Mainstreet Bankshares (MREE) 10QSB 2006 Q2 Quarterly report (small business)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-QSB

(Mark One)

x QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

¨ TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE EXCHANGE ACT

For the transition period from            to            

Commission file number 333-86993

MainStreet BankShares, Inc.

(Exact name of small business issuer as specified in its charter)

Virginia	54-1956616
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

Suite 30, Patrick Henry Mall 730 East Church Street, Martinsville, Virginia	24112
(Address of principal executive offices)	(Zip Code)

Issuer’s telephone number (276) 632-8054

(Former name, former address and former fiscal year, if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 1,603,569 as of July 31, 2006

Transitional Small Business Disclosure Format: (Check one):    Yes  ¨    No  x

MAINSTREET BANKSHARES, INC.

Form 10-QSB

Index

		Page No.
PART I FINANCIAL INFORMATION
Item 1	Financial Statements	3-18
Item 2	Management’s Discussion and Analysis	18-27
Item 3	Controls and Procedures	28
PART II OTHER INFORMATION
Item 4	Submission of Matters to a Vote of Security Holders	28
Item 6	Exhibits	28
	Signatures	29
	Index to Exhibits	30

2

MAINSTREET BANKSHARES, INC.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

The financial statements filed as part of Item 1 of Part I are as follows:

1.	Consolidated Balance Sheet as of June 30, 2006 (unaudited).	4
2.	Consolidated Statements of Income for the quarters ended June 30, 2006 (unaudited) and June 30, 2005 (unaudited).	5
3.	Consolidated Statements of Income for the year-to-date periods ended June 30, 2006 (unaudited) and June 30, 2005 (unaudited).	6
4.	Consolidated Statements of Cash Flows for the year-to-date periods ended June 30, 2006 (unaudited) and June 30, 2005 (unaudited).	7
5.	Notes to Consolidated Financial Statements.	8

3

MAINSTREET BANKSHARES, INC.

Consolidated Balance Sheet

(Unaudited)

June 30, 2006

ASSETS
Cash and due from banks	$	3,958,192
Interest bearing deposits in banks		211,404
Federal funds sold		4,009,000
Securities available for sale		3,741,594
Restricted equity securities		1,361,100
Loans:
Commercial loans		91,908,817
Residential real estate loans		27,235,581
Consumer loans		38,886,800
Total Gross Loans		158,031,198
Unearned deferred fees and costs, net		154,758
Loans, net of unearned deferred fees and costs		158,185,956
Less: allowance for loan losses		(1,894,522	)
Net Loans		156,291,434
Furniture, fixtures and equipment		747,977
Accrued interest receivable		773,125
Other assets		1,221,770
TOTAL ASSETS	$	172,315,596
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest bearing demand deposits	$	15,113,064
Interest checking deposits		8,985,779
Money market deposits		8,980,590
Savings deposits		14,423,189
Time deposits $100,000 and over		36,311,600
Other time deposits		54,734,914
Total Deposits		138,549,136
Short-term borrowings		15,000,000
Accrued interest payable and other liabilities		1,029,950
Total Liabilities		154,579,086
Shareholders’ Equity:
Preferred stock, no par value, authorized 10,000,000 shares; none issued
Common stock, no par value, authorized 10,000,000 shares; issued and outstanding 1,603,569 shares		15,650,606
Retained earnings		2,124,180
Accumulated other comprehensive loss		(38,276	)
Total Shareholders’ Equity		17,736,510
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	172,315,596

See accompanying notes to consolidated financial statements.

4

MAINSTREET BANKSHARES, INC.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended June 30, 2006		Three Months Ended June 30, 2005
Interest Income:
Interest and fees on loans	$	3,119,716	$	1,971,623
Interest on interest-bearing deposits		3,002		724
Interest on federal funds sold		78,215		21,671
Interest on securities available for sale		22,202		24,368
Dividends on restricted equity securities		19,317		10,098
Total Interest Income		3,242,452		2,028,484
Interest Expense:
Interest on time deposits $100,000 and over		381,719		176,774
Interest on other deposits		783,820		446,654
Interest on short-term borrowings		128,307		22,581
Interest on long-term borrowings		58,131		31,456
Total Interest Expense		1,351,977		677,465
Net Interest Income		1,890,475		1,351,019
Provision for loan losses		38,000		219,900
Net Interest Income After Provision for Loan Losses		1,852,475		1,131,119
Noninterest Income:
Service charges on deposit accounts		54,691		44,637
Mortgage brokerage income		76,386		102,478
Servicing fee income		147,021		126,250
Other fee income and miscellaneous income		23,428		15,329
Total Noninterest Income		301,526		288,694
Noninterest Expense:
Salaries and employee benefits		548,659		434,312
Occupancy and equipment expense		138,910		126,453
Professional fees		85,176		56,510
Advertising and promotion		28,475		18,750
Outside processing		77,490		68,219
Franchise tax		40,251		31,800
Other expenses		128,483		107,091
Total Noninterest Expense		1,047,444		843,135
Net Income From Continuing Operations Before Tax	$	1,106,557	$	576,678
Income Tax Expense		363,281		196,619
Net Income From Continuing Operations		743,276		380,059
Discontinued Operations:
Gain on sale of subsidiary, net of $0 tax		—		2,719
Income from discontinued operations, net of $0 tax		—		—
Net Income From Discontinued Operations		—		2,719
Net Income	$	743,276	$	382,778
Basic Net Income Per Share From Continuing Operations	$	.47	$	.24
Basic Net Income Per Share	$	.47	$	.24
Diluted Net Income Per Share From Continuing Operations	$	.44	$	.24
Diluted Net Income Per Share	$	.44	$	.24

See accompanying notes to consolidated financial statements.

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MAINSTREET BANKSHARES, INC.

Consolidated Statements of Income

(Unaudited)

	Six Months Ended June 30, 2006		Six Months Ended June 30, 2005
Interest Income:
Interest and fees on loans	$	6,011,737	$	3,527,767
Interest on interest-bearing deposits		6,602		4,034
Interest on federal funds sold		118,449		32,389
Interest on securities available for sale		44,512		47,923
Dividends on restricted equity securities		36,673		15,056
Total Interest Income Total Interest Income		6,217,973		3,627,169
Interest Expense:
Interest on time deposits $100,000 and over		704,227		305,840
Interest on other deposits		1,459,228		832,599
Interest on federal funds purchased		2,466		—
Interest on short-term borrowings		183,894		40,862
Interest on long-term borrowings		158,772		31,456
Total Interest Expense		2,508,587		1,210,757
Net Interest Income		3,709,386		2,416,412
Provision for loan losses		117,044		384,600
Net Interest Income After Provision for Loan Losses		3,592,342		2,031,812
Noninterest Income:
Service charges on deposit accounts		105,922		89,470
Mortgage brokerage income		156,597		180,126
Servicing fee income		273,271		264,598
Other fee income and miscellaneous income		62,662		25,020
Total Noninterest Income		598,452		559,214
Noninterest Expense:
Salaries and employee benefits		1,090,424		837,078
Occupancy and equipment expense		277,094		250,087
Professional fees		152,349		105,460
Advertising and promotion		51,275		37,500
Outside Processing		158,823		139,271
Franchise tax		80,502		63,000
Other expenses		228,249		218,611
Total Noninterest Expense		2,038,716		1,651,007
Net Income From Continuing Operations Before Tax	$	2,152,078	$	940,019
Income Tax Expense		691,429		320,472
Net Income From Continuing Operations		1,460,649		619,547
Discontinued Operations:
Gain on sale of subsidiary, net of $0 tax		—		1,406,165
Income from discontinued operations, net of $0 tax		—		239,483
Net Income From Discontinued Operations		—		1,645,648
Net Income	$	1,460,649	$	2,265,195
Basic Net Income Per Share From Continuing Operations	$	.92	$	.39
Basic Net Income Per Share	$	.92	$	1.44
Diluted Net Income Per Share From Continuing Operations	$	.89	$	.39
Diluted Net Income Per Share	$	.89	$	1.44

See accompanying notes to consolidated financial statements.

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MAINSTREET BANKSHARES, INC.

Consolidated Statements of Cash Flows

(Unaudited)

	Six Months Ended June 30, 2006			Six Months Ended June 30, 2005
Cash Flows From Operating Activities
Net income from continuing operations	$	1,460,649		$	619,547
Net income from discontinued operations		—			1,645,648
Provision for loan losses		117,044			384,600
Gain on sale of subsidiary		—			(1,606,165	)
Depreciation and amortization		86,379			70,810
Amortization of discounts and premiums, net		(2,447	)		1,942
Increase in accrued interest receivable		(137,767	)		(173,683	)
(Increase) decrease in other assets		153,265			(476,986	)
Increase (decrease) in accrued interest payable and other liabilities		(149,778	)		107,207
Net cash provided by operating activities		1,527,345			572,920
Cash Flows From Investing Activities
(Increase) decrease in interest-bearing deposits		(105,091	)		193,930
(Increase) decrease in federal funds sold		(4,009,000	)		2,280,000
Purchases of furniture, fixtures, and equipment		(18,596	)		(178,609	)
Purchases of securities available for sale		(3,496,455	)		(4,498,632	)
Purchases of restricted equity securities		(349,500	)		(744,850	)
Proceeds from calls and maturities of securities available for sale		2,300,000			2,000,000
Loan originations and principal collections, net		(13,869,141	)		(32,613,122	)
Proceeds from sale of subsidiary		—			6,500,000
Costs of subsidiary sale		—			(212,527	)
Increase in assets held for sale		—			(1,661,809	)
Increase in liabilities held for sale		—			1,422,326
Net cash used in investing activities		(19,547,783	)		(27,513,293	)
Cash Flows From Financing Activities
Increase in time deposits $100,000 and over		6,306,549			6,593,749
Increase in other time deposits		8,954,106			8,874,061
Increase (decrease) in other deposits		(867,280	)		2,697,199
Decrease in federal funds purchased		(2,025,000	)		—
Proceeds from short-term borrowings		15,000,000			4,000,000
Repayment of short-term borrowings		—			(4,000,000	)
Proceeds from long-term borrowings		—			10,000,000
Repayment of long-term borrowings		(10,000,000	)		—
Issuance of common stock		300,000			402,759
Costs of stock issuance		—			(1,662	)
Net cash provided by financing activities		17,668,375			28,566,106
Net increase (decrease) in cash		(352,063	)		1,625,733
Cash and due from banks at beginning of period	$	4,310,255		$	1,862,473
Cash and due from banks at end of period	$	3,958,192		$	3,488,206
Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	2,732,200		$	1,278,412
Cash paid during the period for taxes	$	180,000		$	887,300
Supplemental disclosure of noncash transactions:
Assets of subsidiary sold	$	—		$	61,108,248
Liabilities of subsidiary sold	$	—		$	56,426,941

See accompanying notes to consolidated financial statements.

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MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

Note 1 – Summary of Accounting Policies

(a) General

The accompanying consolidated financial statements of MainStreet BankShares, Inc. are unaudited. However, in the opinion of management, all adjustments necessary for a fair presentation of the financial statements have been included. All adjustments were of a normal recurring nature, except as otherwise disclosed herein. The consolidated financial statements conform to generally accepted accounting principles and general banking industry practices. The information contained in the footnotes included in MainStreet BankShares Inc. 2005 Annual Report of Form 10-KSB should be referred to in connection with the reading of these unaudited interim consolidated financial statements. In certain instances, amounts reported in the 2005 financial statements have been reclassified to conform to the 2006 statement presentation.

MainStreet BankShares, Inc. (the “Corporation”, “MainStreet”, or “BankShares”) incorporated as a Virginia corporation effective January 14, 1999 was a development stage enterprise until July 24, 2000. MainStreet has had two registered stock offerings since its inception raising a total of $14,029,501. The Corporation was primarily organized to serve as a bank holding company. Currently, MainStreet has one wholly-owned subsidiary, Franklin Community Bank, National Association (“Franklin Bank”).

Franklin Bank operates as a locally owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. Franklin Bank’s primary service area is Franklin County, Town of Rocky Mount and surrounding areas. Franklin Bank was organized as a nationally chartered commercial bank and member of the Federal Reserve Bank of Richmond. Franklin Bank opened for business on September 16, 2002.

On September 20, 2004, MainStreet BankShares, Inc. commenced a private placement offering of its common stock to accredited investors and up to 35 non-accredited investors under Rule 506 of the Securities Exchange Act of 1933. The offering was for a target issuance of 183,334 shares of common stock. The offering was set to terminate on October 31, 2004, but the Board of Directors of BankShares extended the offering until January 31, 2005. There were no brokerage or underwriting commissions payable in the private placement. The offering terminated January 31, 2005 having sold 200,789 shares with total proceeds of $1,807,101. The additional capital raised by this offering was used principally to aid in maintaining all regulatory capital ratios at the adequately capitalized level.

On January 13, 2005, MainStreet, Smith River Community Bank, National Association (“Smith River”), and Argentum Capital Management, LLC (“Argentum”) entered into an Agreement pursuant to which MainStreet agreed to sell, and Argentum or its assigns agreed to purchase, all of the outstanding shares of the common stock of Smith River Bank for $6,500,000. The transaction closed on March 23, 2005. As part of the transaction, MainStreet agreed to acquire specified loans from Smith River under certain conditions after the closing. In the event Smith River determines it must charge off one of the specified loans, (after pursuing normal collection efforts), MainStreet will acquire all of Bank’s right, title and interest in the charged off loan. MainStreet’s obligation to purchase such loans will not exceed the principal amount of the loans at the time of purchase plus Smith River’s out of pocket collection expenses. The outstanding principal balance of such loans at June 30, 2006 was $222,543. MainStreet recorded a contingent liability of $250,000 against such loans in 2005. MainStreet paid Smith River $142,171 in June 2006 to indemnify them for one such loan. The reserve against such loans at June 30, 2006 was $107,829. Also as part of the transaction, Smith River has agreed to outsource certain administrative and related activities to MainStreet for a period of three years following the closing for an annual fee of $505,000 to be adjusted annually based upon the terms of the original agreement. MainStreet downstreamed $4,000,000 to

8

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

Franklin Bank immediately following the sale of Smith River. MainStreet and Franklin Bank were well-capitalized at June 30, 2006.

The Corporation reports its activities as a single business segment. In determining the appropriateness of segment definition, the Corporation considered components of the business about which financial information is available and will evaluate it regularly relative to resource allocation and performance assessment.

Due to the sale of Smith River on March 23, 2005, the affiliate fee income and the servicing fee income received monthly since the sale are both shown in servicing fee income. The net income of the bank is shown as income from discontinued operations on the consolidated income statement. Following is a condensed breakdown of the specific categories.

Smith River Community Bank, N.A.

Condensed Income Statement

	Three Months Ended June 30, 2006		Three Months Ended June 30, 2005
Interest Income	$	—	$	—
Interest Expense		—		—
Net Interest Income		—		—
Provision for loan losses		—		—
Net Interest Income after provision for loan losses		—		—
Noninterest Income		—		—
Noninterest Expense		—		—
Net Income	$	—	$	—
	Six Months Ended June 30, 2006		Six Months Ended June 30, 2005
Interest Income	$	—	$	823,586
Interest Expense		—		268,853
Net Interest Income		—		554,733
Provision for loan losses		—		—
Net Interest Income after provision for loan losses		—		554,733
Noninterest Income		—		143,362
Noninterest Expense		—		458,612
Net Income	$	—	$	239,483

9

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

(b) Principles of Consolidation

The consolidated financial statements include the accounts of MainStreet and its wholly-owned subsidiary, Franklin Bank. The net income of Smith River Bank is shown as income from discontinued operations. All significant intercompany accounts and transactions associated with Franklin Bank have been eliminated. The intercompany accounts with Smith River Bank have not been eliminated in order to provide realistic financial information for continuing and discontinued operations. The affiliate fee paid to MainStreet from Smith River during the first quarter of 2005 in the amount of $127,488 has not been eliminated.

(c) Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks.

(d) Securities

BankShares classifies and accounts for its investments in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Securities are classified at purchase date under the specific identification method. Amortization and accretion of premiums and discounts are included in income over the contractual life of the securities. The cost of securities sold is determined on the specific identification method.

(e) Loans

Loans are stated at the unpaid principal balances. Interest on loans is computed by methods which generally result in level rates of return on principal amounts outstanding. It is the BankShares’ policy to discontinue the accrual of interest on loans once they become 90 days past due and are not well-collateralized, or earlier when it becomes doubtful that the full principal and interest will be collected. Once a loan is placed on nonaccrual status, any interest that is collected will be recorded on a cash basis. Interest on impaired loans is recognized in the same manner as loans that are not considered impaired; that is interest is generally recognized on the cash basis once the collection of principal and interest is 90 days or more past due.

BankShares collectively reviews for impairment all consumer loans and smaller homogeneous loans. BankShares considers a loan to be impaired when, based upon current information and events, it believes it is probable that BankShares will be unable to collect all amounts due according to the contractual terms of the loan agreement. BankShares’ impaired loans include nonaccrual loans, troubled debt restructurings, and certain other nonperforming loans. For collateral dependent loans, BankShares bases the measurement of these impaired loans on the fair value of the loan’s collateral properties. For all other loans, BankShares uses the measurement of these impaired loans on the more readily determinable of the present value of expected future cash flows discounted at the loan’s effective interest rate or the observable market price. Impairment losses are recognized through an increase in the allowance for loan losses and a corresponding charge to the provision for loan losses. Adjustments to impairment losses due to changes in the fair value of impaired loans’ collateral properties are included in the provision for loan losses.

(f) Loan Fees and Costs

BankShares adopted Statement of Financial Accounting Standards No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”. Using a method that approximates the interest method, loan origination and commitment fees and certain costs are

10

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

deferred over the contractual life of the related loan as an adjustment to the net interest margin. A regular review will be conducted on the pricing levels of fees and costs as experience with our lending process increases.

(g) Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and are capable of estimation and (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Management reviews the past due reports and risk ratings and discusses individually the loans on these reports with the responsible loan officers. Management provides a quarterly analysis of the allowance based on peer analysis, regulatory reserve analysis and an analysis based on the experience in each category of commercial, real estate or consumer loans. With this information, management then again utilizes the tools and analyzes the risk-rated loans, past dues, concentrations of credit, unsecured loans, and the economic trend to further add to the allowance. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. This allowance, then, is designated as a specific reserve. Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term. However, the amount of the change that is reasonably possible cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms.

(h) Other Real Estate

Other real estate is comprised of properties acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. The properties are carried at the fair market value less selling costs, based on appraised value. Loan losses arising from the acquisition of such properties are charged against the allowance for loan losses. Any subsequent write-downs are charged to expenses. While management uses available information to recognize losses on other real estate, additional write-downs may be necessary based on changes in economic conditions.

(i) Furniture, Fixtures and Equipment

Furniture, fixtures and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are charged to expense on a straight-line basis over the estimated useful lives. Maintenance, repairs, and minor improvements are charged to expense as incurred. Significant improvements are capitalized.

11

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

(j) Organizational Costs

The American Institute of CPA’s has issued Statement of Position 98-5, “Reporting on the Costs of Start-Up Activities.” In general, the SOP requires that organizational and similar start-up costs be expensed. Examples of such costs that have been incurred by the Corporation are legal fees, consulting fees, and regulatory application fees. The Corporation adopted the requirements of the SOP from its inception and has accordingly expensed all organizational costs.

(k) Stock Options and Warrants

Revision to FASB Statement No. 123, “Accounting for Stock-Based Compensation” was effective for MainStreet for the first interim reporting period beginning after December 15, 2005 and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. It 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. Prior to January 1, 2006, MainStreet accounted for its stock options using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees”.

Pro forma information is presented in prior years as if net income had been determined under the fair value based method as prescribed by SFAS No. 123.

	Quarter Ended June 30, 2006			Quarter Ended June 30, 2005
Net income as reported	$	743,276		$	382,778
Deduct total stock-based employee Compensation expense determined under fair value based method for all awards		(—	)		(—	)
Proforma net income	$	743,276		$	382,778
Net income per share:
Basic-as reported	$	.47		$	.24
Basic-proforma	$	.47		$	.24
Diluted-as reported	$	.44		$	.24
Diluted-proforma	$	.44		$	.24
	Six Months Ended June 30, 2006			Six Months Ended June 30, 2005
Net income as reported	$	1,460,649		$	2,265,195
Deduct total stock-based employee compensation expense determined under fair value based method for all awards		(—	)		(—	)
Proforma net income	$	1,460,649		$	2,265,195
Net income per share:
Basic-as reported	$	.92		$	1.44
Basic-proforma	$	.92		$	1.44
Diluted-as reported	$	.89		$	1.44
Diluted-proforma	$	.89		$	1.44

12

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

(l) Advertising Costs

Advertising costs are expensed as incurred.

(m) Income Taxes

The Corporation is subject to federal and state income taxes. The liability (or balance sheet) approach is used in financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed quarterly for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expenses is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.

(n) Net Income Per Share

Statement of Financial Accounting Standards No. 128, “Accounting for Earnings Per Share” requires dual presentation of basic and diluted earnings per share on the face of the statements of income and requires a reconciliation of the numerators and denominators of the basic and diluted earnings per share calculation. Basic income per share is calculated based on the weighted average number of shares of common stock outstanding during each period. For the quarter ending June 30, 2006 and June 30, 2005, basic income per share and average shares outstanding were $.47 and 1,593,020 and $.24 and 1,573,569, respectively. For the year-to-date period ending June 30, 2006 and 2005 basic income per share and average shares outstanding were $.92 and 1,583,348 and $1.44 and 1,568,576, respectively. Diluted income per share is computed using the weighted average number of shares of common stock outstanding during each period adjusted to reflect the dilutive effect of all potential common shares that were outstanding during the period. At June 30, 2006 and June 30, 2005, there were 75,833 warrants outstanding and exercisable. At June 30, 2006 and June 30, 2005, there were 128,377 and 60,000 options, respectively, that were outstanding and exercisable.

(o) Use of Estimates

The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.

The Corporation’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Corporation to recognize additional losses based on their

13

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

Note 2 – Securities

The carrying values, unrealized gains and losses and approximate market values of investment securities at June 30, 2006 are shown in the tables below. The entire investment portfolio is classified as available-for-sale to preserve maximum liquidity for funding needs.

	June 30, 2006
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Approximate Market Value
U.S. government agencies	$	3,799,588	$	—	$	(57,994	)	$	3,741,594
Total securities available for sale	$	3,799,588	$	—	$	(57,994	)	$	3,741,594

Note 3 – Allowance for Loan Losses

Changes in the allowance for loan losses for the six months ended June 30, 2006 and 2005 are as follows:

	2006			2005
Balance at beginning of year	$	1,777,345		$	1,123,214
Provision for loan losses		117,044			384,600
Recoveries		10,213			33,214
Charge-offs		(10,080	)		(8,619	)
Balance at period end	$	1,894,522		$	1,532,409

Net charge-offs (recoveries) of $(133) and $(24,595) for the first six months of 2006 and 2005 equated to 00% and ..(.05)% respectively, of average loans outstanding net of unearned income and deferred fees. The loan loss reserve at June 30, 2006 was $1,894,522 or 1.20% of loans, net of unearned income and deferred fees. There were no loans past due more than 90 days at June 30, 2006 and December 31, 2005. Nonaccrual loans were $0 and $10,975 at June 30, 2006 and December 31, 2005, respectively. These loans are also considered impaired loans. Lost interest related to impaired loans as of June 30, 2006 and June 30, 2005 was $0 and $228, respectively. Overdrafts reclassified to loans at June 30, 2006 and December 31, 2005 were $85,262 and $38,250, respectively.

14

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

Note 4 – Income Per Share

	Three Months Ended June 30, 2006
	Income Numerator		Shares Denominator	Per Share Amount
Basic EPS
Net income from continuing operations, net of tax	$	743,276	1,593,020	$	.47
Net income from discontinued operations, net of tax	$	—	1,593,020	$	.00
Net income available to common shareholders	$	743,276	1,593,020	$	.47
Diluted EPS
Net income from continuing operations, net of tax	$	743,276	1,673,334	$	.44
Net income from discontinued operations, net of tax	$	—	1,673,334	$	.00
Net income available to common shareholders	$	743,276	1,673,334	$	.44
	Three Months Ended June 30, 2005
	Income Numerator		Shares Denominator	Per Share Amount
Basic EPS
Net income from continuing operations, net of tax	$	380,059	1,573,569	$	.24
Net income from discontinued operations, net of tax	$	2,719	1,573,569	$	.00
Net income available to common shareholders	$	382,778	1,573,569	$	.24
Diluted EPS
Net income from continuing operations, net of tax	$	380,059	1,578,609	$	.24
Net income from discontinued operations net of tax	$	2,719	1,578,609	$	.00
Net income available to common shareholders	$	382,778	1,578,609	$	.24

15

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

	Six Months Ended June 30, 2006
	Income Numerator		Shares Denominator	Per Share Amount
Basic EPS
Net income from continuing operations, net of tax	$	1,460,649	1,583,348	$	.92
Net income from discontinued operations, net of tax	$	—	1,583,348	$	.00
Net income available to common shareholders	$	1,460,649	1,583,348	$	.92
Diluted EPS
Net income from continuing operations, net of tax	$	1,460,649	1,642,406	$	.89
Net income from discontinued operations, net of tax	$	—	1,642,406	$	.00
Net income available to common shareholders	$	1,460,649	1,642,406	$	.89
	Six Months Ended June 30, 2005
	Income Numerator		Shares Denominator	Per Share Amount
Basic EPS
Net income from continuing operations, net of tax	$	619,547	1,568,576	$	.39
Net income from discontinued operations, net of tax	$	1,645,648	1,568,576	$	1.05
Net income available to common shareholders	$	2,265,195	1,568,576	$	1.44
Diluted EPS
Net income from continuing operations, net of tax	$	619,547	1,573,616	$	.39
Net income from discontinued operations, net of tax	$	1,645,648	1,573,616	$	1.05
Net income available to common shareholders	$	2,265,195	1,573,616	$	1.44

16

MAINSTREET BANKSHARES, INC.

Notes to Consolidated Financial Statements

(Unaudited)

June 30, 2006

Note 5 – Comprehensive Income

BankShares adopted Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income”. This statement established standards for reporting and presentation of comprehensive income and its components. The following table discloses the reclassifications related to securities available-for-sale that are included in accumulated other comprehensive loss on the balance sheet as of June 30, 2006 and 2005.

	June 30, 2006			June 30, 2005
Net Income	$	1,460,649		$	2,265,195
Net unrealized holding losses during the period		(11,091	)		(26,197	)
Less reclassification adjustments for gains (losses) included in net income		—			—
Accumulated other comprehensive income of subsidiary sold		—			(35,679	)
Income Tax benefit		3,771			8,907
Change in accumulated other comprehensive loss		(7,320	)		(52,969	)
Total Comprehensive Income	$	1,453,329		$	2,212,226

Note 6 – Financial Instruments With Off-Balance-Sheet Risk

In the normal course of business to meet the financing needs of its customers, BankShares is a party to financial instruments with off-balance-sheet risk. These financial instruments involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk. At June 30, 2006, outstanding commitments to extend credit were $36,634,904.

Commitments to extend credit are agreements to lend to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments may expire without ever being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash outlays for the Corporation.

Note 7 – Short-term borrowings

Short-term borrowings as of June 30, 2006 consist of two Federal Home Loan Bank of Atlanta advances. The first advance in the amount of $10,000,000 is a prime rate based advance. Interest is paid monthly at prime minus 2.81%. The interest rate at June 30, 2006 was 5.44%. Early repayment of the advance is subject to a .25% fee of the advance amount being repaid. The maturity date is May 18, 2007. The second advance in the amount of $5,000,000 is a fixed rate credit advance maturing every two weeks. Interest is paid at maturity. The interest rate at June 30, 2006 was 5.31%.

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MAINSTREET BANKSHARES, INC.

June 30, 2006

Note 8 – Contingencies and Other Matters

The Corporation currently is not involved in any litigation or similar adverse legal or regulatory matters.

Item 2. Management’s Discussion and Analysis

Forward-Looking Statements

This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements, which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. The Corporation takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic conditions, either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; and (4) legislative or regulatory changes including changes in accounting standards, may adversely affect the business.

General

MainStreet BankShares, Inc. (the “Corporation”, “MainStreet”, or “BankShares”), incorporated as a Virginia corporation effective January 14, 1999, was a development stage enterprise until July 24, 2000. MainStreet has had two registered stock offerings since its inception raising a total of $14,029,501. The Corporation was primarily organized to serve as a bank holding company. MainStreet has one wholly-owned subsidiary, Franklin Community Bank, National Association (“Franklin Bank.”).

Franklin Bank was organized as a nationally chartered commercial bank and member of the Federal Reserve Bank of Richmond. Franklin Bank opened for business on September 16, 2002. Franklin Bank operates as a locally owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. Franklin Bank’s primary service area is Franklin County, Town of Rocky Mount and surrounding areas.

On September 20, 2004, BankShares commenced a private placement offering of its common stock to accredited investors and up to 35 non-accredited investors under Rule 506 of the Securities and Exchange Act of 1933. The offering was for a target issuance of 183,334 shares of common stock. There were no brokerage or underwriting commissions payable in the private placement. The offering terminated January 31, 2005 having sold 200,789 shares with total proceeds of $1,807,101. The additional capital raised by this offering was used principally to aid in maintaining all regulatory capital ratios at the adequately capitalized level.

On January 13, 2005, MainStreet, Smith River Community Bank, National Association (“Smith River”), and Argentum Capital Management, LLC (“Argentum”) entered into an Agreement pursuant to which MainStreet agreed to sell, and Argentum, or investors obtained by Argentum for this purpose, agreed to purchase, all of the outstanding shares of the common stock of Smith River for $6,500,000. Argentum is a limited liability company engaged in investment banking and headquartered in Durham, North Carolina. The transaction closed on March 23, 2005. As part of the transaction, MainStreet has agreed to acquire specified loans from Smith River under certain conditions after the closing. In the event Smith River determines it must charge off one of the specified loans, (after pursuing normal collection efforts), MainStreet will acquire all of Bank’s right, title, and interest in the charged off loan.

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MAINSTREET BANKSHARES, INC.

June 30, 2006

MainStreet’s obligation to purchase such loans will not exceed the principal amount of the loans at the time of purchase plus Smith River’s out of pocket collection expenses. The outstanding principal balance of such loans at June 30, 2006 was $222,543. MainStreet recorded a contingent liability of $250,000 against such loans in 2005. MainStreet paid Smith River $142,171 in June 2006 to indemnify them for one such loan. The reserve against such loans at June 30, 2006 was $107,829. Also as part of the transaction, Smith River has agreed to outsource certain administrative and related activities to MainStreet for a period of three years following the closing for an annual fee of $505,000 to be adjusted annually based upon the terms of the original agreement. MainStreet downstreamed $4,000,000 to Franklin Bank immediately following the sale of Smith River. MainStreet and Franklin Bank were well-capitalized at June 30, 2006.

Critical Accounting Policies

MainStreet’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors, peer comparisons, regulatory factors, concentrations of credit, past dues, and the trend in the economy as factors in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk.

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and are capable of estimation and (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Management reviews the past due reports and risk ratings and discusses individually the loans on these reports with the responsible loan officers. Management provides a quarterly analysis of the allowance based on peer analysis, regulatory reserve analysis and an analysis based on the experience in each category of commercial, real estate or consumer loans. With this information management then again utilizes the tools and analyzes the risk-rated loans, past dues, concentrations of credit, unsecured loans, and the economic trend to further add to the allowance. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. This allowance, then, is designated as a specific reserve. Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term. However, the amount of the change that is reasonably possible cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms.

Overview

Total assets at June 30, 2006 were $172,315,596 as compared to $153,343,670 at December 31, 2005, an increase of $18,971,926, or 12.37%. An increase in deposits and short-term borrowings funded loan growth. The largest components of total assets at June 30, 2006 were net loans in the amount of $156,291,434, federal funds sold in the amount of $4,009,000 and securities available for sale in the amount of $3,741,594. Total deposits were $138,549,136 at June 30, 2006, an increase of $14,393,375 or

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MAINSTREET BANKSHARES, INC.

June 30, 2006

11.59% over December 31, 2005. Total shareholders’ equity at June 30, 2006 was $17,736,510. MainStreet and Franklin Bank were well capitalized at June 30, 2006. The book value of shareholders’ equity at June 30, 2006 was $11.06 per share.

Net income for the six months ending June 30, 2006 and 2005 was $1,460,649 and $2,265,195. The net income for the first six months of 2005 includes the gain on the sale of Smith River in the amount of $1,406,165 (net of $212,527 cash expenses and $200,000 indemnity loan accrual), income from the discontinued operations of Smith River in the amount of $239,483, and income from continuing operations in the amount of $619,547 (net of tax). Basic earnings per share for the first quarter of 2006 and 2005 were $.92 and $.39, respectively, on net income from continuing operations. Diluted earnings per share for the first quarter of 2006 and 2005 were $.45 and $.15, respectively, on net income from continuing operations. Annualized return on average assets at June 30, 2006 was 1.80% and annualized return on average shareholders’ equity was 17.53%.

Net income for the three months ending June 30, 2006 and 2005 was $743,276 and $382,778. The net income for the three months of 2005 includes additional gain on the sale of Smith River in the amount of $2,719. Basic earnings per share for the second quarter of 2006 and 2005 were $.47 and $.24, respectively, on net income from continuing operations. Diluted earnings per share for the second quarter of 2006 and 2005 were $.44 and $.24, respectively, on net income from continuing operations. Return on average assets and average shareholders’ equity for the second quarter of 2006 was 1.78% and 17.17%, respectively.

MainStreet’s net interest margin was 4.66% and 4.34% for the six month period ending June 30, 2006 and 2005, respectively. For the three month period ending June 30, 2006 and 2005, the net interest margin was 4.63% and 4.46%, respectively. The increase in net interest margin is due to a substantial increase in interest income, contributed by both increases in volumes and rates and loan fee income along with increases in the short-term federal funds rate. The Corporation’s assets have repriced faster than its deposits. The Federal Reserve raised short-term interest rates five times during 2004, eight times in 2005 and four times so far in 2006. These rate increases have certainly increased interest income which has added to the net interest margin. The quarter ended with a prime rate of 8.25%.

The economy in the market area of the Corporation has been vibrant providing the basis for the growth; however, competition continues to be strong in the Franklin market and young financial institutions such as Franklin Bank must price new loans competitively. Franklin Bank’s growth is also quite dependent on consumer and real estate based lending and there is concern over the sustainability of the substantial growth that has been occurring in real estate markets generally. Franklin Bank’s growth in the future may be negatively affected if deterioration in the real estate market occurs. Also, a little more than 50% of Franklin’s loans are variable. As the prime rate changes, these loans generally change immediately. In a rising interest rate environment, this has a positive impact on the net interest margin. In a decreasing interest rate environment, this has a negative impact on the net interest margin. As deposits have matured, they have renewed at higher interest rates. Overall deposit maturity is short because Franklin Bank was organized during a rising interest rate environment. Consumers have tended to invest their deposit dollars in short-ended time deposits and savings instruments. These factors could result in a compression of MainStreet’s net interest margin.

Results of Operations

Net interest income is the difference between total interest income and total interest expense. The amount of net interest income is determined by the volume of interest-earning assets, the level of interest rates earned on those assets, and the cost of supporting funds. The difference between rates earned on interest-earning assets and the cost of supporting funds is measured by the net interest margin.

Net interest income was $3,709,386 for the six months ending June 30, 2006, an increase of $1,292,974 or 53.51% over the $2,416,412 reported for the same period in 2005. Net interest income was $1,890,475 for

20

MAINSTREET BANKSHARES, INC.

June 30, 2006

the three months ending June 30, 2006, an increase of $539,456, or 39.93%. The year to date and quarterly increases in net interest income are primarily due to increased interest and fees on loans, contributed by both increased in volumes and rates, offset by smaller increases in the cost of funding the loan growth. The Corporation has a strong loan to deposit ratio leaving few dollars to be used for investment; therefore, the interest income is from higher yielding assets. Gross loan volume increased $13,853,965 from year-end 2005. As mentioned previously, the net interest margin was 4.66% and 4.34%, respectively, for the six months ended June 30, 2006 and 2005. It was 4.63% and 4.46%, respectively, for the three months ended June 30, 2006. The prime rate, which is the basis for pricing many commercial and consumer loans, follows the short-term interest rate established by the Federal Reserve. The prime rate has been increased four times this year ending the quarter at 8.25%. Deposit rates have been competitive, especially in the second quarter of this year. Also with shorter maturities on deposits, in the future, deposit rates could increase and could impact the net interest margin negatively.

Provision for Loan Losses

A provision for loan losses is charged to earnings for the purpose of establishing an allowance for loan losses that is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Management reviews the past due reports and risk ratings and discusses individually the loans on these reports with the responsible loan officers. Management uses these tools and provides a quarterly analysis of the allowance based on peer analysis, regulatory reserve analysis and an analysis based on the experience in each category of commercial, real estate or consumer loans. As the allowance is maintained losses are, in turn, charged to this allowance rather than being reported as a direct expense.

A provision for loan losses was recorded in the amounts $117,044 and $384,600 for the six month period ending June 30, 2006 and 2005, respectively. Both of these expense numbers are attributed to strong period over period loan growth at Franklin Bank with 2005 experiencing a greater increase in loan volume for the year. The allowance for loan losses was $1,894,522 at June 30, 2006 which equated to 1.20% of loans, net of unearned deferred fees and costs. Net charge-offs (recoveries) of ($133) and ($24,595) for the first six months of 2006 and 2005 equated to (.00%) and (.05%) respectively, of average loans outstanding net of unearned income and deferred fees. The amount of charge-offs can fluctuate substantially based on the financial condition of the borrowers, business conditions in the borrower’s market, collateral values and other factors which are not capable of precise projection at any point in time. No assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in the future.

Provision expense for the second quarter of 2006 and 2005 was $38,000 and $219,900, respectively, both related to loan growth during the respective quarters.

Noninterest Income

Total noninterest income was $598,452 and $559,214 for the six months ending June 30, 2006 and 2005, respectively, an increase of $39,238 or 7.02%. Of total noninterest income service charges on deposit accounts were $105,922 and $89,470 for the above-referenced time periods, respectively, an increase of $16,452 or 18.39%. NSF charges, net of waives and charge-offs, primarily contributed to the increase in service charges. The number of checking accounts are increasing and therefore NSF income has increased. Mortgage brokerage income actually decreased $23,529, or 13.06% in 2006 compared to the 2005 income. This is primarily due to the interest rate increase and a little slowing of the real estate market. Franklin Bank has partnered with several different organizations in which Franklin Bank originates mortgage loans, which for the most part, then close in the companies’ names. Franklin Bank receives fee income from the transactions. Servicing fee income increased slightly, $8,673, for the first six months of 2006 compared to

21

MAINSTREET BANKSHARES, INC.

June 30, 2006

2005 due to increased fees. These are fees paid to MainStreet for backroom servicing provided to Smith River Bank. Other miscellaneous income increased $37,642, or 150.45% over 2005 income of which $18.3 thousand was due to a gain on sale of other real estate. The remainder was primarily due to an increase in debit card income and income received from the check book program.

Noninterest income for the three months ending June 30, 2006 and June 30, 2005 was $301,526 and $288,694, respectively, a slight overall increase of $12,832, or 4.44%. The largest increases were in service charges on deposit accounts of $10,054 and servicing fee income of $20,771. These were offset by a decline of $26,902 in mortgage brokerage income as discussed above.

Noninterest Expense

Total noninterest expense was $991,272 and $807,872 for the six month period ending June 30, 2006 and 2005, respectively, an increase of $183,400 or 22.70%. The following chart shows the categories of noninterest expenses for the six month period ending June 30, 2006 and 2005, the dollar change, and the percentage change.

Expense	YTD 6/30/06	YTD 6/30/05	Dollar Change	Percentage Change
Salaries and employee benefits	1,090,424	837,078	253,346	30.27	%
Occupancy and equipment	277,094	250,087	27,007	10.80	%
Professional fees	152,349	105,460	46,889	44.46	%
Advertising and promotion	51,275	37,500	13,775	36.73	%
Outside processing	158,823	139,271	19,552	14.04	%
Franchise tax	80,502	63,000	17,502	27.78	%
Other expenses	228,249	218,611	9,638	4.41	%

As can be seen by the chart, the largest component of noninterest expense is salaries and employee benefits which also comprised the largest dollar increase in the year to year comparison. A large part of this increase is due to an upswing in staffing because of the growth of the Corporation which would also cause an increase in benefits. During 2006, an incentive plan, primarily based on performance, was implemented and expense accrued was $90,000 for the six months ending June 30, 2006. Benefits expense also increased due to the rising costs of health care which is reflected in increased premiums paid. Also, the 2006 expense includes approximately $18,346 of 401-K match which was implemented in the second quarter of 2005. The 2006 expense was $10,575 greater than the 2005 expense. Since that time, more employees have joined the plan or have increased their percentage of deferral. MainStreet matches ¹/2% up to 6% of the employee’s deferral. MainStreet’s employees are its most valuable resource and asset. Occupancy and equipment costs are the next largest expense of the Corporation and include rent, utilities, janitorial service, repairs and maintenance, real estate taxes, service maintenance contracts and depreciation expense. Of the $27,007 period over period increase, $6,410 was depreciation expense on leasehold improvements in our Rocky Mount office. Also, repairs and maintenance expense attributed $5,177 to the overall increase. Professional fees include fees for audit, legal, and other and increased $46,889 in 2006 over 2005. This increase is primarily due to accruals for technology initiatives planned for 2006. These initiatives are anticipated to include penetration testing and network monitoring. Outside processing primarily includes data processing, payroll processing, check clearings, and insurance. Data processing costs have primarily contributed to the increase of $26,701 in this area. This was offset by a decline in bank insurance of $11,714. MainStreet changed its insurance company for its bond and directors and officers insurance and also went to a three year plan which decreased the annual premiums. Other expenses include OCC assessments, FDIC assessments, travel expense, meals and entertainment, subscriptions and dues, seminars and education, and contributions.

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MAINSTREET BANKSHARES, INC.

June 30, 2006

Expense	QTD 6/30/06	QTD 6/30/05	Dollar Change	Percentage Change
Salaries and employee benefits	548,659	434,312	114,347	26.33	%
Occupancy and equipment	138,910	126,453	12,457	9.85	%
Professional fees	85,176	56,510	28,666	50.73	%
Advertising and promotion	28,475	18,750	9,725	51.87	%
Outside processing	77,490	68,219	9,271	13.59	%
Franchise tax	40,251	31,800	8,451	26.58	%
Other expenses	128,483	107,091	21,392	19.98	%

The quarterly noninterest expense also demonstrates that salaries and employee benefits are the largest expense of the Corporation followed by occupancy and equipment and then other expenses. The next to largest dollar increase was in professional fees due to the technology initiatives discussed above.

Income Taxes

BankShares is subject to both federal and state income taxes. Franklin Bank is not subject to state income taxes. A bank in Virginia is required to pay a franchise tax that is based on the capital of the entity. MainStreet recorded income tax expense on income from continuing operations in the amount of $691,429 and $320,472 for the six month period ending June 30, 2006 and 2005, respectively. For the three month period ending June 30, 2006 and 2005, MainStreet’s income tax expense from continuing operations was $363,281 and $196,619.

BALANCE SHEET

Investment Portfolio

The Corporation’s investment portfolio is used for several purposes as follows:

1) To maintain sufficient liquidity to cover deposit fluctuations and loan demand.

2) To use securities to fulfill pledging collateral requirements.

3) To utilize the maturity/repricing mix of portfolio securities to help balance the overall interest rate risk position of the balance sheet.

4) To make a reasonable return on investments.

Funds not utilized for capital expenditures or lending are invested in securities of the U.S. Government and its agencies, mortgage-backed securities, municipal bonds, corporate debt securities and certain equity securities. Currently, BankShares has invested in U.S. Agencies, Federal Reserve Bank stock and Federal Home Loan Bank stock. BankShares’ policy is not to invest in derivatives or other high-risk instruments. The entire securities portfolio was categorized as available-for-sale at June 30, 2006 and is carried at estimated fair value. Unrealized market valuation gains and losses on securities classified as available-for-sale are recorded as a separate component of shareholders’ equity. Please refer to Note 2 to the Notes to Consolidated Financial Statements for the break down of the securities available for sale portfolio.

Loan Portfolio

BankShares has a credit policy detailing the credit process and collateral in loan originations. Loans to purchase real estate and personal property are generally collateralized by the related property with loan amounts established based on certain percentage limitations of the property’s total stated or appraised value. Credit approval is primarily a function of the credit worthiness of the individual borrower or project based on pertinent financial information, the amount to be financed, and collateral. The loan portfolio was as follows:

	June 30, 2006				December 31, 2005
Commercial	$	91,908,817	58.16	%	$	81,138,129	56.28	%
Residential real estate		27,235,581	17.23			27,982,694	19.41
Consumer		38,886,800	24.61			35,056,410	24.31
Total	$	158,031,198	100.00	%	$	144,177,233	100.00	%

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MAINSTREET BANKSHARES, INC.

June 30, 2006

Gross loans increased $13,853,965 or 9.61% at June 30, 2006 compared to December 31, 2005 due to continuing loan demand. The mix of the type of loans is comparable for the two periods with just a slight increase in the commercial portfolio and a slight decrease in the residential real estate portfolio. Although some continued loan growth for Franklin Bank is expected, it is unlikely that the level of loan growth experienced since the Bank opened in September 2002 will continue. Commercial loans continue to be the primary source of lending.

Although the commercial portfolio is diversified, there are three areas classified as concentrations of credit at June 30, 2006. The areas of concentrations are in loans for real estate with an outstanding balance of $25,396,143; loans for construction of buildings with an outstanding balance of $24,420,628; and loans for construction of heavy and civil engineering buildings with an outstanding balance of $13,514,464.

Nonaccrual loans and loans past due 90 days or more are considered by MainStreet to be nonperforming loans. MainStreet’s policy is to discontinue the accrual of interest on loans once they become 90 days past due and are not well-collateralized, or earlier when it becomes doubtful that the full principal and interest will be collected. Once a loan is placed on nonaccrual status, any interest that is collected will generally be recorded on a cash basis until the loan is satisfied in full or circumstances have changed to such an extent that the collection of both principal and interest is probable.

There were no loans past due more than 90 days at June 30, 2006 or December 31, 2005 other than loans on nonaccual status. Nonaccrual loans were $0 and $10,975 at June 30, 2006 and December 31, 2005, respectively. These loans are also considered impaired loans. Lost interest related to impaired loans as of June 30, 2006 and June 30, 2005 was $0 and $228, respectively.

Deposits

Total deposits at June 30, 2006 and December 31, 2005 were $138,549,136 and $124,155,761, respectively. The deposit mix was as follows:

	June 30, 2006				December 31, 2005
Demand	$	15,113,064	10.91	%	$	13,053,658	10.51	%
Interest checking		8,985,779	6.49			6,776,003	5.46
Money markets		8,980,590	6.48			9,342,298	7.53
Savings		14,423,189	10.41			19,197,943	15.46
Time deposits $100,000 and over		36,311,600	26.21			30,005,051	24.17
Other time deposits		54,734,914	39.50			45,780,808	36.87
Total	$	138,549,136	100.00	%	$	124,155,761	100.00	%

Total deposits increased $14,393,375 or 11.59%. The levels and mix of deposits are influenced by such factors as customer service, interest rates paid, service charges, and the convenience of banking locations. Competition is fierce from other depository institutions in our market. Management attempts to identify and implement the pricing and marketing strategies that will help control the overall cost of deposits and to maintain a stable deposit mix. Management has had to price deposits competitively in the market to attract depositors, especially in the last quarter. The overall cost of interest bearing deposits was 3.72% and 2.64%, respectively for the six months ended June 30, 2006 and 2005. For the three months ending June

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MAINSTREET BANKSHARES, INC.

June 30, 2006

30, 2006 and 2005, the overall cost of interest bearing deposits was 3.91% and 2.77%, respectively. This increase in funding costs is reflective of the increase in the short-term federal funds rate throughout 2004, 2005 and 2006. Competition for deposits has intensified and is expected to continue. This could adversely affect the margin by increasing interest expense. As can be seen by the chart, savings deposits have decreased as a percentage of total deposits while other time deposits and time deposits $100,000 and over have increased. Franklin Bank has utilized the savings accounts and promoted a special rate, highest in the market, during lower interest rate times. As interest rates have increased, consumers have taken those dollars and transferred them into time deposit accounts.

Short-term Borrowings

Short-term borrowings as of June 30, 2006 consist of two Federal Home Loan Bank of Atlanta advances. The first advance in the amount of $10,000,000 is a prime rate based advance. Interest is paid monthly at prime minus 2.81%. The interest rate at June 30, 2006 was 5.44%. Early repayment of the advance is subject to a .25% fee of the advance amount being repaid. The maturity date is May 18, 2007. The second advance in the amount of $5,000,000 is a fixed rate credit advance maturing every two weeks. Interest is paid at maturity. The interest rate at June 30, 2006 was 5.31%.

Shareholders’ Equity

Total shareholders equity was $17,736,510 and $15,983,181 at June 30, 2006 and December 31, 2005, respectively. Book value per share was $11.06 and $10.16 at June 30, 2006 and December 31, 2005, respectively. The initial stock offering was completed during the third quarter of 2000 with net proceeds of $6,708,162. The secondary offering was completed December 31, 2002, and net proceeds from the sale of common stock were $6,874,941. Offering expenses were netted against equity in both offerings. The private placement offering was terminated on January 31, 2005, and net proceeds from the total sale of common stock were $1,727,498.

The maintenance of appropriate levels of capital is a priority and is continually monitored. MainStreet and Franklin Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Quantitative measures established by regulations to ensure capital adequacy require MainStreet and Franklin Bank to maintain minimum capital ratios. Failure to meet minimum capital ratios can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. Also, declining capital can impact the ability of Franklin Bank to grow other loan assets.

The following are MainStreet’s capital ratios at:

	June 30, 2006		December 31, 2005
Tier I Leverage Ratio (Actual)	10.31	%	10.44	%
Tier I Leverage Ratio (Quarterly Ave.)	10.60		10.48
Tier I Risk-Based Capital Ratio	11.29		11.30
Tier II Risk-Based Capital Ratio	12.50		12.55

MainStreet downstreamed to Franklin Bank $4,000,000 of the proceeds from the sale of Smith River Bank in March of 2005. Franklin Bank utilized the proceeds to fund loan growth. MainStreet and Franklin Bank are considered well-capitalized under federal and state capital guidelines at June 30, 2006.

Asset Liability Management

Asset liability management functions to maximize profitability within established guidelines for liquidity, capital adequacy, and interest rate risk. It also helps to ensure that there is adequate liquidity to meet loan demand or deposit outflows and interest rate fluctuations. Liquidity is the ability to meet maturing obligations and commitments, withstand deposit fluctuations, fund operations, and provide for loan

25

MAINSTREET BANKSHARES, INC.

June 30, 2006

requests. MainStreet’s material off balance sheet obligations were primarily loan commitments in the amount of $36,634,904 at June 30, 2006. MainStreet has a liquidity contingency plan that provides guidance on the maintenance of appropriate liquidity and what action is required under various liquidity scenarios. MainStreet’s liquidity is provided by cash and due from banks, interest-bearing deposits, federal funds sold, securities available-for-sale, and loan repayments. MainStreet also has overnight borrowing lines available with their correspondent bank, the ability to borrow from the Federal Reserve Bank’s discount window, and the ability to borrow long-term from the Federal Home Loan Bank of Atlanta. MainStreet’s ratio of liquid assets to total liabilities at June 30, 2006 and December 31, 2005 was 5.15% and 1.94%, respectively. Core deposits are the primary foundation for liquidity.

Interest rate sensitivity is measured by the difference, or gap, between interest sensitive earning assets and interest sensitive interest bearing liabilities and the resultant change in net interest income due to market rate fluctuations, and the effect of interest rate movements on the market. Management utilizes these techniques for management of interest rate risk in order to minimize change in net interest income with interest rate changes. MainStreet BankShares, Inc. has partnered with Compass Bank using the Sendero model to help measure interest rate risk. The asset liability management process requires a number of key assumptions. Management determines the most likely outlook for the economy and interest rates measuring the effect on net interest income in a rising and declining 100, 200, and 300 interest rate environment. It also uses a shock report for these rates along with a ramped approach with each. With this approach, management also reviews the economic value of equity which is the net present value of the balance sheet’s cash flows or the residual value of future cash flows ultimately due to shareholders.

The following table demonstrates the percentage change in net interest income from the current level prime rate of 8.25% in a rising and declining 100, 200, and 300 basis points interest rate environment:

Net Interest Income Percentage Change From Level Rates
Rate Shift	Prime Rate		Change From Level Ramp		Change from Level Shock
+300 bp	11.25	%	16.93	%	29.71	%
+200 bp	10.25		12.14		21.35
+100 bp	9.25		6.76		12.20
-100 bp	7.25		-6.79		-12.11
-200 bp	6.25		-11.85		-20.87
-300 bp	5.25		-13.85		-23.49

As discussed previously, MainStreet is sensitive to change in the interest rate environment particularly due to the large percentage of variable rate loans. In a rising rate environment, it is anticipated that the impact would be positive on the net interest margin. In a declining rate environment, MainStreet has significant exposure to the net interest margin. Management seeks to lower the impact on the net interest margin. Conscious efforts will be made to originate or renew variable rate loans to a fixed rate status. Also, the possibility of off balance sheet instruments may be utilized to aid this initiative.

In order to preserve capital to facilitate growth and expansion, we do not anticipate paying cash dividends in the foreseeable future. Our Board of Directors will make a determination whether to pay cash dividends on the basis of operating results, financial condition, tax considerations, and other relevant factors. Also, at present, the only source of funds from which we could pay cash dividends would be dividends received from Franklin Bank. Franklin Bank similarly does not anticipate paying cash dividends to BankShares in the near future in order to preserve their capital to facilitate growth and expansion of business and to provide a sufficient capital base for its banking activities. Payment of cash dividends by Franklin Bank is limited by regulatory requirements and limitations. In general, the OCC limits annual dividends to retained profits of the current year plus two prior years, without OCC approval. Regulatory restrictions on Franklin Bank’s ability to pay dividends may adversely impact BankShares’ ability to pay dividends to its shareholders.

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MAINSTREET BANKSHARES, INC.

June 30, 2006

The holding company generates revenue through the affiliate fee charged to Franklin Bank and the servicing fee charged to Smith River Bank for its operation and service. These services include accounting, investments, treasury management, compliance (provided to Franklin Bank only), deposit and loan operations, and data processing. BankShares utilizes this affiliate fee and servicing income to meet its obligations. The holding company does not own any real property and has a modest amount of fixed assets.

Stock Compensation Plans

BankShares approved the 2004 Key Employee Stock Option Plan at its Annual Meeting of Shareholders, April 15, 2004. This plan permits the granting of Incentive and Non Qualified stock options as determined by BankShares’ Board of Directors. The maximum aggregate number of shares that may be issued under this plan are 137,000. The minimum exercise price per share for any option granted under this plan is the fair market price on the grant date. Currently, there are 98,377 stock options that have granted under this plan.

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MAINSTREET BANKSHARES, INC.

June 30, 2006

Item 3. Controls and Procedures

MainStreet’s principal executive officer and principal financial officer have reviewed MainStreet’s disclosure controls and procedures (as defined in 204.13a-15(e) and 240.15d-15(e)) as of the end of the period covered by this quarterly report and based on their evaluation believe that MainStreet’s disclosure controls and procedures are effective.

Item 4. Submission of Matters to a Vote of Security Holders

MainStreet BankShares, Inc. held its seventh annual meeting of shareholders on April 20, 2006 at the Piedmont Arts Association, Martinsville, VA 24112. There was one matter submitted to a vote of security holders, which was the election of three directors.

	For	Against
Joseph F. Clark (Class B – Term Expires 2006)	877,590	—
C. Laine Dalton (Class B – Term Expires 2006)	877,590	—
Joel R. Shepherd (Class B – Term Expires 2006)	876,552	1,038

The following classes of directors also continued after the meeting:

Class C Directors – Term Expires 2007
John M. Deekens	Director
Danny M. Perdue	Director
Milford A. Weaver	Director
Class A Directors – Term Expires 2008
Larry A. Heaton	Director
Morton W. Lester	Director
Cecil R. McCullar	Director
Michael A. Turner	Director

Cecil R. McCullar, prior President and CEO of MainStreet BankShares, Inc. retired April 30, 2006. As previously reported on Form 8-K, Mr. McCullar resigned as a director effective May 4, 2006.

Item 6. Exhibits

See index to exhibits.

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: August 11, 2006	By	/s/ Larry A. Heaton
		Larry A. Heaton
		President and Chief Executive Officer
Date: August 11, 2006	By	/s/ Brenda H. Smith
		Brenda H. Smith
		Executive Vice President, Chief Financial Officer and Corporate Secretary

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Index to Exhibits

Number	Description of Exhibit
3(i)**	Restated Articles of Incorporation of the Corporation, dated March 6, 2001.
3(ii)	By-laws of the Corporation, dated August 5, 1999 amended February 20, 2001, amended October 16, 2002, amended September 17, 2003, amended July 13, 2005 and amended April 20, 2006 filed on Form 8-K on April 24, 2006 and herein incorporated by reference.
10.1*	Employment Agreement with Retired President and CEO, Cecil R. McCullar, dated as of June 1, 1999. Amendment to employment agreement with President/CEO, Cecil R. McCullar, filed with the Corporation’s Quarterly Form 10-QSB on May 11, 2005 and herein incorporated by reference.
10.2	Employment agreement with Executive Vice President , Brenda H. Smith, dated October 1, 2002, filed with the Corporation’s Quarterly Form 10-QSB on November 7, 2002 and herein incorporated by reference. Amendment to employment agreement filed with on Form 8-K on April 24, 2006 and herein incorporated by reference.
10.3	Employment Agreement with President and Chief Executive Officer, Larry A. Heaton, entered into December 30, 2005, effective January 1, 2006, filed on Form 8-K, January 4, 2006 and herein incorporated by reference.
10.4	Stock Purchase Agreement By and Among Argentum Capital Management, LLC, and Assigns; MainStreet BankShares, Inc., and Smith River Community Bank, N.A. dated 1/13/05 filed on Form 8-K on January 14, 2005, and herein incorporated by reference.
10.5	Administrative Services Agreement with Smith River Community Bank, N.A. incorporated by reference to the Corporation’s Form 8-K filed March 28, 2005.
10.6	Indemnity Agreement with Smith River Community Bank, N.A. incorporated by reference to the Corporation’s Form 8-K filed March 28, 2005.
10.7	2004 Key Employee Stock Option Plan filed March 16, 2005 on Form S-8 and herein incorporated by reference.
31.1	Certification of President and Chief Executive Officer Pursuant to Rule 13a-15(e) under the Securities and Exchange Act of 1934.
31.2	Certification of Executive Vice President, Chief Financial Officer and Corporate Secretary Pursuant to Rule 13a-15(e) under the Securities and Exchange Act of 1934.
32	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

* (Incorporated by reference to Registration statement #333-86993 on Form SB-2 filed September 13, 1999.)

** (Incorporated by reference to the Corporation’s Annual Form 10-KSB filed March 15, 2001.)

*** (Incorporated by reference to Registration Statement # 333-63424 on Form SB-2 filed June 20, 2001.)

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