Notes to Consolidated Financial Statements

(1)           Business Description and Summary of Significant Accounting Policies

Business Description

The accompanying consolidated financial statements include the accounts of Bacterin International Holdings, Inc., a Delaware corporation, and its wholly owned subsidiary, Bacterin International, Inc., a Nevada corporation, (collectively, the “Company” or “Bacterin”). All intercompany balances and transactions have been eliminated in consolidation. Bacterin’s biologics division develops, manufactures and markets biologics products to domestic and international markets.  Bacterin’s proprietary methods are used in human allografts to create stem cell scaffolds and promote bone and other tissue growth.  These products are used in a variety of applications including enhancing fusion in spine surgery, relief of back pain with a facet joint stabilization, promotion of bone growth in foot and ankle surgery, promotion of skull healing following neurosurgery and cartilage regeneration in knee and other joint surgeries.

The accompanying interim condensed consolidated financial statements of Bacterin for the three months ended March 31, 2012 and 2011 are unaudited and are prepared in accordance with accounting principles generally accepted in the United States of America. They do not include all disclosures required by generally accepted accounting principles for annual financial statements, but in the opinion of management, include all adjustments, consisting only of normal recurring items, necessary for a fair presentation. Interim results are not necessarily indicative of results which may be achieved in the future for the full year ending December 31, 2012.

These financial statements should be read in conjunction with the financial statements and notes thereto which are included in Bacterin’s Annual Report on Form 10-K for the year ended December 31, 2011. The accounting policies set forth in those annual financial statements are the same as the accounting policies utilized in the preparation of these financial statements, except as modified for appropriate interim financial statement presentation.

Bacterin’s device division develops anti-microbial coatings to inhibit infection based upon proprietary knowledge of the phenotypical changes made by microbes as they sense and adapt to changes in their environment. Bacterin develops, employs, and licenses bioactive coatings for various medical device applications.  Bacterin’s strategic coating initiatives include the inhibition of biofilm formation, local (as opposed to systemic) drug delivery, local (as opposed to systemic) pain management, and anti-thrombotic factors for medical device applications.

An operating segment is a component of an enterprise whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. The primary performance measure used by management is net income or loss. The Company operates in two distinct lines of business consisting of the biologics and devices divisions. However, due to the immaterial revenue from devices to date, the Company reports as one segment.

The Company's revenue is derived principally from the sale or license of its medical products, coatings and device implants. The markets in which the Company competes are highly competitive and rapidly changing. Significant technological advances, changes in customer requirements, or the emergence of competitive products with new capabilities or technologies could adversely affect the Company's operating results. The Company's business could be harmed by a decline in demand for, or in the prices of, its products or as a result of, among other factors, any change in pricing or distribution model, increased price competition, changes in government regulations or a failure by the Company to keep up with technological change.  Further, a decline in available tissue donors could have an adverse impact on the business.

Concentrations   and Credit Risk

The Company’s accounts receivable are due from a variety of health care organizations and distributors throughout the world. Approximately 99% and 98% of sales were in the United States for the first quarter of 2012 and 2011, respectively. One customer represented 7% and 4% of revenue for the first quarter of 2012 and 2011, respectively. One customer represented 19% and 6% of accounts receivable at March 31, 2012 and March 31, 2011, respectively. The Company provides for uncollectible amounts when specific credit issues arise. Management’s estimates for uncollectible amounts have been adequate during prior periods, and management believes that all significant credit risks have been identified at March 31, 2012.

Revenue by geographical region is as follows:

Use of Estimates

The preparation of the financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period; the carrying amount of property and equipment and intangible assets; valuation allowances for trade receivables and deferred income tax assets; valuation of the warrant derivative liability; inventory reserve; contingent consideration from acquisitions; and estimates for the fair value of stock options grants and other equity awards upon which the Company determines stock-based compensation expense. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with an original maturity date of three months or less to be cash equivalents.  Cash equivalents are recorded at cost, which approximates market value. At times the Company maintains deposits in financial institutions in excess of federally insured limits.

Accounts Receivable

Accounts receivable represents amounts due from customers for which revenue has been recognized. Normal terms on trade accounts receivable are net 30 days and some customers are offered discounts for early pay.   The Company performs credit evaluations when considered necessary, but generally does not require collateral to extend credit.

The allowance for doubtful accounts is the Company's best estimate of the amount of probable credit losses in the Company's existing receivables. The Company determines the allowance based on factors such as historical collection experience, customer's current creditworthiness, customer concentration, age of accounts receivable balance, general economic conditions that may affect a customer's ability to pay and management judgment. Actual customer collections could differ from estimates. Account balances are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Provisions to the allowance for doubtful accounts are charged to expense. The Company does not have any off-balance sheet credit exposure related to its customers.

Accounts Payable - Related Party

Accounts payable to a related party included amounts due to American Donor Services, a supplier of donors to the Company (See Note 15).

Inventories

Inventories are stated at the lower of cost or market.  Cost is determined using the specific identification method and includes materials, labor and overhead. The Company calculates an inventory reserve for estimated obsolescence or excess inventory based on historical usage and sales, as well as assumptions about future demand for its products. These estimates for excess and obsolete inventory are reviewed and updated on a quarterly basis. Increases in the inventory reserves result in a corresponding expense, which is generally recorded to cost of tissue and medical devices sales.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally three to seven years for computers and equipment, and 30 years for buildings. Leasehold improvements are depreciated over the shorter of their estimated useful life or the remaining term of the lease. Repairs and maintenance are expensed as incurred.

Goodwill

Goodwill represents the excess of costs over fair value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have indefinite useful lives are not amortized, but instead are tested for impairment at least annually and whenever events or circumstances indicate the carrying amount of the asset may not be recoverable. In its evaluation of goodwill, the Company performs an assessment of qualitative factors to determine if it is more-likely-than-not that goodwill might be impaired and whether it is necessary to perform the two-step goodwill impairment. The Company conducts its annual impairment test on December 31 of each year. See further discussion of goodwill in Note 3 below.

Derivative Instruments

The Company accounts for its derivative instruments in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815 “Accounting for Derivative Instruments and Hedging Activities”. The only derivative instruments presented in the accompanying consolidated financial statements relates to warrants issued in connection with certain debt financings. The Company has not designated its warrant derivative liability as a hedging instrument as described in ASC 815 and any changes in the fair market value of the warrant derivative liability is recognized in the statement of operations during the period of change. See Note 10, “Warrants” below.

Intangible Assets

Intangible assets with estimable useful lives must be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment whenever events or circumstances indicate their carrying amount may not be recoverable. Intangible assets primarily consist of patents and include costs to acquire and protect Company patents and are carried at cost less accumulated amortization. The Company amortizes these assets on a straight-line basis over their estimated useful lives of 15 years.

Revenue Recognition

Revenue is recognized when all of the following criteria are met: a) the Company has entered into a legally binding agreement with the customer; b) the products or services have been delivered; c) the Company's fee for providing the products and services is fixed or determinable; and d) collection of the Company’s fee is probable.

The Company’s policy is to record revenue net of any applicable sales, use, or excise taxes.  If an arrangement includes a right of acceptance or a right to cancel, revenue is recognized when acceptance is received or the right to cancel has expired.

The Company ships to certain customers under consignment arrangements whereby the Company’s product is stored by the customer.  The customer is required to report the use to the Company and upon such notice, the Company invoices the customer and revenue is recognized when above criteria has been met.

The Company also receives royalty revenue from third parties related to licensing agreements. The Company has royalty agreements with Nufix, RyMed and Bard Access Systems. Revenue under these agreements represented less than 1% of total revenue for the first quarters of 2012 and 2011.

Research and development services revenue is recognized as performed, based on the incurrence of qualifying costs or achievement of milestones as prescribed in the arrangement.

Non Cash Consulting Expense

From time to time, the Company issues restricted stock awards to consultants and advisors to the Company. These awards are marked to market ratably over the vesting period and are recorded in Non cash consulting expense.

Advertising Costs

The Company expenses advertising costs as incurred. Advertising costs of approximately $18,000 and $21,000 were expensed for the three months ended March 31, 2012 and 2011, respectively.

Research and Development

Research and development costs, which are principally related to internal costs for the development of new technologies and processes for tissue and coatings, are expensed as incurred.

Income Taxes

The Company accounts for income taxes under the asset and liability method of accounting for deferred taxes as prescribed under FASB ASC 740, Accounting for Income Taxes.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. When applicable, a valuation allowance is established to reduce any deferred tax asset when it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized. ASC 740 also requires reporting of taxes based on tax positions that meet a more-likely-than-not standard and that are measured at the amount that is more-likely-than-not to be realized. Differences between financial and tax reporting which do not meet this threshold are required to be recorded as unrecognized tax benefits. ASC 740 also provides guidance on the presentation of tax matters and the recognition of potential IRS interest and penalties. The Company classifies penalty and interest expense related to income tax liabilities as an income tax expense. There are no significant interest and penalties recognized in the statement of operations or accrued on the balance sheet. See further discussion and disclosures in Note 12.

Long-Lived Assets

Long-lived assets, including intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. No impairment was recorded in the first quarter of 2012 or 2011.

Net Loss Per Share

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. Diluted net income (loss) per share is computed in a manner consistent with that of basic earnings per share while giving effect to all potentially dilutive common shares outstanding during the period, which include the assumed exercise of stock options and warrants using the treasury stock method.  Diluted net loss per share was the same as basic net loss per share for the quarter ended March 31, 2012 as shares issuable upon the exercise of stock options and warrants were anti-dilutive as a result of the net losses incurred for those periods.

A reconciliation of the denominator used in the calculation of basic and diluted net (loss) per share is as follows:

Dilutive earnings per share are not reported for the three months ended March 31, 2012 as the effect of including outstanding stock options and warrants is anti-dilutive.

Stock-Based Compensation

The Company records stock-compensation expense according to the provisions of ASC 718.  Under ASC 718, stock-based compensation costs are recognized based on the estimated fair value at the grant date for all stock-based awards.  The Company estimates grant date fair values using the Black-Scholes-Merton option pricing model, which requires assumptions of the life of the award and the stock price volatility over the term of the award.  The Company records compensation cost of stock-based awards using the straight line method, which is recorded into earnings over the vesting period of the award.

Fair Value of Financial Instruments

The carrying values of financial instruments, including trade accounts receivable, accounts payable, other accrued expenses and long-term debt, approximate their fair values based on terms and related interest rates.

We follow a framework for measuring fair value. The framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

Level 1: Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets.

Level 2: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument's level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. During the three months ended March 31, 2012 and March 31, 2011, there was no reclassification in financial assets or liabilities between Level 1, 2 or 3 categories.

The following tables set forth by level, within the fair value hierarchy, our assets and liabilities as of March 31, 2012 and December 31, 2011 that are measured at fair value on a recurring basis:

Warrant derivative liability

Acquisition contingent consideration liability

The valuation technique used to measure fair value of the warrant liability and contingent consideration is based on a lattice model and significant assumptions and inputs determined by us.

Acquisition contingent consideration liability

During the three months ended March 31, 2012, the Company did not change any of the valuation techniques used to measure its liabilities at fair value.

Recent Accounting Pronouncements

In September 2011, the FASB issued ASU 2011-08 on testing goodwill for impairment that will become effective for the Company in the first quarter of 2012; however, early adoption is permitted. Under the new guidance, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the entity determines that this threshold is not met, then performing the two-step impairment test is unnecessary. The Company elected to early adopt this pronouncement in 2011.

(2) Equity

In the second quarter of 2011, we raised net $2,974,618 in a private placement transaction under Rule 506 of Regulation D. The transaction resulted in the issuance of 939,377 shares of our common stock and warrants to purchase 375,747 shares of our common stock.

On July 29, 2011, we entered into Loan and Security Agreement with MidCap Funding III, LLC (“MidCap”), whereby MidCap and Silicon Valley Bank (“SVB”) agreed to provide a $15 million credit facility which allowed us to borrow $7 million and up to an additional $8 million in connection with a permitted acquisition through December 31, 2011. The $8 million portion expired unused as of December 31, 2011. The credit facility is secured by substantially all of our assets and carries an interest rate of LIBOR plus 7.5%, subject to a LIBOR floor rate of 3%. Repayment was interest only for the first nine months, with principal and interest for the subsequent 33 months.

On May 27, 2011, we entered into a Purchase Agreement and Registration Rights Agreement with Lincoln Park Capital Fund, LLC (“LPC”) whereby LPC agreed to purchase up to $31 million of our common stock from time to time pursuant to the terms of the Purchase Agreement and we agreed to register the shares purchased by LPC. Upon signing the Purchase Agreement, LPC purchased 326,798 shares of our common stock for $1,000,002 and also received warrants to purchase 130,719 shares at an exercise price of $3.06 per share, the closing price on May 26, 2011, as part of a private placement transaction pursuant to Rule 506 of Regulation D in the second quarter of 2011 in which we raised a total of $3,027,504 and issued 939,377 shares of our common stock and warrants to purchase 375,747 shares of our common stock.

In consideration for entering into the Purchase Agreement, we issued 128,506 shares of our common stock to LPC as initial commitment shares and we agreed to issue up to 164,675 additional commitment shares on a pro rata basis when LPC purchases additional shares. We may terminate the Purchase Agreement at any time at our sole discretion without any cost to us.

In addition, LPC has committed to invest, up to an additional $30 million through the purchase of shares of our common stock from time to time. The transactions will be at our sole option with no additional warrants granted.

During the first quarter of 2012, pursuant to our previously disclosed May 27, 2011 Purchase Agreement with Lincoln Park Capital Fund, LLC (“LPC”) and S-3 registration statement declared effective on July 19, 2011, we issued 1,475,037 shares of our common stock to LPC for aggregate proceeds of $3,899,996. We intend to use the proceeds for working capital and general corporate purposes.

(3) Acquisition

On July 11, 2011, we signed an Asset Purchase Agreement (“Agreement”) with Robinson MedSurg, LLC (“Seller”), a company engaged in the manufacture, distribution and sale of implantable medical devices for maxillofacial, craniofacial and orthopedic uses. These products are used by many of our current customers and therefore represents an opportunity to expand our product offerings to these customers. Under the terms of the Agreement, we purchased certain assets from Seller, as described in the Agreement, for $1 million in common stock. In addition, we agreed to pay Seller an additional $500,000 in common stock when gross revenue from the sale of products resulting from the purchased assets (“Products”) equals or exceeds $1 million, and an additional $500,000 in common stock when gross revenue from the sale of Products equals or exceeds $2 million, provided that such gross revenue thresholds are achieved within 2 years. We also engaged the sole member of Seller as a consultant. We accounted for this business combination under the acquisition method in accordance with ASC 805 – Business Combinations, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination.

The purchase price was allocated as follows:

Goodwill is primarily made up of business synergies expected from the additional product offerings through our established distribution network. Goodwill is not expected to be deductible for tax purposes.

The consideration for the purchase price was made up of the following components:

The initial valuation of the contingent consideration was based upon management’s estimates of the probability of reaching the milestones that would trigger the requirement to pay the contingent amounts. During the first quarter of 2012, management reviewed and adjusted the assumptions associated with the contingent liability which resulted in a reduction of the contingent liability to $238,140 as of March 31, 2012.

The useful lives of the Customer List and the Trademark are 5 years and 15 years, respectively resulting in the following amortization schedule:

(4)           Inventories

Inventories consist of the following:

(5)           Property and Equipment, Net

Property and equipment, net are as follows:

The Company leases certain equipment under capital leases. For financial $310,289 gross assets in Equipment, and $37,689 of accumulated depreciation relating to assets under capital leases.

Maintenance and repairs expense for the three months ended March 31, 2012 and 2011 was $47,654 and $15,824, respectively.  Depreciation expense related to property and equipment, including property under capital lease for the three months ended March 31, 2012 and 2011 was $194,752 and $147,159, respectively.

(6)           Intangible Assets

Bacterin has been issued various patents with regards to processes for its products.

The following table sets forth information regarding intangible assets:

(7)           Accrued Liabilities

Accrued liabilities consist of the following:

(8)          Long-term Debt

On July 29, 2011, we entered into Loan and Security Agreement with MidCap Funding III, LLC (“MidCap”), whereby MidCap and Silicon Valley Bank (“SVB”) agreed to provide a $15 million credit facility which allowed us to borrow $7 million and up to an additional $8 million in connection with a permitted acquisition through December 31, 2011. The $8 million portion expired unused as of December 31, 2011. The credit facility is secured by substantially all of our assets and carries an interest rate of LIBOR plus 7.5%, subject to a LIBOR floor rate of 3% and contains covenants based upon revenue thresholds, which were met as of March 31, 2012. Repayment was interest only for the first nine months, with principal and interest for the subsequent 33 months.

Long-term debt consists of the following:

The following is a summary of maturities due on the debt as of March 31, 2012:

(9)           Stock-Based Compensation

Our Equity Incentive Plan ("The Plan") provides for stock awards, including options and performance stock awards, to be granted to employees, consultants, independent contractors, officers and directors. The purpose of the incentive compensation plan is to enable us to attract, retain and motivate key employees, directors and, on occasion, independent consultants, by providing them with stock options and restricted stock grants. Stock options granted under the incentive compensation plan may be either incentive stock options to employees, as defined in Section 422A of the Internal Revenue Code of 1986, or non-qualified stock options. The plan is currently administered by the compensation committee of our Board of Directors. The administrator of the plan has the power to determine the terms of any stock options granted under the incentive plan, including the exercise price, the number of shares subject to the stock option and conditions of exercise. Stock options granted under the incentive plan are generally not transferable, vest in installments over the requisite service period and are exercisable during the stated contractual term of the option only by such optionee. The exercise price of all incentive stock options granted under the incentive plan must be at least equal to the fair market value of the shares of common stock on the date of the grant. The Plan has 9 million shares authorized and at March 31, 2012, we had approximately 2,414,690 shares available for issuance. Shares issued under the Plan may be authorized, but unissued, or reacquired shares.

Stock compensation expense recognized in the statement of operations for the quarters ended March 31, 2012 and 2011 is based on awards ultimately expected to vest and reflects an estimate of awards that will be forfeited. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The estimated fair value of stock options granted is done using the Black-Sholes-Merton method applied to individual grants. Key assumptions used to estimate the fair value of stock awards are as follows:

Activity under our stock option plans was as follows:

The total intrinsic value of options exercised in the first quarter of 2012 was $17,400. The aggregate intrinsic value of options outstanding as of March 31, 2012 is $2,970,024. The aggregate intrinsic value of exercisable options as of March 31, 2012 is $2,180,094. As of March 31, 2012, there were 2,840,317 unvested options with a weighted average fair value at the grant date of $1.34 per option. As of March 31, 2012, the total compensation related to nonvested awards not yet recognized is $3,789,300 and is expected to be recognized over 3.8 years.

From time to time we may grant stock options and restricted stock grants to consultants. We account for consultant stock options in accordance with ASC 505-50. Consulting expense for the grant of stock options to consultants is determined based on the estimated fair value of the stock options at the measurement date as defined in ASC 505-50 and is recognized over the vesting period.

The following table summarizes restricted stock award activity during the quarter ended March 31, 2012:

The restricted stock awards generally vest over three to five year periods. The Company recognized non cash consulting expense of $328,253 and $240,991 for the three months ended March 31, 2012 and 2011, respectively. As of March 31, 2012, the total expense related to nonvested restricted stock awards not yet recognized is $3,147,439 and is expected to be recognized over four years.

(10)           Warrants

Associated with the second quarter of 2011 private placement of common stock, 375,747 warrants with exercise prices ranging from $2.95 to $3.52 were issued to the participants. Warrants issued with common stock under this private placement were recorded as additional paid in capital at their estimated fair market value of $312,285 during the second quarter of 2011.

In connection with the July 29, 2011MidCap financing described above, MidCap and SVB received 192,157 warrants to purchase shares of our common stock equal to 7% of the amount drawn on the credit facility divided by the exercise price of $2.55 per share. The warrants have a seven year term. MidCap and SVB also have the right to receive additional warrants if additional amounts are drawn under the facility. The fair value of these warrants, $227,388, was recorded as a discount to the underlying debt and APIC.

The following table summarizes our warrant activities for the period ended March 31, 2012:

The exercise of 128,852 warrants in the first quarter of 2012 resulted in the issuance of 42,452 shares of common stock as the warrants were exercised using the cashless feature of the warrants.

We utilize a lattice model to determine the fair market value of the warrants. The 1,570,565 warrants issued in connection with our 2010 bridge financings and the 375,000 warrants issued in connection with our 2010 WTI financing were accounted for as derivative liabilities in connection with the price protection provisions of the warrants in compliance with ASC 815. There were 133,474 additional warrants issued to WTI in the first quarter of 2011 and an additional 143,700 warrants in the first quarter of 2012 as a result of the LPC share issuance triggering the anti-dilution clause in the original warrant agreement. The lattice model accommodates the probability of exercise price adjustment features as outlined in the warrant agreements. We recorded an unrealized gain of $217,551 resulting from the change in the fair value of the warrant derivative liability for the quarter ended March 31, 2012, respectively. Under the terms of the warrant agreement, at any time while the warrant is outstanding, the exercise price per share can be reduced to the price per share of future subsequent equity sales of our common stock or common stock equivalents that is lower than the exercise price per share as stated in the warrant agreement.

The estimated fair value was derived using the lattice model with the following weighted-average assumptions:

The following table summarizes our activities related to our warrants used in the derivative liability for the period ended March 31, 2012:

(11)           Commitments and Contingencies

Operating Leases

We lease two office facilities under non-cancelable operating lease agreements with expiration dates in 2013. For one facility, we have the option to extend the lease for another ten year term and have right of first refusal on any sale. We lease additional office facilities under month-to-month arrangements. Future minimum payments for the next five years and thereafter as of March 31, 2012, under these leases, are as follows:

Rent expense was $69,000 and $40,000 for the three months ended March 31, 2012 and 2011, respectively. Rent expense is determined using the straight-line method of the minimum expected rent paid over the term of the agreement. We have no contingent rent agreements.

Indemnifications

Our arrangements generally include limited warranties and certain provisions for indemnifying customers against liabilities if our products or services infringe a third-party's intellectual property rights. To date, we have not incurred any material costs as a result of such warranties or indemnifications and have not accrued any liabilities related to such obligations in the accompanying financial statements.

We have also agreed to indemnify our directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person's service as a director or officer, including any action by us, arising out of that person's services as our director or officer or that person's services provided to any other company or enterprise at our request.

Litigation

In November 2009, a complaint was served on the Company in connection with the following court action filed in Utah state court:  Yanaki and Activatek, Inc. v. Cook and Bacterin International, Inc., Case Number 090912772.  The complaint involves attempts by one of the plaintiffs, Yanaki, to sell shares of the Company’s common stock to a third party in a private sale.  Plaintiffs claim, as their primary allegation, that the Company intentionally interfered with the sales contract. Yanaki seeks $300,000, 358,904 shares of the Company’s common stock, attorneys fees, costs and punitive damages.  ActivaTek alleges that Yanaki intended to invest the proceeds from his stock sale in ActivaTek and ActivaTek lost millions of dollars from not receiving that investment.  ActivaTek seeks $5 to $10 million, attorneys fees, costs and punitive damages.  The Company believes this case lacks merit and plans to vigorously defend these claims.

On March 2, 2012, Bacterin International, Inc. ("Bacterin") filed a Complaint and Jury Demand in the United States District Court for the District of Colorado in Civil Action No. 12cv558-REB-MEH against Tissue Transplant Technology, Ltd, a Texas Limited Partnership and its general partner T-TOT, LLC, a Texas Limited Liability Company; and Transplant Technologies of Texas, Ltd, a Texas Limited Partnership, and its general partners TTT, LLC, a Texas Limited Liability Company and JWL Management, LLC, a Texas Limited Liability Company. Defendant Tissue Transplant Technology, LTD is using the trademark "Sterisponge" to identify various allograft products in the marketplace. In view of Bacterin's prior and established rights in the mark "Osteosponge," Bacterin has asserted against Tissue Transplant Technology, LTD claims for trademark infringement under federal law, unfair competition under federal law, trademark infringement under Colorado common law, and unfair competition under Colorado common law. In addition, Bacterin has also asserted against Transplant Technologies of Texas, LTD a claim for cancellation of a Federal Registration for "Sterisponge". Bacterin seeks injunctive relief, damages and exemplary damages to be determined at trial.

On March 2, 2012, Bacterin International, Inc. ("Bacterin") filed a Complaint and Jury Demand in the United States District Court for the District of Colorado in Civil Action No. 12cv555-REB-KLM against Evologics, LLC, a Texas limited liability company. Defendant Evologics is using the trademark "Evosponge" to identify various allograft products in the marketplace. In view of Bacterin's prior and established rights in the mark "Osteosponge," Bacterin has asserted against Evologics claims for trademark infringement under federal law, unfair competition under federal law, trademark infringement under Colorado common law, and unfair competition under Colorado common law. Bacterin seeks injunctive relief, damages and exemplary damages to be determined at trial. The parties have entered into a settlement agreement whereby Evologics has agreed to discontinue use of “Evosponge” within ninety (90) days.

On April 4, 2012, Bacterin International, Inc. filed suit against SeaArk Capital, LLC and its principal, Mark Bartosh, seeking recovery of $1,648,994 for product delivered to SeaArk in 2011. The case is pending in the United States District Court of the Eastern District of Pennsylvania. SeaArk has entered an appearance in the case but has not yet been required to file an answer asserting its defenses, if any.

On April 19, 2012, Bacterin International, Inc. filed a lawsuit in federal court in Dallas, Texas, seeking injunctive relief and damages against Shantal Howell, a former regional vice president of the company.  The suit arises out of the former employee’s breach of contract, breach of fiduciary duties, interference with Bacterin’s business relationships, and misappropriation of Bacterin’s trade secrets.  The company has not yet determined the full extent of damages to be recovered in the lawsuit.

(12)           Income Taxes

In evaluating the realizability of the net deferred tax assets, we take into account a number of factors, primarily relating to the ability to generate taxable income. Where it is determined that it is likely that we will be unable to realize deferred tax assets, a valuation allowance is established against the portion of the deferred tax asset. Because it cannot be accurately determined when or if we will become profitable, a valuation allowance was provided against the entire deferred income tax asset balance.

The 2007 through 2010 tax years remain open to examination by the Internal Revenue Service and the 2005 to 2010 tax years remain open to the Montana Department of Revenue.  These taxing authorities have the authority to examine those tax years until the applicable statute of limitations expire. 

The Company did not recognize any interest or penalties related to income taxes for the three months ended March 31, 2012 and 2011.

(13)           Employee Benefit Plans

 As of January 1, 2011, we switched from a SIMPLE IRA to a 401(k) retirement plan.  Qualified employees may defer their salary and the deferrals are matched up to 2%.  The 2% matching was $92,000 for 2011 and was paid by March 31, 2012.  Employees who made contributions in 2011 must have been employed as of March 31, 2012 to be eligible for the matching contribution.  The plan covers substantially all full-time employees.  Under the terms of the plan, participants may contribute up to the lower of $16,500 of their salary or the statutorily prescribed limit to the plan.  Employees are eligible after six months of employment and may enroll twice a year in January and July.

 (14)           Supplemental Disclosure of Cash Flow Information

Supplemental cash flow information is as follows:

 (15)           Related Party Transactions

Our Chief Executive Officer serves as a Board member of West Coast Tissue Services. In addition, one of our directors, Mitchell Godfrey, serves as a Board member of American Donor Services. Both of these entities recover tissues from donors and we reimburse them for recovery fees including labor costs. These relationships benefit us, thus insuring we have a pipeline of current and future donors which is necessary for our success. As of March 31, 2012, we had an accounts payable balance of $616,510 to American Donor Services. No compensation is paid to our Chief Executive Officer or our director for their services to those entities.

(16)            Subsequent Events

On April 23, 2012, the Company secured an accounts receivable credit facility with Midcap Financial LLC and Silicon Valley Bank. The revolving loan credit facility allows Bacterin to borrow up to $5 million through January 1, 2015. The facility allows borrowings based upon a predetermined formula of up to 80% of Bacterin's eligible accounts receivable, as defined in the credit and security agreement . The Company also amended its existing Loan and Security Agreement with MidCap to allow the Company to borrow up to an additional $3 million for the next six months in connection with a permitted acquisition. The credit facility carries an interest rate of LIBOR plus 4%, subject to a LIBOR floor rate of 2.5%. The Company also agreed to pay a 0.5% collateral management fee on the average outstanding balance of the facility and 1% of the average unused portion of the facility, as well as a 1% origination fee. Prepayment penalties apply.

On May 3, 2012, we provided LPC with notice of termination of our Purchase Agreement dated May 27, 2011.  The Purchase Agreement allowed us to require LPC to purchase up to $30 million of our common stock from time to time, and also allowed us to terminate the Purchase Agreement for any reason or for no reason with one business day's notice to LPC with no termination penalties.