DEF 14A

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

SCHEDULE 14A

Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934 (Amendment No.     )

Filed by the Registrant   x

Filed by a Party other than the Registrant   o

Check the appropriate box:

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x   Definitive Proxy Statement

o   Definitive Additional Materials

o   Soliciting Material Pursuant to §240.14a-12

Derma Sciences, Inc.

(Name of Registrant as Specified In Its Charter)

 

(Name of Person(s) Filing Proxy Statement, if other than the Registrant)

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SEC 1913 (04-05) Persons who are to respond to the collection of information contained in this form are not required to respond unless the form displays a currently valid OMB control number.

[LOGO OMITTED]

DERMA SCIENCES, INC.

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

and

PROXY STATEMENT

214 Carnegie Center
Suite 100
Princeton, New Jersey 08540

May 11, 2006

DERMA SCIENCES, INC.
214 Carnegie Center, Suite 100
Princeton, NJ 08540
(609) 514-4744

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

May 11, 2006

To the Shareholders:

        NOTICE IS HEREBY GIVEN that the Annual Meeting of Shareholders of Derma Sciences, Inc., a Pennsylvania corporation (the “Company”), will be held on May 11, 2006, at 3:30 p.m., at the offices of the Company, 214 Carnegie Center, Suite 100, Princeton, New Jersey, for the following purposes:

1. To elect eight directors for the year following the annual meeting or until their successors are elected;

2. To consider and vote upon the proposal to amend the Company’s Stock Option Plan to increase the aggregate number of shares of Common Stock issuable under the Plan from 3,500,000 to 5,000,000 shares;

3. To consider and vote upon the proposal to adopt a Restricted Stock Plan and reserve 2,500,000 shares of Common Stock for issuance thereunder;

4. To consider and vote upon the proposal to amend the Company’s Articles of Incorporation to increase the number of authorized shares of Common Stock from 30,000,000 to 50,000,000;

5. To consider and vote upon ratification of the appointment of J.H. Cohn LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2006; and

6. To transact such other business as may properly come before the meeting and all adjournments thereof.

        Only shareholders of record at the close of business on April 4, 2006, the record date and time fixed by the Board of Directors, are entitled to notice of, and to vote at, the meeting.

        The Board of Directors unanimously recommends that shareholders vote “FOR” (i) the election as directors of the nominees named in the accompanying Proxy Statement, (ii) the proposal to increase the shares of Common Stock issuable under the Company’s Stock Option Plan to 5,000,000, (iii) the proposal to adopt a Restricted Stock Plan and reserve 2,500,000 shares for issuance thereunder, (iv) the proposal to amend the Company’s Articles of Incorporation to increase the number of authorized shares of Common Stock to 50,000,000, and (v) the ratification of the selection of J.H. Cohn LLP as the Company’s independent registered public accounting firm for the year ended December 31, 2006.

        You are cordially invited to attend the meeting. Whether or not you plan to attend personally, and regardless of the number of shares you own, it is important that your shares be represented. Accordingly, WE URGE YOU TO COMPLETE THE ENCLOSED PROXY CARD AND RETURN IT PROMPTLY IN THE ENVELOPE PROVIDED. If you attend the Annual Meeting and wish to vote in person, you may withdraw your proxy at that time.

By Order of the Board of Directors,

EDWARD J. QUILTY

Chairman of the Board

DERMA SCIENCES, INC.
214 Carnegie Center, Suite 100
Princeton, NJ 08540
(609) 514-4744

PROXY STATEMENT

        This statement is furnished by the Board of Directors of Derma Sciences, Inc. (the “Company”) in connection with the Board’s solicitation of proxies for use at its Annual Meeting of Shareholders (the “Meeting”) to be held at 3:30 p.m. on Thursday, May 11, 2006, at the offices of the Company, 214 Carnegie Center, Suite 100, Princeton, New Jersey, 08540, and at any adjournments thereof. The purpose of the Meeting and the matters to be acted upon are set forth in the accompanying Notice of Annual Meeting of Shareholders.

        If the accompanying form of Proxy is executed properly and returned, shares represented by it will be voted at the Meeting in accordance with the instructions on the Proxy. However, if no instructions are specified, shares will be voted for the election as directors of those nominees named in the Proxy, for amendment of the Company’s Stock Option Plan to increase the shares of Common Stock issuable thereunder to 5,000,000, for adoption of the Restricted Stock Plan and reservation of 2,500,000 shares of Common stock for issuance thereunder, for amendment of the Company’s Articles of Incorporation to increase the authorized shares of Common Stock to 50,000,000 and for ratification of the selection of J.H. Cohn LLP as independent registered public accounting firm for the year ended December 31, 2006. The Board knows of no matters which are to be presented for consideration at the Meeting other than those specifically described in the Notice of Annual Meeting of Shareholders, but if other matters are properly presented, it is the intention of the persons designated as proxies to vote on them in accordance with their judgment.

        A Proxy may be revoked at any time prior to the time it is voted by written notice to the Secretary of the Company at the above address or by delivery of a proxy bearing a later date. Any shareholder may attend the Meeting and vote in person whether or not a Proxy was previously submitted.

        The close of business on April 4, 2006, has been fixed as the record date (the “Record Date”) for the determination of shareholders entitled to notice of, and to vote at, the Meeting. On the Record Date, the Company had 12,285,768 shares of Common Stock, 150,003 shares of Series A Convertible Preferred Stock, 440,003 shares of Series B Convertible Preferred Stock, 619,055 shares of Series C Convertible Preferred Stock and 1,071,346 shares of Series D Convertible Preferred Stock outstanding and entitled to vote. The foregoing shares of Common and Preferred Stock (collectively, “Shares”) are the only voting securities of the Company.

        The presence at the Meeting, in person or by proxy, of the holders of 7,283,088 Shares (a majority of the aggregate number of shares of Common Stock and Preferred Stock issued and outstanding and entitled to vote as of the Record Date) is necessary to constitute a quorum to transact business. Proxies marked “Abstain” and broker proxies that have not voted on a particular proposal (“Broker Non-Votes”), if any, will be counted in determining the presence of a quorum. Other than for election of directors (discussed below), each holder of Common Stock and Preferred Stock as of the Record Date is entitled to one vote per Share.

        Election of the director nominees named in Proposal No. 1 requires the affirmative vote of a plurality of the total number of votes cast for the election of directors at the Meeting by the holders of Common Stock and Preferred Stock, voting together as a single class. Votes may be cast in favor of or withheld with respect to all of the director nominees, or any of them. Abstentions and Broker Non-Votes, if any, will not be counted as having been voted and will have no effect on the election of directors except to the extent the failure to vote for a nominee results in another nominee receiving a larger number of votes. Shareholders may cumulate their votes in the election of directors.

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That is, shareholders may multiply the number of Shares owned and entitled to vote at the Meeting by the number of directors (8) to be elected and cast the resulting number of votes for any one or more candidates.

        Adoption of Proposals No. 2 through No. 5 requires the affirmative vote of a majority of the total number of shares of the Common Stock and Preferred Stock represented and entitled to vote at the Meeting, voting together as a single class. In determining whether Proposals No. 2 through No. 5 have received the requisite number of affirmative votes, abstentions will be counted and will have the same effect as votes against the proposals, and broker non-votes, if any, will have no effect on the votes for the proposals.

        The expense of solicitation will be borne by the Company. The solicitation of Proxies will be largely by mail, but may include telephonic, telegraphic or oral communications by officers or other representatives of the Company. The Company will also reimburse brokers or other persons holding shares in their names or in the names of their nominees for reasonable out-of-pocket expenses in connection with forwarding Proxies and proxy materials to the beneficial owners of such shares.

        It is expected that the Notice of Annual Meeting, Proxy Statement and form of Proxy will first be mailed to shareholders on or about April 8, 2006.

PROPOSAL 1 — ELECTION OF DIRECTORS

        A board of eight directors, constituting the entire Board of Directors specified by the bylaws of the Company, will be elected at the Meeting by the shareholders of the Company to hold office until their successors have been elected and qualify. It is intended that, unless authorization to do so is withheld, the proxies will be voted “FOR” the election of the director nominees named below. Each nominee has consented to be named in this Proxy Statement and to serve as a director if elected. However, if any nominee becomes unable to stand for election as a director at the Meeting, an event not now anticipated by the Board, the Proxy will be voted for a substitute designated by the Board.

        The nominees are listed below with brief statements of their principal occupation and other information:

Name of Nominee	Age	Director Since	Principal Occupation
Edward J. Quilty	55	March, 1996	Chairman of the Board, President and Chief Executive Officer of the Company
Srini Conjeevaram	47	May, 1998	Managing Director of SC Capital Management, LLC
Stephen T. Wills, CPA, MST	49	May, 2000	Executive Vice President - Operations and Chief Financial Officer of Palatin Technologies, Inc.
James T. O'Brien	67	May, 2001	Consultant to the pharmaceutical industry
C. Richard Stafford, Esq.	70	May, 2002	Consultant to the pharmaceutical industry
Richard J. Keim	70	May, 2002	Managing Director of Kensington Management Group, LLC
Robert G. Moussa	59	May 2005	President and Chief Executive Officer of Robert Moussa & Associates
Bruce F. Wesson	63	Nominee	President of Galen Associates

        All director nominees, with the exception of Edward J. Quilty, are “independent” as defined in Nasdaq Marketplace Rule 4200. The term of office of each person elected as director will continue until the Company’s next Annual Meeting of Shareholders or until his successor has been elected and qualifies.

Information Relative to Directors and Nominees

        Edward J. Quilty has served as Chief Executive Officer of the Company since November, 1996, Chairman of the Board since May, 1996 and as a director of the Company since March, 1996. Mr. Quilty was the Chairman of the Board of Palatin Technologies, Inc., a publicly traded biopharmaceutical company specializing in peptide drug design for diagnostic and therapeutic agents from November, 1995 until May, 2000. During the period

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

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

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

        James T. O’Brien has served as a director of the Company since May, 2001. He currently serves as a consultant to the pharmaceutical and healthcare industries. Most recently, he served as President of O’Brien Marketing & Communications. Previously, Mr. O’Brien served from 1989 to 1991 as President and Chief Operating Officer for Elan Corporation (NYSE: ELN), a multi-national medical products and pharmaceutical company. In 1986, Mr. O’Brien founded O’Brien Pharmaceuticals and served as its President and Chief Executive Officer until the acquisition of this company by Elan Corporation. During the period 1980 to 1986, Mr. O’Brien held several division presidencies with the Revlon Health Care Group. Prior to his association with Revlon, he served for seventeen years with Sandoz Pharmaceuticals, Inc., most recently as Vice President of U.S. Marketing and Sales. Mr. O’Brien serves on the board of directors of Pharmaquest, Inc. and serves as chairman of the board of directors of Benedictine College. He earned a Bachelor of Science in Business Administration from Benedictine College, Atchison, Kansas, in 1960 and attended the Harvard University Advanced Management Program in 1974.

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

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

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

        Bruce F. Wesson is a nominee for election to the Board of Directors of the Company. He presently serves as President of Galen Associates, a health care venture capital firm with which he has been associated since 1991. Prior to joining Galen, Mr. Wesson served for over twenty three years as Senior Vice President and Managing Director of the Corporate Finance Division of Smith Barney. During his tenure at Smith Barney, Mr. Wesson chaired Smith Barney’s Valuation and Opinion Committee in which capacity he maintained responsibility for the firm’s valuations and fairness opinions. Mr. Wesson serves as a director of Chemtura Corporation, QMED, Acura Pharmaceuticals, Inc., Encore Medical Corp. and several of Galen Associate’s portfolio companies. Mr. Wesson earned a Bachelor of Arts degree from Colgate University, Hamilton, New York, in 1964 and a Master of Business Administration degree from Columbia University, New York, New York, in 1967.

Compensation of Directors

        Upon election or appointment, outside directors receive options to purchase 20,000 shares of the Company’s Common Stock at a price per share equal to the fair market value of the Common Stock on the date of the option grant. These options vest at the rate of 5,000 on the date of grant and 5,000 per year thereafter. For each year of service, outside directors historically received options to purchase 70,000 shares of the Company’s Common Stock at a price per share equal to the fair market value of the Common Stock on the date of the option grant. These options vested at the rate of 55,000 on the date of grant and 5,000 per year thereafter. If shareholders approve adoption of the Company’s Restricted Stock Plan, the foregoing compensation formula will be modified as follows: (i) the annual grant to outside directors of options to purchase shares of the Company’s Common Stock will be reduced to 25,000, such options to vest at the rate of 10,000 on the date of grant and 5,000 per year thereafter, and (ii) outside directors will receive annually 25,000 shares of Restricted Stock. Details relative to the Restricted Stock Plan and Restricted Stock are set forth below under the heading Proposal 3 – Adoption of the Restricted Stock Plan.

        In addition, each outside director receives cash compensation at the rate of $12,000 per year, payable quarterly. All directors are reimbursed for expenses incurred in connection with each board and committee meeting attended. Inside directors receive no compensation for their services as directors.

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Board Committees

Audit Committee

        The Company maintains an Audit Committee that is currently composed of Stephen T. Wills, CPA, MST, Chairman, Srini Conjeevaram, Robert G. Moussa and Richard J. Keim. Messrs. Wills, Conjeevaram, Moussa and Keim are considered to be “independent” as defined in Nasdaq Marketplace Rule 4200. The Audit Committee reviews the results and scope of the audit and the financial recommendations provided by the Company’s independent registered public accounting firm. The Audit Committee operates under a written charter a copy of which is attached hereto as Appendix A. The Audit Committee held four meetings in 2005. Details relative to the Audit Committee’s financial expert, together with the Audit Committee Report, are set forth below under the heading Additional Information.

Compensation Committee

        The Company maintains a Compensation Committee that is currently composed of James T. O’Brien, Chairman, Stephen T. Wills, CPA, MST, Srini Conjeevaram, C. Richard Stafford, Esq., Robert G. Moussa and Richard J. Keim. Messrs. O’Brien, Wills, Conjeevaram, Stafford, Moussa and Keim are considered to be “independent” as defined in Nasdaq Marketplace Rule 4200. The Compensation Committee reviews the compensation of management and recommends to the Board of Directors the amounts and types of cash and equity incentives to be offered to management. The Compensation Committee operates under a written charter a copy of which is attached hereto as Appendix B. The Compensation Committee held four meetings in 2005. The Compensation Committee Report is set forth below under the heading Additional Information.

Nominating Committee

        The Company maintains a Nominating Committee that is currently composed of C. Richard Stafford, Esq., Chairman, Srini Conjeevaram, Stephen T. Wills, CPA, MST and Richard J. Keim. Messrs. Stafford, Conjeevaram, Wills and Keim are considered to be “independent” as defined in Nasdaq Marketplace Rule 4200. The Nominating Committee reviews the qualifications of prospective directors for consideration by the Board of Directors as management’s nominees for directors. The Nominating Committee does not operate under a written charter. The Nominating Committee held one meeting in 2005.

        The Company will consider nominations for directors submitted by shareholders. Shareholder nominations for election to the Board of Directors must be made by written notification received by the Company not later than sixty days prior to the next annual meeting of shareholders. Such notification shall contain, at a minimum, the following information:

1. The name and residential address of the proposed nominee and of each notifying shareholder;

2. The principal occupation of the proposed nominee;

3. A representation that the notifying shareholder intends to appear in person or by proxy at the meeting to nominate the person specified in the notice;

4. The total number of shares of the Company owned by the notifying shareholder;

5. A description of all arrangements or understandings between the notifying shareholder and the proposed nominee and any other person or persons pursuant to which the nomination is to be made by the notifying shareholder;

6. Any other information regarding the nominee that would be required to be included in a proxy statement filed with the SEC; and

7. The consent of the nominee to serve as director of the Company, if elected.

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        The Committee will return, without consideration, any notice of proposed nomination which does not contain the foregoing information.

        The Nominating Committee has not established specific criteria or minimum qualifications that must be met by committee-nominated or shareholder-nominated nominees for director. Regardless of the source of a given nominee’s nomination, the Nominating Committee evaluates each nominee based solely upon his/her educational attainments, relevant experience and professional stature. The Nominating Committee primarily seeks nominations for director from institutional security holders, members of the investment banking community and current directors.

        During 2005, there were eight meetings of the Board of Directors.

        The Board of Directors unanimously recommends that shareholders vote “FOR” the election as directors of the nominees listed above.

PROPOSAL 2 – AMENDMENT TO THE COMPANY’S STOCK OPTION PLAN

Summary of the Plan

General Purpose

        The Company’s Board of Directors believes that providing selected persons with an opportunity to invest in the Company will give such persons additional incentive to increase their efforts on behalf of the Company and will enable the Company and its subsidiaries to attract and retain the best available associates, officers, directors, consultants and advisors. The Company’s Board of Directors has approved an amendment to the Derma Sciences, Inc. Stock Option Plan (the “Plan”) to increase the number of shares of Common Stock reserved for issuance upon the exercise of options granted under the Plan from 3,500,000 shares to 5,000,000 shares.

        The Plan was adopted on July 18, 1991 and most recently amended and restated on March 31, 2006. The Plan is attached to this Proxy Statement as Appendix C.

Amendment

        The Board of Directors has approved the most recent amendment to the Plan to increase the number of shares available for issuance under the Plan from 3,500,000 to 5,000,000.

        As of December 31, 2005, the Company had issued 3,036,625 shares pursuant to the Plan, leaving 463,375 shares available for future issuance. The Board of Directors believes that an increase in shares available for issuance is necessary for the Company to have the ability to attract and retain the best available personnel.

        Approval of this amendment requires the affirmative vote of the holders of a majority of the shares of the Company’s common and preferred stock represented at the Annual Meeting.

Administration of the Plan

        The Plan is administered by a committee of disinterested directors designated by the Board of Directors (the “Compensation Committee”). Subject to the restrictions of the Plan, the Compensation Committee determines who is eligible to receive stock options, the nature, amount and timing of options granted under the Plan, the exercise price and vesting schedule of any options granted, and all other terms and conditions of the options to be granted.

        Both Nonqualified Options and Incentive Options may be issued under the Plan. An Incentive Option may not have an exercise price less than fair market value of the Common Stock on the date of grant or an exercise period that exceeds ten years from the date of grant and is subject to certain other limitations which allow the option holder to qualify for favorable tax treatment. None of these restrictions apply to the grant of Nonqualified Options which may have an exercise price less than the fair market value of the underlying common stock on the date of

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grant and may be exercisable for an indeterminate period of time. The Company has undertaken not to issue options with exercise prices less than fair market value on the date of grant.

Federal Income Tax Consequences of the Plan

        The Plan permits the granting of Incentive Stock Options as well as Nonqualified Stock Options. Generally, no income is recognized when either type of option is granted to the option holder, but the subsequent tax treatment differs widely.

Nonqualified Stock Options

        No income is recognized by an optionee for federal income tax purposes upon the grant of a nonqualified stock option. Upon exercise of a nonqualified stock option, the optionee recognizes ordinary income in an amount equal to the excess of the fair market value of the shares on the date of exercise over the option price of the shares. Income recognized by optionees who are employees of the Company upon the exercise of nonqualified stock options is considered compensation subject to withholding at the time the income is recognized, and therefore, the Company or one of its affiliates must make the necessary arrangements with the optionee to ensure that the amount of the tax required to be withheld is available for payment. The nonqualified stock options granted under the Plan are designed to provide the Company with a deduction, subject to certain limitations, equal to the amount of ordinary income recognized by the optionee at the time of recognition.

        The basis of shares transferred to an optionee pursuant to exercise of a nonqualified stock option is the price paid for the shares plus an amount equal to any income recognized by the optionee as a result of the exercise of the option. If an optionee thereafter sells shares acquired upon exercise of a nonqualified stock option, the difference between the amount realized and the basis of the shares constitutes capital gain or loss to the optionee for federal income tax purposes.

Incentive Stock Options

        No income is recognized by an optionee for federal income tax purposes upon the grant or the exercise of an incentive stock option. The basis of shares transferred to an optionee pursuant to the exercise of an incentive stock option is the price paid for the shares. If the optionee holds such shares for at least one year after transfer of the shares to the optionee and two years after the grant of the option, whichever is later, the optionee recognizes capital gain or loss upon sale of the shares received upon exercise of the option equal to the difference between the amount realized on such sale and the exercise price. Generally, if the shares are not held for that period, the optionee recognizes ordinary income upon disposition in an amount equal to the excess of the fair market value of the purchased shares on the date of exercise over the option price of the shares, or if less (and if the disposition is a transaction in which loss, if any, is recognized), the gain on disposition. Any additional gain realized by the optionee upon such disposition is a capital gain.

        The excess of the fair market value of shares on the date of the exercise of an incentive stock option over the option price for the shares is an item of adjustment for purposes of the alternative minimum tax.

        The Company is not entitled to a deduction upon the exercise of an incentive stock option by an optionee. If the optionee disposes of the shares of stock received pursuant to such exercise prior to the expiration of one year following transfer of the shares to the optionee or two years after grant of the option, however, the Company may, subject to certain limitations, deduct an amount equal to the ordinary income recognized by the optionee upon disposition of the shares at the time the income is recognized by the optionee.

        The Board of Directors unanimously recommends that shareholders vote “FOR” amendment of the Company’s Stock Option Plan to increase the number of shares of the Company’s Common Stock issuable under the Plan from 3,500,000 to 5,000,000.

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PROPOSAL 3 – ADOPTION OF THE RESTRICTED STOCK PLAN

Summary of the Plan

General Purpose

        The Company’s Board of Directors believes that providing outside directors, executive officers and selected consultants with an opportunity to benefit from appreciation in the Company’s Common Stock will give such persons additional incentive to increase their efforts on behalf of the Company and will enable the Company and its subsidiaries to attract and retain the best available executive officers, directors, consultants and advisors. The Company’s Board of Directors has approved adoption of the Derma Sciences, Inc. Restricted Stock Plan (the “Plan”) and the reservation of 2,500,000 shares of Common Stock for issuance under the Plan.

        The Plan was adopted on March 31, 2006 and is attached to this Proxy Statement as Appendix D.

Administration of the Plan

        The Plan is administered by a committee of disinterested directors designated by the Board of Directors (the “Compensation Committee”). Subject to the restrictions of the Plan, the Compensation Committee determines who is eligible to receive awards of Restricted Stock, the amount and timing of awards under the Plan, the vesting of awards and all other terms and conditions of the Restricted Stock awarded.

Operation of the Plan

        The Compensation Committee, subject to approval of the Board of Directors, is authorized to award shares of Restricted Stock to outside directors, executive officers and such consultants and professional advisors to the Company as the Compensation Committee may determine. Awards of Restricted Stock to each outside director may not exceed 25,000 shares annually and shall vest upon the earlier of three years from the date of grant or upon a change of control of the Company.

        Awards to the President and Chief Executive Officer and other Executive Officers of the Company are dependant upon the Company’s Common Stock attaining, and maintaining for forty consecutive trading days, prices of at least $1.00, $2.00 and $3.00. Upon the Company’s Common Stock attaining each of the foregoing prices, the President and Chief Executive Officer may be awarded up to 100,000, 200,000 and 300,000 shares, respectively, of Restricted Stock and each other Executive Officer may be awarded up to 50,000, 100,000 and 150,000 shares, respectively, of Restricted Stock. The Restricted Stock Agreements relative to the foregoing awards may provide that such awards will vest, if at all, upon a change of control in the Company.

        The Committee may grant selected consultants and advisors during a given calendar year up to 20,000 shares each of Restricted Stock which awards shall vest, if at all, upon a change of control in the Company effected not later than December 31, 2015.

Federal Income Tax Consequences of the Plan

        Internal Revenue Code Section 83 generally provides that property, such as shares of the Restricted Stock, transferred in connection with the performance of services will not be currently taxable if such property is imbued with a “substantial risk of forfeiture”. The above described vesting provisions to which awards of Restricted Stock are subject constitute substantial risks of forfeiture and serve both to delay taxability of the award to the recipient, as well as deductibility of the corresponding compensation expense by the Company, until the shares of Restricted Stock vest, i.e. the substantial risks of forfeiture lapse and the right to receive the Restricted Stock becomes nonforfeitable.

        The Board of Directors unanimously recommends that shareholders vote “FOR” adoption of the Company’s Restricted Stock Plan and the reservation of 2,500,000 shares of the Company’s Common Stock for issuance under the Plan.

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PROPOSAL 4 - AMENDMENT TO ARTICLES OF INCORPORATION TO INCREASE THE NUMBER OF SHARES OF AUTHORIZED COMMON STOCK

        Under the Company’s Amended and Restated Articles of Incorporation, the Company is authorized to issue up to 30,000,000 shares of Common Stock, par value $.01 per share. The Company’s Board of Directors has approved an amendment to the Articles of Incorporation that increases the maximum number of authorized shares of the Company’s Common Stock by 20,000,000 shares to a total of 50,000,000 shares (“Common Stock Amendment”) and has recommended that the Company’s shareholders approve the Common Stock Amendment. If the Company’s shareholders do not approve the Common Stock Amendment, then the number of authorized shares of the Company’s Common Stock will remain at 30,000,000.

        The purpose of the proposed Common Stock Amendment is to provide sufficient shares for corporate purposes including the conversion of Class A, Class B, Class C and Class D Preferred Stock and Class F and Class G Warrants into Common Stock, the exercise of stock options that have been granted to certain present and former officers, employees, directors and advisors of the Company, possible future grants of restricted stock, possible future acquisitions, stock splits or other corporate purposes. Once authorized, the additional shares of the Company’s Common Stock may be issued by the Company’s Board of Directors without further action by the Company’s shareholders, unless such action is required by law or applicable stock exchange requirements. If the Common Stock Amendment is not approved by the Company’s shareholders, the Company will examine other means to ensure that sufficient shares of Common Stock are available for the purposes enumerated above. These means could include the reverse split of the Company’s Common Stock or the redesignation of previously authorized Preferred Stock as Common Stock.

        The Board of Directors unanimously recommends that shareholders vote “FOR” approval of the Amendment of the Company’s Articles of Incorporation to increase the shares of authorized Common Stock to 50,000,000.

PROPOSAL 5 - RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Independent Registered Public Accounting Firm Fees

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

		2005		2004
Audit fees	$	196,775	$	188,645
Audit-related fees		-		16,985
Tax fees		14,540		26,265
Totals	$	211,315	$	231,895

Fee Analysis and Pre-Approval Policy

Audit Fees

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

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Audit Related Fees

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

Tax Fees

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

Audit Committee Pre-Approval Policy

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

Independent Registered Public Accounting Firm’s Presence at Annual Meeting

        Representatives of the firm of J.H. Cohn LLP are expected to be present at the Annual Meeting and will have an opportunity to make a statement if they so desire and will be available to respond to appropriate questions.

        The Board of Directors unanimously recommends that shareholders vote “FOR” the ratification of the selection of J.H. Cohn LLP as the Company’s independent registered public accounting firm for the year ended December 31, 2006.

EXECUTIVE OFFICERS

        The executive officers of the Company are:

Name	Age	Positions with the Company	Executive Officer of the Company Since
Edward J. Quilty	55	Chairman of the Board, President and Chief Executive Officer	May, 1996
John E. Yetter, CPA	53	Vice President and Chief Financial Officer	August, 2000
Robert C. Cole	53	Executive Vice President - Sales	January, 2003
Frederic Eigner	56	Executive Vice President of Operations and General Manager, Derma Sciences Canada Inc.	March, 2005
Barry J. Wolfenson	39	Vice President - Marketing and Business Development	March, 2006

        Messrs. Quilty, Yetter, Cole, Eigner and Wolfenson are members of the Company's operating review committee. Additional information relative to Edward J. Quilty is included in the preceding pages under "Election of Directors."

        John E. Yetter, CPA has served as Vice President and Chief Financial Officer of the Company since August, 2000. Prior to joining the Company, Mr. Yetter held a variety of senior financial positions with Bristol-Myers Squibb Company. Before his association with Bristol-Myers Squibb, he held several supervisory financial positions with Cooper Industries, Inc., Price Waterhouse and Hulse Manufacturing Company. Mr. Yetter is a member of the American Institute of Certified Public Accountants and the New York Society of Certified Public Accountants. He earned a Bachelor of Science in Accounting, magna cum laude, from Boston College School of Management, Boston, Massachusetts in 1975.

        Robert C. Cole recently assumed the office of Executive Vice President for Sales of the Company. Previously, he served as the Company's Vice President - Sales and Marketing since January, 2003. Prior to joining the Company, Mr. Cole held a variety of executive sales positions with B. Braun Medical and predecessor firms

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beginning in 1974, most recently as Vice President, Sales, Eastern Zone. Mr. Cole earned his Bachelor of Science degree in Biology, cum laude, from St. Vincent's College, Latrobe, Pennsylvania, in 1974.

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

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

        Executive officers are elected by, and serve at the discretion of, the Board of Directors.

EXECUTIVE COMPENSATION

Compensation of Executive Officers

Summary Compensation Table

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

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

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

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

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

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

_____________________________

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

Option Grants Table

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

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

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

_________________

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

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

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

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

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

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

Aggregate Year End Option Value Table

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

                                Number of Shares                $ Value of Unexercised
                             Underlying Unexercised              In-The-Money Options
                          Options at December 31, 2005         At December 31, 2005 (1)
                        -------------------------------     ------------------------------
   Name                          Exercisable                         Exercisable
   ----                          -----------                         -----------
   Edward J. Quilty                709,805                             $56,938
   John E. Yetter, CPA             361,250                             $28,013
   Robert C. Cole                  316,250                             $14,563
   Frederic Eigner                 221,875                              $6,094
   Barry Wolfenson                 120,000                              $2,500

_________________

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

Employment Arrangements

Edward J. Quilty

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

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John E. Yetter, CPA

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

Robert C. Cole

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

Frederic Eigner

        The Company employs Frederic Eigner, its Vice President and Executive Vice President – Operations and General Manager of Derma Sciences Canada Inc., pursuant to a one-year employment agreement, renewed effective March 1, 2006, providing for base compensation in the amount of $151,163 ($174,960 Canadian) per year and incentive compensation in the discretion of the Company’s board of directors. The agreement further provides for the payment of severance compensation in the amount of one-year’s base salary upon failure of the Company to renew the agreement for successive one-year terms or for termination of Mr. Eigner’s employment other than “for cause”. In addition, upon a change in control of the Company, Mr. Eigner may, within six-months of the change in control, tender his resignation and receive one-year’s severance compensation.

Barry J. Wolfenson

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

Stock Option Plan

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

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

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

EQUITY COMPENSATION PLAN INFORMATION

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

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

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

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

_________________

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

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

CODE OF ETHICS

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

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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

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			Percent
	Number of Shares		Beneficially
Name and Address of Beneficial Owner (1)	Beneficially Owned (17)		Owned (17)
Galen III Partnerships (2)		5,675,513		35.04%
Kensington Management Group, LLC (3)		1,475,500		11.72%
Voyager Partners (4)		1,428,572		11.63%
Edward J. Quilty (5)		1,145,489		8.78%
Hambrecht & Quist California (6)		624,167		5.08%
Norman H. Pessin (7)		1,003,000		7.91%
Bushido Capital Master Fund (8)		1,000,000		7.82%
William R. Grant (9)		900,000		7.21%
Endeavor Asset Management (10)		800,000		6.31%
Stephen T. Wills, CPA, MST (11)		531,668		4.19%
James T. O'Brien (12)		446,600		3.53%
C. Richard Stafford, Esq. (13)		370,000		2.93%
John E. Yetter, CPA (14)		401,250		3.17%
Robert C. Cole (15)		356,250		2.82%
Frederic Eigner (16)		221,875		1.77%
All directors and officers as a group (9 persons) (17)		10,624,145		73.95%

_________________

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

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

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

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

(5) Edward J. Quilty’s ownership consists of: 385,684 shares of Common Stock, 50,000 warrants to purchase Common Stock at $1.05 per share (“Class G Warrants”) and exercisable options to purchase 709,805 shares of Common Stock. No additional options to purchase Common Stock will become exercisable within 60 days of March 31, 2006.

(6) Hambrecht & Quist California can be reached at: One Bush Street, San Francisco, California 94104. Ownership consists of: 624,167 shares of Common Stock.

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

(8) Bushido Capital Master Fund can be reached at 275 Seventh Avenue, Suite 2000, New York, New York 10001. Ownership consists of 500,000 shares of Common Stock and 500,000 Class G Warrants.

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

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

(11) Stephen T. Wills’ ownership consists of: 119,668 shares of Common Stock and exercisable options to purchase 412,000 shares of Common Stock. No additional options to purchase Common Stock will become exercisable within 60 days of March 31, 2006.

(12) James T. O’Brien’s ownership consists of: 81,600 shares of Common Stock, 40,000 Class G Warrants and exercisable options to purchase 325,000 shares of Common Stock. No additional options to purchase Common Stock will become exercisable within 60 days of March 31, 2006.

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

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

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

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

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

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

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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

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

ADDITIONAL INFORMATION

Audit Committee Charter

        The Company’s Board of Directors has adopted a written charter for the Audit Committee. A copy of the Charter of the Audit Committee is attached to this Proxy Statement as Appendix A.

Audit Committee

Audit Committee Financial Expert

        Stephen T. Wills, CPA, MST has been determined by the Company’s Board of Directors to be its Audit Committee Financial Expert. In making this determination, the Board relied on Mr. Wills’ extensive education and experience in financial matters as set forth in his biographical sketch appearing elsewhere in this Proxy Statement. Among his qualifications, the Board considers that Mr. Wills possesses the following financial capabilities:

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1. An understanding of accounting principles generally accepted in the United States and financial statements;

2. The ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;

3. Experience preparing, auditing, analyzing and evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the Company’s financial statements, together with experience actively supervising persons engaged in the foregoing activities;

4. An understanding of internal controls and procedures for financial reporting; and

5. An understanding of audit committee functions.

Audit Committee Members

        The following individuals are members of the Audit Committee of the Company’s Board of Directors:

        Stephen T. Wills, CPA, MST, Chairman
        Srini Conjeevaram
        Richard J. Keim
        Robert G. Moussa

Audit Committee Report

        THE FOLLOWING REPORT OF THE AUDIT COMMITTEE SHALL NOT BE DEEMED TO BE SOLICITING MATERIAL OR TO BE FILED WITH THE SECURITIES AND EXCHANGE COMMISSION UNDER THE SECURITIES ACT OF 1933 OR THE SECURITIES EXCHANGE ACT OF 1934 OR INCORPORATED BY REFERENCE IN ANY DOCUMENT SO FILED.

        The Audit Committee met privately with both the independent registered public accounting firm and Company financial personnel, each of whom has unrestricted access to the Audit Committee. The Audit Committee met with management periodically during the year to consider the adequacy of the Company’s internal controls and the objectivity of its financial reporting. The Audit Committee discussed these matters with the Company’s independent registered public accounting firm and with appropriate Company financial personnel. The Audit Committee also discussed with the Company’s senior management and independent registered public accounting firm the process used for certifications by the Company’s chief executive officer and chief financial officer which are required by the Securities and Exchange Commission and the Sarbanes-Oxley Act of 2002 for certain of the Company’s filings with the Securities and Exchange Commission.

        Management has primary responsibility for the implementation of the system of internal controls, and for the preparation of the consolidated financial statements in accordance with accounting principles generally accepted in the United States. The Company’s independent registered public accounting firm audited the financial statements prepared by management, expressed an opinion as to whether those financial statements fairly present the financial position, results of operations and cash flows of the Company in conformity with accounting principles generally accepted in the United States and discussed with the Audit Committee any issues they believe should be raised with the Audit Committee.

        The Audit Committee reviewed with management and with the Company’s independent registered public accounting firm the Company’s financial statements and met separately with both management and the independent registered public accounting firm to discuss and review those financial statements and reports prior to their issuance. Management has represented to the Audit Committee, and the independent registered public accounting firm have

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confirmed, that the financial statements were prepared in accordance with accounting principles generally accepted in the United States.

        The Audit Committee obtained from and discussed with the independent registered public accounting firm a formal written statement describing all relationships between the auditors and the Company that might bear on the auditors’ independence under Independence Standards Board No. 1, “Independence Discussions with Audit Committees,” discussed with the auditors any relationships that may impact their objectivity and independence and satisfied itself as to the auditors’ independence. The Audit Committee implemented a procedure to monitor auditor independence and reviewed non-audit services performed by the independent registered public accounting firm.

        The Audit Committee discussed and reviewed with the independent registered public accounting firm all communications required by standards of the Public Company Accounting Oversight Board (United States), including those described in Statement on Auditing Standards No. 61, as amended, “Communication with Audit Committees” and, with and without management present, discussed and reviewed the results of the independent registered public accounting firm’s examination of the financial statements.

        Based on the above-mentioned reviews and discussions with management and the independent registered public accounting firm, the Audit Committee recommended to the Board that the Company’s audited consolidated financial statements be included in its Annual Report on Form 10-KSB for the year ended December 31, 2005. The Audit Committee also recommended the reappointment of J.H. Cohn LLP as the Company’s independent registered public accounting firm and the Board concurred in such recommendation.

For the Audit Committee:

Stephen T. Wills, CPA, MST, Chairman

Compensation Committee

        The following individuals are members of the Compensation Committee of the Company’s Board of Directors:

James T. O’Brien, Chairman

Srini Conjeevaram

Stephen T. Wills, CPA, MST

C. Richard Stafford, Esq.

Richard J. Keim

Robert G. Moussa

Compensation Committee Report

        The Compensation Committee is charged with the following responsibilities: (i) recommendations to the Board of Directors relative to the compensation of executive officers, (ii) administration of the 1994 stock option plan and recommendations to the Board relative to the grant of options to employees, directors and consultants of the Company, (iii) review of, and recommendations to the Board concerning, proposed employment agreements with executive officers, and (iv) evaluation of the performance of, and determination of compensation policies for, executive officers. With the exception of Edward J. Quilty, the members of the Compensation Committee are not employees of the Company.

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Executive Compensation Policy

        Competition for qualified senior management personnel in the Company’s industry is intense. In order to attract and retain qualified personnel, the Company must offer compensation which is comparable to similarly situated companies and which provides the potential for substantial rewards if the Company is successful over the long-term. The objectives of the Company’s executive compensation policy are to attract, retain and reward executive officers and other key employees who contribute to its success and to motivate these individuals to enhance stockholder value. The Company seeks to pay compensation at levels competitive with other medical device companies and provide significant equity-based incentives for executives and other key employees to respond to the Company’s challenges and opportunities.

Determining Executive Compensation

        The Compensation Committee meets several times per year in order to: (i) review the effectiveness of the Company’s executive compensation policy in advancing the Company’s objectives, (ii) make recommendations to the Board for any adjustments, and (iii) recommend annual compensation for the coming year. The Company’s Chief Executive Officer and the Chairman of the Audit Committee gather and report on information about compensation levels in comparable companies. The performance of each executive officer and the financial condition of the Company are reviewed in relation to the following major components of executive compensation:

        1.   Base salary. The employment agreement with each executive sets an initial base salary in accordance with industry norms and the subject executive’s experience and qualifications. The Compensation Committee annually reviews each executive officer’s base salary. Among the factors taken into consideration are: (i) individual and corporate performance, (ii) levels of responsibility, (iii) prior experience, (iv) breadth of knowledge of the industry, and (v) competitive pay practices. If salaries at comparable companies have increased, the Compensation Committee normally recommends similar increases. Provided, however, increases will be recommended only if the subject executive’s historical performance warrants an increase and if the increase is prudent in view of the Company’s financial condition.

        2.   Annual bonus. In addition to base salary, the Company seeks to reward executives each year for the achievement of specific goals which may be financial, operational or technological. In this regard, the Compensation Committee considers objectively measurable goals such as obtaining new investment capital, negotiating valuable contracts or meeting sales objectives, together with subjective goals such as quality of management performance and consistency of effort.

        3.   Equity incentives. Historically, the Company’s equity incentives have consisted exclusively of stock options awarded both pursuant to, and outside, the Company’s 1991 stock option plan (the “Plan”). Effective February 6, 2003, the Company undertook to issue options exclusively under the Plan. The exercise price of options granted under the Plan is at least 100% of the fair market value of the Common Stock on the date of grant. Recently, the Compensation Committee recommended to the Board of Directors that the Company incorporate grants of restricted stock in its equity incentive policy. The Board of Directors has acquiesced in this recommendation. The Compensation Committee determines the number and terms of recommended option and restricted stock grants based on practices at comparable companies in the medical device industry and the Company’s policy of linking equity incentives to performance.

For the Compensation Committee:

James T. O’Brien, Chairman

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OTHER BUSINESS

        Management of the Company knows of no other business which will be presented for consideration at the Meeting, but should any other matters be brought before the Meeting it is intended that the persons named in the accompanying proxy will vote at their discretion.

SHAREHOLDER PROPOSALS

        Any shareholder desiring to present a proposal to other shareholders at the next Annual Meeting must transmit such proposal to the Company so that it is received by the Company on or before January 15, 2007. All such proposals should be in compliance with applicable regulations of the Securities and Exchange Commission.

ANNUAL REPORT

        THE COMPANY WILL PROVIDE WITHOUT CHARGE TO EACH BENEFICIAL HOLDER OF COMMON STOCK ON THE RECORD DATE, UPON WRITTEN REQUEST OF ANY SUCH PERSON, A COPY OF THE COMPANY’S ANNUAL REPORT ON FORM 10-KSB FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. ANY SUCH REQUEST SHOULD BE MADE IN WRITING TO THE CORPORATE SECRETARY, DERMA SCIENCES, INC., 214 CARNEGIE CENTER, SUITE 100, PRINCETON, NEW JERSEY 08540.

	By Order of the Board of Directors,
	Edward J. Quilty
April 6, 2006	Chairman

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APPENDIX A

DERMA SCIENCES, INC.

AUDIT COMMITTEE

CHARTER

Organization

        There shall be a committee of the Board of Directors of the Corporation to be known as the Audit Committee. The Audit Committee shall be composed of not less than two (2) directors each of whom is independent of the Corporation and management of the Corporation and free of any relationship that may interfere with his/her free exercise of such independence.

Statement of Policy

        The Audit Committee shall assist the Board of Directors in fulfilling its responsibilities to the shareholders, potential shareholders, the investment community and others relative to the Corporation’s financial statements, the financial reporting process, the systems of internal accounting and financial controls, the internal audit function, the annual independent audit of the Corporation’s financial statements, and the legal compliance and ethics programs as established by management and the Board of Directors. In so doing, it is the responsibility of the Audit Committee to maintain free and open communication between the Committee, independent registered public accounting firm, the internal financial personnel and management of the Corporation. In discharging its oversight role, the Audit Committee shall have the authority to:

1. Investigate any matter discovered by it or brought to its attention;
 

2. Examine all books, records and facilities of the Corporation;
 

3. Interview any and all personnel of the Corporation; and
 

4. Retain outside counsel or other experts for the foregoing purposes.
 

Responsibilities and Processes

        The primary responsibility of the Audit Committee is to oversee the Corporation’s financial reporting processes on behalf of the Board of Directors and report the results of its activities to the Board. The Committee shall take appropriate actions to set the overall corporate “tone” for quality financial reporting, sound business

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practices and ethical behavior. The following shall be the principal processes of the Audit Committee which processes may be supplemented by the Committee, as appropriate:

        1. The Committee shall have the authority and responsibility to evaluate and, where appropriate, recommend replacement of the independent registered public accounting firm.

        2. The Committee shall discuss with the auditors their independence from management and the Corporation and the matters included in the written disclosures required by the Independence Standards Board.

        3. Annually, the Committee shall recommend to the Board of Directors the selection of the Corporation’s independent registered public accounting firm, subject to approval of the Corporation’s shareholders.

        4. The Committee shall discuss with the internal financial personnel and the independent registered public accounting firm the overall scope and plans for their respective procedures and audits.

        5. The Committee shall discuss with management, the internal financial personnel and the independent registered public accounting firm the adequacy and effectiveness of the Corporation’s accounting and financial controls, systems to monitor and manage business risk and legal and ethical compliance programs.

        6. The Committee shall meet separately with the internal financial personnel and the independent registered public accounting firm, with and without management present, to discuss the results of their examinations.

        7. The Committee shall review the interim financial statements with management and the independent registered public accounting firm prior to the filing of the Corporation’s Quarterly Reports on Form 10-QSB.

        8. The Committee shall discuss the results of the quarterly review and any other matters required to be communicated to the committee by the independent registered public accounting firm under standards of the Public Company Accounting Oversight Board (United States). The chairperson of the Committee may represent the entire Committee for the purposes of this review.

        9. The Committee shall review with management and the independent registered public accounting firm the financial statements to be included in the Corporation’s Annual Report on Form 10-KSB. (or the annual report to shareholders if distributed prior to the filing of Form 10-KSB). In this connection, the Audit Committee shall exercise its judgment about the quality of conformity to generally accepted accounting principles, the reasonableness of significant judgments and the clarity of the disclosures in the financial statements.

        10. The Committee shall review the results of the annual audit and any other matters required to be communicated to the committee by the independent registered public accounting firm under standards of the Public

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Company Accounting Oversight Board (United States) and shall report to management its recommendations, if any, occasioned thereby.

Procedure

        Meetings of the Audit Committee shall be called upon the request of any member thereof. Notice of such meeting shall be given to each member of the Audit Committee at least three (3) days before the meeting, either orally or in writing. Presence at a meeting of the Audit Committee shall constitute waiver of notice thereof.

        A majority of the members of the Audit Committee shall constitute a quorum for the purpose of taking any action upon any matter that may come before the Committee.

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APPENDIX B

DERMA SCIENCES, INC.

COMPENSATION COMMITTEE

CHARTER

Organization

        There is hereby established a committee of the Board of Directors of the Corporation to be known as the Compensation committee. The Compensation Committee shall be composed of at least three (3) directors who are independent of the management of the Corporation and are free of any relationship that, in the opinion of the Board of Directors, would interfere with their exercise of independent judgment as a Compensation Committee member.

Mandate

        The Compensation Committee shall recommend to the Board of Directors the form, amount and terms of compensation to be paid to the Chief Executive Officer and other executive officers of the Corporation and shall prepare, or cause to be prepared, such data and reports as may be required, from time to time, by the Corporation’s independent registered public accounting firm, the Securities and Exchange Commission, the Internal Revenue Service or other governmental or regulatory agencies.

Powers and Responsibilities

         The Compensation Committee shall:

1. Periodically, and no less often than annually, review the compensation of the Chief Executive Officer and other executive officers of the Corporation with a view to determining: (1) the reasonableness of such compensation and the methods of determination thereof, and (2) the comparability of such compensation to compensation paid by corporations of similar size, and engaged in similar activities, as the Corporation;
 

2. Recommend to the Board of Directors of the Corporation the amount, form and terms of compensation to be paid to the Chief Executive Officer and other executive officers of the Corporation;
 

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3. Administer the various deferred compensation plans, incentive plans and benefit programs of the Corporation to the extent that the Corporation assumes responsibility for the administration thereof;
 

4. Evaluate the job performance of the Chief Executive Officer and other executive officers of the Corporation;
 

5. Review, analyze and submit to the Board of Directors its recommendations relative to the addition to, and/or modification of, the Corporation’s current and deferred compensation programs; and
 

6. Investigate any matter within the scope of its authority and retain outside counsel or consultants for this purpose.

Procedure

        Meetings of the Compensation Committee shall be called upon the request of any member thereof. Notice of such meeting shall be given to each member of the Compensation Committee at least 48 hours before the meeting, either orally or in writing. Presence at a meeting of the Compensation Committee shall constitute waiver of notice thereof.

        A majority of the members of the Compensation Committee shall constitute a quorum for the purpose of taking any action upon any matter that may come before the Committee.

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APPENDIX C

DERMA SCIENCES, INC.

AMENDED AND RESTATED STOCK OPTION PLAN

        THIS DERMA SCIENCES, INC. STOCK OPTION PLAN, made, adopted and declared effective July 18, 1991 and amended and restated January 14, 1994, May 22, 1996, July 14, 1998, February 6, 2003, February 24, 2004 and March 31, 2006 by Derma Sciences, Inc. (herein referred to as the “Plan”).

        1.   Purpose. The Plan is intended to enable Derma Sciences, Inc. and its subsidiaries (the “Company”) to attract and retain capable officers, other employees, capable outside consultants, advisors and directors, to provide them with incentives to promote the best interests of the Company through the grant of incentive stock options and nonqualified stock options (collectively, “Options”).

        As used in the Plan, the term “incentive stock options” means options which are intended to qualify as incentive stock options within the meaning of §422 of the Internal Revenue Code of 1986, as amended, (the “Code”). The term “nonqualified stock options” means options which are not intended to qualify as incentive stock options.

        2.   Administration. The Plan shall be administered by the Compensation Committee of the Board of Directors of the Company whose members shall, inter alia, be “non-employee directors” as this term is utilized in Rule 16b-3(b)(3)(i) of the Securities Exchange Act of 1934.

        Subject to the terms of the Plan, the Committee shall have full and final authority in its absolute discretion to select the persons to whom Options shall be granted under the Plan and to set the date of grant and the other terms of such Options. The Committee also shall have the authority to establish and rescind, from time to time, such rules and regulations, not inconsistent with the provisions of this Plan, for the proper administration of this Plan and Options granted hereunder, and to make such determinations and interpretations under or in connection with this Plan as it deems necessary or advisable. The Committee may correct any defect, supply any omission and reconcile any inconsistency in this Plan or in any Option granted hereunder in the manner and to the extent it shall deem desirable. All such rules, regulations, determinations and interpretations shall be binding and conclusive upon the Company and its officers, employees, directors and outside consultants and advisors (including former officers, employees and directors) of the Company, and upon their respective legal representatives, beneficiaries, successors and assigns and upon all other persons claiming under or through any of them. No member of the Board of Directors of the Company (the “Board”) or of the Committee shall be liable for any action or determination made in good faith with respect to the Plan or any Option granted hereunder.

        3.   Eligibility. The persons eligible to receive options (“Eligible Individuals”) under the Plan shall be the directors (excluding members of the Committee), officers and other employees of the Company, outside consultants and advisors.

        4.   Stock Subject to the Plan. Subject to adjustment as provided in paragraph 7 hereof, 5,000,000 shares (the “Shares”) of $.01 par value common stock (the “Common Stock”) shall be available for the grant of Options under the Plan, which shares may be authorized but unissued Shares or reacquired Shares, as the Company shall determine.

        If any Option granted under the Plan expires or otherwise terminates, in whole or in part, without having been exercised, the Shares subject to the unexercised portion of such Option shall be available for the granting of Options under the Plan as fully as if such Shares had never been subject to an Option.

        5.   Grants, Terms and Conditions of Options. From time to time until the expiration or earlier termination of the Plan, the Committee may grant Options to Eligible Individuals (such grantees are hereinafter referred to as “Optionees”) under the Plan; provided, however, that grants of incentive and nonqualified stock options shall be separate and not in tandem. Options granted pursuant to the Plan shall be in such form as the Committee shall from time to time approve, and shall be subject to the following terms and conditions:

        (a)   Price. The option price per Share under each Option granted under the Plan shall be determined and fixed by the Committee in its discretion but shall not be less than (i) in the case of an Incentive Stock Option granted

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to a person who owns more than 10% of the combined voting power of all shares of stock of the Company or any subsidiary on the date of grant, the greater of $.01 or 110% of the fair market value of the Shares on the date of grant of such Option, and (ii) in all other cases the greater of $.01 or 100% of the fair market value of the Shares on the date of grant of such Option. The fair market value of a Share on any day shall mean that amount determined by such method of determining fair market value as shall be permitted by the Code, or the rules or regulations thereunder, and used by the Committee from time to time. For purposes of this paragraph 5 an individual shall be deemed to own any shares of stock of the Company which are attributed to such individual under § 424(d) of the Code.

        (b)   Term. Subject to earlier termination as provided in subparagraphs (c) through (f) below and in paragraph 8 hereof, the duration of each Option shall not be more than ten (10) years from the date of grant; provided that the duration of any Option granted to a person who owns more than 10% of the combined voting powers of all shares of stock of the Company on the date of grant of the Option shall not be more than five (5) years from the date of grant.

        (c)   Exercise and Payment. Except as otherwise provided in paragraph 8 hereof, options shall be exercisable in such installments and on such dates, as the Committee may specify; provided that the Committee may determine that Options will become immediately exercisable in whole or in part in the event of death, disability or termination of employment. Except as otherwise provided in subparagraphs (d) through (f) below, Optionees must be in the employ of the Company at the time of Option exercise. Any Shares which may be purchased upon exercise of an Option (“Option Shares”), the right to the purchase of which has accrued, may be purchased at any time up to the expiration or termination of the Option. Options may be exercised, in whole or in part, from time to time, by giving written notice of exercise to Derma Sciences, Inc. at its principal office, specifying the number of Shares to be purchased, and accompanied by payment in full of the aggregate purchase price for the Shares. Only full Shares shall be delivered and any fractional share which might otherwise be deliverable upon exercise of an Option granted hereunder shall be forfeited.

        The purchase price shall be payable: (i) in cash or its equivalent, or (ii) if the Committee, in its discretion, so provides in the stock option agreement or, in the case of nonqualified stock options, if the Committee, in its discretion, so determines at or prior to the time of exercise, in whole or in part through the transfer of Common Stock previously acquired by the Optionee, provided the Common Stock so transferred has been held for the applicable holding period set forth below:

        (i)   If such previously acquired shares of Common Stock were acquired through exercise of an incentive stock option and are being tendered as payment of the option price under an incentive stock option, such shares have been held by the Optionee for a period not less than the holding period described in § 422(a)(1) of the Code;

        (ii)   If such previously acquired shares of Common Stock were acquired through exercise of an incentive stock option or a nonqualified stock option and are being tendered as payment of the option price under a nonqualified stock option, such shares have been held by the Optionee for more than six months; or

        (iii)   If such previously acquired shares of Common Stock were acquired through exercise of a nonqualified stock option and are being tendered as payment of the option price under an incentive stock option, such Shares have been held by the Optionee for more than six months.

        In the event such purchase price is paid, in whole or in part, with shares of Common Stock, the portion of the purchase price so paid shall be equal to the fair market value, as determined by, or in the manner prescribed by, the Committee in accordance with subparagraph (a) above, on the date of exercise of the Option, of the shares of Common Stock so tendered in payment of such purchase price.

        (d)   Death of Optionee. If an Optionee’s employment is terminated by reason of his death prior to the expiration date of his Option, or if an Optionee whose employment is terminated (as described in subparagraphs (e) and (f) below) shall die within three (3) months following his termination of employment but prior to the expiration date of his Option or expiration of the period determined under subparagraphs (e) or (f) below, if earlier, such Option may be exercised by the Optionee’s estate, personal representative or beneficiary who acquired the right to exercise such Option by bequest or inheritance or by reason of the death of the Optionee, to the extent of the number of Shares with respect to which the Optionee could have exercised it on the date of his death, or to any greater extent permitted by the Committee, at any time prior to the earlier of: (i) one year following the date of the Optionee’s

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death, or (ii) the expiration date of such Option (which, in the case of death following a termination of employment pursuant to subparagraphs (e) or (f) below, shall be deemed to mean the expiration of the exercise period determined thereunder).

        (e)   Disability of Optionee. If an Optionee shall become permanently and totally disabled during his employment with the Company and his employment with the Company is terminated as a consequence of such permanent and total disability prior to the expiration date of his Option, such Option may be exercised by the Optionee, to the extent of the number of Shares with respect to which the Optionee could have exercised it on the date of such termination of employment, or to any greater extent permitted by the Committee, at any time prior to the earlier of: (i) one year following the date of the Optionee’s termination of employment, or (ii) the expiration date of such Option. In the event of the Optionee’s legal disability, such Option may be so exercised by the Optionee’s legal representative.

        (f)   Termination of Employment of Optionee. If an Optionee’s employment with the Company is terminated prior to the expiration date of his Option, such Option may be exercised by the Optionee, to the extent of the number of Shares with respect to which the Optionee could have exercised it on the date of such termination, or to any greater extent permitted by the Committee, at any time prior to the later of: (i) three (3) months after the date of termination, or (ii) the expiration date of such Option; provided, however, if an Optionee’s employment is terminated by the Company “for cause” (as defined below), the Optionee shall have no right to exercise his Option on or after the date or such termination. As used herein, termination of an Optionee’s employment by the Company shall be “for cause” if the Board reasonably concludes that the Optionee has materially failed to perform his or her responsibilities to the Company, materially failed to follow directives or policies established by or at the direction of the Board, or conducted himself or herself in a manner materially detrimental to the interests of the Company.

        (g)   Transferability. No option shall be assignable or transferable by an Optionee otherwise than by will or by the laws of descent and distribution, and during the lifetime of the Optionee, his Options shall be exercisable only by him, or in the event of his legal disability, by his legal representative.

        (h)   Rights as a Shareholder. An Optionee shall have no rights as a shareholder with respect to any Shares covered by his Option until the exercise of such Option and his payment for such Shares.

        (i)   Annual Limit on Incentive Stock Options. The aggregate fair market value (determined in accordance with Subparagraph (a) above as of the time an incentive stock option is granted) of the Shares with respect to which incentive stock options are exercisable for the first time by an Eligible Individual during any calendar year (under the Plan and any other incentive stock option plan of the Company) may not exceed one hundred thousand dollars ($100,000), or such other number as may be in effect under the Code from time to time.

        (j)   Option Agreement and Further Conditions. As soon as practicable after the grant of an Option, each Optionee shall enter into, and be bound by the terms of, a stock option agreement (the “Option Agreement”) which shall state the number of Shares to which the Option pertains and specify whether the Option is intended to be an incentive stock option or a nonqualified stock option. The Option Agreement shall set forth such terms, conditions and restrictions regarding the Option not inconsistent with the Plan (and, in the case of incentive stock options, the provisions of § 422(b) of the Code) as the Committee shall determine. Without limiting the generality of the foregoing, the Committee, in its discretion, may impose further conditions upon the exercisability of Options and restrictions on transferability with respect to Shares issued upon exercise of Options.

        (k)   Withholding. The obligation of the Company to deliver Shares upon the exercise of any Option (or cash in lieu thereof) shall be subject to any applicable federal, state and local tax withholding requirements.

        6.   Listing and Registration of Shares. Each Option under the Plan shall be subject to the requirement that, if at any time the Company shall determine, in its discretion, that the listing, registration or qualification of the Option or Shares covered thereby upon any securities exchange or under the laws of any jurisdiction, or the consent or approval of any governmental or regulatory body, is necessary or desirable as a condition of, or in connection with, the granting of such Option, or the exercise thereof, then no such Option may be exercised in whole or in part unless and until such listing, registration, qualification, consent or approval shall have been effected or obtained, on conditions acceptable to the Company. Each Optionee, or his legal representative or beneficiaries, also may be required to give satisfactory assurance that Shares acquired upon exercise of an Option are being acquired for investment and not with a view to distribution, and certificates representing such Shares may be legended accordingly.

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        7.   Adjustments. The number of Shares which may be issued under the Plan, as stated in paragraph 4 hereof, and the number of Shares issuable upon exercise of outstanding Options under the Plan (as well as the exercise price per share under such outstanding Options), shall be equitably adjusted by the Committee to reflect any stock dividend, stock split, share combination, or similar change in the capitalization of the Company.

        8.   Merger, Liquidation or Sale. In the event of a proposed dissolution, liquidation or sale of substantially all of the assets of the Company, or of a merger or consolidation involving a 50% change of ownership or control of the Company, the Committee shall, in its unlimited discretion, have the power prior to such event: (a) to terminate all outstanding Options upon at least seven (7) days prior notice to each Optionee and, if the Committee deems it appropriate, to cause the Company to pay to each Optionee an amount in cash with respect to each Share to which a terminated Option pertains equal to the difference between the option price and the value, as determined by the Committee in its sole discretion, of the consideration to be received by the holders of shares of Common Stock in connection with such transaction, or (b) to provide for the exchange of Options outstanding under the Plan for options to acquire securities or other property to be delivered in connection with the transaction and in connection therewith to make an equitable adjustment, as determined by the Committee in its sole discretion, in the option price and number of Shares or amount of property subject to the Option and, if deemed appropriate, provide for a cash payment to Optionees in partial consideration for such exchange. Anything hereinbefore or hereinafter to the contrary notwithstanding, upon the approval of the Board of Directors of the Company to implement a dissolution, liquidation, sale of substantially all of the assets of the Company or merger or consolidation involving a 50% change of ownership or control of the Company, all unexercised Options issued hereunder shall become immediately exercisable.

        9.   Acquisitions. Notwithstanding any other provision of this Plan, Options may be granted hereunder in substitution for options held by officers and employees of other corporations who are about to, or have, become employees of the Company as a result of a merger, consolidation, acquisition of assets or similar transaction by the Company. The terms, including the option price, of the substitute options so granted may vary from the terms set forth in this Plan to such extent as the Committee may deem appropriate to conform, in whole or in part, to the provisions of the options in substitution for which they are granted.

        10.   Amendment or Discontinuance of the Plan. The Board at any time, and from time to time, may suspend or discontinue the Plan or amend it and any outstanding Options in any respect whatsoever; provided, however, that without the approval of the holders of at least a majority of the outstanding shares of Common Stock as may be required by applicable law: (a) the maximum number of Shares with respect to which Options may be granted under the Plan shall not be increased except as permitted under paragraph 7 hereof, (b) the lowest price at which Options may be granted shall not be reduced, and (c) the duration of the Plan under paragraph 14 shall not be extended; and provided further, that no such suspension, discontinuance or amendment shall materially impair the rights of any holder of an outstanding Option without the consent of such holder.

        11.   Absence of Rights. The recommendations or selection of an Eligible Individual as a recipient of an Option under the Plan shall not entitle such person to any Option unless and until the grant actually has been made by appropriate action of the Committee, and any such grant is subject to the provisions of the Plan. Further, the granting of an Option to a person shall not entitle that person to continued employment by the Company or affect the terms and conditions of such employment, and the Company shall have the absolute right, in its discretion, to retire such person in accordance with its retirement policies or otherwise to terminate his employment, whether or not such termination may result in a partial or total termination of this Option.

        IN WITNESS WHEREOF, this amendment and restatement of the Plan has been executed March 31, 2006.

DERMA SCIENCES, INC.

By: /s/ Edward J. Quilty                 

      Edward J. Quilty

      President and Chief Executive Officer

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APPENDIX D

DERMA SCIENCES, INC.

RESTRICTED STOCK PLAN

THIS DERMA SCIENCES, INC. RESTRICTED STOCK PLAN, made, adopted and declared effective March 31, 2006 by Derma Sciences, Inc. (herein referred to as the "Plan").

ARTICLE I

DEFINITIONS

        1.1 Definitions. As used herein, the following terms shall have the meanings hereinafter set forth unless the context clearly indicates to the contrary:

(a) “Award” shall mean an award of Restricted Stock pursuant to the provisions of Article IV hereof.

(b) “Awardee” shall mean an Eligible Person to whom Restricted Stock has been awarded hereunder.

(c) “Board” shall mean the Board of Directors of the Company.

(d) “Change of Control” of the Company shall be deemed to have occurred if (i) a third person, including a “group” as defined in Section 13(d)(3) of the Securities Exchange Act of 1934, acquires Shares of the Company having more than fifty percent (50%) of the total number of votes that may be cast for the election of directors of the Company; or (ii) as the result of any cash tender or exchange offer, merger or other business combination, or any combination of the foregoing transactions (a “Transaction”), the persons who were directors of the Company before the Transaction shall cease to constitute a majority of the Board of the Company or any successor to the Company.

(e) “Committee” shall mean the administrative body provided for in Section 3.2.

(f) “Company” shall mean Derma Sciences, Inc.

(g) “Eligible Person” shall mean a director of the Company who is not an employee of the Company or any of its Subsidiaries, an executive officer of the Company or such professional consultants to the Company as the Board may from time to time designate (such eligible Persons, “Eligible Directors”, “Eligible Officers” and “Eligible Consultants”, respectively).

(h) “Market Stock Price” shall mean, as of any date, the closing sale price of the Company’s common stock quoted for the forty (40) trading days preceding such date on the OTC Bulletin Board or such other exchange or trading medium as the Board shall from time to time designate.

(i) “Plan Effective Date” shall mean the date upon which the Plan becomes effective in accordance with the provisions of Section 2.3.

(j) “Restricted Stock Agreement” shall mean the agreement between the Company and the Awardee with respect to Restricted Stock awarded hereunder.

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(k) “Restricted Stock” shall mean Stock that is the subject of an Award.

(l) “Stock” shall mean the common stock of the Company or, in the event that the outstanding shares of Stock are hereafter changed into or exchanged for shares of a different stock or securities of the Company or some other corporation, such other stock or securities.

(m) “Subsidiary” shall mean any corporation the majority of the outstanding capital stock of which is owned, directly or indirectly, by the Company.

ARTICLE II

GENERAL

        2.1 Name. This Plan shall be known as the Derma Sciences, Inc. Restricted Stock Plan.

        2.2 Purpose. The purpose of the Plan is to advance the interests of the Company and its stockholders by affording to Eligible Persons an opportunity to acquire or increase their proprietary interest in the Company by the grant of Awards under the terms set forth herein. By encouraging Eligible Persons to become owners of Company Shares, the Company seeks to increase their incentive for enhancing stockholder value and to motivate, retain and attract those highly competent individuals upon whose judgment, initiative, leadership and continued efforts the success of the Company in large measure depends.

        2.3 Effective Date and Term. The Plan shall become effective upon its approval by the Board and shall remain in effect indefinitely. Provided, however, the Plan shall terminate on the first anniversary thereof unless prior to that time the Plan shall have been approved by a majority of the shareholders of the Company present and voting at a meeting of shareholders called for that purpose.

        2.4 Limitations. Subject to adjustment pursuant to the provisions of Section 6.1 hereof, the aggregate number of shares of Stock which may be issued as Awards shall not exceed 2,500,000. Any such Awards may be either authorized and unissued shares of Stock or shares of Stock issued and thereafter acquired by the Company.

        2.5 Awards Granted Under the Plan. For purposes of Section 2.4, the aggregate number of shares of Restricted Stock issued under this Plan at any time shall equal the number of shares of Restricted Stock actually issued pursuant to all Awards less any shares subject to an Award that has been cancelled, has expired or has been forfeited.

ARTICLE III

PARTICIPANTS AND ADMINISTRATION

        3.1 Eligibility. Any Eligible Person shall be eligible to participate in the Plan.

        3.2 Designation of the Committee. The Plan shall be administered by the Compensation Committee of the Board and/or by the Board or another committee of the Board, as appointed from time to time by the Board (any

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such administrative body, the “Committee”). The Board shall fill vacancies on, and from time to time may remove or add members to, the Committee. The Committee shall act pursuant to a majority vote or unanimous written consent.

        3.3 Duties and Powers of the Committee. Subject to the provisions of this Plan and subject, in all events, to approval of the Board, the Committee shall be authorized and empowered to do all things necessary or desirable in connection with the administration of this Plan with respect to the Awards over which such Committee has authority, including, without limitation, the following:

(a)	to prescribe, amend and rescind rules and regulations relating to this Plan and to define terms not otherwise defined herein;
(b)	to determine the number of shares of Stock subject to Awards;
(c)	to prescribe and amend the terms of the agreements or other documents evidencing Awards made under this Plan;
(d)	to determine whether, and the extent to which, adjustments are required pursuant to Section 6.1 hereof;
(e)	to interpret and construe this Plan, any rules and regulations under the Plan and the terms and conditions of any Award granted hereunder, and to make exceptions to any such provisions in good faith and for the benefit of the Company; and
(f)	to make all other determinations deemed necessary or advisable for the administration of the Plan.

        3.4 Determinations of the Committee. All decisions, determinations and interpretations by the Committee or the Board regarding the Plan shall be final and binding on all current or former Eligible Persons of the Company and their beneficiaries, heirs, successors and assigns. The Committee or the Board, as applicable, shall consider such factors as it deems relevant, in its sole and absolute discretion, to making such decisions, determinations and interpretations including, without limitation, the recommendations or advice of any officer of the Company or Eligible Persons and such attorneys, consultants and accountants as it may select.

        3.5 Company Assistance. The Committee may designate officers or other Company employees to assist the Committee in the administration of the Plan and may grant authority to such persons to execute agreements evidencing Awards made under this Plan or other documents entered into under this Plan on behalf of the Committee or the Company. The Company shall supply full and timely information to the Committee on all matters relating to Eligible Persons and such other pertinent facts as the Committee may require. The Company shall furnish the Committee with such clerical and other assistance as is necessary in the performance of its duties.

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ARTICLE IV

RESTRICTED STOCK AWARDS

        4.1 Awards to Eligible Directors. The Committee may grant to any Eligible Director that is a member of the Board during all or any portion of each calendar year during the term of the Plan an Award of up to 25,000 shares of Restricted Stock as of a date determined by the Committee. Awards to Eligible Directors shall vest upon the earlier of three (3) years from the date of grant or upon a Change of Control of the Company.

        4.2 Awards to Eligible Officers. The Committee may grant to the President and Chief Executive Officer and to each Executive Officer of the Company, during the period from the Effective Date through December 31, 2008, up to that number of shares of Restricted Stock as determined by the Company’s Market Stock Price in accordance with the table set forth below:

Maximum Restricted Stock Awards
Eligible Officers
	Restricted Stock Awards to:
Attained	President and	Each Other
Market Stock Price	Chief Executive Officer	Executive Officer (4)
$1.00	100,000	50,000
$2.00	200,000	100,000
$3.00	300,000	150,000

        The foregoing Market Stock Price shall be attained not later than March 31, 2009. Satisfaction of the $2.00 Market Stock Price shall be deemed satisfaction of the $1.00 Market Stock Price and satisfaction of the $3.00 Market Stock Price shall be deemed satisfaction of the $2.00 and $1.00 Market Stock Prices. The foregoing Awards shall be cumulative and shall vest as of the date of satisfaction of the above set forth conditions to the Awards. Provided, however, if the fair market value of the common stock of the Company, as established by a Change of Control Transaction occurring not later than March 31, 2009, is greater than the Market Stock Price pursuant to which the subject Award was made, then the number of shares of Restricted Stock awarded to each Eligible Officer shall be increased pro rata. Provided, further, the Restricted Stock Agreement evidencing a given Award may, at the election of the Eligible Officer, provide for deferral of vesting of the subject Award until a Change of Control shall have occurred.

        4.3 Awards to Eligible Consultants. The Committee may grant to each Eligible Consultant for each calendar year during the term of the Plan an Award of up to 20,000 shares of Restricted Stock as of a date determined by the Committee. Awards to Eligible Consultants shall vest, if at all, upon a Change of Control of the Company effected not later than December 31, 2015.

        4.4 Rights of Awardees. Unless and until the Shares vest in the subject Awardee in accordance with the terms hereof, the Awardee shall not be entitled to vote the Shares or exercise any of the incidents of ownership thereof.

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ARTICLE V

TERMINATION, AMENDMENT AND MODIFICATION OF PLAN

        5.1 Termination, Amendment and Modification of Plan. The Committee may, with the consent of the Board, at any time terminate, and may at any time and from time to time and in any respect amend or modify, the Plan provided that, if under applicable laws or the rules of any securities exchange upon which the Company’s common stock is listed, the consent of the Company’s stockholders is required for such amendment or modification, such amendment or modification shall not be effective until the Company obtains such consent, and provided, further, that no termination, amendment or modification of the Plan shall in any manner affect any Award theretofore granted pursuant to the Plan without the consent of the Awardee.

ARTICLE VI

MISCELLANEOUS

        6.1 Adjustment Provisions. If the outstanding shares of Stock of the Company are increased, decreased, or exchanged for a different number or kind of shares or other securities, or if additional shares or new or different shares or other securities are distributed with respect to such shares of Stock or other securities, through merger, consolidation, sale of all or substantially all of the assets of the Company, reorganization, recapitalization, reclassification, stock dividend, stock split, reverse stock split or other distribution with respect to such shares of Stock or other securities, an appropriate and proportionate adjustment may be made in (i) the maximum number and kind of shares issuable hereunder, and (ii) the number and kind of shares or other securities subject to the outstanding Awards. Adjustments under this Section 6.1 will be made by the Committee subject to approval of the Board. No fractional interests will be issued under the Plan resulting from any such adjustments.

        6.2 Compliance with Government Regulations. No Awards will be made hereunder unless and until all applicable requirements imposed by federal and state securities and other laws, rules, and regulations and by any regulatory agencies having jurisdiction and by any stock exchanges upon which the Stock may be listed have been fully met. As a condition precedent to the issuance of shares of Stock pursuant hereto, the Company may require the Eligible Person to take any reasonable action to comply with such requirements.

        6.3 Withholding. The Company may make such provisions as it deems appropriate to withhold any taxes the Company determines it is required to withhold in connection with any Award. The Company may require the Eligible Person to satisfy any relevant tax requirements before authorizing any issuance of Restricted Stock to the subject Eligible Person.

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        6.4 Non-Transferability. For so long as it is unvested and subject to any restrictions pursuant to this Plan, an Award may be owned during the life of the Eligible Person solely by the Eligible Person or the Eligible Person’s duly appointed guardian or personal representative. No Award will be assignable or subject to any encumbrance, pledge or charge of any nature prior to the vesting of same.

        6.5 Other Compensation Plans. The adoption of the Plan shall not affect any other stock option or incentive or other compensation plans in effect for the Company or any Subsidiary, nor shall the Plan preclude the Company from establishing any other forms of incentive or other compensation for employees, directors or consultants of the Company or any Subsidiary.

        6.6 Plan Binding on Successors. The Plan shall be binding upon the successors and assigns of the Company. 6.7 Governing Law. This Plan and any Awards hereunder shall be governed by, interpreted and construed in accordance with the laws of the State of New Jersey and applicable federal law.

        IN WITNESS WHEREOF, this Derma Sciences, Inc. Restricted Stock Plan has been executed and adopted March 31, 2006.

DERMA SCIENCES, INC.

By:                      

      Edward J. Quilty

      President and Chief Executive Officer

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DERMA SCIENCES, INC.
PROXY SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS
Annual Meeting of Shareholders to be held on May 11, 2006

The undersigned hereby constitutes and appoints Edward J. Quilty, with full power of substitution, as proxy of the undersigned to vote all of the shares of Derma Sciences, Inc. that the undersigned may be entitled to vote at the Annual Meeting of Shareholders of Derma Sciences, Inc. to be held at the offices of the Company, 214 Carnegie Center, Suite 100, Princeton, New Jersey on May 11, 2006, at 3:30 p.m., and any adjournments thereof. This proxy shall be voted on the proposals described in the Proxy Statement as specified below.

The Board of Directors recommends a vote “FOR” each of the following:

1. ELECTION OF DIRECTORS:

Nominees: Edward J. Quilty, Srini Conjeevaram, Stephen T. Wills, CPA, MST, James T. O’Brien, C. Richard Stafford, Esq., Richard J. Keim, Robert G. Moussa and Bruce F. Wesson. To withhold authority to vote for an individual nominee, place a line through such nominee’s name. To cumulate votes, indicate the votes allocated to each nominee above such nominee’s name.

 FOR all nominees  WITHHOLD AUTHORITY for all nominees

2. AMENDMENT OF THE COMPANY’S STOCK OPTION PLAN TO INCREASE THE SHARES OF COMMON STOCK ISSUABLE THEREUNDER TO 5,000,000:

 FOR  AGAINST  ABSTAIN

3. ADOPTION OF THE RESTRICTED STOCK PLAN AND RESERVATION OF 2,500,000 SHARES OF COMMON STOCK FOR ISSUANCE THEREUNDER:

 FOR  AGAINST  ABSTAIN

4. AMENDMENT OF THE COMPANY’S ARTICLES OF INCORPORATION TO INCREASE THE AUTHORIZED SHARES OF COMMON STOCK TO 50,000,000:

 FOR  AGAINST  ABSTAIN

5. RATIFICATION OF THE SELECTION OF J.H. COHN LLP AS THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM FOR THE YEAR ENDING DECEMBER 31, 2006:

 FOR  AGAINST  ABSTAIN

6. DISCRETIONARY AUTHORITY:

In his discretion, the proxy is authorized to vote upon such other matters as may come before the meeting and any adjournments thereof.

 FOR  AGAINST  ABSTAIN

THIS PROXY, WHEN PROPERLY EXECUTED, WILL BE VOTED IN THE MANNER DIRECTED HEREIN BY THE UNDERSIGNED SHAREHOLDER(S). IF NO DIRECTION IS MADE, THIS PROXY WILL BE VOTED “FOR” ALL NOMINEES AND “FOR” PROPOSALS 2, 3, 4 AND 5.

THE UNDERSIGNED HEREBY ACKNOWLEDGES RECEIPT OF THE NOTICE OF THE MEETING AND THE PROXY STATEMENT. The undersigned also hereby ratifies all that the proxy named herein may do by virtue hereof and hereby confirms that this proxy shall be valid and may be voted regardless of whether the undersigned’s name is signed as set forth below or a seal is affixed or the description, authority or capacity of the person signing is given or other defect of signature exists.

________________________________	_____________________
Signature of Shareholder	Date
________________________________	_____________________
Signature of Co-Owner	Date
PLEASE MARK, DATE AND SIGN THIS PROXY AND RETURN IT IN THE ENCLOSED ENVELOPE. Please sign this proxy exactly as your name appears in the address at the left. If shares are registered in more than one name, all owners should sign. If you are signing in a fiduciary or representative capacity, such as attorney-in-fact, executor, administrator, trustee or guardian, please give full title and attach evidence of authority. Corporations, please sign with full corporate name by a duly authorized officer or officers. If a partnership, please sign in partnership name by an authorized person.
I/WE PLAN TO ATTEND THE MEETING	

EX-13

[LOGO OMITTED]

DERMA SCIENCES, INC.

2005 Annual Report

214 Carnegie Center, Suite 100
Princeton NJ 08540
609-514-4744

Description of Business

Overview

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

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

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

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

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

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

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

The Company’s Markets

Wound Care

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

Wound Closure and Fasteners

        The Company markets a line of wound closure strips, nasal tube fasteners and a variety of catheter fasteners to doctors, clinics, nursing homes, hospitals and other institutions. The Company’s wound closure strips eliminate the need for sutures on the surface of many surgical wounds, decrease the incidence of scarring and infection and promote

2

wound healing. In contrast to the characteristics of surgical tapes, these wound closure strips yield to the movement of the skin thereby reducing traction blisters at the wound site. In addition, these wound closure strips provide excellent adherence, optimum surgical wound security and protection from irritation and skin shearing.

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

Skin Care

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

Directors and Executive Officers

        The directors and executive officers of the Company are:

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

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

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

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

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

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

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

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

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

Management's Discussion and Analysis or Plan of Operations

Reference to Consolidated Financial Statements

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

Results of Operations

Overview

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

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

        The following table highlights 2005 versus 2004 operating results:

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

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

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

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

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Gross to Net Sales Adjustments

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

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

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

        Gross to net sales adjustments comprise the following:

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

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

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

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

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

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

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Rebate Reserve Roll Forward

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

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

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

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

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

                                       2005             2004
                                       ----             ----

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

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

Net Sales and Gross Profit

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

Operating Expenses

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

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

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

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

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

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

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

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

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

Goodwill Impairment Loss

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

Interest Expense

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

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Other Income/Expense

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

Income Taxes

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

Net Loss

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

Liquidity and Capital Resources

Operational Overview

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

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

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

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

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

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

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

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

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

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

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

        In connection with implementing the agreement, the Company sold to the distributor its existing inventory of saleable finished product on hand and all saleable finished product it committed to manufacture prior to signing of the agreement for delivery by the Company through September 2005 at the agreed upon prices to initially stock and maintain its distribution pipeline. Other than the one-time sale in May and June 2005 of its existing inventory on

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hand, which is estimated to represent two to two and one-half months sales, prospective sales are expected to resume historical trends affected only by existing market conditions and the growth opportunities inherent in the agreement. Given economic order quantities and normal lead times associated with the products sold to the distributor, it is expected that a two to three month safety stock will be required prospectively by the distributor to maintain required customer service requirements. In addition, the Company incurred one-time costs consisting of severance and other costs to dismantle its distribution capabilities and sub-lease its distribution warehouse. A summary of the estimated one-time benefit and costs of the agreement recognized in the twelve months ended December 31, 2005 is outlined below:

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

                      Gross Profit                 600,000
                      Expenses                     105,000

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

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

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

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

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

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

        On February 25, 2004, the Company closed a private offering of 2,057,145 shares of its common stock at a price of $1.05 per share. Offering proceeds were used to fund the acquisition of the Kimberly-Clark Corporation

12

wound care business and for general working capital purposes. Offering proceeds of $1,961,797, net of offering expenses of $198,203, were received.

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

Cash Flow

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

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

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

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

Working Capital

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

Financing Arrangements – United States

        On January 31, 2005, the Company entered into a three-year revolving credit facility agreement (the “New Agreement”) with a new U.S. lender for a maximum principal amount of $2,000,000. The New Agreement replaces a $2,000,000 revolving credit facility that expired on January 31,

13

2005 with the previous U.S. lender. At January 31, 2005, maximum potential advances under the New Agreement were approximately $1,700,000. On January 31, 2005, the Company applied advances of approximately $1,300,000 under the New Agreement in satisfaction of the prior U.S. lender’s outstanding obligations. Future advances will be utilized to fund strategic initiatives and general working capital requirements. The Company incurred loan origination and legal fees of approximately $147,300 in connection with the implementation of the New Agreement. These fees have been deferred and are being amortized to interest expense over the three-year term of the New Agreement.

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

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

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

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

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

        On January 13, 2005, in connection with the refinancing of the U.S. line of credit, the Company paid off and cancelled the outstanding irrevocable standby letter of credit issued by the U.S. lender in the amount of $200,000 held by the Company’s Canadian lender as additional security for its credit facility. The $200,000 paid to the Canadian lender was applied as a permanent principal reduction against the principal amount due in 2007 associated with the Company’s outstanding term loan with the Canadian lender. Subsequently, on January 31, 2005, the Canadian lender agreed as part of refinancing of the U.S. line of credit to retain its second lien security interest and guarantee position

14

against the Company’s U.S. assets and not to exercise its rights under its second lien security interest and guarantee against the U.S. assets without the new U.S. lender’s approval.

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

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

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

Financing Arrangements – Canada

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

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

        Over the term of the Canadian Agreement, the Company has agreed to comply with a number of financial covenants governing minimum working capital, current ratios, tangible net worth, interest coverage, total indebtedness to tangible net worth and total indebtedness to adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens, payments of dividends and protection of collateral are included in the Canadian Agreement. In the

15

event of a margin deficiency (as defined) or covenant violation, the Company is required to advance up to an additional $430,000 ($500,000 Canadian) of working capital to Derma Sciences Canada Inc. in order to correct the deficiency. This additional working capital may be repaid to the Company 45 days after the margin deficiency or covenant violation has been cured upon the condition that such repayment not result in a margin deficiency, covenant violation or any other event of default.

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

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

Prospective Assessment

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

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

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

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

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

16

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

Additional Financial Information

Forward Looking Statements

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

Critical Accounting Policies

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

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

Revenue Recognition and Adjustments to Revenue

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

Goodwill

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

Inventory

        The Company writes down the value of inventory by the estimate of the difference between the cost of the inventory and its net realizable value. The estimate takes into account projected sales of the inventory on hand and the age of the inventory in stock. If actual future demand or market conditions are less favorable than those projected by

17

management, additional inventory write-downs may be required. The provision for the write-down of inventory is recorded in cost of sales.

Recent Accounting Pronouncements Affecting the Company

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

        In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). This statement revises SFAS No. 123, “Accounting for Stock-Based Compensation,” which provided alternative methods of disclosure for stock-based employee compensation. It also supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and its related implementation guidance. SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS 123(R) requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. SFAS 123(R) eliminates the alternative whereby the Company used APB 25‘s intrinsic value method of accounting that was provided in SFAS 123 as originally issued. Under APB 25, issuing stock options to employees generally resulted in recognition of no compensation cost. The effective date for SFAS 123(R) was modified by the SEC in April 2005 and now is effective for public entities as of the beginning of the next fiscal year that begins after December 15, 2005 and applies to all awards granted after the required effective date and to awards modified, repurchased or cancelled after that date. The cumulative effect of initially applying this statement, effective January 1, 2006, will be zero as all outstanding stock options as of December 31, 2005 were fully vested. The Company used the intrinsic value method through December 31, 2005 and, accordingly, the adoption of SFAS 123(R) will impact the Company’s results of operations based upon the grant of future options the materiality of which will be determined by the amount and fair value of future stock option grants. Notes 1 and 12 to the Company’s financial statements contain additional information on the Company’s stock based compensation and stock options.

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

18

Annual Report

        THE COMPANY WILL PROVIDE WITHOUT CHARGE TO EACH BENEFICIAL HOLDER OF COMMON STOCK ON THE RECORD DATE, UPON WRITTEN REQUEST OF ANY SUCH PERSON, A COPY OF THE COMPANY'S ANNUAL REPORT ON FORM 10-KSB FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. ANY SUCH REQUEST SHOULD BE MADE IN WRITING TO THE CORPORATE SECRETARY, DERMA SCIENCES, INC., 214 CARNEGIE CENTER, SUITE 100, PRINCETON, NEW JERSEY 08540.

19

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Derma Sciences, Inc.

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

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

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

/s/ J.H. Cohn LLP

Roseland, New Jersey
February 24, 2006

20

DERMA SCIENCES, INC.

Consolidated Balance Sheets

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

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

See accompanying consolidated notes.

21

DERMA SCIENCES, INC.

Consolidated Statements of Operations

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

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

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

See accompanying consolidated notes.

22

DERMA SCIENCES, INC.

Consolidated Statements of Shareholders' Equity

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

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

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

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

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

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

See accompanying consolidated notes.

23

DERMA SCIENCES, INC.

Consolidated Statements of Cash Flows

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

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

See accompanying consolidated notes.

24

DERMA SCIENCES, INC.

Notes To Consolidated Financial Statements

1.     Organization and Summary of Significant Accounting Policies

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

      Summary of Significant Accounting Policies:

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

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

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

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

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

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

25

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

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

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

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

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

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

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

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

26

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

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

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

         Volatility Factor

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

         Dividend Yield                     0%                   0%

         Expected Option Life               5 Years              5 Years

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

                                                                       2005            2004
                                                                       ----            ----

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

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

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

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

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

27

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

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

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

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

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

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

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

28

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

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

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

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

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

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

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

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

29

3. Accounts Receivable

Accounts receivable include the following:

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

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

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

4. Inventories

Inventories include the following:

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

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

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

5. Equipment and Improvements, net

Equipment and improvements include the following:

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

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

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

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

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

30

6. Goodwill Impairment

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

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

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

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

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

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

7. Other Intangible Assets, net

        Other intangible assets, net include the following:

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

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

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

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

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

31

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

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

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

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

Estimated amortization expense for years ending December 31,

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

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

8. Other Assets, net

        Other assets, net include the following:

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

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

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

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

9. Line of Credit Borrowings

        Short-term borrowings include the following:

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

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

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

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      U.S. Line of Credit

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

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

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

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

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

33

        On January 13, 2005 in connection with the refinancing of the U.S. line of credit, the Company paid off and cancelled the outstanding irrevocable standby letter of credit issued by the former U.S. lender in the amount of $200,000 held by the Company’s Canadian lender as additional security for its credit facility. The $200,000 paid to the Canadian lender was applied as a permanent principal reduction against the principal amount due in 2007 associated with the Company’s outstanding term loan with the Canadian lender (see Note 11). Subsequently, on January 31, 2005 the Canadian lender agreed as part of refinancing of the U.S. line of credit to retain its second lien security interest and guarantee position against the Company’s U.S. assets and not to exercise its rights under its second lien security interest and guarantee against the U.S. assets without the U.S. lender’s approval.

      Canadian Line of Credit

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

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

10. Accrued Expenses and Other Current Liabilities

        Accrued expenses and other current liabilities include the following:

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

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

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11. Long-Term Debt

        Long-term debt includes the following:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

12. Shareholders’ Equity

      Preferred Stock

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

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

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

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

      Common Stock

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

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

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

      Stock Purchase Warrants

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

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

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

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

      Stock Options

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

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

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

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

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

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

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

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

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

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

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

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

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

      Shares Reserved for Future Issuance

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

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

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

13. Operating Segments

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

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of catheter fasteners and net dressings. The skin care segment consists of bath sponges, antibacterial skin cleansers, hair and body soaps, lotions and moisturizers designed to enable customers to implement and maintain successful skin care / hygiene programs.

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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

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

2004
- ----

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

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

14. Income Taxes

Loss before income taxes consists of the following components:

                                            2005               2004
                                            ----               ----

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

41

under the Internal Revenue Code section 382 regarding changes in ownership of corporations. Due to uncertainties surrounding the Company’s ability to use its net operating loss carryforwards, a valuation allowance has been provided as of December 31, 2005.

15. Operating Leases

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

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

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

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

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

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

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

16. Retirement Benefits

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

17. Related Party Transactions

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

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

18. Appointment of Canadian Distributor

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

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

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

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

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

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

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

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

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19. Distribution Agreement Upset Fee

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

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

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

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

20. Employee Termination Costs

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

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

21. Subsequent Events

Comvita Licensing, Manufacturing and Sales Agreement

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

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

44

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

45