Acquisition of MainStreet

On January 1, 2015, the Company completed its acquisition of MainStreet BankShares, Inc. ("MainStreet"). The merger of MainStreet with and into the Company was effected pursuant to the terms and conditions of the Agreement and Plan of Reorganization, dated as of August 24, 2014, between the Company and MainStreet, and a related Plan of Merger. Immediately after the merger, Franklin Community Bank, N.A., MainStreet's wholly owned bank subsidiary, merged with and into the Bank. Pursuant to the MainStreet merger agreement, holders of shares of MainStreet common stock received $3.46 in cash and 0.482 shares of the Company's common stock for each share of MainStreet common stock held immediately prior to the effective date of the merger, plus cash in lieu of fractional shares. Each option to purchase shares of MainStreet common stock that was outstanding immediately prior to the effective date of the merger vested upon the merger and was converted into an option to purchase shares of the Company's common stock, adjusted based on a 0.643 exchange ratio. Each share of the Company's common stock outstanding immediately prior to the merger remained outstanding and was unaffected by the merger. The cash portion of the merger consideration was funded through a cash dividend of $6,000,000 from the Bank to the Company, and no borrowing was incurred by the Company or the Bank in connection with the merger. Replacement stock option awards representing 43,086 shares of the Company's common stock were granted in conjunction with the MainStreet acquisition. The value of the consideration transferred with the replacement awards did not result in any goodwill.

The transaction was accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed, and consideration exchanged were recorded at estimated fair values on the acquisition date. Fair values are preliminary and subject to refinement for up to one year after the closing date of the acquisition.

In connection with the merger, the consideration paid, and the fair value of identifiable assets acquired and liabilities assumed as of the merger date are summarized in the following table (dollars in thousands):



Consideration Paid:
Common shares issued (825,586)	$	20,483
Cash paid to shareholders	5,935
Value of consideration	26,418

Assets acquired:
Cash and cash equivalents	18,173
Investment securities	18,800
Restricted stock	587
Loans	115,050
Premises and equipment	1,030
Deferred income taxes	2,773
Core deposit intangible	1,839
Other real estate owned	168
Banked owned life insurance	1,955
Other assets	1,077
Total assets	161,452

Liabilities assumed:
Deposits	137,323
Other liabilities	3,001
Total liabilities	140,324
Net assets acquired	21,128
Goodwill resulting from merger with MainStreet	$	5,290

The following table details the changes in fair value of net assets acquired and liabilities assumed from the amounts originally reported in the Form 10-Q for the quarterly period ended June 30, 2015 (dollars in thousands):



Goodwill at June 30, 2015	$	5,167

Effect of adjustments to:
Loans	(353		)
Premises and equipment	289
Other Assets	187
Goodwill at September 30, 2015	$	5,290

The increase in goodwill made during the third quarter of 2015 was due to a reevaluation of the loan portfolio, fair value appraisals of premises, and a change in estimated tax refunds due to MainStreet. As a part of the reevaluation, numerous loans were transferred to the purchased credit impaired portfolio primarily because of concerns over underlying collateral values, repayment terms and debt service coverage. The transfer resulted in a reduction in goodwill and accretion income of $353,000.

In many cases, the fair values of assets acquired and liabilities assumed were determined by estimating the cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. The most significant category of assets for which this procedure was used was that of acquired loans. The Company acquired the $122,447,000 loan portfolio at a fair value discount of $7,397,000. The estimated fair value of the performing portion of the portfolio was $87,803,000. The excess of expected cash flows above the fair value of the performing portion of loans will be accreted to interest income over the remaining lives of the loans in accordance with FASB Accounting Standards Codification ("ASC") 310-20.

Certain loans, those for which specific credit-related deterioration since origination was identified, are recorded at fair value, reflecting the present value of the amounts expected to be collected. Income recognition on these loans is based on reasonable expectations about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.

The following table details the acquired loans that are accounted for in accordance with FASB ASC 310-30 as of January 1, 2015, after adjusting for the aforementioned reevaluation in the third quarter (dollars in thousands):



Contractually required principal and interest at acquisition	$	33,066
Contractual cash flows not expected to be collected (nonaccretable difference)	1,828
Expected cash flows at acquisition	34,894
Interest component of expected cash flows (accretable yield)	7,647
Fair value of acquired loans accounted for under FASB ASC 310-30	$	27,247

In accordance with GAAP, there was no carryover of the allowance for loan losses that had been previously recorded by MainStreet.

In connection with the acquisition of MainStreet, the Company acquired an investment portfolio with a fair value of $18,800,000. The fair value of the investment portfolio was determined by taking into account market prices obtained from independent valuation sources.

In connection with the acquisition of MainStreet, the Company recorded a deferred income tax asset of $2,773,000 related to tax attributes of MainStreet, along with the effects of fair value adjustments resulting from applying the acquisition method of accounting.

In connection with the acquisition of MainStreet, the Company acquired other real estate owned with a fair value of $168,000. Other real estate owned was measured at fair value less estimated cost to sell.

In connection with the acquisition of MainStreet, the Company acquired premises and equipment with a fair value of $1,030,000.

The fair value of savings and transaction deposit accounts acquired from MainStreet was assumed to approximate their carrying value as these accounts have no stated maturity and are payable on demand. Certificates of deposit accounts were valued by comparing the contractual cost of the portfolio to an identical portfolio bearing current market rates. The portfolio was segregated into pools based on segments: retail, individual retirement accounts, and brokered. For each segment, the projected cash flows from maturing certificates were then calculated based on contractual rates and prevailing market rates. The valuation adjustment for each segment is equal to the present value of the difference of these two cash flows, discounted at the assumed market rate for a certificate with a corresponding maturity. This valuation adjustment of $290,000 will be accreted to reduce interest expense over the average remaining maturities of the respective pools, which is estimated to be 12 months.

A core deposit intangible of $1,839,000 was recognized in connection with the acquisition of MainStreet. This intangible will be amortized over a 10 year period on an accelerated cost recovery basis.

Direct costs related to the acquisition were expensed as incurred. During 2015, the Company incurred $1,948,000 acquisition related expenses.

The following table presents unaudited pro forma information as if the acquisition of MainStreet had occurred on January 1, 2014. This pro forma information gives effect to certain adjustments, including acquisition accounting fair value adjustments, amortization of core deposit intangible and related income tax effects. The pro forma information does not necessarily reflect the results of operations that would have occurred had the merger with MainStreet occurred in 2014. In particular, expected operational cost savings are not reflected in the pro forma amounts (dollars in thousands).



	Pro forma Nine Months Ended
	September 30, 2015			September 30, 2014
Net interest income	$	37,584		$	37,302
Provision for loan loss	(700		)	(150		)
Non-interest income	9,469			9,055
Non-interest expense and income taxes	(35,660		)	(34,644		)
Net income	$	10,693		$	11,563



	Pro forma Three Months Ended
	September 30, 2015			September 30, 2014
Net interest income	$	12,378		$	12,512
Provision for loan loss	—			—
Non-interest income	3,055			3,205
Non-interest expense and income taxes	(11,245		)	(11,868		)
Net income	$	4,188		$	3,849