Alarion Financial Services 10-K 2009 FY Annual report

Exhibit 13.1

ALARION FINANCIAL SERVICES, INC.

Holding Company for

Audited Consolidated Financial Statements

At December 31, 2009 and 2008 and For the Years Then Ended

(Together with Report of Independent Registered Public Accounting Firm)

Report of Independent Registered Public Accounting Firm

Alarion Financial Services, Inc.

Ocala, Florida:

We have audited the accompanying consolidated balance sheets of Alarion Financial Services, Inc. and Subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 2009 and 2008, and the results of its operations and its cash flows for years then ended, in conformity with U.S. generally accepted accounting principles.

HACKER, JOHNSON & SMITH PA

/s/ HACKER, JOHNSON & SMITH PA

Tampa, Florida

March 30, 2010

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

($ in thousands, except per share amounts)

	At December 31,
	2009			2008
Assets
Cash and due from banks	$	3,993		1,666
Interest bearing time deposits in banks		5,895		2,097
Interest-earning deposits and federal funds sold		12,210		5,708
Cash and cash equivalents		22,098		9,471
Interest bearing time deposits in banks		2,287		12,410
Securities available for sale		31,282		13,123
Loans, net of allowance for loan losses of $3,035 and $2,714		234,680		205,307
Accrued interest receivable		939		731
Premises and equipment, net		13,310		13,604
Other real estate owned		1,583		651
Federal Home Loan Bank stock, at cost		1,499		1,356
Deferred income taxes		1,156		1,103
Other assets		1,749		883
Total assets	$	310,583		258,639
Liabilities and Stockholders’ Equity
Liabilities:
Noninterest-bearing demand deposits		18,136		15,161
NOW, money-market and savings deposits		73,537		43,109
Time deposits < $100,000		97,322		94,547
Time deposits > = $100,000		60,994		50,097
Total deposits		249,989		202,914
Federal Home Loan Bank advances		21,000		22,000
Other borrowings		7,633		7,584
Accrued interest payable		640		1,118
Accrued expenses and other liabilities		615		387
Total liabilities		279,877		234,003
Commitments (Notes 4, 10 and 18)
Stockholders’ equity:
Preferred stock, $.01 par value; 1,000,000 shares authorized:
Preferred stock, Series A, $.01 par value; $1,000 liquidation value; 6,514 shares outstanding in 2009		—		—
Preferred stock, Series B, $.01 par value; $1,000 liquidation value; 326 shares outstanding in 2009		—		—
Additional paid-in capital, preferred		6,840		—
Preferred stock discount		(265	)	—
Common stock, $.01 par value; 4,000,000 shares authorized, 2,653,208 shares issued and outstanding in 2009 and 2008		27		27
Additional paid-in capital, common		26,680		26,613
Accumulated deficit		(2,531	)	(2,142	)
Accumulated other comprehensive (loss) income		(45	)	138
Total stockholders’ equity		30,706		24,636
Total liabilities and stockholders’ equity	$	310,583		258,639

See Accompanying Notes to Consolidated Financial Statements.

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(In thousands, except per share amounts)

	Year Ended December 31,
	2009			2008
Interest income:
Loans	$	12,921		11,781
Securities		844		705
Other		496		380
Total interest income		14,261		12,866
Interest expense:
Deposits		5,916		6,734
Borrowings		816		651
Total interest expense		6,732		7,385
Net interest income		7,529		5,481
Provision for loan losses		1,012		1,115
Net interest income after provision for loan losses		6,517		4,366
Noninterest income:
Deposit account fees		377		340
Net gain on sale of securities		227		—
Net gain on sales of loans held for sale		877		831
Other		41		21
Total noninterest income		1,522		1,192
Noninterest expenses:
Salaries and employee benefits		3,573		3,402
Occupancy and equipment		1,127		823
Data processing		584		472
Professional services		278		253
Advertising and promotion		142		189
Office supplies and printing		112		135
Impairment of Silverton Bank stock		625		—
FDIC assessment		498		188
Other		1,036		839
Total noninterest expenses		7,975		6,301
Earnings (loss) before income tax expense (benefit)		64		(743	)
Income tax expense (benefit)		57		(258	)
Net earnings (loss)		7		(485	)
Preferred stock dividend requirements and accretion of preferred stock to par		396		—
Loss available to common shareholders	$	(389	)	(485	)
Loss per common share – basic	$	(0.15	)	(0.19	)
Loss per common share – diluted	$	(0.15	)	(0.19	)
Weighted-average number of common shares outstanding, basic		2,653,208		2,616,290
Weighted-average number of common shares outstanding, diluted		2,653,208		2,616,290
Dividends per common share		—		—

See Accompanying Notes to Consolidated Financial Statements.

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

Years Ended December 31, 2009 and 2008

($ in thousands)

	Preferred Stock								Common Stock				Accumulated Deficit		Accumulated Other Comprehensive Income(Loss)	Total Stockholders’ Equity
							Additional Paid-in Capital	Discount	Shares	Amount		Additional Paid-In Capital
	Series A			Series B
	Shares	Amount		Shares	Amount
Balance at December 31, 2007	—	$	—	—	$	—	—	—	2,183,485	$	22	21,856	(1,657	)	30	20,251
Comprehensive loss:
Net loss	—		—	—		—	—	—	—		—	—	(485	)	—	(485	)
Net change in unrealized gain on securities available for sale, net of taxes of $64	—		—	—		—	—	—	—		—	—	—		108	108
Comprehensive loss																(377	)
Share-based compensation	—		—	—		—	—	—	—		—	64	—		—	64
Common stock options and warrants exercised	—		—	—		—	—	—	469,723		5	4,693	—		—	4,698
Balance at December 31, 2008	—	$	—	—	$	—	—	—	2,653,208	$	27	26,613	(2,142	)	138	24,636

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity, Continued

Years Ended December 31, 2009 and 2008

($ in thousands)

	Preferred Stock									Common Stock				Accumulated Deficit		Accumulated Other Comphensive Income (Loss )		Total Stockholders’ Equity
	Series A			Series B			Additional Paid-in Capital	Discount					Additional Paid-In Capital
	Shares	Amount		Shares	Amount					Shares	Amount
Balance at December 31, 2008	—	$	—	—	$	—	—	—		2,653,208	$	27	26,613	(2,142	)	138		24,636
Comprehensive loss:
Net earnings	—		—	—		—	—	—		—		—	—	7		—		7
Net change in unrealized gain on securities available for sale, net of taxes of $110	—		—	—		—	—	—		—		—	—	—		(183	)	(183	)
Comprehensive loss																		(176	)
Share-based compensation	—		—	—		—	—	—		—		—	67	—		—		67
Proceeds from issuance of 6,514 shares of Series A preferred stock to U.S. Treasury	6,514		—	—		—	6,514	—		—		—	—	—		—		6,514
Preferred stock warrants exercised by U.S. Treasury	—		—	326		—	326	(326	)	—		—	—	—		—		—
Preferred stock dividend requirements and Series B preferred stock accretion	—		—	—		—	—	61		—		—	—	(396	)	—		(335	)
Balance at December 31, 2009	6,514	$	—	326	$	—	6,840	(265	)	2,653,208	$	27	26,680	(2,531	)	(45	)	30,706

See Accompanying Notes to Consolidated Financial Statements.

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In thousands)

	Year Ended December 31,
	2009			2008
Cash flows from operating activities:
Net earnings (loss)	$	7		(485	)
Adjustments to reconcile net earnings (loss) to net cash (used in) provided by operating activities:
Provision for loan losses		1,012		1,115
Share-based compensation		67		64
Depreciation and amortization		626		426
Net increase in loans held for sale		(3,810	)	(1,171	)
Deferred income tax expense (benefit)		57		(258	)
Net amortization of deferred loan fees and costs		54		116
Loss on sale of other real estate owned		12		—
Write-off of other real estate owned		76		—
Net (decrease) increase in accrued interest payable		(478	)	319
Net (increase) decrease in accrued interest receivable		(208	)	200
Net increase in other assets		(1,491	)	(30	)
Impairment of Silverton Bank stock		625		—
Net gain on sale of securities		(227	)	—
Net increase in accrued expenses and other liabilities		228		83
Net cash (used in) provided by operating activities		(3,450	)	379
Cash flows from investing activities:
Proceeds from principal repayments and maturities on securities available for sale		8,602		18,203
Purchase of securities available for sale		(31,296	)	(10,616	)
Proceeds from sale of securities available for sale		4,469		—
Net decrease (increase) in time deposits in banks		10,123		(10,364	)
Loan disbursements, net of repayments		(27,712	)	(41,446	)
Purchase of premises and equipment		(332	)	(4,874	)
Proceeds from sale (purchase) of other real estate owned		63		(521	)
Proceeds from sale of premises and equipment		—		446
Purchase of Federal Home Loan Bank stock		(143	)	(520	)
Net cash used in investing activities		(36,226	)	(49,692	)
Cash flows from financing activities:
Net increase in deposits		47,075		38,671
Net increase in other borrowings		49		2,777
Net (decrease) increase in advances from Federal Home Loan Bank		(1,000	)	9,000
Proceeds from common stock options and warrants exercised		—		4,698
Proceeds from preferred stock issued		6,514		—
Preferred stock dividend requirements and Series B stock accretion		(335	)	—
Net cash provided by financing activities		52,303		55,146
Net increase in cash and cash equivalents		12,627		5,833
Cash and cash equivalents at beginning of year		9,471		3,638
Cash and cash equivalents at end of year	$	22,098		9,471

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows, Continued

(In thousands)

	Year Ended December 31,
	2009			2008
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest, net of capitalized interest of $180 in 2008	$	7,210		7,066
Income taxes	$	—		—
Noncash transactions:
Accumulated other comprehensive income (loss), net change in unrealized gain (loss) on securities available for sale, net of taxes	$	(183	)	108
Transfer of loans to other real estate owned	$	1,147		130
Transfer of other real estate owned to loans	$	64		—

See Accompanying Notes to Consolidated Financial Statements.

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

At December 31, 2009 and 2008 and for the Years Then Ended

(1) Summary of Significant Accounting Policies

Organization. Alarion Financial Services, Inc. (the “Holding Company”) owns 100% of the outstanding common stock of Alarion Bank (the “Bank”) and North Central Florida Developers Corporation. The Holding Company’s primary activity is the operation of the Bank and North Central Florida Developers Corporation. The Bank is a state (Florida)-chartered commercial bank. The Bank offers a variety of banking and financial services to individual and corporate customers through its six banking offices located in Ocala, Gainesville and Alachua, Florida. The deposit accounts of the Bank are insured up to the applicable limits by the Federal Deposit Insurance Corporation. North Central Florida Developers Corporation holds loans or assets that might require a longer term hold to realize full economic value.

Management has evaluated events occurring subsequent to the balance sheet date through March 30, 2010 (the financial statement issuance date), determining no events require additional disclosure in these financial statements.

Basis of Presentation. The accompanying consolidated financial statements include the accounts of the Holding Company, the Bank and North Central Florida Developers Corporation (collectively, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting practices of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following summarizes the more significant of these polices and practices.

Use of Estimates. In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of deferred tax assets and other real estate owned.

Cash and Cash Equivalents. For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks, interest-earning deposits (including time deposits with original maturities of ninety days or less) and federal funds sold, all of which mature within ninety days.

At December 31, 2009 and 2008, the Bank was not required by law or regulation to maintain cash reserves with the Federal Reserve Bank, in accounts with other banks or in the vault.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Securities. Securities may be classified as either trading, held to maturity or available for sale. Securities that are held principally for resale in the near term are considered trading securities and recorded at fair value with changes in fair value recorded in operations. Debt securities that the Company has the positive intent and ability to hold to maturity are classified as “held to maturity” and are reported at amortized cost. Available-for-sale securities consist of securities not classified as trading securities nor as held-to-maturity securities. Unrealized holding gains and losses, net of tax, on available-for-sale securities are excluded from operations and reported in accumulated other comprehensive income (loss). Gains and losses on the sale of available-for-sale securities are recorded on the trade date and are determined using the specific-identification method. Purchase premiums and discounts are recognized in interest-income using the interest method over the terms of the securities.

Loans. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs.

Loan origination fees are capitalized and certain direct origination costs are deferred. Both are recognized as an adjustment of the yield of the related loan.

The accrual of interest on loans is discontinued at the time the loan is ninety days delinquent unless the loan is well collateralized and in process of collection. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to operations. Loan losses will be charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, will be credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Allowance for Loan Losses, Continued. The allowance consists of specific and general components. The specific component relates to loans that are considered impaired. For such loans, an allowance is established when the discounted cash flows or the collateral value of the impaired loan is lower than the carrying value of that loan. The general component covers all other loans and is based on historical peer group loss experience adjusted for qualitative factors, such as economic conditions and other trends or uncertainties that could affect management’s estimate of probable losses.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial, commercial real estate and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual residential real estate, home equity or consumer loans for impairment disclosures.

Loans Held for Sale. Loans held for sale are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to operations. Information related to loans held for sale is included in Footnote 3.

Loan origination fees are deferred and direct loan origination costs are capitalized until the related loan is sold, at which time the net fees are included in the net gain on sale of loans held for sale in the consolidated statements of operations.

Premises and Equipment. Land is stated at cost. Other premises, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Interest costs are capitalized in connection with construction of new banking offices. Depreciation and amortization expense are computed using the straight-line method over the shorter of the estimated useful life of each type of asset or related lease term which includes certain renewal options.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Other Real Estate Owned. Other real estate owned represents assets acquired through foreclosure and is initially recorded at the lower of fair value or the loan balance plus acquisition costs at the date of foreclosure, establishing a new cost basis. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in operations.

Comprehensive Loss.Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net earnings (loss). Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the consolidated balance sheet, such items, along with net earnings (loss), are components of comprehensive loss.

The components of accumulated other comprehensive (loss) income and related tax effects are as follows (in thousands):

	Year Ended December 31,
	2009			2008
Unrealized holding (losses) gains on available for sale securities	$	(66	)	172
Reclassification adjustment for gains realized in operations		(227	)	—
Net change in unrealized gains		(293	)	172
Income tax effect		110		(64	)
Net unrealized (loss) gain	$	(183	)	108

The reclassification adjustment above relates to gains on investment securities that were realized and included in net earnings in 2009 that also had been included in other comprehensive loss as unrealized holding gains in the period in which they arose. These gains must be deducted through other comprehensive loss of the period in which they are included in net earnings to avoid including them in comprehensive loss twice.

Transfer of Financial Assets. Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Income Taxes. On January 1, 2009, the Company adopted the recent accounting guidance relating to accounting for uncertainty in income taxes, which sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Income Taxes, Continued.The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.

Deferred income taxes result from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. As of December 31, 2009, management is not aware of any uncertain tax positions that would have a material effect on the Company’s consolidated financial statements.

The Company recognizes interest and penalties on income taxes as a component of income taxes.

The Holding Company, North Central Florida Developers Corporation and the Bank file consolidated income tax returns. Income taxes are allocated between the Holding Company and its subsidiaries as though separate income tax returns were filed.

Stock Compensation Plan. The Company has adopted the fair vale recognition provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 718,Stock Compensation (“ASC 718”), and expenses the fair value of any stock options as they vest. Under the fair value recognition provisions of ASC 718, the Company recognizes stock-based compensation in the accompanying consolidated statements of operations.

Loss Per Common Share. Loss per common share (“EPS”) has been computed on the basis of the weighted-average number of shares of common stock outstanding. Outstanding stock options and warrants were not considered dilutive securities for 2009 and 2008 due to the fact that there was a loss available to common shareholders.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Off-Balance-Sheet Instruments. In the ordinary course of business the Company has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, unused lines of credit and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when they are funded.

Fair Value Measurements. Generally Accepted Accounting Principles (“GAAP”) defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measurements.

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The statement utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities that are not active. Such inputs may include interest rates and yield curves, volatilities, prepayment speeds, credit risks, and default rates.

Level 3: Unobservable inputs to measure fair value of assets and liabilities for which there is little, if any market activity at the measurement date, using reasonable inputs and assumptions based upon the best information at the time, to the extent that inputs are available without undue cost and effort.

The following describes valuation methodologies used for assets and liabilities measured at fair value:

Securities Available for Sale. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, certain mortgage products and exchange-traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Examples of such instruments, which would generally be classified within Level 2 of the valuation hierarchy, include certain collateralized mortgage and debt obligations and certain high-yield debt securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Securities classified within Level 3 include certain residual interests in securitizations and other less liquid securities.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Fair Value Measurements, Continued.

Impaired Loans. Estimates of fair value are determined based on a variety of information, including the use of available appraisals, estimates of market value by licensed appraisers or local real estate brokers and the knowledge and experience of the Company’s management related to values of properties in the Company’s market areas. Management takes into consideration the type, location and occupancy of the property as well as current economic conditions in the area the property is located in assessing estimates of fair value. Accordingly, fair value estimates for impaired loans is classified as Level 3.

Other Real Estate Owned.The Company’s other real estate owned is recorded at lower of cost or fair market value less estimated selling costs. Estimates of fair values are determined based on a variety of information, including the use of available appraisals, estimates of market value by licensed appraisers or local real estate brokers and the knowledge and experience of the Company’s management related to values of properties in the Company’s market areas. Management takes into consideration the type, location and occupancy of the property as well as current economic conditions in the area the property is located in assessing estimates of fair value. Accordingly, the fair values estimates for other real estate owned are classified as Level 3.

Fair Values of Financial Instruments.The following methods and assumptions were used by the Company in estimating fair values of financial instruments:

Cash and Cash Equivalents and Interest Bearing Time Deposits in Banks. The carrying amounts of these financial instruments approximate their fair value.

Securities. The fair value for securities available for sale are based on the framework for measuring fair value.

Loans. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for certain fixed-rate residential mortgage, commercial real estate and commercial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair value for impaired loans are based on the framework for measuring fair value.

Federal Home Loan Bank Stock. Fair value of the Company’s investment in Federal Home Loan Bank stock is based on its redemption value, which is its cost of $100 per share.

Deposits. The fair values disclosed for demand, NOW, money-market and savings deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). Fair values for fixed-rate time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on time deposits to a schedule of aggregated expected monthly maturities of time deposits.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Fair Values of Financial Instruments, Continued.

Federal Home Loan Bank Advances.Fair value of the advances from the Federal Home Loan Bank are estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar types of borrowings.

Other Borrowings.The carrying amounts of other borrowings approximates their fair value.

Accrued Interest. The carrying amounts of accrued interest approximate their fair values.

Off-Balance-Sheet Financial Instruments. Fair values for off-balance-sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Recent Pronouncements.In 2009, the FASB Accounting Standards Codification (“ASC”) became the single source of authoritative GAAP in the United States of America recognized by the Financial Accounting Standards Board (“FASB”) to be applied to nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) are also sources of authoritative GAAP for SEC registrants. The ASC superseded all existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the ASC is nonauthoritative. The Company’s policies were not affected by the conversion to ASC.

In 2009, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 166,Accounting for Transfers of Financial Assets – an amendment of FASB Statement No. 140, (“SFAS No. 166”) (this SFAS was incorporated into the ASC on January 1, 2010) amending the accounting for the transfers of financial assets. This new standard enhances reporting about transfers of financial assets, including loan participations and securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. It also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The standard was effective January 1, 2010 and had no impact on the Company’s consolidated financial statements.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(1) Summary of Significant Accounting Policies, Continued

Recent Pronouncements, Continued.In 2009, the FASB issued SFAS No. 167,Amendments to FASB Interpretation No. 46(R),(“SFAS No. 167”) (this SFAS was incorporated into the ASC on January 1, 2010) on how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The standard requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its effect on the entity’s financial statements. The standard was effective January 1, 2010 and had no impact on the Company’s consolidated financial statements.

Reclassifications. Certain amounts in the 2008 financial statements have been reclassified to conform with the 2009 presentation.

(2) Securities Available for Sale

Securities available for sale have been classified according to management’s intent. The carrying amount and fair value of securities available for sale are as follows (in thousands):

	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses		Approximate Fair Value
Available for Sale:
At December 31, 2009:
U.S. Government agency securities	$	1,029	—	(24	)	1,005
Mortgage-backed securities		30,325	150	(198	)	30,277
	$	31,354	150	(222	)	31,282
At December 31, 2008:
U.S. Government agency securities		3,000	10	—		3,010
Mortgage-backed securities		9,903	210	—		10,113
	$	12,903	220	—		13,123

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(2) Securities, Continued

Securities sold are as follows (in thousands):

	Year Ended December 31,
	2009		2008
Gross proceeds	$	4,469	—
Gross gains	$	227	—
Gross losses	$	—	—
Net gains	$	227	—

Available-for-sale securities at December 31, 2009, measured at fair value on a recurring basis are summarized below (in thousands):

			Fair Value Measurements Using
	Fair Value as of December 31, 2009		Quoted Prices In Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Available-for-sale securities	$	31,282	—	31,282	—

The scheduled maturities of securities available for sale at December 31, 2009 are as follows (in thousands):

	Amortized Cost		Approximate Fair Value
Due from one to five years	$	1,029	1,005
Mortgage-backed securities		30,325	30,277
	$	31,354	31,282

At December 31, 2009 and 2008, securities with a carrying value of approximately $18.2 million and $8.8 million, respectively, were pledged for other borrowings and public funds.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(2) Securities, Continued

Securities with gross unrealized losses at December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous loss position, are as follows (in thousands):

	Less Than Twelve Months			Over Twelve Months
	Gross Unrealized Losses		Fair Value	Gross Unrealized Losses	Fair Value
Securities available for sale:
U.S. Government agencies	$	24	1,005	—	—
Mortgage-backed securities		198	17,530	—	—
Total securities available for sale	$	222	18,535	—	—

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

The unrealized losses on fifteen securities available for sale were caused by market conditions. It is expected that the securities would not be settled at a price less than the par value of the investments. Because the decline in fair value is attributable to changes in market conditions and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(3) Loans

The components of loans are as follows (in thousands):

	At December 31,
	2009			2008
Commercial real estate	$	144,234		102,788
Residential real estate and home equity		45,877		34,286
Residential mortgages held for sale		6,325		2,515
Construction		15,400		45,569
Commercial		22,362		19,635
Consumer		3,130		2,928
Total loans		237,328		207,721
Allowance for loan losses		(3,035	)	(2,714	)
Net deferred loan costs		387		300
Loans, net	$	234,680		205,307

In 2009 and 2008, the Company originated residential mortgages for sale totaling $62,315,000 and $53,038,000, respectively, and sold residential mortgages totaling $58,505,000 and $51,868,000, respectively.

An analysis of the change in the allowance for loan losses follows (in thousands):

	Year Ended December 31,
	2009			2008
Beginning balance	$	2,714		2,046
Provision for loan losses		1,012		1,115
Recoveries		1		—
Charge-offs		(692	)	(447	)
Ending balance	$	3,035		2,714

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(3) Loans, Continued

The following is a summary of information regarding nonaccrual and impaired loans (in thousands):

	At December 31,
	2009			2008
Nonaccrual loans	$	2,842		1,497
Accruing loans past due ninety days or more	$	—		—
Collateral dependent loans identified as impaired:
Gross loans with no related allowance for losses		1,932		644
Gross loans with related allowance for losses recorded		1,667		2,964
Less allowances on these loans		(246	)	(588	)
Net loans with related allowance		1,421		2,376
Net investment in collateral dependent impaired loans		3,353		3,020
Noncollateral dependent loans identified as impaired:
Gross loans with no related allowance for losses		1,034		—
Gross loans with related allowance for losses recorded		2,094		—
Less allowance on these loans		(513	)	—
Net loans with related allowance		1,581		—
Net investment in noncollateral dependent impaired loans		2,615		—
Net investment in impaired loans	$	5,968		3,020

Impaired collateral-dependent loans are carried at fair value when the current collateral value is lower than the carrying value of the loan. Those impaired collateral-dependent loans which are measured at fair value or a nonrecurring basis at December 31, 2009 are as follows (in thousands):

	Fair Value(1)		Level 1	Level 2	Level 3	Total Losses	Losses Recorded in Operations in 2009
Impaired loans	$	1,421	—	—	1,421	246	238

⁽¹⁾ In addition, loans with a carrying value of $1,932,000 at December 31, 2009 were measured for impairment using Level 3 inputs and had a fair value in excess of carrying value.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(3) Loans, Continued

The average net investment in impaired loans and interest income recognized and received on impaired loans are as follows (in thousands):

	Year Ended December 31,
	2009		2008
Interest income recognized on impaired loans	$	155	7
Interest income received on impaired loans	$	155	7
Average net recorded investment in impaired loans	$	4,115	518

(4) Premises and Equipment

A summary of premises and equipment follows (in thousands):

	At December 31,
	2009			2008
Land	$	3,492		3,442
Buildings		7,770		6,104
Leasehold improvements		634		612
Furniture, fixtures and equipment		3,248		2,992
Construction in process		—		1,661
Total, at cost		15,144		14,811
Less accumulated depreciation and amortization		(1,834	)	(1,207	)
Premises and equipment, net	$	13,310		13,604

The Company leases its Ocala corporate headquarters facility under an operating lease. This lease is for a term of five years, contains an escalation clause, requires monthly lease payments and common area maintenance charges with options to renew through 2025. Rent expense under this operating lease during the years ended December 31, 2009 and 2008 was $80,000. The Company offsets occupancy expense with sub-leases on various suites in the building. This provided rental income, net of operating expenses, for 2009 and 2008 of $4,000 and $25,000 respectively. The future minimum lease payments, which include certain renewal options, as of December 31, 2009 are as follows (in thousands):

Year Ending December 31,	Expense		Income
2010	$	92	89
2011		98	40
2012		100	13
2013		100	—
2014		100	—
2015 and thereafter		1,044	—
	$	1,534	142

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(5) Other Real Estate Owned

Expenses applicable to other real estate owned, which are included in other noninterest expenses on the consolidated statement of operations, follows (in thousands):

	Year Ended December 31,
	2009		2008
Loss on sale of other real estate owned	$	12	—
Write-off of other real estate owned		76	—
Operating expenses		44	—
	$	132	—

Other real estate owned is recorded at the lower of cost or fair value less estimated costs to sell. Other real estate owned which is measured at fair value on a nonrecurring basis is as follows (in thousands):

	At December 31, 2009						Losses Recorded in Operations in 2009
	Fair Value		Level 1	Level 2	Level 3	Total Losses
Other real estate owned	$	1,583	—	—	1,583	76	76

(6) Deposits

A schedule of maturities of time deposits at December 31, 2009 follows (in thousands):

Year Ending December 31,	Amount
2010	$	108,301
2011		29,659
2012		16,400
2013		875
2014		3,081
	$	158,316

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(7) Other Borrowings

The Company enters into repurchase agreements with customers that sweep funds from deposit accounts into investment accounts. These investment accounts are not federally insured and are treated as borrowings. These agreements require the Company to pledge securities as collateral for these borrowings. At December 31, 2009 and 2008, the outstanding balance of such borrowings totaled approximately $7.6 million and $7.6 million, respectively, and the Company pledged securities with a carrying value of approximately $10.5 million and $7.9 million, respectively, as collateral for these agreements.

(8) Federal Home Loan Bank Advances

The maturity and interest rate of the Federal Home Loan Bank (“FHLB”) advances are as follows ($ in thousands):

			At December 31,
Maturity	Interest Rate		2009		2008
2009	0.61	%	$	—	1,000
2009	1.24	%		—	2,000
2009	2.73	%		—	2,000
2010	2.86	%		2,000	2,000
2010	3.54	%		2,000	2,000
2011	0.76	%		1,000	—
2011	1.04	%		1,000	—
2011	1.23	%		2,000	—
2016	4.47	%		5,000	5,000
2016	4.71	%		3,000	3,000
2017	4.22	%		5,000	5,000
			$	21,000	22,000

The Company has entered into a collateral agreement with the FHLB which consists of a blanket floating lien on the entire loan portfolio and the pledge of all the Company’s FHLB stock. One advance with a 2016 maturity date and interest rate of 4.47% has a call feature benefiting the issuer with a call date of February 23, 2010. The advance with a 2017 maturity date has a call feature benefiting the issuer with a call date of February 18, 2010.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(9) Income Taxes

Allocation of the Federal and state income taxes (benefit) is as follows (in thousands):

	Year Ended December 31,
	2009		2008
Deferred:
Federal	$	49	(220	)
State		8	(38	)
Income taxes (benefit)	$	57	(258	)

The reasons for the differences between the statutory Federal income tax rate and the effective tax rate are summarized as follows ($ in thousands):

	Year Ended December 31,
	2009				2008
	Amount		% of Pretax Earnings		Amount			% of Pretax Loss
Income taxes (benefit) at statutory rate	$	22	34.0	%	$	(253	)	(34.0	)%
Increase (decrease) resulting from:
State taxes, net of Federal tax benefit		5	7.8			(25	)	(3.4	)
Share-based compensation		23	35.9			22		3.0
Other		7	11.4			(2	)	(.3	)
Income taxes (benefit)	$	57	89.1	%	$	(258	)	(34.7	)%

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(9) Income Taxes, Continued

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below (in thousands).

	At December 31,
	2009			2008
Deferred tax assets:
Allowance for loan losses	$	1,044		998
Net operating loss carryforwards		694		583
Foreclosed property expenses		50		—
Organizational and start-up costs		160		176
Unrealized loss on securities available for sale		27		—
Other		62		52
Deferred tax assets		2,037		1,809
Deferred tax liabilities:
Premises and equipment		(484	)	(290	)
Deferred loan costs		(337	)	(294	)
Prepaid expenses		(60	)	(40	)
Unrealized gains on securities available for sale		—		(82	)
Deferred tax liabilities		(881	)	(706	)
Net deferred tax asset	$	1,156		1,103

At December 31, 2009, the Company has approximately $1.8 million of net operating loss carryforwards available to offset future taxable income. These carryforwards will begin to expire in 2025.

The Company files income tax returns in the U.S. federal jurisdiction, and the State of Florida. The Company is no longer subject to the U.S. federal or state and local income tax examinations by tax authorities for years before 2006.

(10) Off-Balance-Sheet Financial Instruments

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are commitments to extend credit, unused lines of credit and standby letters of credit and may involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments reflect the extent of involvement the Company has in these financial instruments.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(10) Off-Balance-Sheet Financial Instruments, Continued

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, unused lines of credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Company upon extension of credit is based on management’s credit evaluation of the counterparty.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These letters of credit are primarily issued to support third-party borrowing arrangements and generally have expiration dates within one year of issuance. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. At December 31, 2009, the Company held collateral supporting substantially all of these commitments and management does not anticipate any potential losses if these letters of credit are funded.

Standby letters of credit and commitments to extend credit typically result in loans with a market interest rate when funded. A summary of the amounts of the Company’s financial instruments with off-balance-sheet risk at December 31, 2009 follows (in thousands):

	Contract Amount
Commitments to extend credit	$	5,689
Unused lines of credit	$	25,555
Standby letters of credit	$	373

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(11) Significant Group Concentrations of Credit Risk

The Company grants the majority of its loans to borrowers throughout the northeast Florida area, including Marion and Alachua counties. Although the Company has a diversified loan portfolio, a significant portion of its borrowers’ ability to honor their contracts is dependent upon the economy of this area. The Company does not have any significant concentrations to any one industry or customer.

(12) Stock Option Plan

The Company adopted a stock option plan for its employees and directors (the “Plan”). Fifteen percent of the total amount of shares outstanding, up to 450,000 shares (currently 397,981 shares), have been reserved under the Plan. Stock options are granted at an exercise price equal to or greater than the fair market value of the common stock on the date of grant. Options granted to directors vest immediately and for employees, the options primarily vest over two years starting with the date of grant and ending on the second anniversary thereof. At December 31, 2009, 98,396 options remain available for granting. A summary of stock option transactions under the Plan for the years ended December 31, 2009 and 2008 follows:

	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
Options outstanding at December 31, 2007	253,808		$	10.13
Options exercised	(17,486	)		10.00
Options forfeited	(5,602	)		10.37
Options granted	31,250			10.16
Options outstanding at December 31, 2008	261,970			10.14
Options forfeited	(10,501	)		10.16
Options granted	24,600			10.00
Options outstanding at December 31, 2009	276,069		$	10.13	6.89 years	$	—
Options exercisable at December 31, 2009	257,360		$	10.13	6.75 years	$	—

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(12) Stock Option Plan, Continued

The fair value of each option granted is estimated on the date of the grant using the Black-Scholes option-pricing model with the following assumptions:

	Year Ended December 31,
	2009			2008
Risk-free interest rate		1.46	%	4.04-4.58	%
Dividend yield		—	%	—	%
Expected stock volatility		10.00	%	6.18-6.92	%
Expected life in years		5.50		5.00-5.50
Per share grant-date fair value of options issued during the year	$	1.29		1.86-2.22

The Company examined its historical pattern of option exercises in an effort to determine if there were any pattern based on certain employee populations. From this analysis, the Company could not identify any patterns in the exercise of options. As such, the Company used the guidance in Staff Accounting Bulletin No. 107 issued by the Securities and Exchange Commission to determine the estimated life of options. Expected volatility is based on historical volatility of similar size financial institutions. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield assumption is based on the Company’s history and expectation of dividend payments.

There were no options exercised during the year ended December 31, 2009 and 17,486 exercised during the year ended December 31, 2008. There was no intrinsic value or tax benefit related to these options exercised. At December 31, 2009 there was approximately $13,000 of total unrecognized compensation expense related to the nonvested share-based compensation arrangements granted under the plans. The cost is expected to be recognized over a weighted-average period of ten months. The total fair value of shares vesting and recognized as compensation expense was approximately $67,000 for the year ended December 31, 2009 and $64,000 in 2008. The associated income tax benefit recognized was $8,000 for 2008. There was no associated income tax benefit recognized in 2009.

(13) Employee Benefit Plan

The Company has a 401(k) profit sharing plan available to all employees electing to participate after meeting certain length-of-service requirements. The Company contributed $83,000 to the plan in 2009, and $86,000 in 2008.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(14) Related Party Transactions

The Company enters into transactions during the ordinary course of business with officers and directors of the Company and entities in which they hold a significant financial interest. The following summarizes these transactions (in thousands):

	At December 31,
	2009		2008
Loan balances at end of year	$	11,497	9,264
Deposits held from related parties-Balance at end of year	$	5,673	5,573

(15) Stockholders’ Equity and Dividend Restrictions

During the initial offering of common stock, the Company sold units, with each unit containing one share of common stock and one warrant. Each warrant entitled the holder to purchase one share of additional common stock for $10 at any time over a three-year period. Warrants totaling 452,237 were exercised in 2008. The Company called 50% of the initial warrant amount in February 2007. The remaining 50% expired on February 28, 2008.

On January 23, 2009 the U.S. Treasury Department (the “Treasury”) purchased $6.5 million of the Company’s senior preferred stock as part of the US Treasury’s Capital Purchase Program. While the preferred shares are outstanding, the Company will pay the Treasury a five percent dividend on the senior preferred shares for the first five years following the investment, and a nine percent dividend thereafter. The Treasury also received warrants to purchase an additional $325,700 of the Company’s senior preferred stock at an exercise price of $0.01. The Treasury exercised these warrants on January 23, 2009. The senior preferred shares issued upon exercise of the warrants pay dividends at an annual rate of nine percent. While the senior preferred shares are outstanding, the Company must comply with restrictions on executive compensation and limitations on dividends and stock repurchases. The Company can repay the Treasury under the conditions established in the purchase agreements, and the Treasury can sell their investment to third parties.

The Company is limited in the amount of dividends it may pay by the amount of dividends the Bank may pay to the Holding Company. The Bank is limited in the amount of cash dividends that may be paid by Florida law. The amount of cash dividends that may be paid is based on the Bank’s net earnings of the current year combined with the Bank’s retained earnings of the preceding two years, as defined by state banking regulations. However, for any dividend declaration, the Bank must consider additional factors such as the amount of current period net earnings, liquidity, asset quality, capital adequacy and economic conditions. It is likely that these factors would further limit the amount of dividends which the Bank could declare. In addition, bank regulators have the authority to prohibit banks from paying dividends if they deem such payment to be an unsafe or unsound practice.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(16) Regulatory Matters

The Bank is subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and percents (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2009, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2009, the most recent notification from the regulatory authorities categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage percents as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and percents are also presented in the table ($ in thousands):

	Actual				For Capital Adequacy Purposes				For Well Capitalized Purposes
	Amount		Percent		Amount		Percent		Amount		Percent
As of December 31, 2009:
Total Capital (to Risk- Weighted Assets)	$	28,332	11.49	%	$	19,726	8.00	%	$	24,658	10.00	%
Tier I Capital (to Risk- Weighted Assets)		25,297	10.26			9,862	4.00			14,794	6.00
Tier I Capital (to Average Assets)		25,297	8.37			12,089	4.00			15,112	5.00
As of December 31, 2008:
Total Capital (to Risk- Weighted Assets)		23,852	10.74			17,767	8.00			22,209	10.00
Tier I Capital (to Risk- Weighted Assets)		21,138	9.52			8,882	4.00			13,322	6.00
Tier I Capital (to Average Assets)		21,138	8.37			10,102	4.00			12,627	5.00

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(17) Fair Value of Financial Instruments

The estimated fair values of the Company’s financial instruments are as follows (in thousands):

	At December 31,
	2009			2008
	Carrying Amount		Fair Value	Carrying Amount	Fair Value
Financial assets:
Cash and cash equivalents	$	22,098	22,098	9,471	9,471
Interest bearing time deposits in banks		2,287	2,287	12,410	12,410
Securities available for sale		31,282	31,282	13,123	13,123
Loans, net		234,680	237,399	205,307	206,369
Accrued interest receivable		939	939	731	731
Federal Home Loan Bank stock		1,499	1,499	1,356	1,356
Financial liabilities:
Deposits		249,989	253,975	202,914	204,654
Other borrowings		7,633	7,633	7,584	7,584
Federal Home Loan Bank advances		21,000	19,788	22,000	20,018
Accrued interest payable		640	640	1,118	1,118
Off-balance-sheet financial instruments		—	—	—	—

(18) Legal Contingencies

Various legal claims arise from time to time in the normal course of business which, in the opinion of management, will not have a material effect on the Company’s financial statements.

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(19) Holding Company Only Financial Information

The Holding Company’s unconsolidated financial information is as follows (in thousands):

Condensed Balance Sheets
	At December 31,
	2009			2008
Assets
Cash	$	3,332		1,165
Investment in subsidiaries		27,302		23,378
Other assets		122		104
Total assets	$	30,756		24,647
Liabilities and Stockholders' Equity
Other liabilities		50		11
Stockholders’ equity		30,706		24,636
Total liabilities and stockholders’ equity	$	30,756		24,647
Condensed Statements of Operations
	Year Ended December 31,
	2009			2008
Revenues	$	19		40
Operating expenses, net of income tax benefit		118		136
Net loss before earnings (loss) of subsidiaries		(99	)	(96	)
Earnings (loss) of subsidiaries		106		(389	)
Net earnings (loss)	$	7		(485	)

(continued)

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

(19) Holding Company Only Financial Information, Continued

Condensed Statements of Cash Flows
	Year Ended December 31,
	2009			2008
Cash flows from operating activities:
Net earnings (loss)	$	7		(485	)
Adjustment to reconcile net earnings (loss) to net cash used in operating activities:
Share-based compensation		67		64
Equity in (earnings) loss of subsidiaries		(106	)	389
Increase in other assets		(18	)	(22	)
Increase in other liabilities		39		3
Net cash used in operating activities		(11	)	(51	)
Cash flows from investing activity-
Investment in subsidiaries		(4,001	)	(4,021	)
Cash flows from financing activities:
Common stock warrants and options exercised		—		4,698
Proceeds from preferred stock issued		6,514		—
Preferred stock dividend requirements and Series B stock accretion		(335	)	—
Net cash provided by financing activities		6,179		4,698
Net increase in cash		2,167		626
Cash at beginning of the year		1,165		539
Cash at end of year	$	3,332		1,165
Supplemental disclosure of cash flow information:
Noncash transaction-
Accumulated other comprehensive (loss) income, net change in unrealized gain (loss) on securities available for sale of subsidiary, net of taxes	$	(183	)	108

(continued)