Caterpillars are items found in Knock On Wood.
In Knock on Wood, they're used as both currency and are necessary to beat the level. Some doors will by blockaded by Ryvok's troops, who will only let you past if you bribe them. Other NPCs, like the Sailor in Mystic Woodlands, will charge you Caterpillars to get to certain places that are necessary to go to complete the level.
Looking very much like the Elm Sawfly larvae, also known as the Canadian Yellow Caterpillar, Caterpillars are a bright yellow and have a black stripe running down their backs. They also have heads with two beady black eyes.