2007
                            
                            
                            10,950
                            
                            
                            $
                            10,950
                            
                            
                            
                            12,054,166
                            
                            
                            $
                            3,978,019
                            
                            
                            $
                            34,320,133
                            
                            
                            $
                            (37,240,374
                            )
                            
                            $
                            1,068,628Preferred
      dividend
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            
                            
                            
                            
                            (76,650
                            )
                            
                            
                            (76,650
                            )Common
      stock issued
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            3,661,606
                            
                            
                            
                            1,208,328
                            
                            
                            
                            3,368,672
                            
                            
                            
                            —
                            
                            
                            
                            4,577,000Common
      stock issued for settlement of accounts payable
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            136,634
                            
                            
                            
                            45,021
                            
                            
                            
                            139,729
                            
                            
                            
                            —
                            
                            
                            
                            184,750Common
      stock issued  in connection with conversion of
    debt
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            1,293,939
                            
                            
                            
                            427,045
                            
                            
                            
                            884,835
                            
                            
                            
                            —
                            
                            
                            
                            1,311,880Common
      stock issued to extend debt maturity
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            25,000
                            
                            
                            
                            8,250
                            
                            
                            
                            6,750
                            
                            
                            
                            —
                            
                            
                            
                            15,000Common
      stock issued  for services provided
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            26,166
                            
                            
                            
                            8,635
                            
                            
                            
                            24,072
                            
                            
                            
                            —
                            
                            
                            
                            32,707Warrants
      reclassified from equity to liability
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (4,343,922
                            )
                            
                            
                            —
                            
                            
                            
                            (4,343,922
                            )Stock-based
      compensation-Restricted stock
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            713,384
                            
                            
                            
                            —
                            
                            
                            
                            713,384Stock-based
      compensation-Stock options
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            919,889
                            
                            
                            
                            —
                            
                            
                            
                            919,889Net
      loss
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (4,373,524
                            )
                            
                            
                            (4,373,524
                            )BALANCES,
      December 31, 2008
                            
                            
                            10,950
                            
                            
                            $
                            10,950
                            
                            
                            
                            17,197,511
                            
                            
                            $
                            5,675,298
                            
                            
                            $
                            36,033,542
                            
                            
                            $
                            (41,690,548
                            )
                            
                            $
                            29,242Preferred
      dividend
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (76,650
                            )
                            
                            
                            (76,650
                            )Cumulative
      effect of change in accounting principal
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (1,582,843
                            )
                            
                            
                            875,123
                            
                            
                            
                            (707,720
                            )Debt
      discount related to warrants issued in connection with January debt
      financing
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            1,311,311
                            
                            
                            
                            —
                            
                            
                            
                            1,311,311Issuance
      of warrants
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            3,752,075
                            
                            
                            
                            —
                            
                            
                            
                            3,752,075Warrants
      reclassified from equity to liability
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (3,532,780
                            )
                            
                            
                            —
                            
                            
                            
                            (3,532,780
                            )Warrant
      exchange
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            5,965,495
                            
                            
                            
                            1,968,494
                            
                            
                            
                            5,254,640
                            
                            
                            
                            5,000
                            
                            
                            
                            7,228,134Warrants
      reclassified from liability to equity
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            2,152,940
                            
                            
                            
                            —
                            
                            
                            
                            2,152,940Extinguishment
      of related party debt discount
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (245,571
                            )
                            
                            
                            —
                            
                            
                            
                            (245,571
                            )Stock-based
      compensation – Stock options
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            1,279,216
                            
                            
                            
                            —
                            
                            
                            
                            1,279,216Stock-based
      compensation – Warrants
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            195,416
                            
                            
                            
                            —
                            
                            
                            
                            195,416Common
      stock issued in connection with exercise of stock options
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            21,868
                            
                            
                            
                            7,217
                            
                            
                            
                            20,119
                            
                            
                            
                            —
                            
                            
                            
                            27,336Common
      stock issued in connection with conversion of debt
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            246,189
                            
                            
                            
                            81,242
                            
                            
                            
                            177,256
                            
                            
                            
                            —
                            
                            
                            
                            258,498Common
      stock issued to extend debt maturity
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            25,000
                            
                            
                            
                            8,250
                            
                            
                            
                            19,000
                            
                            
                            
                            —
                            
                            
                            
                            27,250Net
      loss
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            (17,531,255
                            )
                            
                            
                            (17,531,255
                            )BALANCES,
      December 31, 2009
                            
                            
                            10,950
                            
                            
                            $
                            10,950
                            
                            
                            
                            23,456,063
                            
                            
                            $
                            7,740,501
                            
                            
                            $
                            44,834,321
                            
                            
                            $
                            (58,418,330
                            )
                            
                            $
                            (5,832,558
                            )





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


34


PATIENT
SAFETY TECHNOLOGIES, INC.


Consolidated
Statements of Cash Flows





For the Year Ending December 31,2009
                    
                    
                    2008Operating
      activities:Net
      loss
                    
                    $
                    (17,531,255
                    )
                    
                    $
                    (4,373,524
                    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
                    
                    
                    366,755
                    
                    
                    
                    351,957Amortization
      of patents
                    
                    
                    324,941
                    
                    
                    
                    324,941Amortization
      of debt discount
                    
                    
                    588,374
                    
                    
                    
                    —Issuance
      of common stock for extension of note term
                    
                    
                    27,250
                    
                    
                    
                    —Non-cash
      interest
                    
                    
                    —
                    
                    
                    
                    168,104Issuance
      of warrants
                    
                    
                    3,752,075
                    
                    
                    
                    —Provision
      for obsolete inventory
                    
                    
                    168,996
                    
                    
                    
                    —Loss
      on write off of fixed assets
                    
                    
                    55,233
                    
                    
                    
                    91,030Issuance
      of common stock for loan fees
                    
                    
                    —
                    
                    
                    
                    15,000Write-off
      of notes receivable
                    
                    
                    121,064
                    
                    
                    
                    (36,663
                    )Gain
      on warrant exchange
                    
                    
                    (164,226
                    )
                    
                    
                    —Loss
      on extinguishment of debt
                    
                    
                    537,919
                    
                    
                    
                    —Stock
      and warrant based compensation
                    
                    
                    1,474,632
                    
                    
                    
                    1,665,981Change
      in fair value of warrant derivative liability
                    
                    
                    5,564,125
                    
                    
                    
                    (2,582,043
                    )Write
      off of restricted certificate of deposit
                    
                    
                    93,630
                    
                    
                    
                    —Write
      off of security deposit
                    
                    
                    9,080
                    
                    
                    
                    —Change
      in deferred tax liability
                    
                    
                    (236,632
                    )
                    
                    
                    (452,079
                    )Changes
      in operating assets and liabilities:Accounts
      receivable
                    
                    
                    (487,611
                    )
                    
                    
                    (314,205
                    )Inventories
                    
                    
                    (585,679
                    )
                    
                    
                    (199,909
                    )Prepaid
      expenses
                    
                    
                    (20,047
                    )
                    
                    
                    20,272Other
      assets
                    
                    
                    (14,844
                    )
                    
                    
                    (15,308
                    )Accounts
      payable
                    
                    
                    1,133,836
                    
                    
                    
                    250,739Accrued
      liabilities
                    
                    
                    (171,122
                    )
                    
                    
                    514,864Deferred
      revenue
                    
                    
                    8,099,144
                    
                    
                    
                    —Net
      cash provided by (used in) operating activities
                    
                    
                    3,105,638
                    
                    
                    
                    (4,570,843
                    )Investing
      activities:Purchase
      of property and equipment
                    
                    
                    (411,388
                    )
                    
                    
                    (282,312
                    )Proceeds
      of asset sales, net
                    
                    
                    —
                    
                    
                    
                    315,957Net
      cash (used in) provided by investing activities
                    
                    
                    (411,388
                    )
                    
                    
                    33,645Financing
      activities:Proceeds
      from issuance of notes payable
                    
                    
                    2,000,000
                    
                    
                    
                    650,000Proceeds
      from issuance of common stock and warrants
                    
                    
                    —
                    
                    
                    
                    4,577,000Proceeds
      from issuance of common stock in connection with warrant
      exchange
                    
                    
                    1,706,143
                    
                    
                    
                    —Principal
      payments on notes payable
                    
                    
                    (3,181,376
                    )
                    
                    
                    (722,380
                    )Proceeds
      from exercise of stock options
                    
                    
                    27,336
                    
                    
                    
                    —Payments
      of preferred dividends
                    
                    
                    (95,812
                    )
                    
                    
                    (76,650
                    )Net
      cash provided by financing activities
                    
                    
                    456,291
                    
                    
                    
                    4,427,970Net
      increase (decrease) in cash and cash equivalents
                    
                    
                    3,150,541
                    
                    
                    
                    (109,228
                    )Cash
      and cash equivalents at beginning of period
                    
                    
                    296,185
                    
                    
                    
                    405,413Cash
      and cash equivalents at end of period
                    
                    $
                    3,446,726
                    
                    
                    $
                    296,185Supplemental
      disclosures of cash flow information:Cash
      paid during the period for interest
                    
                    $
                    110,000
                    
                    
                    $
                    5,737Cash
      paid during the period for taxes
                    
                    $
                    9,799
                    
                    
                    $
                    800Non
      cash investing and financing activities:Dividends
      accrued
                    
                    $
                    76,650
                    
                    
                    $
                    76,650Reclassification
      of accrued interest to notes payable
                    
                    $
                    227,673
                    
                    
                    $
                    —Debt
      discount recorded in connection with issuance of notes
    payable
                    
                    $
                    1,311,311
                    
                    
                    $
                    —Reclassification
      of warrant equities to derivative liability
                    
                    $
                    (4,240,500
                    )
                    
                    $
                    (4,343,922
                    )Reclassification
      of warrant derivative liability to equity
                    
                    $
                    2,152,940
                    
                    
                    $
                    —Issuance
      of common stock in payment of notes payable and accrued
      interest
                    
                    $
                    211,722
                    
                    
                    $
                    1,166,728Issuance
      of common stock in connection with warrant exchange
                    
                    $
                    (5,752,227
                    )
                    
                    $
                    103,101Reclassification
      of related party unamortized debt discount
                    
                    $
                    (245,571
                    )
                    
                    $
                    —Acquisition
      of fixed assets pursuant to capital lease
                    
                    $
                    77,604
                    
                    
                    $
                    —Forgiveness
      of debt
                    
                    $
                    —
                    
                    
                    $
                    36,663Issuance
      of common stock for an accrued liability
                    
                    $
                    —
                    
                    
                    $
                    134,750Issuance
      of common stock for accounts payable
                    
                    $
                    —
                    
                    
                    $
                    50,000





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


35


Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 1.
DESCRIPTION OF BUSINESS
 
 Patient
Safety Technologies, Inc. ("PST" or the "Company") is a Delaware
corporation. The Company’s operations are conducted through its wholly-owned
operating subsidiary, SurgiCount Medical, Inc. (“SurgiCount”), a California
corporation.
 
 The
Company’s operating focus is the development, marketing and sales of products
and services focused in the medical patient safety markets.  The
SurgiCount Safety-SpongeTMSystem
is a patented system of bar-coded surgical sponges, SurgiCounterTM scanners, and
software applications integrated to form a comprehensive counting and
documentation system.  This system is designed to reduce the number of
retained surgical sponges unintentionally left inside of patients during
surgical procedures by allowing faster and more accurate counting of surgical
sponges.
 
 2.
LIQUIDITY AND GOING CONCERN
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. At December 31, 2009, the Company
has an accumulated deficit of $58,418,330 and a working capital deficit of
$11,369,127.  For the year ended December 31, 2009, the Company
incurred a loss of $17,531,255 and generated positive cash flow from operating
activities of $3,105,638, primarily from the $8,000,000 proceeds from the
November 2009 renewal of its agreement with Cardinal Health.  Given
the operating requirements of the Company, these conditions raise substantial
doubt about the Company’s ability to continue as a going concern.
 
 Management
believes that existing cash resources, combined with projected cash flow from
operations, will not be sufficient to fund the Company’s working capital
requirement for the next twelve months, and that in order to continue to operate
as a going concern it will be necessary to raise additional
funds.  Management plans to raise the additional required funds
through debt and/or equity financing transactions.
 
 The
Company believes that it will be successful in raising additional new funds, as
required.   However no assurances can be made that it will be
successful obtaining a sufficient amount of financing to continue to fund its
operations or that the Company will achieve profitable operations and positive
cash flow. The consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
 
 3.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES
 
 Principles
of Consolidation
  The
accompanying consolidated financial statements for 2009 include the accounts of
the Company and its subsidiary.  All significant intercompany balances
and transactions have been eliminated in consolidation.
 
 Cumulative
Effect of Changes in Accounting Principles
 
 On
January 1, 2009, the Company adopted the provisions of Financial Accounting
Standards Board (“FASB”) ASC 815-40, Derivatives and Hedging – Contracts
in Entity’ Own Equity (“ASC 815-40”).  In accordance with ASC
815-40, the cumulative effect of the change in accounting principle recorded by
the Company in connection with certain warrants to acquire shares of the
Company’s common stock (see Note 12), was recognized by the Company as an
adjustment to the opening balances of accumulated deficit, additional paid in
capital and warrant liability based the difference between amounts recognized in
the statement of financial position before and after the initial application of
this guidance as summarized in the following table:
  36
 
 Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 As reported on
                        December 31, 2008
                      
                      
                      As adjusted on
                        January 1, 2009
                      
                      
                      Effect of change in
                        accounting principleWarrant
      Liability
                      
                      $
                      1,761,878
                      
                      
                      $
                      2,469,598
                      
                      
                      $
                      707,720Additional
      paid in capital
                      
                      $
                      36,033,542
                      
                      
                      $
                      34,450,699
                      
                      
                      $
                      (1,582,843
                      )Accumulated
      deficit
                      
                      $
                      (41,690,548
                      )
                      
                      $
                      (40,815,425
                      )
                      
                      $
                      875,123
 
 Use
of Estimates
 
 The
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America (“GAAP”).  The
preparation of these financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the dates of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those
estimates.  These estimates and assumptions include, but are not
limited to, assessing the following: the valuation of accounts receivable and
inventory, impairment of goodwill and other intangible assets, the fair value of
stock-based compensation and derivative liabilities, valuation allowance related
to deferred tax assets, warranty obligations, provisions for returns and
allowances and the determination of assurance of the collection of revenue
arrangements.
 
 Reclassifications
 
 Certain
prior year amounts have been reclassified to conform to the 2009 presentation.
These reclassifications had no effect on previously reported results of
operations or accumulated deficit.
 
 Revenue
Recognition
 
 The
Company recognizes revenue from the sale of products to end-users and
distributors when persuasive evidence of a sale exists, the product is complete,
tested and has been shipped which coincides with transfer of title and risk of
loss, the sales price is fixed and determinable, collection of the resulting
receivable is reasonably assured, there are no material contingencies and the
Company does not have significant obligations for future
performance.  When collectability is not reasonably assured, the
Company defers the revenue over the cash collection period.Provisions for
estimated future product returns and allowances are recorded in the period of
the sale based on the historical and anticipated future rate of
returns.  Revenue is recorded net of any discounts or trade-in
allowances given to the buyer.
 
 The
Company derives its revenue primarily from the sale of the surgical sponges and
towels used in its Safety-Sponge® System to its distributors.  The
Company’s revenues are generated by the sales and marketing efforts of its
direct sales force and independent distributor.  Its products are
ordered directly by the hospitals through an independent distributor and the
product is shipped and billed directly by the independent distributor. Although hardware sales
are not considered a recurring item, the Company expects that once an
institution adopts its Safety-Sponge® System, they will be committed to its use
and therefore provide a recurring source of revenues for sales of products
(surgical sponges and towels) used in the Safety-Sponge® System.
  ·
              Hardware Cost Reimbursement
      Revenues:  During fiscal year 2009, the Company began a
      program in which the scanners and related hardware used in the
      Safety-Sponge® System are provided to the hospitals without charge for
      their use. Prior to the third quarter of 2009, the Company’s business
      model included the sale of its SurgiCounterTM scanners and related software
      used in its Safety-Sponge® System to most hospitals that adopted the
      Company’s system.  Beginning with the third quarter of 2009, the
      Company modified its business model and began to provide its SurgiCounterTM
      scanners and related software to all hospitals at no cost when they adopt
      its Safety-Sponge® System.Under
      the new supply and distribution agreement with Cardinal Health entered
      into in November 2009, the Company is reimbursed an agreed upon percentage
      of the cost of the scanners provided by the Company to hospitals which
      receive their surgical sponges and towels through Cardinal. Reimbursements
      received from Cardinal are initially deferred and are recognized as
      revenue on a pro-rata basis over the life of the specific hospital
      contract.Because
      the Company no longer engages in direct SurgiCounterTM scanner
      sales and generally anticipate only recognizing revenues
      associated with its SurgiCounterTM scanners in connection with
      reimbursement arrangements under its agreement with Cardinal
      Health.
  37
 
 Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
  ·
              Hardware, Software and
      Maintenance Agreement Revenues: As the software included in the
      Company’s SurgiCounterTM scanner is not incidental to the product being
      sold, the sale of the software falls within the scope of Accounting Standards
      Codification(“ASC”)ASC 985-605,
      formerly Statement of Position (“SOP”) 97-2.  The
      SurgiCounterTM scanner is considered to be a software-related element, as
      defined in ASC 985-605, because the software is essential to the
      functionality of the scanner, and the maintenance agreement, which
      provides for product support including unspecified product upgrades and
      enhancements developed by the Company during the period covered by the
      agreement is considered to be post-contract customer support (“PCS”) as defined in ASC
      985-605.  These items are considered to be separate deliverables
      within a multiple-element arrangement, and based on the fact that there is
      vendor specific objective evidence for the non-delivered element the total
      price of this arrangement is allocated to each respective deliverable
      based on the residual fair value of each element, and recognized as
      revenue as each element is delivered. For the hardware and software
      elements, delivery is generally considered to be at the time of shipment
      where terms are FOB shipping point.  In the event that terms of the
      sale are FOB customer, the delivery is considered to occur at the time
      that delivery to the customer has been completed.  Delivery with
      respect to the initial one-year maintenance agreement is considered to
      occur on a monthly basis over the term of the one-year period, and
      revenues related to this element are recognized on a pro-rata basis during
      this period.
  ·
              Surgical Sponge
      Revenues:The surgical products (sponges and towels) used in
      the Company’s Safety-Sponge® System are sold separately from the hardware
      and software described above and those products are not considered to be
      part of a multiple-element arrangement.  Accordingly, revenues
      related to the sale of products used in the Company’s Safety-Sponge®
      System are recognized in accordance with Staff Accounting
      Bulletin (“SAB”) 104. 
      Generally revenues from the sale of surgical products used in the
      Safety-Sponge® System are recognized upon shipment as most surgical
      products used in the Safety-Sponge® System are sold FOB shipping
      point.  In the event that terms of the sale are FOB customer, revenue
      is recognized at the time delivery to the customer has been completed.
      Advanced payments are classified as deferred revenue and recognized as
      product is shipped to the customer.
  Provisions
for estimated future product returns and allowances are recorded in the period
of the sale based on the historical and anticipated future rate of
returns.  The Company records shipping and handling costs charged to
customers as revenue and shipping and handling costs to cost of revenue as
incurred.  Revenue is reduced for any discounts or trade in allowances
given to the buyer.
 
 Financial
Instruments
 
 The
carrying amounts of financial instruments such as cash and cash equivalents,
restricted cash, accounts receivable and accounts payable approximate their fair
values because of the short-term nature of these financial instruments.
Convertible debentures and note payable arrangements were based on borrowing
rates currently available to the Company for loans with similar terms and
maturities, and were reported at their carrying values, which the Company
believes approximates fair value.   Warrants classified as
derivative liabilities are reported at their estimated fair value using the
Black Scholes valuation model, with changes in fair value being reported in
current period earnings (loss) in other income/(expense) (see Note
14).
 
 Cash
and Cash Equivalents
 
 Cash
equivalents are short-term, highly liquid investments with maturities of three
months or less at the time of purchase.  These investments generally
consist of money market funds and commercial paper and are stated at cost, which
approximates fair market value.
  38
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Concentration
of Credit Risk
 
 From time
to time, the Company maintains its cash balances in accounts at a financial
institution that exceed the Federal Deposit Insurance Corporation coverage of
$250,000.  The Company has not experienced any losses in such
accounts.
 
 Accounts
Receivable
 
 Accounts
receivable are recorded at the invoice amount and do not bear
interest.  Historically, the Company has not incurred any credit
losses on extended credits.  An allowance for bad debts has not been
recorded and is not considered necessary due to the nature of the Company's
customer base and the lack of historical write offs.  If customer
payment timeframes were to deteriorate, additional allowances for doubtful
accounts would be required.
 
 Inventories
 
 Inventories
at December 31, 2009, are stated at the lower of cost or market on the first-in,
first-out (FIFO) basis.  The FIFO cost for all inventories
approximates replacement cost.
  The
Company maintains reserves for excess and obsolete inventory resulting from the
potential inability to sell its products at prices in excess of current carrying
costs. The markets in which the Company operates are highly competitive, and new
products and surgical procedures are introduced on an ongoing basis. Such
marketplace changes may cause the Company’s products to become obsolete. The
Company makes estimates regarding the future recoverability of the costs of
these products and records a provision for excess and obsolete inventories based
on historical experience and expected future trends.
  Property,
Plant and Equipment
 
 Property,
plant and equipment is stated at cost. Depreciation is amortized straight-line
over the estimated useful lives of 3 to 5 years. Upon retirement or disposition
of equipment, the related cost and accumulated depreciation or amortization is
removed and a gain or loss is recorded, as applicable.
 
 Impairment
of Long Lived Assets and Intangible Assets with Finite Lives
 
 Property
and equipment and intangible assets with finite lives are amortized using the
straight line method over their estimated useful lives.  These assets
are assessed for potential impairment when there is evidence that events or
changes in circumstances indicate that the carrying amount of such assets may
not be recoverable. Conditions that would indicate impairment and trigger an
assessment include, but are not limited to, a significant adverse change in the
legal factors or business climate that could affect the value of an asset, an
adverse action or assessment by a regulator or a current expectation that, more
likely than not, a long-lived asset will be sold or otherwise disposed of
significantly before the end of its previously estimated useful life. If, upon
assessment, the carrying amount of an asset exceeds its estimated fair value, an
impairment charge is recognized for the amount by which the carrying amount of
the asset exceeds its estimated fair value of the asset.  As of
December 31, 2009 and 2008 there was no impairment recorded.
  Impairment
of Goodwill
 
 The
Company evaluates the carrying value of goodwill during the fourth quarter of
each year and between annual evaluations if events occur or circumstances change
that would more likely than not reduce the fair value of the reporting unit
below its carrying amount. Such circumstances could include, but are not limited
to (1) a significant adverse change in legal factors or in business climate, (2)
unanticipated competition, or (3) an adverse action or assessment by a
regulator. When evaluating whether goodwill is impaired, the Company compares
the fair value of the reporting unit to which the goodwill is assigned to the
reporting unit’s carrying amount, including goodwill. The fair value of the
reporting unit is estimated using a combination of the income, or discounted
cash flows, and the market approach, which utilizes comparable companies’ data.
If the carrying amount of a reporting unit exceeds its fair value, then the
amount of the impairment loss must be measured. The impairment loss would be
calculated by comparing the implied fair value of the reporting unit goodwill to
its carrying amount. In calculating the implied fair value of the reporting unit
goodwill, the fair value of the reporting unit is allocated to all of the other
assets and liabilities of that unit based on their fair values. The excess of
the fair value of a reporting unit over the amount assigned to its other assets
and liabilities is the implied fair value of goodwill. An impairment loss would
be recognized when the carrying amount of goodwill exceeds its implied fair
value. The Company’s evaluation of goodwill completed during 2009 and 2008
resulted in no impairment losses.
  39
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Cost
Method Investment
 
 The
investment balance at December 31, 2009 and 2008 represents non-marketable
shares of preferred stock owned by the Company in a privately held company that
is reported using the cost method. Under the cost method, the Company does not
record its proportional share of earnings and losses of the investee, and income
on the investment is only recorded to the extent of dividends distributed from
earnings of the investee received subsequent to the date of
acquisition.
 
 The
Company reviews the carrying value of its cost-method investment for impairment
each reporting period in which the Company determines that an impairment
indicator is present. If an impairment is present, the fair value of the
investment must be estimated in order to test impairment of the
investment.  Examples of impairment indicators include: 1) a
significant deterioration in the earnings performance, credit rating, asset
quality, or business prospects of the investee, 2) a significant adverse change
in the regulatory, economic, or technical environment of the investee, 3) a
significant adverse change in the general market condition of either the
geographic area or the industry in which the investee operates, 4) a bona fide
offer to purchase (whether solicited or unsolicited), an offer by the investee
to sell, or a completed auction process for the same or similar security for an
amount less than the cost of the investment, 5) factors that raise significant
concerns about the investee’s ability to continue as a going concern, such as
negative cash flow from operations, working capital deficiencies, or
non-compliance with statutory capital requirements or debt
covenants.
 
 When an
impairment test demonstrates that the fair value of an investment is less than
its carrying value, Company management will determine whether the impairment is
either temporary or other-than-temporary. Examples of factors that may be
indicative of an other-than-temporary impairment include: i) the length of time
and extent to which market value has been less than cost, ii) the financial
condition and near-term prospects of the issuer, iii) and the intent and ability
of the Company to retain its investment in the issuer for a period of time
sufficient to allow
 for any
anticipated recovery in market value.
 
 If the
decline in fair value is determined by management to be other-than-temporary,
the cost basis of the investment is written down to its estimated fair value as
of the balance sheet date of the reporting period in which the assessment is
made. This fair value becomes the investment’s new cost basis, which is not
changed for subsequent recoveries in fair value. Any recorded impairment
write-down will be included in earnings as a realized loss in the period such
write-down occurs. As of December 31, 2009 and 2008, the Company determined that
no impairment indicators were present.
 
 Research
and Development
 
 Research
and development costs are expensed in the period incurred.  Research
and development expenses for the years ended December 31, 2009 and 2008 were
$321,116 and $270,858, respectively.
 
 Marketing
 
 Marketing
costs are expensed in the period incurred and reported under sales and marketing
expenses.  Marketing expenses, which include sales related travel,
trade shows, promotional products and advertising for the years ended December
31, 2009 and 2008, were $893,127 and $834,426, respectively.
 
 Income
Taxes
 
 Income
taxes are accounted for under the asset and liability
method.  Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit
carry-forwards.  Deferred tax assets 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.  To the extent that available evidence about future
taxable earnings indicates that it is more likely than not that the tax benefit
associated with the deferred tax assets will not be realized, a valuation
allowance is established.
  40
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Derivative
Financial Instruments
 
 The
Company reviews the terms of convertible debt and equity instruments it issues
to determine whether there are embedded derivative instruments, including an
embedded conversion option, that are required to be bifurcated and accounted for
separately as a derivative financial instrument.  In circumstances
where the convertible instrument contains more than one embedded derivative
instrument, including conversion option, that is required to be bifurcated, the
bifurcated derivative instruments are accounted for as a single, compound
derivative instrument.  Also, in connection with the sale of
convertible debt and equity instruments, the Company may issue freestanding
warrants that may, depending on their terms, be accounted for as derivative
instrument liabilities, rather than as equity.
 
 Derivative
instruments are initially recorded at fair value and are then revalued at each
reporting date with changes in the fair value reported as charges or credits to
income. When the convertible debt or equity instruments contain embedded
derivative instruments that are to be bifurcated and accounted for as
liabilities, the total proceeds allocated to the convertible host instruments
are first allocated to the fair value of all the bifurcated derivative
instruments.  The remaining proceeds, if any, are then allocated to
the convertible instruments themselves, usually resulting in those instruments
being recorded at a discount from their face amount.
 
 The
discount from the face value of the convertible debt, together with the stated
interest on the instrument, is amortized over the life of the instrument through
periodic charges to income, using the effective interest method.
 
 Stock-Based
Compensation
 
 At
December 31, 2009, the Company had two stock option plans, which are
described more fully in Note 15 to the Consolidated Financial Statements.
Pursuant to the provisions of theCompensation-Stock Compensation
Topic of the FASB Codification, the Company measures the cost of employee
stock options based on the grant-date fair value and recognizes that cost using
the straight line method over the period during which a recipient is required to
provide services in exchange for the options, typically the vesting period. The
risk-free interest rate for periods within the expected life of options granted
is based on the U.S. Treasury yield curve in effect at the time of grant.
Expected stock price volatility is based on historical volatility of the
Company’s stock. The expected option life, representing the period of time that
options granted are expected to be outstanding, is based on historical option
exercise and employee termination data.
 
 Beneficial
Conversion Feature of Convertible Notes Payable
 
 The
convertible feature of certain notes payable provides for a rate of conversion
that is below market value.  Such feature is normally characterized as
a Beneficial Conversion Feature (“BCF”).  Pursuant
to ASC 470-20, (formerly EITF Issue No. 98-5, Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratio, EITF No. 00-27, Application of EITF Issue No. 98-5
To Certain Convertible Instruments and APB 14, Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants), the estimated fair value of
the BCF is recorded in the consolidated financial statements as a discount from
the face amount of the notes.  Such discounts are amortized to expense
over the term of the notes (or conversion of the notes, if sooner).
 
 Warrant
Derivative Liability
 
 Pursuant
to ASC 815-40 Derivatives and
Hedging, an evaluation of outstanding warrants is made to determine
whether warrants issued are required to be classified as either equity or a
liability.  If the classification required under ASC 815-40 changes as
a result of events during a reporting period, the instrument is reclassified as
of the date of the event that caused the reclassification.  In the
event that this evaluation results in a partial reclassification, the Company’s
policy is to first reclassify warrants with the latest date of
issuance.  The estimated fair value of warrants classified as
derivative liabilities is determined using the Black-Scholes option pricing
model.  The fair value of warrants classified as derivative
liabilities is adjusted for changes in fair value at each reporting period, and
the corresponding non-cash gain or loss is recorded in current period earnings
(loss).  There is no limit on the number of times a contract may be
reclassified.
  41
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Net
Loss per Common Share
 
 Loss per
common share is determined by dividing the loss applicable to common
shareholders by the weighted average number of common shares outstanding. The
Company complies with FASB ASC 260-10 Earnings Per Share(previously SFAS No. 128, Earnings per Share), which requires dual
presentation of basic and diluted earnings per share on the face of the
consolidated statements of operations. Basic loss per common share excludes
dilution and is computed by dividing loss attributable to common stockholders by
the weighted-average common shares outstanding for the period. Diluted loss per
common share reflects the potential dilution that could occur if convertible
preferred stock or debentures, options and warrants were to be exercised or
converted or otherwise resulted in the issuance of common stock that then shared
in the earnings of the entity.
 
 Because
the effects of outstanding options, warrants and the conversion of convertible
preferred stock and convertible debt are anti-dilutive in all periods presented,
shares of common stock underlying these instruments as shown below have been
excluded from the computation of loss per common share:
 
 2009
                    
                    
                    2008Convertible
      Debentures
                    
                    
                    500,000
                    
                    
                    
                    543,409Convertible
      Preferred Stock
                    
                    
                    246,375
                    
                    
                    
                    246,375Warrants
                    
                    
                    8,064,978
                    
                    
                    
                    10,719,896Stock
      Options
                    
                    
                    5,821,000
                    
                    
                    
                    1,627,000Total
                    
                    
                    14,632,353
                    
                    
                    
                    13,136,680
 
 Segment
Information
 
 The
Company presents it business as one reportable segment due to the similarity in
nature of products marketed, financial performance measures, methods of
distribution and customer markets.  The Company’s chief operating
decision making officer reviews financial information on the Company’s patient
safety products on a consolidated basis.
 
 Legal
and Other Contingencies
 
 The
Company is involved in various proceedings, legal actions and claims arising in
the normal course of business that are more fully described in Note 19 to the
Consolidated Financial Statements. The outcomes of these matters will generally
not be known for prolonged periods of time. In certain of the legal proceedings,
the claimants seek damages, as well as other compensatory relief, which could
result in the payment of significant claims and settlements. In legal matters
for which management has sufficient information to reasonably estimate the
Company’s future obligations, a liability representing management’s best
estimate of the probable cost, or the minimum of the range of probable losses
when a best estimate within the range is not known, for the resolution of these
legal matters is recorded. The estimates are based on consultation with legal
counsel, previous settlement experience and settlement strategies.
 
 Recent
Accounting Pronouncements
 
 In June
2009, the FASB issued Statement No. 168, The FASB Accounting Standards
CodificationTM and the Hierarchy of Generally Accepted Accounting Principles,a replacement of FASB Statement No. 162(the “ASC”). Effective
for interim and annual periods ended after September 15, 2009, the ASC became
the source of authoritative GAAP recognized by the FASB to be applied by
nongovernmental entities. Rules and interpretive releases of the Securities and
Exchange Commission (“SEC”) under authority of federal securities laws are also
sources of authoritative GAAP for SEC registrants. This statement does not
change existing GAAP, but reorganizes GAAP into Topics. In circumstances where
previous standards require a revision, the FASB will issue an Accounting
Standards Update (“ASU”) on the Topic. The Company’s adoption of this standard
during the year ended December 31, 2009 did not have any impact on the Company’s
consolidated financial statements.
  42
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 On
January 1, 2009, the Company adopted the guidance codified in ASC 350-30, Intangibles – Goodwill and
Other (previously FASB FAS 142-3, Determination of Useful Life of
Intangible Assets). ASC 350-30 amends the factors that should be
considered in developing the renewal or extension assumptions used to determine
the useful life of a recognized intangible asset also requires expanded
disclosure related to the determination of intangible asset useful lives and is
effective for fiscal years beginning after December 15, 2008. Earlier adoption
is not permitted. The Company’s adoption of ASC 350-30 did not have a material
impact on its consolidated financial statements.
 
 In June
2008, the FASB ratified guidance issued by the EITF as codified in ASC 815-40,
Derivatives and Hedging –
Contracts in Entity’s Own Equity(previously EITF Issue No. 07-5, Determining whether an Instrument
(or Embedded Feature) is indexed to an Entity’s own Stock). ASC 815-40 is
effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years. Early
application is not permitted. ASC 815-10 – specifies that a contract that would
otherwise meet the definition of a derivative but is both (a) indexed to the
Company’s own stock and (b) classified in stockholders’ equity in the statement
of financial position would not be considered a derivative financial instrument.
ASC 815-40 provides a new
two-step model to be applied in determining whether a financial instrument or an
embedded feature is indexed to an issuer’s own stock and thus able to qualify
for the ASC 815-10 scope exception. The Company’s adoption of ASC 815-40
effective January 1, 2009, resulted in the identification of certain warrants
that were determined to be ineligible for equity classification because of
certain provisions that may result in an adjustment to their exercise price.
Accordingly, these warrants were reclassified as liabilities upon the effective
date of ASC 815-40 and re-measured at fair value as of December 31, 2009 with
changes in the fair value recognized in other income for the year ended December
31, 2009. The cumulative effect of the change in accounting for these warrants
was recognized as an adjustment to the opening balance of accumulated deficit at
January 1, 2009 based on the difference between the amounts recognized in the
consolidated balance sheet before the initial adoption of ASC 815-40 and the
amounts recognized in the consolidated balance sheet as a result of the initial
application of ASC 815-40. (See Notes 3 and 13).
 
 In May
2009, the FASB issued ASC 855-10, Subsequent Events (ASC
855-10). The objective of this statement is to establish principles and
requirements for subsequent events. In particular, ASC 855-10 sets forth the
period after the balance sheet date during which management of a reporting
entity shall evaluate events or transactions that may occur for potential
recognition or disclosure in the financial statements, the circumstances under
which an entity shall recognize events or transactions occurring after the
balance sheet date in its financial statements, and the disclosures that an
entity shall make about events or transactions that occurred after the balance
sheet date. ASC 855-10 is effective for interim or annual financial statements
issued after June 15, 2009.  In February 2010, the FASB issued ASU
2010-09, Subsequent Events(ASC Topic 855) — Amendments to Certain Recognition
and Disclosure Requirements. ASU 2010-09 removes the requirement for an
SEC filer to disclose a date in both issued and revised financial
statements.  The adoption of these pronouncements did not have a
material effect on its consolidated financial statements.
 
 In
October 2009, the FASB issued ASU 2009-13, Multiple Deliverable Revenue
Arrangements, which addresses the accounting for multiple deliverable
arrangements to enable vendors to account for products and services
(deliverables) separately rather than as a combined unit. The amendments in ASU
2009-13 are effective prospectively for revenue arrangements entered into or
materially modified in the fiscal years beginning on or after June 15, 2010.
Early adoption is permitted. The impact of this accounting update on the
Company’s consolidated financial statements has not been evaluated.
 
 In
October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements That
Include Software Elements, which changes the accounting model for revenue
arrangements that include both tangible products and software elements that are
“essential to the functionality,” and scopes these products out of current
software revenue guidance. The new guidance will include factors to help
companies determine what software elements are considered “essential to the
functionality.” The amendments included in ASU 2009-14 are effective
prospectively for revenue arrangements entered into or materially modified in
the fiscal years beginning on or after June 15, 2010. Early adoption is
permitted. The impact of this accounting update on the Company’s consolidated
financial statements has not been evaluated.
  43
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 In
January 2010, the FASB issued FASB ASU 2010-06, Improving Disclosures about Fair
Value Measurementswhich clarifies certain existing disclosure
requirements in ASC 820 as well as requires disclosures related to significant
transfers between each level and additional information about Level 3 activity.
FASB ASU 2010-06 begins phasing in the first fiscal period after December 15,
2009. The impact of this accounting update on the Company’s consolidated
financial statements has not been evaluated.
 
 4.
RESTRICTED CERTIFICATE OF DEPOSIT
 
 At
December 31, 2008, the Company had a restricted certificate of deposit of
$93,630, which included accrued interest income of $6,130 held by a financial
institution securing a letter of credit.  This restricted certificate
of deposit was held to cover a portion of the security deposit related to a
lease on the Company’s prior corporate offices sublet to a third party lessee
that runs through January 2012.  In October 2009, the third party
lessor defaulted on the lease, requiring the beneficiary to draw on the letter
of credit being secured by the restricted certificate of deposit, thus resulting
in a charge to general and administrative expenses for $93,630 in
2009.
 
 5.
INVENTORY
 
 Inventories
consisted of the following:
 December
      31,
                    
                    December
      31,2009
                    
                    2008Finished
      goods
                    
                    $
                    734,819
                    
                    
                    $
                    199,909Reserve
      of obsolescence
                    
                    
                    (168,996
                    )
                    
                    
                    —Total
      inventory, net
                    
                    $
                    565,823
                    
                    
                    $
                    199,909
 
 6.
PROPERTY AND EQUIPMENT
 
 Property
and equipment at December 31, 2009 and 2008 are comprised of the
following:
 
 December
      31,
                      
                      
                      December
      31,2009
                      
                      
                      2008Computer
      software and equipment
                      
                      $
                      1,097,181
                      
                      
                      $
                      1,085,961Furniture
      and equipment
                      
                      
                      298,333
                      
                      
                      
                      215,423Hardware
      for customer use
                      
                      
                      394,861
                      
                      
                      
                      —Property
      and equipment, gross
                      
                      
                      1,790,375
                      
                      
                      
                      1,301,384Less:
      accumulated depreciation
                      
                      
                      (1,045,729
                      )
                      
                      
                      (678,974
                      )Property
      and equipment, net
                      
                      $
                      744,646
                      
                      
                      $
                      622,410
 
 The
furniture and equipment balance at December 31, 2009 includes $77,604 of office
furniture acquired as part of the Newtown, PA sublease, which has been recorded
as a capital lease, and which will be amortized over the term of the sublease
through April 2013 (see Note 19). Depreciation expense for the years ended
December 31, 2009 and 2008 was $366,755 and $351,957,
respectively.
  44
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 7.
GOODWILL AND PATENTS
 
 The
Company recorded goodwill in the amount of $1,700,000 in connection with its
acquisition of SurgiCount Medical, Inc. in February 2005.  During the
year ended December 31, 2007, cumulative gross revenues of SurgiCount exceeded
$1,000,000 and as such the Company issued 100,000 shares of common stock, valued
at approximately $145,000 to the SurgiCount founders, as contingent
consideration, which was recorded as additional goodwill.  In
addition, in connection with the SurgiCount acquisition, the Company recorded
patents acquired that were valued at $4,700,000.
  The
Company performs its annual impairment analysis of goodwill in the fourth
quarter of each year according to the provisions of ASC- 350 Valuation Analysis(formerly
SFAS 142, Goodwill and Other
Intangible Assets. This statement requires that the Company perform a
two-step impairment test on goodwill. In the first step, the Company compares
the fair value of each reporting unit to its carrying value. If the fair value
of the reporting unit exceeds the carrying value of the net assets assigned to
the reporting unit, goodwill is not impaired and the Company is not required to
perform further testing. If the carrying value of the net assets assigned to the
reporting unit exceeds the fair value of the reporting unit, then the Company
must perform the second step of the impairment testing to determine the implied
fair value of the reporting unit’s goodwill. The implied fair value of goodwill
is calculated by deducting the fair value of all tangible and intangible assets
of the reporting unit, excluding goodwill, from the fair value of the reporting
unit as determined in the first step. If the carrying value of a reporting
unit’s goodwill exceeds its implied fair value, then an impairment loss equal to
the difference would be recorded.
  During
2009, the Company conducted its annual test for impairment, at year-end and
determined goodwill was not impaired.
 
 Goodwill
was $1,832,027 of December 31, 2009 and 2008.
 
 Patents,
net, as of December 31, 2009 and 2008 are composed of the
following:
  December 31,
                                2009
                              
                              
                              December31,
                                2008Patents
                              
                              $
                              4,684,576
                              
                              
                              $
                              4,684,576Accumulated amortization
                              
                              
                              (1,570,551
                              )
                              
                              
                              (1,245,610
                              )$
                              3,114,025
                              
                              
                              $
                              3,438,966
 
 The patents
are subject to amortization over their estimated useful life of 14.4
years.  Amortization expense was $324,941 for the years ended December
31, 2009 and 2008.  The following table presents estimated
amortization expense for each of the succeeding five calendar years and
thereafter:
 
 2010
                    
                    $
                    324,9412011
                    
                    
                    324,9412012
                    
                    
                    324,9412013
                    
                    
                    324,9412014
                    
                    
                    324,941Thereafter
                    
                    
                    1,489,320Total
                    
                    $
                    3,114,025
 
 8.
LONG-TERM INVESTMENTS
 
 Long-term
investments at December 31, 2009 and 2008 are comprised of the
following:
  45
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 December 31,
                      2009
                    
                    
                    December 31,
                      2008Alacra
      Corporation
                    
                    $
                    666,667
                    
                    
                    $
                    666,667$
                    666,667
                    
                    
                    $
                    666,667
 
 Alacra
Corporation
 
 At
December 31, 2009 and 2008, the Company had an investment in shares of Series F
convertible preferred stock of Alacra, Inc. (“Alacra”), a global provider
of business and financial information in New York, recorded at its cost of
$666,667.  The Company has the right, to the extent that Alacra has
sufficient available capital, to have the Series F convertible preferred stock
redeemed by Alacra for face value plus accrued dividends beginning on December
31, 2006. During the year ended December 31, 2007, Alacra redeemed one-third of
the Series F convertible preferred stock.  The Company expects to
receive proceeds from the redemption of one-half of the current carrying value
in 2010 and the remaining balance in 2011.
 
 9.
CONVERTIBLE NOTE & NOTES PAYABLE
 
 Convertible
Note
 
 Convertible
notes at December 31, 2009 and 2008 are comprised of the following:
 
 2009
                    
                    
                    2008Ault
      Glazer Capital Partners, LLC (a) *
                    
                    $
                    1,424,558
                    
                    
                    $
                    1,424,558David
      Spiegel (b)
                    
                    
                    —
                    
                    
                    
                    65,115Total
      convertible notes
                    
                    
                    1,424,558
                    
                    
                    
                    1,489,673Less:  unamortized
      discount
                    
                    
                    —
                    
                    
                    
                    (13,738
                    )1,424,558
                    
                    
                    
                    1,475,935Less:
      current portion
                    
                    
                    (1,424,558
                    )
                    
                    
                    (1,424,558
                    )Convertible
      notes - long term portion
                    
                    $
                    —
                    
                    
                    $
                    51,377
 
 
 Maturities
of the convertible notes at December 31, 2009 are as follows:
 
 Years Ending December
      31,2010
                    
                    $
                    1,424,5582011
                    
                    
                    —Thereafter
                    
                    
                    —Total
                    
                    $
                    1,424,558
 
 * Related
Party (See Note 16 to the Consolidated Financial Statements)
 
 (a)
                Effective
      June 1, 2007, the  Company restructured the entire unpaid
      principal and interest under promissory notes issued to Ault Glazer
      Capital Partners, LLC (“Ault Glazer”) into a
      new Convertible Secured Promissory Note (the "AG Capital Partners
      Convertible Note") in the principal amount of $2.5 million. The AG
      Capital Partners Convertible Note bears interest at the rate of 7% per
      annum and is due on the earlier of December 31, 2010, or the occurrence of
      an event of default.
  46
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 On
September 5, 2008, the Company entered into an Amendment and Early Conversion of
the Secured Convertible Promissory Note (the “Amendment”) in respect of the
AG Capital Partners Convertible Note.  The Amendment allowed for the
conversion, prior to the maturity date, of the outstanding principal balance of
the AG Capital Partners Convertible Note into 1,300,000 shares of the Company’s
common stock and $450,000 in cash payments.  According to the
Amendment, after the cash payments were made, the AG Capital Partners
Convertible Note could be converted into 1,300,000 shares of common stock upon
Ault Glazer’s satisfaction of certain conditions.  The Company made
the agreed upon $450,000 cash payment on September 5, 2008.
 
 On
September 12, 2008, the parties executed an Agreement for the Advancement of
Common Stock Prior to Close of the Amendment and Early Conversion of Secured
Convertible Promissory Note, dated September 5, 2008 (the “Advancement”).  Pursuant
to the Advancement, the Company agreed to issue 300,000 shares of the Company’s
common stock on September 12, 2008 to Ault Glazer in advance of the satisfaction
of the conditions in the Amendment with the understanding that Ault Glazer would
satisfy the conditions stated in the Amendment prior to September 19,
2008.  The stated purpose of the Advancement was to facilitate Ault
Glazer’s satisfaction of each of the conditions stated in the
Amendment.
 
 Ault
Glazer failed to satisfy the conditions by the September 19, 2008 deadline as
stated in the Advancement.  Although the conditions remained
unsatisfied, the Company made two additional issuances of shares to Ault Glazer
pursuant to the Amendment as follows: the Company issued another 250,000 shares
on October 10, 2008 and another 250,000 shares on November 6,
2008.   As of this date, there remain 500,000 shares issuable to
Ault Glazer upon Ault Glazer meeting the conditions of the
Amendment.
 
 During
the fiscal year ended December 31, 2008, the Company incurred interest expense
of $127,637 on the AG Capital Partners Convertible Note.  During the fiscal
year ended December 31, 2009, in light of the failure to satisfy the
conditions of the Amendment and the Advancement, the Company did not
accrue interest expense on the AG Capital Partners Convertible
Note.
 
 (b)
                On
      October 27, 2008, the Company issued a Discount Convertible Debenture to
      David Spiegel in the principal amount of $65,115 (the“Spiegel Note”) with a
      9% original issue discount of $15,115.  The Spiegel Note was
      convertible at any time at the option of the holder, in whole or in part,
      into the Company’s common stock at a conversion price of $1.50 per share.
      During the year ended December 31, 2009 and 2008, the Company incurred
      interest expense and amortization of the debt discount of $13,738 and
      1,337, respectively on the Spiegel Note.  The Spiegel Note was
      paid in full on December 15,
2009.
 
 Notes
Payable
 
 Notes
payable at December 31, 2009 and 2008 are comprised of the
following:
  2009
                      
                      
                      2008Herbert
      Langsam (a)*
                      
                      $
                      —
                      
                      
                      $
                      600,000Catalysis
      Offshore (b)*
                      
                      
                      —
                      
                      
                      
                      250,000Catalysis
      Partners (b)*
                      
                      
                      —
                      
                      
                      
                      250,000Total
      notes payable – current
                      
                      $
                      —
                      
                      
                      $
                      1,100,000
 
 * Related
party (see Note 15 to the Consolidated Financial Statements)
 
 (a)
              On
      May 1, 2006, the Company executed a $500,000 Secured Promissory Note (the
      “First Langsam Note”) due
      November 1, 2006, payable to the Herbert Langsam Irrevocable Trust.
      Herbert Langsam is a Member of the Board of Directors of the Company. The
      First Langsam Note accrued interest at the rate of 12% per annum, although
      from November 1, 2006 through December 2008; the First Langsam Note
      accrued interest at rate of 16% per annum as the Company was in default.
      In December 2008, Mr. Langsam agreed to extend the maturity of the First
      Langsam Note to June 30, 2009, and then in August 2009, agreed to further
      extend the maturity of this note to December 31, 2009. The Company also
      entered into a Security Agreement on May 1, 2006, granting the Herbert
      Langsam Irrevocable Trust a security interest in all of the Company’s
      assets as collateral for the satisfaction and performance of the Company’s
      obligations pursuant to the First Langsam
Note.
  47
 
 Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 On
November 13, 2006, the Company executed an additional $100,000 Secured
Promissory Note (the “Second
Langsam Note” and, together with the First Langsam Note, the “Langsam Notes”) due May 13,
2007 payable to the Herbert Langsam Irrevocable Trust. The Second Langsam Note
accrued interest at the rate of 12% per annum, although from May 13, 2007
through December 2008, the Second Langsam Note accrued interest at rate of 16%
per annum as the Company was in default. As additional consideration for
entering into the Second Langsam Note, the Company granted Mr. Langsam warrants
to purchase 50,000 shares of the Company’s common stock at an exercise price of
$1.25 per share.  These warrants were subsequently exchanged in the
first warrant exchange transaction that closed July 21, 2009 (see Note 12 to the
Consolidated Financial Statements). On November 13, 2006, the Company also
entered into a Security Agreement granting the Herbert Langsam Irrevocable Trust
a security interest in all of the Company’s assets as collateral for the
satisfaction and performance of the Company’s obligations pursuant to the Second
Langsam Note. In December 2008, Mr. Langsam agreed to extend maturity of the
Second Langsam Note to June 30, 2009, and then in August, 2009, agreed to
further extend maturity of this note to December 31, 2009.
 
 On
December 29, 2008, in connection with his agreement to extend the maturity dates
of both the Langsam Notes to June 30, 2009, the Company granted Mr. Langsam
25,000 shares of the Company’s common stock. On August 13, 2009, in connection
with the further extension of the maturity date of these notes from June 30,
2009 to December 31, 2009, the Company granted Mr. Langsam an additional 25,000
shares of the Company’s common stock.
 
 During
the year ended December 31, 2009 and 2008, the Company incurred interest
expense, excluding amortization of debt discount, of $68,862 and $48,395,
respectively, on the Langsam Notes.  At December 31, 2009 and 2008,
accrued interest on the Langsam Notes totaled $0 and $184,708, respectively. The
Langsam Notes, principal balance of $600,000 and accrued interest of $184,708
was paid on December 15, 2009.
 
 (b)
              Between
      February 28, 2008 and March 20, 2008, Catalysis Offshore, Ltd. and
      Catalysis Partners, LLC (collectively “Catalysis”), related
      parties, each loaned $250,000 to the Company. As consideration for the
      loans, the Company issued Catalysis promissory notes in the aggregate
      principal amount of $500,000 (the “Catalysis Notes”). The
      Catalysis Notes accrued interest at the rate of 8% per annum and had
      maturity dates of May 31, 2008. The managing partner of Catalysis is
      Francis Capital Management, LLC (“Francis Capital”), an
      investment management firm. John Francis, a Director of the Company and
      President of Francis Capital, has voting and investment control over the
      securities held by Catalysis. Francis Capital, including shares directly
      held by Catalysis, beneficially owns approximately 3,200,000 shares of the
      Company’s common stock and warrants for purchase of 45,000 shares of the
      Company’s common stock. On January 29, 2009 the Catalysis Notes were
      converted into new notes as part of the Senior Secured Note and Warrant
      Purchase Agreement described below.
 
 On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior Secured
Promissory Notes (the “Senior
Notes”) in the principal amount of $2,550,000 and warrants to purchase
1,530,000 shares of the Company’s common stock (the “January Warrant”), to several
accredited investors (the “January Investors”). The
January Investors paid $2,000,000 in cash and converted $550,000 of existing
debt and accrued interest on the Catalysis Notes into the Senior Notes. The
Senior Notes accrued interest, which was compounded to principal quarterly in
arrears, at 10% per annum, throughout the term of the Senior Notes, and unless
earlier converted in a Financing Round, had a maturity date of January 29, 2011.
During the year ended December 31, 2009 a total of $177,984 was reclassified
from accrued interest to principal on notes payable. The January Warrants have
an exercise price of $1.00 and expire on January 29, 2014. The Company recorded
a debt discount in the amount of $1,311,311 based on the estimated relative fair
value allocated to the warrants.
 
 On August
18, 2009 the Company converted approximately $212,000 of existing Senior Notes
and accrued interest owed to Arizona Bay Technology Ventures, LP into 246,189
shares of common stock at $0.86 per share.  The Company recognized a
loss on extinguishment of debt in the amount of $46,776.
  48
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 On
December 15, 2009, the Company repaid the Senior Notes in the amount of
$2,569,384 including principal and accrued interest.  The Company
recognized a loss on extinguishment of debt in the amount of $491,143 relating
to the unamortized debt discount associated with the Senior Notes.  In
accordance with ASC 470-50, the remaining unamortized debt discount on related
party debt of $245,571 was recorded to additional paid in capital.
 
 For the
year ended December 31, 2009 the Company recognized $574,636 in debt discount
amortization. During the year ended December 31, 2009, the Company incurred
interest expense of $229,690 on the Senior Notes.
 
 10.
ACCRUED LIABILITIES
 
 Accrued
liabilities at December 31, 2009 and 2008 are comprised of the
following:
  2009
                    
                    
                    2008Accrued  interest
                    
                    $
                    —
                    
                    
                    $
                    236,605Accrued  lease  liability
                    
                    
                    7,547
                    
                    
                    
                    56,251Accrued  dividends  on  preferred  stock
                    
                    
                    114,976
                    
                    
                    
                    134,138Accrued  salaries
                    
                    
                    47,449
                    
                    
                    
                    16,726Accrued  officer  severance
                    
                    
                    —
                    
                    
                    
                    268,413Accrued  director's  fees
                    
                    
                    162,500
                    
                    
                    
                    145,000Contingent  tax  liability
                    
                    
                    740,726
                    
                    
                    
                    701,046Accrued  commissions
                    
                    
                    13,200
                    
                    
                    
                    —Other
                    
                    
                    156,478
                    
                    
                    
                    37,449Total
      accrued liabilities
                    
                    $
                    1,242,876
                    
                    
                    $
                    1,595,628
 
 11.
DEFERRED REVENUE
 
 Deferred
revenue as of December 31, 2009 and 2008 consists of the following:
 
 2009
                    
                    
                    2008Cardinal
      Health advance payment on purchase order
                    
                    $
                    8,000,000
                    
                    
                    $
                    —Scanner
      reimbursement revenue
                    
                    
                    99,144
                    
                    
                    
                    —Total
                    
                    $
                    8,099,144
                    
                    
                    $
                    —
 
 In
November 2009, the Company renewed its distribution arrangement with Cardinal
Health through the execution of a new Supply and Distribution Agreement on
November 19, 2009.  This new agreement has a five-year term and names
Cardinal Heath as the exclusive distributor in the United States, Puerto Rico
and Canada of current products used in the Company’s Safety-Sponge® System. In
connection with the execution of the new supply and distribution agreement,
Cardinal Health issued a $10,000,000 purchase order for products used in the
Company’s Safety-Sponge® System, calling for deliveries over the 12-month period
ending November 2010 and paid the Company $8,000,000 upon execution of agreement
as partial pre-payment for such products, and agreed to pay up to $2,000,000
directly to the Company’s supplier upon delivery of invoices for product
delivered under the purchase order.  As of December 31, 2009, no
product covered by the $10,000,000 purchase order had been delivered to Cardinal
Health, and accordingly, the entire amount of the pre-payment received was
recorded as deferred revenue.
  49
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Prior to
the third quarter of 2009, the Company’s business model included the sale of its
SurgiCounterTM scanners and related software used in the Company’s Safety-Sponge®
System to most hospitals that adopted its system.  Beginning with the
third quarter of 2009, the Company modified its business model and began to
provide its SurgiCounterTM scanners and related software to all hospitals at no
cost when they adopt its Safety-Sponge® System.  Because the Company
no longer engages in direct SurgiCounterTM scanner
sales and generally anticipates only recognizing revenues associated
with its SurgiCounterTM scanners in connection with reimbursement arrangements
under the Company’s agreement with Cardinal Health, the Company does not expect
its SurgiCounterTM scanners to continue to represent a sizable source of
revenues. Deferred scanner revenue associated with the reimbursement from
Cardinal Health, will be recognized over the life of the specific hospital
contract.
 
 As of
December 31, 2009, there was no deferred revenue associated with maintenance
agreements.
 
 12.
EQUITY TRANSACTIONS
 
 Series
A Preferred Stock
  The
Series A preferred stock has a cumulative 7% quarterly dividend and is
convertible into the number of shares of common stock by dividing the purchase
price for the convertible preferred stock by conversion price in effect,
currently $4.44. The convertible preferred stock has anti-dilution provisions,
which can change the conversion price in certain circumstances. In the event the
Company subdivides its outstanding shares of common stock into a greater number
of shares of common stock the conversion price in effect would be reduced,
thereby increasing the total number of shares of common stock that the
convertible preferred stock is convertible into.  At any time until
February 22, 2010, the holder had the right to convert the shares of convertible
preferred stock into the Company’s common stock.  Upon liquidation,
dissolution or winding up of the Company, the stockholders of the convertible
preferred stock are entitled to receive $100 per share plus any accrued and
unpaid dividends before distributions to any holder of the Company’s common
stock.  At any time on or after February 22, 2003, the Company may
redeem the convertible preferred stock at a redemption price in cash equal to
the liquidation preference per share plus any accrued and unpaid dividends
thereon through the date of such redemption.
  The
Company incurred $76,650 in Series A Preferred Stock dividend expense for the
years ended December 31, 2009 and 2008.
  Common
Stock
 
 In May
2008 the Company entered into a subscription agreement with several accredited
investors in a private placement exempt from the registration requirements of
the Securities Act.  The Company issued and sold to these accredited
investors an aggregate of 2,100,000 shares of its common stock and warrants to
purchase an additional 1,300,000 shares of its common stock.  The
warrants are exercisable for a period of five years, have an exercise price
equal to $1.40.  These issuances resulted in aggregate gross proceeds
to the Company of approximately $2,200,000 and the extinguishment of
approximately $426,000 in existing debt.  The Company used the net
proceeds from this private placement transaction primarily for general corporate
purposes and repayment of existing liabilities.
  Between
April 2008 and June 2008, the Company issued approximately 1,700,000 warrants to
officers, directors and consultants of the Company.  The warrants were
issued in place of prior issuances of stock options with exercise prices well
above market price that were cancelled.  The exercise prices of the
warrants were $1.25 and $1.75 and vested over four years.  During this
same time period, approximately 263,000 warrants were issued to directors and
consultants with an exercise price of $1.25 and $1.75 that vested upon
grant.  The Company recognized $195,416 and $713,384 in stock-based
compensation warrant expense for the year ended December 31, 2009 and 2008,
respectively.
  On July
31, 2008, the Company issued 153,000 shares of its common stock to Ault
Glazer.  The shares were issued in satisfaction of unpaid accrued
interest of approximately $103,000 due on the senior secured promissory note
held by Ault Glazer and prepaid interest of approximately
$128,000.  The accrued interest paid, which was in default, was
converted into shares of the Company’s common stock at a conversion price of
$1.50 per share.  (See Note 9).
 
 On August
1, 2008 the Company entered into a subscription agreement with several
accredited investors in a private placement exempt from the registration
requirements of the Securities Act.  The Company issued and sold to
these accredited investors an aggregate of 2,000,000 shares of its common stock
and warrants to purchase an additional 1,200,000 shares of its common
stock.  The warrants are exercisable for a period of five years, have
an exercise price equal to $1.40.  These issuances resulted in
aggregate gross proceeds to the Company of approximately $2,400,000 million and
$83,000 in debt extinguishment which included $50,000 paid in common stock and
$37,000 was forgiven.  The Company used the net proceeds from this
private placement transaction primarily for general corporate purposes and
repayment of existing liabilities.
  50
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Between
September 12, 2008 and November 6, 2008 the Company issued 800,000 shares of
common stock to Ault Glazer.  The shares were issued in partial
satisfaction of the convertible secured note held by Ault Glazer. The issuance
of the Company’s common stock reduced the principal balance of the note. (See
Note 9).
 
 On
December 29, 2008, in connection with his agreement to extend the maturity dates
of both the Langsam Notes to June 30, 2009, the Company granted Mr. Langsam
25,000 shares of the Company’s common stock. On August 13, 2009, in connection
with the further extension of the maturity date of these notes from June 30,
2009 to December 31, 2009, the Company granted Mr. Langsam an additional 25,000
shares of the Company’s common stock.
 
 On
January 2, 2009, the Company issued 2,576,326 million warrants to purchase
shares of the Company’s common stock to warrant holders, pursuant to the
anti-dilution clauses in their original warrants. The warrants are exercisable
through the term of the original warrant and have an exercise price of
$0.75.
 
 On
January 29, 2009, the Company entered into a Senior Secured Note and Warrant
Purchase Agreement, pursuant to which, the Company sold Senior Notes in the
principal amount of $2,550,000 and January Warrants to purchase 1,530,000 shares
of the Company’s common stock to the January Investors in consideration for
$2,000,000 in cash proceeds and conversion of $550,000 owed under existing
promissory notes. The January Warrants have an exercise price of $1.00 and
expire on January 29, 2014. (See Note 12).
 
 On July
29, 2009, the Company completed the first closing of a private placement of its
common stock. The shares were issued and sold to accredited investors who
were holders of common stock warrants of the Company. The shares of common stock
were issued at a per share price of $0.86, paid by cancellation of the
common stock warrants held by these holders, and in some cases an additional
cash contribution by the holders. Holders not making cash
investment tendered warrants to purchase 1,774,994 million shares of common
stock and received 597,190 shares of the Company’s common stock. Holders
who elected to make cash investment tendered warrants to purchase 4,780,990
shares of common stock and $1,511,727 in cash, and received 4,780,990 shares of
the Company’s common stock.  The exchange resulted in a recognized net
gain of $163,377.
 
 On
September 18, 2009, the Company completed the second and final closing of a
private placement of its common stock. The shares were issued and sold to
accredited investors who were holders of common stock warrants of the Company.
The shares of common stock were issued at a per share price of $0.86, paid by
cancellation of the common stock warrants held by these holders, and in some
cases an additional cash contribution by the holders. Holders not making cash
investment tendered warrants to purchase 59,460 shares of common stock and
received 20,383 shares of the Company’s common stock. Holders who elected to
make cash investment tendered warrants to purchase 566,571 shares of common
stock and $194,691in cash, and received 567,571 shares of the Company’s common
stock. The exchange resulted in a recognized net gain of $849.
 
 For the
warrants classified in equity prior to the exchange, the Company accounted for
the warrants cancelled as an exchange of warrants for common
shares, whereby the repurchase price of the warrants was considered to be
the fair value of the common shares issued in the exchange, less any cash
received by the Company from the warrant holders. Under this treatment, the
fair value of the warrant exchanged was estimated at the date of the exchange
based on the original terms of the warrant and was compared to the
repurchase price, and additional expense was recognized by the Company to the
extent that the repurchase price exceeded the fair value of the warrant
prior to the exchange.
 
 For the
warrants classified as derivative liabilities prior to the exchange, the Company
accounted for the warrants exchanged as an issuance of common shares to
extinguish a liability, and as such, the difference between the reacquisition
price and the net carrying amount of the debt was recognized in earnings in the
period of extinguishment. The Company determined that the value of the common
stock issued was more clearly evident than the value of the debt, and therefore
should be used in the determination of the reacquisition price. In exchanges of
warrants classified as derivative liabilities, whereby the Company also receives
cash from the warrant holder as part of the exchange, the amount of cash
received was netted against the value of the common shares issued to determine
the reacquisition price. Warrants classified as derivative liabilities prior to
the exchange were adjusted to the then current fair value on the date of the
exchange, and the change in fair value was recognized through earnings. The
adjusted fair value was used in the exchange transaction to determine the gain
or loss.
  51
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 13.
WARRANTS AND WARRANT DERIVATIVE LIABILITY
 
 The
following table summarizes warrants to purchase common stock activity for the
two years ended December 31, 2009:
 Amount
                    
                    
                    Range of Exercise
                      PriceWarrants
      outstanding December 31, 2007
                    
                    
                    6,114,521
                    
                    
                    $
                    1.25
      - 6.05Issued
                    
                    
                    4,617,875
                    
                    
                    $
                    1.40
      - 2.00Cancelled/Expired
                    
                    
                    (12,500
                    )
                    
                    $
                    3.55Warrants
      outstanding December 31, 2008
                    
                    
                    10,719,896
                    
                    
                    $
                    1.25
      - 6.05Issued
                    
                    
                    5,996,326
                    
                    
                    $
                    0.75
      - 4.00Cancelled/Expired
                    
                    
                    (8,651,244
                    )
                    
                    $
                    0.75
      - 5.95Warrants
      outstanding December 31, 2009
                    
                    
                    8,064,978
                    
                    
                    $
                    0.75
      - 6.05
 At
December 31, 2009, stock purchase warrants will expire as follows:
 
 #
      of
                        Warrants
                      
                      
                      Range
      of
                        Exercise
                        Price2010
                      
                      
                      337,000
                      
                      
                      $
                      2.00
      - 6.052011
                      
                      
                      2,301,419
                      
                      
                      $
                      0.75
      - 4.50
                      *2012
                      
                      
                      818,000
                      
                      
                      $
                      2.002013
                      
                      
                      1,786,267
                      
                      
                      $
                      0.75
      - 1.40
                      *2014
                      
                      
                      1,890,000
                      
                      
                      $
                      1.82
      - 4.002015
                      
                      
                      932,292
                      
                      
                      $
                      1.25Total
                      
                      
                      8,064,978
                      
                      
                      $
                      0.75 - 6.05
  
    Warrants
 
 On
January 2, 2009, the Company issued 2,576,326 million warrants to purchase
shares of the Company’s common stock to warrant holders, pursuant to the
anti-dilution clauses in their original warrants. The warrants are exercisable
through the term of the original warrant and have an exercise price of $0.75.
This resulted in a one-time expense of $1,324,075.
 
 In
connection with the January Warrants, the Company issued 1,530,000 warrants to
purchase the Company’s common stock. The January Warrants have an exercise price
of $1.00 and expire on January 29, 2014. The Company recorded a debt discount in
the amount of $1,311,311 based on the estimated relative fair value allocated to
the warrants.
 
 On
November 17, 2009, the Company issued 15,000 warrants to Tatum Partners, LLP in
connections with services provided by Mary A. Lay, the former Interim Chief
Financial Officer.  This resulted in a one-time expense of
$20,633.
 
 On
November 19, 2009, in connection with the execution of a new supply and
distribution agreement with Cardinal Health (see “Business—Customers and
Distribution—Cardinal Health – Exclusive U.S. Distributor,” above), the Company
issued Cardinal Health warrants to purchase 1,250,000 shares of its common stock
at $2 per share and 625,000 shares of its common stock at $4 per share pursuant
to a Warrant Purchase Agreement dated effective November 19,
2009.  This resulted in a one-time expense of
$2,407,813.
  52
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Warrant
Derivative Liability
 
 As of
December 31, 2008, warrants to purchase a total of 5,339,172 shares, with an
estimated fair value of $1,761,878 were recorded as a warrant derivative
liability due to a lack of sufficient authorized shares outstanding based on the
Company’s evaluation of criteria under FASB guidance as codified in ASC 815-40,
Derivatives and Hedging(previously EITF 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock).
 
 During
2009, an additional 6,938,082 warrants with a value of $4,240,000 were
reclassified from additional paid in capital to liability in accordance with ASC
815-40. On August 6, 2009, the shareholders voted to approve a proposal to
increase the total number of authorized shares from 25,000,000 to 100,000,000
shares of common stock and the Company amended its articles of incorporation
reflecting the increase. As such, in accordance with ASC 815-40, certain
warrants previously classified as liabilities due to a lack of sufficient
authorized shares outstanding were reclassified to equity at fair value on the
date of the increase in authorized shares of common stock. A total of 2,853,577
warrants with a fair value of $2,152,940 were reclassified from liability to
additional paid in capital.
 
 Effective
January 1, 2009, upon the adoption of guidance codified in FASB ASC 815-40,
Derivatives and Hedging(previously EITF 07-5, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock), the Company reclassified approximately 1,200,000 outstanding
warrants that were previously classified as equity to a derivative liability.
This reclassification was necessary as the Company determined that certain terms
included in these warrant agreements provided for a possible future adjustment
to the warrant exercise price, and accordingly, under the provisions of ASC
815-40, these warrants did not meet the criteria for being considered to be
indexed to the Company’s stock. As such, these warrants no longer qualified for
the exception to derivative liability treatment provided for in ASC 815-10. The
estimated fair value of the warrants reclassified at January 1, 2009 pursuant to
ASC 815-40 was determined to be $707,720. The cumulative effect of the change in
accounting for these warrants of $875,123 was recognized as an adjustment to the
opening balance of accumulated deficit at January 1, 2009 based on the
difference between the amounts recognized in the consolidated balance sheet
before the initial adoption of ASC 815-40 and the amounts recognized in the
consolidated balance sheet as a result of the initial application of ASC 815-40.
The amounts recognized in the consolidated balance sheet as a result of the
initial application of ASC 815-40 on January 1, 2009 were determined based on
the amounts that would have been recognized if ASC 815-40 had been applied from
the issuance date of the warrants.
 
 At
December 31, 2009, warrants to purchase a total of 2,567,686, with an estimated
fair value of $3,666,336, are included in liabilities in the accompanying
balance sheet. Based on the change in fair value of the warrant derivative
liability, the Company recorded a non-cash loss of $5,564,125 for the year ended
December 31, 2009.
 
 14.
FAIR VALUE MEASUREMENTS
 
 Fair
Value Hierarchy
 
 The
Company adopted the fair value measurement and disclosure requirements of FASB
guidance as codified in ASC 820 (previously SFAS No. 157, Fair Value Measurements)
effective January 1, 2008 for financial assets and liabilities measured on a
recurring basis. ASC 820 defines fair value, establishes a framework for
measuring fair value under generally accepted accounting principles and expands
disclosures about fair value measurements. This standard applies in situations
where other accounting pronouncements either permit or require fair value
measurements. ASC 820 does not require any new fair value
measurements.
 
 Fair
value is defined in ASC 820 as the price that would be received upon sale of an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. Fair value measurements are to be
considered from the perspective of a market participant that holds the assets or
owes the liability. ASC 820 also establishes a fair value hierarchy, which
requires an entity to maximize the use of observable inputs and minimize the use
of unobservable inputs when measuring fair value.
  53
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 The
standard describes three levels of inputs that may be used to measure fair
value:
 
 Level 1:
Quoted prices in active markets for identical or similar assets and
liabilities.
 
 Level 2:
Quoted prices for identical or similar assets and liabilities in markets that
are not active or observable inputs other than quoted prices in active markets
for identical or similar assets and liabilities.
 
 Level 3:
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities.
 
 Financial
Instruments Measured at Fair Value on a Recurring Basis
 
 ASC 820
requires disclosure of the level within the fair value hierarchy used by the
Company to value financial assets and liabilities that are measured at fair
value on a recurring basis. At December 31, 2009, the Company had outstanding
warrants to purchase common shares of its stock that are classified as warrant
derivative liabilities with a fair value of $3,666,336. The warrants are valued
using Level 3 inputs because there are significant unobservable inputs
associated with them.
 
 The table
below sets forth a summary of changes in the fair value of the Company’s
Level 3 assets and liabilities for the year ended December 31,
2009:
 
 January 1,
                      2009
                    
                    
                    Transfers
                      into Level 3
                    
                    
                    Transfers
                      from Level 3
                    
                    
                    Net realized
                      losses
                      included in
                      earnings
                    
                    
                    December
                      31, 2009Warrant
      derivativeliability
                    
                    $
                    (2,469,598
                    )
                    
                    $
                    (3,532,780
                    )
                    
                    $
                    7,900,167
                    
                    
                    $
                    (5,564,125
                    )
                    
                    $
                    (3,666,336
                    )
 
 The
balance as of January 1, 2009 includes the initial reclassification of warrants
based on the adoption of ASC 815-40 in the amount of $707,720 (see Note 3 and
13).  Losses included in earnings for the period ended December 31,
2009, are reported in other income/expense in the amount of
$5,564,125.
 
 15.
STOCK OPTION PLANS
 
 In
September 2005, the Board of Directors of the Company approved the Amended and
Restated 2005 Stock Option and Restricted Stock Plan (the “2005 SOP”) and the Company’s
stockholders approved the 2005 SOP in November 2005. The 2005 SOP reserves
2,000,000 shares of common stock for grants of incentive stock options,
nonqualified stock options, warrants and restricted stock awards to employees,
non–employee directors and consultants performing services for the Company.
Options granted under the 2005 SOP have an exercise price equal to or greater
than the fair market value of the underlying common stock at the date of grant
and become exercisable based on a vesting schedule determined at the date of
grant. The options generally expire 10 years from the date of grant. Restricted
stock awards granted under the 2005 SOP are subject to a vesting period
determined at the date of grant.
 
 On March
11, 2009, the Board of Directors of the Company approved the 2009 Stock Option
Plan (the “2009 SOP”)
and the Company’s stockholders approved the 2009 SOP August 6, 2009. The 2009
SOP reserves 3,000,000 shares of common stock for grants of incentive stock
options, nonqualified stock options, warrants and restricted stock awards to
employees, non–employee directors and consultants performing services for the
Company. Options granted under the 2009 SOP have an exercise price equal to or
greater than the fair market value of the underlying common stock at the date of
grant and become exercisable based on a vesting schedule determined at the date
of grant. The options generally expire 10 years from the date of grant.
Restricted stock awards granted under the 2009 SOP are subject to a vesting
period determined at the date of grant.
 
 All
options that the Company granted during the year ended December 31, 2009 and
2008 were granted at the per share fair market value on the grant date. Vesting
of options differs based on the terms of each option. The Company utilized the
Black-Scholes option pricing model and the assumptions used for each period are
as follows:
  54
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Year Ended
                    December 31,2009
                  
                  
                  2008Weighted
      average risk free interest rate
                  
                  
                  2.37
                  %
                  
                  
                  3.5
                  %Weighted
      average life (in years)
                  
                  6.0
      years
                  
                  
                  5
      yearsVolatility
                  
                  
                  141
                  %
                  
                  
                  106
                  %Expected
      dividend yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %Weighted
      average grant-date fair value per share of options granted
                  
                  $
                  0.88
                  
                  
                  $
                  0.93
 
 A summary
of stock option activity for the year ended December 31, 2009 is presented
below:
  Outstanding OptionsWeightedAverageWeighted
                        
                        
                        Remaining
                        
                        
                        AggregateNumber of
                        
                        
                        Average
                          Exercise
                        
                        
                        Contractual
                          Life
                        
                        
                        Intrinsic
                          ValueShares
                        
                        
                        Price
                        
                        
                        (years)
                        
                        
                        
                        (1
                        )Balance
      at December 31, 2007
                        
                        
                        1,650,000
                        
                        
                        $
                        3.49
                        
                        
                        
                        8.43
                        
                        
                        $
                        —Options
      Granted
                        
                        
                        745,000
                        
                        
                        $
                        1.53
                        
                        
                        
                        9.76Exercised
                        
                        
                        —
                        
                        
                        $
                        —
                        
                        
                        
                        —Forfeited
                        
                        
                        —
                        
                        
                        $
                        —
                        
                        
                        
                        —Cancelled
                        
                        
                        (768,000
                        )
                        
                        $
                        4.59
                        
                        
                        
                        8.25Balance
      at December 31, 2008
                        
                        
                        1,627,000
                        
                        
                        $
                        2.40
                        
                        
                        
                        8.44
                        
                        
                        $
                        —Options
      Granted (2)
                        
                        
                        6,392,500
                        
                        
                        $
                        0.96
                        
                        
                        
                        9.31Exercised
                        
                        
                        (21,868
                        )
                        
                        $
                        1.25
                        
                        
                        
                        8.45Forfeited
                        
                        
                        (15,000
                        )
                        
                        $
                        4.30Cancelled
                        
                        
                        (2,161,632
                        )
                        
                        $
                        0.81Balance
      at December 31, 2009
                        
                        
                        5,821,000
                        
                        
                        $
                        1.41
                        
                        
                        
                        8.96
                        
                        
                        $
                        4,301,385Vested
      and exercisable as of December 31, 2009
                        
                        
                        2,314,490
                        
                        
                        $
                        1.88
                        
                        
                        
                        8.28
                        
                        
                        $
                        1,478,390Unvested
      as of December 31, 2009
                        
                        
                        3,506,510
                        
                        
                        $
                        1.09
                        
                        
                        
                        9.40
                        
                        
                        $
                        2,822,995
 
 1)
              The
      aggregate intrinsic value is calculated as the difference between the
      exercise price of the underlying awards and the closing stock price of
      $1.90 of the Company’s common stock at December 31,
  2009.
 2)
              Includes
      3,150,000 non-qualified options that were issued outside the 2005 and 2009
      stock option plans.
 
 The total
grant date fair value of stock options granted during the years ended December
31, 2009 and 2008 was $5,620,313 and $748,913, respectively.  During
the years ended December 31, 2009 and 2008, the Company recognized stock-based
compensation expense relating to stock options of $1,279,216 and $919,889,
respectively.
 
 As of
December 31, 2009, there was approximately $3,340,427 of unrecognized
compensation costs related to outstanding employee stock options. This amount is
expected to be recognized over a weighted average period of 3.39 years. To the
extent the forfeiture rate is different from what the Company anticipated;
stock-based compensation related to these awards will be different from the
Company’s expectations.
 
 16.
RELATED PARTY TRANSACTIONS
 
 Convertible
Note and Notes Payable
 
 As of
December 31, 2009 and 2008, the Company had convertible notes and notes payable
agreements issued to related parties with aggregate outstanding principal
balances of $1,424,558 and $2,524,558 million, respectively (See Note
10):
  55
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 December 31,
                              2009
                            
                            
                            December 31,
                              2008Notes Payable:Herbert
      Langsam
                            
                            $
                            —
                            
                            
                            $
                            600,000Catalysis
      Offshore
                            
                            
                            —
                            
                            
                            
                            250,000Catalysis
      Partners
                            
                            
                            —
                            
                            
                            
                            250,000Total
      Notes Payable
                            
                            $
                            —
                            
                            
                            $
                            1,100,000Convertible Notes:Ault
      Glazer Capital Partners, LLC
                            
                            
                            1,424,558
                            
                            
                            $
                            1,424,558Notes
      Payable and Convertible Notes
                            
                            $
                            1,424,558
                            
                            
                            $
                            2,524,558
 
 A
Plus International, Inc.
 
 During
the years ended December 31, 2009 and 2008, the Company recognized cost of
revenues of approximately $2,049,426 and $1,382,164, respectively, in connection
with the manufacture of surgical products used in the Safety-Sponge® System by A
Plus. At December 31,
2009 and 2008 the Company’s accounts payable included $1,683,080 and $164,341
respectively, owed to A Plus in connection with the manufacture and supply of
surgical products used in the Safety-Sponge® System. Effective June 1, 2009, the
terms of the Company’s supply agreement with A Plus were clarified to provide
that title to surgical products purchased, transferred to the Company upon
receipt by A Plus at its Chino, California warehouse. Wenchen Lin, a Director
and significant beneficial owner of the Company is a founder and significant
owner of A Plus.
 
 Kane
Aviation
 
 From time
to time, the Company may use the services of an aircraft owning partnership
principally owned by Steven H. Kane, the Company’s Chief Executive Officer for
air travel.  During the years ended December 31, 2009 and 2008, the
Company incurred $15,800 and $0 respectively, of expenses related to the use of
such air travel services.
 
 17.  INCOME
TAXES
 
 For
financial reporting purposes, income (loss) before income taxes includes the
following components for the years ended December 31, 2009 and
2008:
 
 2009
                      
                      
                      2008United
      States
                      
                      $
                      (17,709,652
                      )
                      
                      $
                      (4,813,000
                      )Foreign
                      
                      
                      —
                      
                      
                      
                      —$
                      (17,709,652
                      )
                      
                      $
                      (4,813,000
                      )
 
 The
(benefits) provisions for income taxes for the years ended December 31, 2009 and
2008 are as follows:
  2009
                      
                      
                      2008Current:Federal
                      
                      $
                      44,942
                      
                      
                      $
                      —State
                      
                      
                      13,295
                      
                      
                      
                      17,500Total
      Current Tax Expense
                      
                      
                      58,237
                      
                      
                      
                      17,500Deferred:Federal
                      
                      
                      (183,740
                      )
                      
                      
                      (428,860
                      )State
                      
                      
                      (52,894
                      )
                      
                      
                      (28,069
                      )Total
      Deferred Tax Benefit
                      
                      
                      (236,634
                      )
                      
                      
                      (456,929
                      )Total
      Benefit for Income Tax
                      
                      $
                      (178,397
                      )
                      
                      $
                      (439,429
                      )
  56
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Deferred
income taxes reflect the net tax effects of (a) temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes, and (b) operating losses and tax
credit carryforwards.
 
 For the
years ended December 31, 2009 and 2008, a reconciliation of the federal
statutory tax rate to the Company's effective tax rate is as
follows:
 
 2009
                    
                    
                    2008Statutory
      Rate
                    
                    
                    (34.00
                    )
      %
                    
                    
                    (34.00
                    )
      %State
      Rate
                    
                    
                    (2.80
                    )%
                    
                    
                    (7.02
                    )%FIN
      48 Adjustments
                    
                    
                    18.11
                    %
                    
                    
                    80.74
                    %Non-deductible
      Items
                    
                    
                    0.23
                    %
                    
                    
                    0.94
                    %Warrant
      Derivative Liability
                    
                    
                    9.57
                    %
                    
                    
                    (17.96
                    )%Incentive
      Stock Option
                    
                    
                    0.00
                    %
                    
                    
                    11.58
                    %Warrant
      Expense
                    
                    
                    7.89
                    %
                    
                    
                    0.00
                    %Other
                    
                    
                    0.00
                    %
                    
                    
                    5.70
                    %Valuation
      allowance
                    
                    
                    (0.00
                    )%
                    
                    
                    (48.97
                    )%Total
      Effective Tax Rate
                    
                    
                    (1.00
                    )%
                    
                    
                    (8.99
                    )%
  Deferred
income taxes reflect the net tax effects of temporary differences between
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for tax purposes.  Significant components of the
Company’s deferred tax assets as of December 31, 2009 and 2008 are as
follows:
 
 2009
                    
                    
                    2008Deferred
      Tax Assets:Compensation
      related accruals
                    
                    $
                    376,704
                    
                    
                    $
                    329,000Inventory
                    
                    
                    67,319
                    
                    
                    
                    —Other
                    
                    
                    38,034
                    
                    
                    
                    25,000Total
      Deferred Tax Assets
                    
                    
                    482,057
                    
                    
                    
                    354,000Deferred
      Tax Liabilities:Book
      and tax basis differences arising from purchased patents
                    
                    
                    (1,240,455
                    )
                    
                    
                    (1,370,000
                    )Other
                    
                    
                    (47,370
                    )
                    
                    
                    26,400Total
      Net Deferred Tax Liability
                    
                    
                    (805,768
                    )
                    
                    
                    (1,042,400
                    )Less
      valuation allowance
                    
                    
                    —
                    
                    
                    
                    —Net
      Deferred Tax Liability
                    
                    $
                    (805,768
                    )
                    
                    $
                    (1,042,400
                    )
 
 In
assessing the reliability of deferred tax assets, management considers whether
it is more likely than not that some portion or all of the deferred tax assets
will be realized.  The ultimate realization of deferred tax assets
depends upon the generation of future taxable income during the periods in which
those temporary differences become deductible.  As of December 31,
2009, the Company has provided a valuation allowance in the amount of
$0.  The federal and state net operating losses expire in varying
amounts through 2029.
 
 On
January 1, 2007 the Company adopted the provisions of ASC 740-10, Income
Taxes, relating to accounting for uncertain tax positions.  ASC 740-10
addresses the determination of how tax benefits claimed or expected to be
claimed on a tax return should be recorded in the financial statements. Under
ASC 740-10, the Company must recognize the tax benefit from an uncertain tax
position only if it is more likely than not that the tax position will be
sustained on examination by the taxing authorities, based on the technical
merits of the position. The tax benefits recognized in the financial statements
from such a position are measured based on the largest benefit that has a
greater than 50% likelihood of being realized upon ultimate resolution. The
Company did not recognize any additional liabilities for uncertain tax positions
as a result of the implementation of ASC 740-10.
  57
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 As of
December 31, 2009, the Company has not yet completed its analysis of the
deferred tax assets for federal and state net operating losses of $12,300,420
and $3,086,294, respectively.  The Company has not yet completed its
analysis of the deferred tax asset for stock compensation of
$2,804,089.  As such, these amounts have been removed from the
Company's deferred tax assets.  The Company will complete an analysis
of the net operating losses under Internal Revenue Code §382 regarding the
limitation of the net operating losses. Future changes in ownership could limit
the ability to recognize the benefits of its deferred tax assets.
  A
reconciliation of the beginning and ending amount of unrecognized tax benefits
is as follows:
  2009
                    
                    
                    2008Gross
      unrecognized tax benefits at January 1
                    
                    $
                    —
                    
                    
                    $
                    —Changes
      to unrecognized tax positions from a prior period
                    
                    
                    57,760Increases
      for tax positions in current year
                    
                    
                    —
                    
                    
                    
                    —Gross
      unrecognized tax benefits at December 31
                    
                    $
                    57,760
                    
                    
                    $
                    —
 
 The
Company’s uncertain tax positions are related to tax years that remain subject
to examination by the relevant taxing authorities. The Company is currently open
to audit under the statute of limitations by the Internal Revenue Service for
the calendar years ended December 31, 2005 through December 31, 2008.
The Company and its subsidiary’s state tax returns are also open to audit under
similar statute of limitations for the calendar years ended December 31,
2004 through December 31, 2008. The Company is currently not under
examination by any taxing authorities.
  The
Company accrues interest, as applicable, on unrecognized tax benefits as a
component of income tax expense. Penalties, if incurred, would be recognized as
a component of income tax expense. The Company had no such accrued interest or
penalties included in the accrued liabilities associated with unrecognized tax
benefits as of the date of adoption.
  Additionally,
the Company is subject to tax examinations for payroll, value added, sales-based
and other taxes. The Company is currently not under examination by the taxing
authorities relating to these other types of taxes.  Where
appropriate, the Company has made accruals for these matters, which are
reflected in the Company’s consolidated financial statements.
  18.MAJOR CUSTOMERS,
SUPPLIERS, SEGMENT AND RELATED INFORMATION
  Major
Customers
 
 During
the years ended December 31, 2009 and 2008, due to its exclusive distribution
agreement with Cardinal Health, the Company had one customer that represented in
excess of 88% and 80% of total revenues in 2009 and 2008,
respectively.  No other single customer accounted for more than 10% of
total revenues in either period.
 
 Suppliers
 
 The
Company relies primarily on third-party supplier, A Plus, to supply all the
surgical sponges and towels used in its Safety-Sponge® System. The Company also
relies on a number of third parties to manufacture certain other components of
its Safety-Sponge® System.  If A Plus or any of the Company’s other
third-party manufacturers cannot, or will not, manufacture its products in the
required volumes, on a cost-effective basis, in a timely manner, or at all, the
Company will have to secure additional manufacturing capacity.  Any
interruption or delay in manufacturing could have a material adverse effect on
the Company’s business and operating results.
  58
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Furthermore,
all products obtained from A Plus are manufactured in China.  As such,
the supply of product from A Plus is subject to various political, economic, and
other risks and uncertainties inherent in importing products from this country,
including among other risks, export/import duties, quotas and embargoes;
domestic and international customs and tariffs; changing taxation policies;
foreign exchange restrictions; and political conditions and governmental
regulations.
  Segment
and Related Information
  The
Company presents its business as one reportable segment due to the similarity in
nature of products marketed, financial performance measures, methods of
distribution and customer markets. The Company’s chief operating decision making
officer reviews financial information on the Company’s patient safety products
on a consolidated basis.
  The
following table summarizes revenues by geographic region. Revenues are
attributed to countries based on customer location:
  Years Ended December 31,
                                      
                                      2009
                                      
                                      2008Revenues:United
      States
                                      
                                      $
                                      4,503,535
                                      
                                      $
                                      2,779,871Other
                                      
                                      
                                      —
                                      
                                      
                                      —Total
      revenues
                                      
                                      $
                                      4,503,535
                                      
                                      $
                                      2,779,871
  The
following table summarizes revenues by product line.
 
 Years Ended December 31,
                                  
                                  2009
                                  
                                  2008Revenues:Surgical
      sponges and towels
                                  
                                  $
                                  4,234,903
                                  
                                  $
                                  2,423,007Scanners
      and related products
                                  
                                  
                                  268,632
                                  
                                  
                                  356,864Total
      revenues
                                  
                                  $
                                  4,503,535
                                  
                                  $
                                  2,779,871
  19.  COMMITMENTS
AND CONTINGENCIES
 
 Operating
and Capital Lease
 
 In
November 2007, the Company entered into a 36 month lease agreement for
approximately 4,000 square feet of office space in Temecula, CA, which expires
December 31, 2010.  Monthly lease payments for the remaining lease
term of this lease are $9,757.  For the years ended December 31, 2009
and 2008, the Company recorded rent expense of $117,625 and $114,439.  In
December 2009, the Company entered into a 40 month sublease agreement for office
space in Newtown, PA, which expires in April 2013, at a fixed monthly total
lease payment for the entire term of the lease of $11,576.  In
connection with the Newtown, PA office sublease, the Company acquired certain
office furniture valued at $100,000 from the building landlord for a nominal
one-time payment.  Accordingly, a portion of the total monthly lease
payment for this facility has been allocated to the acquisition of this
furniture and recorded as a capital lease.
 
 The
following table summarizes operating and capital lease obligations as of
December 31, 2009:
  59
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 Operating
                            
                            
                            CapitalYears
      ending December 31,2010
                            
                            $
                            236,535
                            
                            
                            $
                            31,1122011
                            
                            
                            113,164
                            
                            
                            
                            31,1122012
                            
                            
                            110,721
                            
                            
                            
                            31,1122013
                            
                            
                            35,394
                            
                            
                            
                            10,3702014
                            
                            
                            —
                            
                            
                            
                            —Total
      minimum lease payments
                            
                            $
                            495,814
                            
                            
                            $
                            103,706Amount
      representing interest
                            
                            
                            
                            
                            
                            
                            (26,102
                            )Present
      value of leasePayments
                            
                            
                            
                            
                            
                            $
                            77,604Less:
      current portion
                            
                            
                            
                            
                            
                            
                            (19,330
                            )Long
      term capital lease
                            
                            
                            
                            
                            
                            $
                            58,274
 
 Contingent
Tax Liability
 
 In the
process of preparing the Company’s federal tax returns for prior years, the
Company’s management found there had been errors in reporting income to the
recipients and the respective taxing authorities, related to stock grants made
to those certain employees and consultant recipients. In addition, the Company
determined that required tax withholding relating to these stock grants had not
been made, reported or remitted, as required in fiscal years 2006 and 2007. Due
to the Company’s failure to properly report this income and withhold/remit
required amounts, the Company may be held liable for the amounts that should
have been withheld plus related penalties and interest. The Company has
estimated its contingent liability based on the estimated required federal and
state withholding amounts, the employee and employer portion of social security
taxes as well as the possible penalties and interest associated with the error.
Although the Company’s liability may ultimately be reduced if it can prove that
the taxes due on this income were paid on a timely basis by some or all of the
recipients, the estimated liability including estimated interest and penalties,
accrued by the Company is based on the assumption that it will be liable for the
entire amounts due to the uncertainty with respect to whether or not the
recipients made such payments.
 
 As the
Company determined that it is probable that it will be held liable for the
amounts owed, and as the amount could be reasonably estimated, an accrual for
the estimated liability, which is included in accrued liabilities as of December
31, 2009 and 2008, is $740,726 and $701,046, respectively.
 
 Legal
Proceedings
 
 On
October 15, 2001, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P.
filed a lawsuit against the Company, Sunshine Wireless, LLC, and four other
defendants affiliated with Winstar Communications, Inc.  This lawsuit
alleged that the Winstar defendants conspired to commit fraud and breached their
fiduciary duty to the plaintiffs in connection with the acquisition of the
plaintiff's radio production and distribution business.  The complaint
further alleged that the Company and Sunshine joined the alleged
conspiracy.  On February 25, 2003, the case against the Company and
Sunshine was dismissed.  However, on October 19, 2004, Jeffrey A. Leve
and Jeffrey Leve Family Partnership, L.P. exercised their right to
appeal.  On June 1, 2005, the United States Court of Appeals for the
Second Circuit affirmed the February 25, 2003 judgment of the district court
dismissing the claims against the Company.
 
 On July
28, 2005, Jeffrey A. Leve and Jeffrey Leve Family Partnership, L.P. filed
another lawsuit against the Company, Sunshine and four other defendants
affiliated with Winstar.  That lawsuit attempted to collect a federal
default judgment of $5 million entered against two entities, Winstar Radio
Networks, LLC and Winstar Global Media, Inc., by attempting to enforce the
judgment against the Company and others under the doctrine of de factomerger.  The action was tried before a Los Angeles County
Superior Court judge, without a jury, in 2008.  On August 5, 2009, the
Superior Court issued a statement of decision in the Company’s favor, and on
October 8, 2009, the Superior Court entered judgment in the Company’s favor, and
judged plaintiffs’ responsible for $2,708.70 of the Company’scourt
costs.  On November 6, 2009, the plaintiffs filed a notice of appeal
in the Superior Court of the State of California, County of Los Angeles Central
District.  The Company has engaged appellate counsel, believes the
plaintiff’s case to be without merit and intends to continue to defend the case
vigorously.
  60
  Patient
Safety Technologies, Inc.
 Notes
to Consolidated Financial Statements
 
 20.
SIGNFICANT FOURTH QUARTER ADJUSTMENTS
 
 During
the fourth quarter of fiscal 2009, the Company recorded the following unusual or
infrequently occurring items or adjustments that were deemed to be material to
the fourth quarter results:
 
 ·
              An
      expense of $2,407,813 relating to the issuance of warrants in connection
      with the Cardinal Health Supply and Distribution Agreement (See Note
      13).
 ·
              A
      loss on extinguishment of liabilities of $491,134 in connection with the
      payment of the principal and accrued interest amounts owed on the Senior
      Notes (See Note 9).
 ·
              An
      impairment loss of $153,904 on the write-off of notes receivables that
      were deemed to be uncollectible.
 ·
              An
      adjustment of $136,435 to record additional stock based compensation
      expense.
 
 During
the fourth quarter of fiscal 2008, the Company recorded the following unusual or
infrequently occurring items or adjustments that were deemed to be material to
the fourth quarter results:
 ·
              An
      accrual of $253,666 relating to salaries owed to former members of
      management pursuant to their respective employee
    agreements.
 
 21.
SUBSEQUENT EVENTS
 
 On
January 26, 2010, the Board of Directors, in accordance with the Company’s
Bylaws, increased the size of the Board of Directors from seven members to nine
members and appointed Eugene A. Bauer, MD and William M. Hitchcock as members of
the Board of Directors to fill such vacancies.  Both Dr. Bauer and Mr.
Hitchcock will serve until at the next annual meeting of the Company’s
stockholders, or until their successors have been duly elected and qualified or
until their earlier death, resignation or removal, in accordance with the
Company’s Bylaws.  At the same meeting, the Company’s Board of
Directors designated Mr. Howard E. Chase, a current Director, as
Chairman.
  61
  ITEM
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
 
 None.
 
 ITEM
9A(T). CONTROLS AND PROCEDURES
 
 Limitations
on the Effectiveness of Controls
 
 We seek
to improve and strengthen our control processes to ensure that all of our
controls and procedures are adequate and effective. We believe that a control
system, no matter how well designed and operated, can only provide reasonable,
not absolute, assurance that the objectives of the control system are met. In
reaching a reasonable level of assurance, management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. In addition, the design of any system of controls also
is based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time, a control may
become inadequate because of changes in conditions, or the degree of compliance
with policies or procedures may deteriorate. No evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company will be detected.
 
 Evaluation
of Disclosure Controls and Procedures
  As of the
end of the period covered by this report, we conducted an evaluation, under the
supervision and with the participation of our Chief Executive Officer and Chief
Financial Officer of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule
15d-15(e) of the Exchange Act.  In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives and management
necessarily is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based upon that evaluation,
our chief executive officer and chief financial officer concluded that, as of
the end of the period covered by this report, our disclosure controls and
procedures were not effective at the reasonable assurance level discussed above
because of the existence of the material weaknesses in our internal control over
financial reporting described below.
 
 Notwithstanding
the conclusion that our disclosure controls and procedures were not effective as
of the end of the period covered by this report, the Chief Executive Officer and
the Chief Financial Officer believe that the consolidated financial statements
and other information contained in this annual report present fairly, in all
material respects, our business, financial condition and results of
operations.
 
 Material
Weaknesses in Internal Control Over Financial Reporting
 
 In
connection with our assessment of internal controls over financial reporting as
of December 31, 2009, we identified the following material weaknesses in our
internal control over financial reporting due to:
 
 ·
              Ineffective
      control environment due to the following identified
      weaknesses:
 o
              Failure
      to retain individuals competent in the application of generally accepted
      accounting principles (“GAAP”) to complex accounting
      transactions.
 o
              Failure
      to establish sufficiently detailed accounting policies and procedures and
      to properly train accounting department
staff.
 ·
              Ineffective
      internal control policies and procedures relating to the period end close
      process including lack of controls relating to journal entries, post
      closing adjustments and management review of conclusions regarding
      accounting and financial reporting
matters.
 ·
              Ineffective
      internal control policies and procedures designed to provide reasonable
      assurance regarding the accuracy and integrity of spreadsheets used in the
      financial reporting system.
  62
  To remedy
these material weaknesses, we have implemented policies and procedures to
formalize our period end close process as well as to address the application of
our accounting policies to ensure conformity with GAAP.  We are also
seeking to hire qualified personnel, or engage outside resources, as applicable,
with appropriate knowledge/experience in the application of GAAP to complex
accounting transactions and we are strengthening internal policies and
procedures designed to ensure the accuracy and integrity of spreadsheets used in
the financial reporting system.
 
 Management’s
Report on Internal Control Over Financial Reporting
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f)
under the Exchange Act. Our internal control system was designed to provide
reasonable assurance to our management and board of directors regarding the
preparation and fair presentation of published financial statements. All
internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.
 
 Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we conducted an evaluation of the
effectiveness of our internal control over financial reporting based on the
framework in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). Based on our
evaluation under the framework in Internal Control—Integrated Framework, our
management concluded that our internal control over financial reporting was not
effective as of December 31, 2009 because of the existence of material
weaknesses in our internal control over financial reporting described
above.
 
 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.
 
 Changes
in Internal Control over Financial Reporting
  There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act)
during the most recent fiscal quarter that have materially affected or are
reasonably likely to materially affect our internal control over financial
reporting.
 
 ITEM
9B. OTHER INFORMATION
 
 None.
 
 PART
III
 
 ITEM
10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
  Information
required by Item 10 of Part III of this annual report on Form 10-K will be
included in our Proxy Statement relating to our 2010 Annual Meeting of
Stockholders, our “2010 Proxy Statement,” under captions relating to our
director nominees, our directors, our executive officers, compliance with
Section 16(a) reporting requirements, board meetings and committees and
corporate governance matters, and such information is incorporated in this
section by reference. The information under the heading “Employees—Executive
Officers of the Registrant” in Item 1 of this annual report on Form 10-K is
also incorporated in this section by reference. The information regarding our
Code of Business Conduct and Ethics, including information regarding amendments
and waivers thereunder, included in Item 1 of this annual report on Form
10-K is also incorporated in this section by reference.
  63
  ITEM
11. EXECUTIVE COMPENSATION
 
 The
information appearing under the headings “Director Compensation” and “Executive
Compensation” in our 2010 Proxy Statement is incorporated in this section by
reference.
 
 ITEM
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
  The
information appearing under the heading “Beneficial Ownership of Our Common
Stock and Preferred Stock” in our 2010 Proxy Statement is incorporated in this
section by reference.
  The
information appearing under the heading “Equity Compensation Plan Information”
in our 2010 Proxy Statement is incorporated in this section by
reference.
 
 ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
 
 The
information appearing under the headings “Certain Relationships and Related
Party Transactions,” “Independence of the Board of Directors” and “Board
Meetings and Committees” in our 2010 Proxy Statement is incorporated in this
section by reference.
 
 ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 The
information appearing under the headings “Auditor’s Fees” and “Policies and
Procedures Relating to Approval of Services by Auditor” in our 2010 Proxy
Statement is incorporated in this section by reference.
 
 PART
IV
 
 ITEM
15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
 Item
15(a)
 
 (1)  Financial
Statements:
 
 (i)    The
following financial statements are included in Item 8 of this annual report
on Form 10-K:
 
 Report of
Independent Registered Public Accounting Firm
 Consolidated
Balance Sheets at December 31, 2009 and 2008
 Consolidated
Statements of Operations for the years ended December 31, 2009 and
2008
 Consolidated
Statements of Stockholders’ Equity (Deficit) for the years
ended December
31, 2009 and 2008
 Consolidated
Statements of Cash Flows for the years ended December 31, 2009 and
2008
 Notes to
Consolidated Financial Statements
 
 (2)   Financial Statement
Schedules:
  Schedules
have been omitted because they are inapplicable, not required, or the
information is included elsewhere in the financial statements or notes
thereto.
 
 (3) 
 Exhibits
 
 The
exhibits listed on the accompanying Exhibit Index are incorporated in this
annual report on Form 10-K by this reference and filed as part of this report.
Each management contract or compensatory plan or arrangement required to be
filed as an exhibit to this annual report on Form 10-K is indicated by a “**” on
the accompanying Exhibit Index. See “Exhibit Index” for important information
regarding our exhibits.
 
 (b)    See Item
15(a)(3) above.
 (c)    See
Item 15(a)1 and 15(a)2 above
  64
  SIGNATURES
 
 Pursuant
to the requirements of 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.
 
 PATIENT
      SAFETY TECHNOLOGIES, INC.By:
                /s/ Steven H. KaneName:
                Steven
      H. KaneTitle:
                President
      and Chief Executive Officer
  POWER
OF ATTORNEY
  KNOWN ALL
PERSONS BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Steven H. Kane and Marc L. Rose, each of whom may act
without joinder of the other, as their true and lawful attorneys-in-fact and
agents, each with full power of substitution and resubstitution, for such person
and in his or her name, place and stead, in any and all capacities, to sign any
and all amendments to the annual report on Form 10-K, and to file the same, with
all exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorneys-in-fact and agents, or their substitutes, may
lawfully do or cause to be done by virtue hereof.
  Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
 
 Signature
                
                Title
                
                Date/s/
      Steven H. Kane
                
                Director,
      President and Chief Executive Officer
                  (Principal
      Executive Officer)
                
                March
      31, 2010Steven
      H. Kane/s/
      Marc L. Rose
                
                Chief
      Financial Officer (Principal Financial Officer and
                
                March
      31, 2010Marc
      L. Rose
                
                Principal
      Accounting Officer), Treasurer and Secretary/s/
      Howard E. Chase
                
                Chairman
      of the BoardHoward
      E. Chase
                
                
                
                March
      31, 2010/s/
      Eugene A. Bauer
                
                DirectorEugene
      A. Bauer, M.D.
                
                
                
                March
      31, 2010/s/
      John P. Francis
                
                DirectorJohn
      P. Francis
                
                
                
                March
      31, 2010/s/
      Louis Glazer
                
                DirectorLouis
      Glazer, M.D., Ph.G.
                
                
                
                March
      31, 2010/s/
      William M. Hitchcock
                
                DirectorWilliam
      Hitchcock
                
                
                
                March
      31, 2010/s/
      Herbert Langsam
                
                DirectorHerbert
      Langsam
                
                
                
                March
      31, 2010/s/
      Wenchen Lin
                
                DirectorWenchen
      Lin
                
                
                
                March
      31, 2010/s/
      Loren L. McFarland
                
                DirectorLoren
      L. McFarland
                
                
                
                March
      31, 2010
  65
  EXHIBIT
INDEX
  Agreements
included as exhibits to this annual report on Form 10-K are included to provide
information regarding their terms and are not intended to provide any other
factual or disclosure information about our company (including its consolidated
subsidiary) or the other parties to the agreements. Where an agreement contains
representations and warranties by any party, those representations and
warranties have been made solely for the benefit of the other parties to the
agreement or express third-party beneficiaries as explicitly set forth in the
agreement. Any such representations and warranties:
  ·
              should
      not be treated as categorical statements of fact, but rather as an
      allocation of risk;
  ·
              may
      have been qualified by disclosures that were made to the other party in
      connection with the negotiation of the applicable agreement, which
      disclosures are not necessarily reflected in the
  agreement;
  ·
              may
      apply standards of materiality in a way that is different from what may be
      viewed as material to you or other investors;
  and
  ·
              were
      made only as of the date of the applicable agreement or such other date or
      dates as may be specified in the agreement and may be subject to more
      recent developments.
  Accordingly,
any such representations and warranties may not describe the actual state of
affairs as of the date they were made or at any other time.
 
 Exhibit
                                          Number
                                        
                                        Description2.1
                                        
                                        Agreement
      and Plan of Merger and Reorganization, dated as of February 3, 2005, by
      and among Franklin Capital Corporation (n/k/a Patient Safety Technologies,
      Inc.), SurgiCount Acquisition Corp., SurgiCount Medical, Inc., Brian
      Stewart and Dr. William Stewart (incorporated by reference to
      our current report on Form 8-K filed with the SEC on February 9,
      2005)3.1
                                        
                                        Amended
      and Restated Certificate of Incorporation (incorporated by reference to
      Appendix A to the our definitive proxy statement on Schedule 14A filed
      with the SEC on July 13, 2009)3.2
                                        
                                        By-laws
      (incorporated by
      reference to the company’s Form N-2 filed with the SEC on July 31,
      1992)4.1
                                        
                                        Certificate
      of Designation of Series A Convertible Preferred Stock (included in Exhibit 3.1
      hereto)10.1***
                                        
                                        Supply
      and Distribution Agreement dated effective November 19, 2009, by and
      between Patient Safety Technologies, Inc. and Cardinal Health 200, LLC
      (incorporated by
      reference to our current report on Form 8-K filed with the SEC on November
      24, 2009)10.2
                                        
                                        Warrant
      Purchase Agreement dated effective as of November 19, 2009 by and between
      Patient Safety Technologies, Inc. and Cardinal Health, Inc. (incorporated by reference to
      our current report on Form 8-K filed with the SEC on November 24,
      2009)10.3
                                        
                                        Registration
      Rights Agreement dated effective as of November 19, 2009, by and between
      Patient Safety Technologies, Inc. and Cardinal Health, Inc. (incorporated by reference to
      our current report on Form 8-K filed with the SEC on November 24,
      2009)10.4
                                        
                                        Warrant
      dated November 19, 2009 issued to Cardinal Health, Inc. to purchase up to
      1,250,000 shares of our common stock at $2.00 per share, expiring November
      19, 2014 (incorporated
      by reference to our current report on Form 8-K filed with the SEC on
      November 24, 2009)10.5
                                        
                                        Warrant
      dated November 19, 2009 issued to Cardinal Health, Inc. to purchase up to
      625,000 shares of our common stock at $4.00 per share, expiring November
      19, 2014 (incorporated
      by reference to our current report on Form 8-K filed with the SEC on
      November 24, 2009)10.6*
                                        
                                        Amended
      and Restated Exclusive License and Supply Agreement dated May 15, 2008, by
      and among SurgiCount Medical, Inc. and A Plus International,
      Inc.10.7
                                        
                                        Subscription
      Agreement dated January 26, 2007 between Patient Safety Technologies, Inc.
      and A Plus International, Inc. (incorporated by reference to
      our current report on Form 8-K filed with the SEC on February 2,
      2007)
  66
  Exhibit
                                                          Number
                                                        
                                                        Description10.8
                                                        
                                                        Form
      of Exchange Agreement dated July 29, 2009 between Patient Safety
      Technologies, Inc. and certain investors (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 3,
      2009)10.9
                                                        
                                                        Form
      of Purchase Agreement dated July 29, 2009 between Patient Safety
      Technologies, Inc. and certain investors (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 3,
      2009)10.10
                                                        
                                                        Form
      of Senior Secured Note and Warrant Purchase Agreement dated January 29,
      2009 (incorporated by
      reference to our current report on Form 8-K filed with the SEC on February
      3, 2009)10.11
                                                        
                                                        Form
      of Security Agreement dated January 29, 2009 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on February 3,
      2009)10.12
                                                        
                                                        Form
      of Senior Secured Note dated January 29, 2009 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on February 3,
      2009)10.13
                                                        
                                                        Form
      of Warrant dated January 29, 2009 to purchase shares of our common stock
      at $1.00 per share, expiring January 29, 2014 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on February 3,
      2009)10.14
                                                        
                                                        Form
      of Securities Purchase Agreement dated August 1, 2008 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 14,
      2008)10.15
                                                        
                                                        Registration
      Rights Agreement dated August 1, 2008 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 14,
      2008)10.16
                                                        
                                                        Form
      of Warrant dated August 1, 2008 to purchase shares of our common stock at
      $1.40 per share, expiring August 1, 2013 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 14,
      2008)10.17
                                                        
                                                        Form
      of Securities Purchase Agreement dated May 20, 2008 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 2,
      2008)10.18
                                                        
                                                        Registration
      Rights Agreement dated May 20, 2008 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 2,
      2008)10.19
                                                        
                                                        Form
      of Warrant dated May 27, 2008 to purchase shares of our common stock at
      $1.40 per share, expiring May 27, 2013 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 2,
      2008)10.20
                                                        
                                                        Securities
      Purchase Agreement dated as of October 17, 2007 between Patient Safety
      Technologies and Francis Capital Management, LLC (incorporated by reference to
      our current report on Form 8-K filed with the SEC on October 22,
      2007)10.21
                                                        
                                                        Registration
      Rights Agreement dated as of October 17, 2007 between Patient Safety
      Technologies and Francis Capital Management, LLC (incorporated by reference to
      our current report on Form 8-K filed with the SEC on October 22,
      2007)10.22
                                                        
                                                        Secured
      Convertible Promissory Note issued August 10, 2007 with an effective date
      of June 1, 2007 to Ault Glazer Capital Partners, LLC in the amount of
      $2,530,558.40 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 16,
      2007)10.23
                                                        
                                                        Amendment
      and Early Conversion of Secured Promissory Note dated as of September 5,
      2008 between Ault Glazer Capital Partners, LLC (incorporated by reference to
      our annual report on Form 10-K filed with the SEC on April 16,
      2009)10.24
                                                        
                                                        Security
      Agreement dated August 10, 2007 in favor of Ault Glazer Capital Partners,
      LLC (incorporated by
      reference to our current report on Form 8-K filed with the SEC on August
      16, 2007)10.25
                                                        
                                                        Guaranty
      of Payment by SurgiCount Medical, Inc. in favor of Ault Glazer Capital
      Partners, Inc. in connection with the $2,530,558.40 Promissory Note issued
      August 10, 2007 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on August 16,
      2007)
  67
 
 Exhibit
                                                        Number
                                                      
                                                      Description10.26
                                                      
                                                      Form
      of Subscription Agreement entered into between March 7, 2007 to April 5,
      2007 (incorporated by
      reference to our annual report on Form 10-K  filed with the SEC
      on May 16, 2007)10.28
                                                      
                                                      Subscription
      Agreement dated January 29, 2007 between Patient Safety Technologies, Inc.
      and David Wilstein and Susan Wilstein, as Trustees of the Century Trust
      (incorporated by
      reference to our current report on Form 8-K filed with the SEC on February
      2, 2007)10.29
                                                      
                                                      Form
      of Warrant dated January 29, 2007 issued to Century Trust to purchase
      12,000 shares of our common stock at $2.00 per share, expiring January 29,
      2012 (incorporated by
      reference to Exhibit C to Exhibit 10.4 to our current report on Form 8-K
      filed with the SEC on February 2, 2007)10.30
                                                      
                                                      Form
      of Warrant dated September 8, 2006 issued to Steven J. Caspi to purchase
      up to $312,500 of shares of our common stock (consisting of 250,000 shares
      of our common stock at $1.25 per share, or a combination of shares of our
      common stock and shares of common stock of our subsidiary, SurgiCount
      Medical, Inc.), expiring September 8, 2011 (incorporated by reference to
      our amended current report on Form 8-K/A filed with the SEC on March 1,
      2007)10.31
                                                      
                                                      Form
      of SurgiCount Medical, Inc. Warrant dated September 8, 2006 issued to
      Steven J. Caspi to purchase up to $312,500 in shares of common stock of
      SurgiCount Medical, Inc. (or 250,000 shares of our common stock at $1.25
      per share), expiring September 8, 2011 (incorporated by reference to
      our amended current report on Form 8-K/A filed with the SEC on March 1,
      2007)10.32
                                                      
                                                      Form
      of Warrant dated November 3, 2006 issued to Charles J. Kalina III to
      purchase 100,000 shares of our common stock at $1.25 per share, expiring
      November 3, 2011(incorporated by reference to
      our annual report on Form 10-K filed with the SEC on May 16,
      2007)10.33
                                                      
                                                      Form
      of Warrant dated July 12, 2006 issued to Charles J. Kalina III to purchase
      85,000 shares of our common stock at $2.69 per share, expiring July 11,
      2011 (incorporated by
      reference to our current report on Form 8-K filed with the SEC on July 14,
      2006)10.34
                                                      
                                                      Warrant
      dated June 6, 2006 issued to Alan E. Morelli to purchase 401,460 shares of
      our common stock at $3.04 per share, expiring June 6, 2011 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on June 9,
      2006)10.35
                                                      
                                                      Form
      of non-callable Warrant dated April 22, 2005 issued to James Colen to
      purchase 10,000 shares of our common stock at $6.05 per share, expiring
      April 22, 2010 (incorporated by reference to
      our current report on Form 8-K filed with the SEC on April 26,
      2005)10.36
                                                      
                                                      Form
      of callable Warrant dated April 22, 2005 issued to James Colen to purchase
      10,000 shares of our common stock at $6.05 per share, expiring April 22,
      2010 (incorporated by
      reference to the company’s current report on Form 8-K filed with the SEC
      on April 26, 2005)10.37*
                                                      
                                                      Lease
      for 43460 Ridge Park Drive, Temecula, California10.38
                                                      
                                                      Sublease
      for 5 Caufield Place, Suite 102, Newtown, Pennsylvania (incorporated by reference to
      the company’s current report on Form 8-K filed with the SEC on January 7,
      2010)10.39**
                                                      
                                                      2005
      Stock Option Plan (incorporated by reference to
      Appendix A to our definitive proxy statement on Schedule 14A filed with
      the SEC on March 2, 2005)10.40**
                                                      
                                                      2009
      Stock Option Plan (incorporated by reference to
      Appendix B to our definitive proxy statement on Schedule 14A filed with
      the SEC on July 13, 2009)10.41**
                                                      
                                                      Form
      of Stock Option Agreement (incorporated by reference to
      our registration statement on Form S-8 filed with the SEC on February 16,
      2010)10.42**
                                                      
                                                      Employment
      Agreement dated May 7, 2009 between Patient Safety Technologies Inc. and
      Steven H. Kane (incorporated by reference to
      our quarterly report on Form 10-Q filed with the SEC on May 20,
      2009)
 
  68
 
 Exhibit
                                            Number
                                          
                                          Description10.43**
                                          
                                          Employment
      Agreement dated effective as of November 24, 2009 between Patient Safety
      Technologies Inc. and Marc L. Rose (incorporated by reference to
      our current report on Form 8-K filed with the SEC on December 1,
      2009)10.44**
                                          
                                          Employment
      Agreement dated January 5, 2009 between Patient Safety Technologies, Inc.
      and David I. Bruce (incorporated by reference to
      our annual report on Form 10-K filed with the SEC on April 16,
      2009)10.45**
                                          
                                          Separation
      Agreement and General Release dated May 6, 2009 between Patient Safety
      Technologies, Inc. and David Bruce (incorporated by reference to
      our quarterly report on Form 10-Q filed with the SEC on May 20,
      2009)10.46**
                                          
                                          Executive
      Services Agreement dated July 11, 2008 between Patient Safety
      Technologies, Inc. and Tatum, LLC for the services of Mary A. Lay (incorporated by reference to
      our annual report on Form 10-K filed with the SEC on April 16,
      2009)10.47**
                                          
                                          Employment
      Agreement dated January 5, 2009 between Patient Safety Technologies, Inc.
      and Brian Stewart (incorporated by reference to
      our amended annual report on Form 10-K/A filed with the SEC on July 13,
      2009)14.1
                                          
                                          Code
      of Business Conduct and Ethics (incorporated by reference to
      our amended annual report on Form 10-K/A filed with the SEC on July 13,
      2009)21.1*
                                          
                                          Subsidiary
      of the company*23.1*
                                          
                                          Consent
      of Squar, Milner, Peterson, Miranda & Williamson,
  LLP*31.1*
                                          
                                          Certification
      of Chief Executive Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*31.2*
                                          
                                          Certification
      of Chief Financial Officer required by Rule 13a-14(a) or Rule
      15d-14(a)*32.1*
                                          
                                          Certification
      of Chief Executive Officer and Chief Financial Officer required by Rule
      13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of
      the United States
Code*
 
 *
              Filed
      herewith.
 **
              Management
      or compensatory plan or
arrangement.
 ***
              Confidential
      treatment requested for certain confidential portions of this exhibit.
      These confidentialportions
      have been omitted from this exhibit and filed separately with the
      Commission.
  69