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Valley Financial Corp/VA – ‘SB-2’ on 10/6/04

On:  Wednesday, 10/6/04, at 5:04pm ET   ·   Accession #:  1193125-4-167692   ·   File #:  333-119570

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

10/06/04  Valley Financial Corp/VA          SB-2                   4:1.5M                                   RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: SB-2        Prospectus                                          HTML   1.39M 
 2: EX-5.1      Opinion of Leclair, Ryan, Flippin, Densmore, P.C.   HTML     10K 
 3: EX-21       Subsidiaries of the Registrant                      HTML      4K 
 4: EX-23.1     Consent of Larrowe & Company, P.L.C.                HTML      7K 

As filed with the Securities and Exchange Commission on October 6, 2004.

Registration No.             

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form SB-2

REGISTRATION STATEMENT

Under

THE SECURITIES ACT OF 1933

VALLEY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

36 Church Avenue

Roanoke, Virginia 24011

(540) 342-2265

(Address and telephone number of principal executive offices)

36 Church Avenue

Roanoke, Virginia 24011

(540) 342-2265

(Address of principal place of business or intended principal place of business)

Copies to:

Approximate date of commencement of proposed sale to the public: As soon as possible after the effective date of this Registration Statement.

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the securities Act registration statement number of the earlier effective registration statement for the same offering. ¨

If delivery of the prospectus is expected to be made pursuant to Rule 434 of the Securities Act, please check the following box. ¨

CALCULATION OF REGISTRATION FEE

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with section 8(a) of the securities act, or until the registration statement shall become effective on such date as the commission, acting pursuant to said section 8(a), may determine.

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

275,000 Shares

VALLEY FINANCIAL CORPORATION

The Holding Company for

Common Stock

Valley Financial Corporation is offering 275,000 shares of common stock. We own and operate Valley Bank, which is headquartered in Roanoke, Virginia and operates seven full-service banking offices in the Roanoke Valley, a metropolitan center of southwest Virginia. Valley Bank is a community-oriented bank that provides commercial and consumer banking services for individuals and small- to medium-sized businesses.

Our common stock is quoted on the OTC Bulletin Board under the symbol “VYFC”. As of October 5, 2004, the last reported sale price of the common stock on the OTC Bulletin Board was $14.00 per share. Only a limited market currently exists for our common stock.

Investing in our common stock involves risks. You should read the “Risk Factors” section beginning on page 6 before investing.

These securities have not been approved or disapproved by the Securities and Exchange Commission, any state securities commission, any bank regulatory agency, or any other government agency nor has any such commission or agency passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

The shares of common stock offered are not deposit accounts and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

The date of this prospectus is                      , 2004.

SUMMARY

This summary may not contain all of the information that may be important to you. You should read carefully the entire prospectus, including “Risk Factors” and the financial statements and related notes included in the prospectus, before making an investment decision.

Valley Financial and Valley Bank

Valley Financial Corporation is a one-bank holding company headquartered in Roanoke, Virginia. Our wholly owned subsidiary, Valley Bank, began operating as a commercial bank in May 1995. Valley Bank operates seven full service banking offices in the greater Roanoke area. As of June 30, 2004 we had assets of $347 million, shareholders’ equity of $22.7 million and reported net income of $1.3 million, or $0.35 per share, for the first half of 2004. We have grown substantially since our formation and are continuing to experience rapid growth. For the six months ended June 30, 2004, total assets increased by 21% and net income decreased by 0.8% over the year-ago period.

Valley Financial owns and manages Valley Bank and does not engage in any other business. Valley Bank is a community-oriented bank that offers a variety of banking products and services, including an array of deposit products, consumer loans, commercial loans, and home mortgages. Valley Bank also offers safe deposit boxes, certain cash management services, and automatic deposit services.

Our strategic plan is directed towards enhancing profitability and shareholder value by increasing our market share in the Roanoke Valley market area. We have historically succeeded in growing our market share by providing a high level of personal service, local decision-making, and targeting banking relationships with small- to medium-sized businesses, professional firms, and individuals.

Valley Bank’s

Roanoke Valley Market Area

Valley Bank operates primarily in the Roanoke Valley area of southwest Virginia. This area includes the cities of Roanoke and Salem, Roanoke County and parts of the counties of Bedford, Botetourt and Franklin. The Roanoke Metropolitan Statistical Area, which excludes Bedford County, has an estimated population of 290,497 and is the regional and commercial center of southwest Virginia. Combined FDIC-insured deposits in the Roanoke MSA were approximately $3.9 billion as of June 30, 2003, the most recent date for which this data is available, with approximately $2.2 billion residing in the City of Roanoke. More than 75% of these deposits in the Roanoke MSA were held at larger, out-of-state institutions. We believe this creates a significant opportunity for a locally owned and managed institution like us to gain market share. While we have grown our share of the deposits in our market every year since inception, it is currently less than 6%, which we believe provides us with a significant opportunity for future growth. We believe a locally owned and managed community bank like ours has the ability to continue to take market share away from our out-of-state competitors.

Experienced Management

The President and Chief Executive Officer of Valley Financial and Valley Bank since June 1996 is Ellis L. Gutshall, who has 30 years’ experience in banking. Mr. Gutshall joined Valley Financial in 1995 as Senior Vice President and Chief Lending Officer. Immediately prior to that, he was Executive Vice President of First Virginia Bank – Southwest in Roanoke, Virginia.

A. Wayne Lewis has served Valley Financial and Valley Bank as Senior Vice President and Chief Operating Officer since operations began in 1995 and as Executive Vice President since 1996. Mr. Lewis has more than 42 years of banking experience, including having served as Executive Vice President of Dominion Bankshares Corporation, a $10.6 billion financial institution that was acquired by First Union Corporation in 1993.

J. Randy Woodson has been Executive Vice President and Chief Lending Officer of Valley Financial and Valley Bank since 2002, and Senior Vice President since 1998. Mr. Woodson has 20 years’ banking experience. Prior to joining Valley, he was a Senior Vice President in the commercial lending area for SunTrust Bank.

Reasons for the Offering

We have grown rapidly since our formation and we now need additional equity capital to support future growth. Since the end of 2000, our assets have more than doubled to $347 million at June 30, 2004. We have strived to enhance shareholder value by leveraging our existing capital; however, without additional equity capital our ability to grow will be constrained. Our goal is to leverage the capital from this offering in a manner that enhances future earnings per share and shareholder value. We may expand operations throughout the Roanoke Valley through additional branch offices and automated

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teller machines. We also intend to make increased use of alternative delivery systems such as the Internet and telephone.

Plan of Distribution

The shares sold in this offering will be distributed to the three buyers shortly after the registration statement is declared effective.

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The number of shares of our common stock outstanding after this offering is based on the number of shares outstanding on June 30, 2004. After the completion of this offering, 4,073,030 shares will be outstanding immediately after the offering. The number of shares outstanding after the offering excludes 256,772 shares that are reserved for issuance under Valley Financial’s Incentive Stock Plan, of which options to purchase 236,145 shares (including 22,670 shares for Messrs. Gutshall and Lewis) are outstanding at a weighted average exercise price of $5.92, and 82,098 shares that are reserved for options granted under the employment agreements of Messrs. Gutshall and Lewis at an exercise price of $3.175.

We were founded as a Virginia corporation in 1994. Our principal executive offices are located at 36 Church Avenue, SW, Roanoke, Virginia 24011. Our telephone number is (540) 342-2265.

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SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected consolidated financial data for Valley Financial Corporation and subsidiary. The selected unaudited financial data presented below for, and as of the end of, the six-month periods ended June 30, 2004 and 2003 are derived from the unaudited consolidated financial statements of Valley Financial Corporation and subsidiary. The unaudited consolidated financial statements as of June 30, 2004 and 2003, and for the six-month periods then ended include, in the opinion of management, all material adjustments considered necessary for a fair presentation. Operating results for the six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The unaudited consolidated financial statements as of June 30, 2004 and for the six-month period ended June 30, 2004 and 2003, are included elsewhere in this prospectus. The selected consolidated financial data presented below for, and as of the end of, the year ended December 31, 2003 and 2002, are derived from the consolidated financial statements of Valley Financial Corporation and subsidiary, which financial statements have been audited by Larrowe & Company, P.L.C., independent public accountants. The consolidated financial statements as of December 31, 2003 and 2002 and for the years then ended, and the report thereon, are included elsewhere in this prospectus. The selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our financial statements and notes thereto and other financial data included elsewhere in this prospectus. If anyone should want a copy of our financial reports or any other materials filed with the Securities and Exchange Commission, they are available at the Commission’s Public Reference Room at 450 Fifth Street, N.W. Washington, D.C. 20549 or on the internet at http://www.sec.gov. The public may obtain information on the operation of the Public Reference room by calling 1-800-SEC-0330.

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SELECTED CONSOLIDATED FINANCIAL DATA

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RISK FACTORS

You should consider carefully the following risk factors before deciding to buy our common stock. These risk factors may adversely impact our business and financial condition. Additional risks and uncertainties not presently known to us, or risks that we currently consider immaterial, may also impair our business. You should read this section together with the other information in this prospectus.

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USE OF PROCEEDS

We estimate that we will receive approximately $3,825,000 in net proceeds from the sale of 275,000 shares of our common stock, assuming an offering price of $14.00 per share and after deducting one-half (our portion) of the estimated offering expenses totaling $50,000. We will contribute a substantial portion of the net proceeds to

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Valley Bank and retain the balance in Valley Financial. The net proceeds retained by Valley Financial will be used for working capital and other general corporate purposes, including providing additional contributions to Valley Bank’s capital, as needed.

MARKET FOR COMMON STOCK

Market for Company Stock

The common stock is quoted under the symbol “VYFC” on the OTC Bulletin Board, an electronic quotation and trade reporting service of the National Association of Securities Dealers. According to information obtained by company management and believed to be reliable, the quarterly range of closing prices per share (adjusted for the 2 for 1 stock split effected in the form of a stock dividend declared April 28, 2004 and paid on May 31, 2004) for our common stock for the calendar periods presented was as follows:

Trading volume in our common stock is limited. Since January 1, 2004, an average of approximately 9,900 shares was traded each week. As of June 30, 2004, there were approximately 469 shareholders of record and another approximately 800 beneficial holders of our common stock.

Determination of Offering Price

The price set for this sale of common stock was negotiated between the Company and the individual and entities to whom we are selling the stock. It was set as of the day of the contract for purchase, September 27, 2004. Since the contract for purchase is contingent upon the registration of these shares, the market price on the date of sale may not be the same as the contract purchase price.

DIVIDEND POLICY

We paid our first semi-annual cash dividend on July 1, 2004. There can be no assurance that cash dividends like this will be declared in the future. Our board of directors will determine whether to declare future cash dividends based on an analysis of factors the board deems relevant. For the foreseeable future, we expect that we will retain a substantial portion of our earnings to support the development and growth of our business. On April 28, 2004, we did declare a 2 for 1 stock split which was effected in the form of a stock dividend, paid on May 31, 2004 to shareholders of record as of May 14, 2004.

We will depend on dividends received from Valley Bank to fund dividends on our common stock. As a banking corporation organized under Virginia law, Valley Bank is restricted as to the maximum amount of dividends it may pay to Valley Financial. A Virginia bank may not pay dividends from its original capital. All dividends must be paid out of net undivided profits on hand, after deducting expenses, losses, interest, and taxes accrued and contribution to capital necessary for Valley Bank’s original capital to be restored to its initial level. As of June 30, 2004, the net profits of Valley Bank available for distribution to Valley Financial as dividends without regulatory approval were approximately $10.2 million.

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As a practical matter, the Board of Governors of the Federal Reserve System recommends that banking organizations pay dividends only if the net income available to shareholders in the past year fully funds those dividends and the expected rate of earnings retention is consistent with capital needs, asset quality, and overall financial condition. Valley Financial’s dividend policy complies with this recommendation.

CAPITALIZATION

The following table sets forth our consolidated capitalization at June 30, 2004 on an actual basis and as adjusted to reflect the receipt of $3,825,000 in net proceeds from our sale of 275,000 shares of common stock at a price of $14.00 per share, assuming offering expenses total $50,000 and our portion is $25,000.

DILUTION

Your investment will be immediately diluted because your purchase price per share exceeds our book value per share. The book value per share is determined by dividing our net worth (assets less liabilities) by the total shares outstanding. Our book value as of June 30, 2004 was $22,705,000 or $5.98 per share. The purchase price per share in this offering will cause both an immediate dilution in book value to new investors and an immediate increase in book value to the existing shareholders of Valley Financial.

The following table illustrates this dilution per share assuming the sale of 275,000 shares of common stock at an offering price of $14.00 per share, net of one-half of offering expenses totaling $50,000.

BUSINESS

General

Valley Financial Corporation was incorporated in Virginia in 1994, primarily to own all of the capital stock of Valley Bank. We presently engage in no business other than owning and managing Valley Bank. Valley Bank is a state bank organized under Virginia law, and engages in the business of commercial banking. Valley Bank opened for business on May 15, 1995. Its deposits are insured by the FDIC and it is a member of the Federal Reserve System. As of June 30, 2004, we had total assets of $347.0 million, net loans of $248.7 million, total deposits of $253.0 million, and shareholders’ equity of $22.7 million.

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We presently operate seven offices. Presented in the following table is the location of each branch, the date it opened for business and the deposits as of June 30, 2004.

Strategy

Our strategy is to enhance shareholder value by increasing net income through continued loan growth, while controlling the cost of deposits and the growth of non-interest expense. To achieve this goal, we plan to provide our customers with products and services comparable to those offered by our competitors and to continue to provide our customers with a high level of personal service and local decision-making. We also may continue to expand our network of branches and automated teller machines throughout the Roanoke Valley and to make increased use of alternative delivery systems, such as the Internet and telephone.

Market Area

Valley Bank’s primary service area consists of the cities of Roanoke and Salem, Roanoke County and portions of Botetourt, Bedford, and Franklin County, Virginia. We are a community bank and conduct a general commercial banking business, emphasizing the needs of small- to medium-sized businesses, professional concerns, and individuals.

The Roanoke Metropolitan Statistical Area (MSA) is the commercial center for southwest Virginia, and is located approximately 165 miles west of Richmond, Virginia, 178 miles northwest of Charlotte, North Carolina, 178 miles east of Charleston, West Virginia and 222 miles southwest of Washington, D.C. Hollins University and Roanoke College, with student enrollments of approximately 1,100 and 1,900 respectively, are located in the Roanoke MSA. Virginia Tech, with a student body of approximately 26,000 and Radford University, with a student body of more than 9,000 are each a 45-minute drive away. In total, there are 20 colleges and universities within a 60-mile radius of Roanoke.

The population in the Roanoke MSA was estimated at 290,497 at year-end 2003 and its recent growth has been slower than that in other key Virginia markets. The Roanoke MSA had an unemployment rate of 2.9% in August 2004, lower than all Virginia MSAs except Northern Virginia and Charlottesville. Per capita income increased almost 20% from 1997 to 2001, roughly the same rate as the national average. At the same time, a low cost of living makes the area one of the nation’s most affordable. An Old Dominion University study that married per capita income with cost of living ranked the Roanoke Valley 11^th highest in the United States for “real per capita income.” According to the ACCRA Cost of Living Index, the Valley’s cost of living is 92.8, compared to the national average benchmark of 100 and well below the 137.7 ratio for Washington, DC.

The business community in the Roanoke MSA is diverse. The largest components of the economy (as a % of jobs) are services at 39%, retail trade at 14%, manufacturing at 12% and government at 11%. The Roanoke MSA’s position as a regional center creates a strong medical, legal, and business professional community. Carilion Health System, Lewis-Gale Hospital/Clinic and the Veterans Administration Hospital are among the area’s largest employers. Other large private employers include Advance Auto Parts, Allstate Insurance Co., ITT Industries, Kroger Mid-Atlantic, Manpower, Inc., Norfolk Southern Corporation, Wachovia Bank, and Wal-Mart Stores.

Lending Services

Valley Bank offers a range of short- to medium-term commercial and personal loans. Commercial loans include both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements), and purchase of equipment and machinery. Consumer loans include secured and unsecured loans for financing automobiles, home improvements, education, and personal investments. Valley Bank also makes various types of real estate loans.

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Our lending efforts are directed primarily to making loans to individuals and businesses in our market area. We believe that our lending and credit policies are conservative. As of June 30, 2004, we had approximately $251.5 million in total loans and $ 80.1 million in unfunded loan commitments and unused lines of credit outstanding.

Valley Bank’s lending activities are subject to a variety of lending limits imposed by state law. While different limits apply in certain circumstances based on the type of loan or the nature of the borrower (including the borrower’s relationship to Valley Bank), in general Valley Bank is subject to a loan-to-one borrower limit of 15% of Valley Bank’s capital and surplus in the case of loans which are not fully secured by readily marketable or other permissible types of collateral. Valley Bank voluntarily may choose to impose a policy limit on loans to a single borrower that is less than the legal lending limit. Valley Bank’s present legal lending limit of $4,371,000 is sufficient to satisfy the credit needs of a large portion of its targeted market segment. Valley Bank has established relationships with correspondent banks to participate in loans when loan amounts exceed our legal lending limits or internal lending policies.

Valley Bank attempts to react to prevailing market conditions and demands in our lending activities, while avoiding excessive concentration in any particular loan category. We have fixed specific goals as to lending concentration by type of loan. This mix of loans is intended to provide sufficient diversification to balance the risks within the loan portfolio. We manage the portfolio within the following ranges:

The risk of nonpayment of loans is inherent in all loans. However, management carefully evaluates all loan applicants and attempts to minimize credit risk-exposure with thorough loan application and approval procedures. In determining whether to make a loan, Valley Bank lending personnel analyze the borrower’s income and ability to service the loan and credit history, and evaluate the need for collateral to secure recovery in the event of default. Valley Bank maintains an allowance for loan losses based upon management’s assumptions and judgments regarding the ultimate collectibility of loans in its portfolio and based upon a percentage of the outstanding balances of specific loans when their ultimate collectibility is considered questionable. Certain risks with regard to specific categories of loans are described below.

Commercial Loans. Commercial lending activities are directed principally toward businesses whose demand for funds will fall within Valley Bank’s legal lending limit. These businesses include small- to medium-sized professional firms, retail and wholesale businesses, light industry, and manufacturing concerns operating in and around the primary service area. The types of loans provided include term loans with fixed and variable interest rates and working capital lines of credit with variable rates secured by equipment, inventory, accounts receivable, and commercial real estate. Valley Bank also offers to commercial customers, through an affiliation with Private Business, Inc., an automated accounts receivable-financing product designed to enhance a company’s cash flow.

Commercial business loans generally have a higher degree of risk than residential mortgage loans, but have commensurately higher yields. To manage these risks, Valley Bank generally secures appropriate collateral and monitors the financial condition of its business borrowers. In addition, personal guarantees are generally obtained from the principals of business borrowers and/or third parties to further support the borrower’s ability to service the debt and reduce the risk of nonpayment. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from his employment and other income and are secured by real estate whose value tends to be easily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the financial success of the business borrower itself. Further, the collateral for commercial business loans may depreciate over time and cannot be appraised with as much precision as residential real estate.

Real Estate Loans. Real estate lending includes commercial and residential development/construction loans, home improvement loans, home equity loans and commercial and residential mortgage loans. Valley Bank also participates in the origination of a limited number of fixed-rate residential mortgage loans that are referred to mortgage brokers. Residential loans are secured by first mortgages on one-to-four family residences in the primary service area. Home improvement loans and home equity loans are generally secured by second mortgages on single

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family residences in the primary service area. Commercial mortgage loans are secured by first mortgages on commercial properties, generally owner-occupied, in the primary service area.

The risk associated with residential mortgage lending varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. Commercial real estate lending entails significant additional risk. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income-producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy generally.

Consumer Loans. Consumer loans are made on a secured or unsecured basis and are oriented primarily to the requirements of Valley Bank’s customers, with an emphasis on loans for automobiles, home improvements, debt consolidation, and other personal needs.

Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans.

Deposit Products and Other Banking Services

Valley Bank offers deposit products that are typically available in most banks including checking accounts, NOW accounts, savings accounts, Individual Retirement Accounts, and other time deposits ranging from money market accounts to longer-term certificates of deposit. The transaction accounts and time deposits are tailored to our principal market area at rates competitive to those offered in the area. All deposit accounts are insured by the FDIC up to the maximum amount allowed by law (generally $100,000 per depositor, subject to aggregation rules). Valley Bank solicits accounts from individuals, businesses, associations and organizations, and governmental authorities.

Other bank services include safe deposit boxes, cash management, lockbox, overdraft protection, and online banking services, travelers checks, direct deposit of payroll and social security checks, and automatic drafts for various accounts. Valley Bank is associated with the Star, Cirrus, and The Exchange shared networks of automated teller machines that may be used by bank customers throughout Virginia and other regions. Valley Bank also offers VISA and MasterCard credit card and VISA debit card services.

Valley Bank does not plan to exercise trust powers during the next several years. Valley Bank may in the future offer a full-service trust department, but cannot do so without the prior approval of its federal and state regulators. The Bank anticipates offering certain investment and insurance products in the near future.

Competition

Banking in the Roanoke Valley is highly competitive. Valley Bank competes as a financial intermediary with other commercial banks, savings & loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other institutions operating in the Roanoke Valley and elsewhere.

Valley Bank’s market area is a highly concentrated, highly branched banking market. As of June 30, 2004 there were approximately 13 commercial banks operating approximately 108 offices in the Roanoke Valley. The only locally owned and operated commercial bank headquartered in Roanoke, Salem or Roanoke County is Valley Bank. SunTrust Bank is a part of the SunTrust family of banks, with a regional presence based in Richmond. Sun Trust substantially expanded its presence in the Roanoke market when it recently acquired NBC Bank. Bank of America, Wachovia Bank, First Citizens Bank, and BB&T Bank all are subsidiaries of holding companies headquartered in North Carolina. BB&T recently acquired First Virginia, formerly headquartered in Falls Church,

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Virginia which owned First Virginia Bank-Southwest with operations in Roanoke. In addition, five out-of-town Virginia based community banks, First National Bank of Christiansburg, Bank of Floyd, First National Exchange Bank, Bank of Botetourt, and The Bank of Fincastle, have each opened one or more branches in localities where we have offices. Also, numerous credit unions operate offices in the Roanoke Valley. Further, various other financial companies, ranging from local to national firms, provide financial services to residents of this market area.

We believe that Valley Bank will be able to compete effectively in this market, and that the community will continue to respond to Valley Bank’s community bank focus and emphasis on service to small businesses, individuals, and professional concerns but there can be no assurance of this.

Employees

At June 30, 2004, Valley Bank had 80 full-time employees, including its officers. Valley Financial does not have any regular employees other than its officers. We believe that our employee relations are excellent.

Properties

We own all our banking facilities except for the Main Office and the South Roanoke office. We lease approximately 16,101 square feet of recently-renovated office space on the first three floors of a seven story office building in downtown Roanoke for our Main Office. The lease expires December 31, 2009, with options to renew for two additional five-year terms. On July 6, 2004 we entered into a lease for approximately 2,087 additional square feet of space in the main office building. Rental payments will commence when renovations are completed, currently estimated to be January 2005. Our South Roanoke office is a recently renovated 914 square foot facility. That lease has an initial term of 12 years from January 1997 with one five-year renewal option.

Our Starkey Road office is a 2,700 square foot building constructed in 1995 on a one-acre site at 4467 Starkey Road in southwest Roanoke County near Tanglewood Mall. The Salem Office is located at 8 East Main Street in Salem, and is a Colonial Williamsburg style building constructed in 1999 with two floors containing 6,000 square feet, of which we occupy the first story and lease the second story to outside parties. The structure is located on an approximately one-half acre site near the center of the City of Salem. The Hershberger Road office is a 2,420 square foot building on a one-acre tract at 1518 Hershberger Road in northwest Roanoke City that we purchased in 2000, renovated and opened as a branch bank in 2001. The Vinton Office is a 3,000 square foot building constructed in 2002 on a 0.6-acre plot at 1003 Hardy Road, Town of Vinton, Roanoke County. Our newest facility is the Lewis-Gale office, which is a 3,000 square foot building constructed in 2003 on a 1.35-acre site next to Lewis-Gale Hospital at 3850 Keagy Road in southwest Roanoke City.

Legal Proceedings

Neither Valley Bank nor Valley Financial is a party to any pending legal proceeding or aware of any threatened legal proceeding where Valley Bank or Valley Financial may be exposed to any material loss. From time to time in the normal course of business Valley Bank files standard claims to collect loans.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

Critical Accounting Policies

Valley Financial’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The notes to the audited consolidated financial statements included in Valley Financial’s Annual Report on Form 10-KSB for the year ended December 31, 2003 contain a summary of its significant accounting policies. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity and requires management to make difficult and

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subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, we consider the policy related to this area critical.

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) Statement of Financial Accounting Standards (“SFAS”) 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable, and (ii) SFAS 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, and (iii) SFAS 118, Accounting by Creditors for Impairment of a Loan, Income Recognition and Disclosures – an amendment of SFAS 114, which allows a creditor to use existing methods for recognizing interest income on an impaired loan.

Our allowance for loan losses has two basic components: (i) the formula allowance, and (ii) the special allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. Prevailing economic conditions are also considered in the provision calculation. The allowance for loan losses is evaluated on a regular basis by management. On a quarterly basis, management performs a detailed analysis of the allowance for loan losses to verify the adequacy of the allowance in meeting possible losses in the loan portfolio.

December 31, 2003 and 2002

The following is management’s discussion and analysis of the financial condition and results of operations of Valley Financial as of and for the years ended December 31, 2003 and 2002. The discussion should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto.

Overview

Valley Financial was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of Valley Bank. Valley Bank opened for business on May 15, 1995. In July 1995 Valley Financial completed its initial public offering of 964,040 shares (1,518,363 shares after the effects of the 1.05 for 1 stock split declared January 20, 2000 and the 3 for 2 stock split declared April 24, 2002) of its common stock, no par value, at a price of $10.00 per share ($6.35 per share after the effects of the 1.05 for 1 stock split declared January 20, 2000 and the 3 for 2 stock split declared April 24, 2002). The initial Offering resulted in gross proceeds to Valley Financial of $9.6 million, reduced by $551,000 of direct stock issuance costs associated with the offering, for net proceeds of $9.1 million. Valley Financial completed its second stock offering effective November 17, 2000. The secondary offering resulted in gross proceeds to Valley Financial of $3.3 million, reduced by $122,000 direct stock issuance costs associated with the offering, for net proceeds of $3.2 million. Of the proceeds of the secondary offering, $2.3 million was used to repay a subordinated capital note initiated as of June 30, 2000, with the remainder used to purchase investment securities at the company level. Valley Financial’s investment in Valley Bank was $25.2 million as of December 31, 2003.

Total assets at December 31, 2003 were $309.0 million, up $60.2 million or 24.2% from $248.8 million at December 31, 2002. The principal components of Valley Financial’s assets at the end of the period were $43.2 million in securities available-for-sale, including restricted equity securities, $23.0 million in securities held to maturity, and $222.6 million in gross loans.

Total liabilities at December 31, 2003 were $287.4 million, up from $229.8 million at December 31, 2002, an increase of $57.6 million or 25.1%. Deposits increased $40.8 million or 22.4% to $223.0 million over the $182.2 million level at December 31, 2002. Long-term convertible and overnight Federal Home Loan Bank advances increased by $7.0 million and $5.0 million, respectively. The remainder of the increase was primarily due to a $4.0 issuance of guaranteed preferred beneficial interests in the Company’s junior subordinated debentures, an increase in federal funds purchased in the amount of $2.6 million, offset by a decrease of $1.2 million in the overnight repurchase agreement program with appropriate commercial customers program.

Total shareholders’ equity at December 31, 2003 was $21.6 million, consisting of $9.1 million in net proceeds from the Company’s initial public offering, $3.2 million in net proceeds from the Company’s secondary offering, $111,000 in proceeds from the exercise of stock options, increased by retained earnings of $9.0 million and including $197,000 of unrealized gains on securities available-for-sale, net of related deferred tax expense.

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Exclusive of the unrealized losses on securities available-for-sale, shareholders’ equity was $21.4 million at December 31, 2003. At December 31, 2002 total shareholders’ equity was $19.0 million. Exclusive of unrealized losses on securities available-for-sale, shareholders’ equity was $18.7 million at December 31, 2002.

Valley Financial had net income of $2.6 million for the year ended December 31, 2003 compared with $2.3 million for the year ended December 31, 2002, an increase of 13.0%. An improved net interest income combined with increased noninterest income, offset by increases in noninterest expense in all major categories, contributed to the 13.0% increase for calendar year 2003.

Profitability as measured by our return on average assets (“ROA”) was 0.9% in 2003 and return on average equity (“ROE”) was 12.9% in 2003. The ROA and ROE ratios were 1.0% and 12.9% in 2002, respectively. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities available-for-sale.

Net Interest Income

Net interest income is the amount by which interest and fees generated from loans and investments exceeds the interest expense associated with funding those assets, and represents our principal source of earnings. Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Changes in the interest rate environment and our cost of funds also affect net interest income.

Net interest income was $9.5 million for 2003 and is attributable to interest income from loans and securities exceeding the cost of interest paid on deposits and borrowed funds. Net interest income in 2003 increased $1.2 million or 14.5% over the $8.3 million level in 2002. Total interest income was $15.2 million for 2003 as compared to $13.7 million in 2002, an increase of $1.5 million or 10.9%. This increase is attributable to Valley Bank’s reinvestment of funding growth into loans and securities. Total interest expense was $5.8 million for 2003 as compared to $5.5 million in 2002, an increase of $300,000 or 5.5%. The net interest margin on a fully taxable equivalent basis was 3.7% for the year ended 2003 as compared to 4.1% for the year ended 2002. Valley Bank is diligently trying to reprice deposits significantly downward and by restructuring the investment portfolio to shorten maturities and to obtain a more attractive yield. The yield on average loans actually decreased by 0.6% to 6.4% from its level of 7.0% in 2002, as approximately one- third of the loan portfolio is variable rate. Valley Bank’s overall yield on earning assets was 5.9% for the year ended 2003, as compared to 6.7% for the prior year ended 2002.

As discussed above, our net interest income is affected by the change in the amount and mix of interest-earning assets and interest-bearing liabilities (referred to as “volume change”) as well as by changes in yields earned on interest-earning assets and rates paid on deposits and borrowed funds (referred to as “rate change”). The Rate/Volume Analysis table presents, for the periods indicated, a summary of changes in interest income and interest expense for the major categories of interest-earning assets and interest-bearing liabilities and the amounts of change attributable to variations in volumes and rates. Changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

Noninterest Income

Noninterest income of $1.3 million in 2003 consisted of service charges and fees on accounts, securities gains and losses in the amount of $7,000, income earned on bank owned life insurance, other income on real estate loans, and other miscellaneous income, and represented an increase of $480,000 or 57.3% over the 2002 level of $837,000. Securities gains and losses were $34,000 in 2002. Exclusive of securities gains and losses, noninterest income increased $507,000 or 63.1% in 2003 over its 2002 level. Future levels of noninterest income are expected to increase as a direct result of business growth and expansion.

Noninterest Expense

Noninterest expense for 2003 was $6.4 million, an increase of $1.0 million or 18.5% over the $5.4 million level in 2002. Noninterest expense in 2003 included costs associated with the opening of Valley Bank’s Lewis-Gale office on December 8, 2003. Noninterest expense in 2002 included costs associated with the opening of Valley Bank’s Vinton office on May 20, 2002 and expenses associated with the introduction of online banking in May 2002. All major categories, with the exception of franchise tax expense, experienced increases due to growth and expansion.

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Franchise tax expense for 2003 was offset by the purchase of historical tax credits. Noninterest expenses are expected to continue to increase in future years as a direct result of business growth and expansion.

Income Taxes

During 2003 and 2002 we recorded federal income tax provision in the amounts of $771,000 and $871,000, respectively. The anticipated federal income tax liability equates to an effective tax rate of 22.9% and 27.8%, respectively. During the first quarter of 2003, Valley Bank purchased federal and state historical tax credits in the amounts of $174,000 and $217,000, respectively. The tax credits were purchased at a total cost of $156,000 and $151,000, respectively. The tax credits were expensed in the amount of $282,000 during 2003, comprised of $156,000 federal and $126,000 state, as purchased tax credit expense (a noninterest expense). The federal tax credits offset income tax expense in 2003 while the state tax credits offset franchise tax expense in 2003. Approximately $25,000 in state credits remain available for carry-forward to offset 2004 franchise tax expense. Other factors contributing to the difference between the effective tax rate and the statutory rate of 34 percent include tax-exempt interest income on municipal securities, net of disallowance, and tax-exempt income earned on bank owned life insurance.

Earning Assets

Average earning assets were $261.8 million at December 31, 2003 as compared to $207.9 million as of December 31, 2002, an increase of $53.9 million, or 25.9%. Total average earning assets were 93.2% of total average assets at December 31, 2003 as compared to 93.7% at December 31, 2002. Average loans represented the largest component of average earning assets and increased 22.8% to $203.9 million at December 31, 2003, up from $166.1 million as of December 31, 2002. Average loans were 77.9% and 72.5% of average earning assets and average total assets as of December 31, 2003 as compared to 79.9% and 74.9%, respectively one year earlier. Average investment securities, both taxable and nontaxable, increased 35.7% to $53.6 million, up from $39.5 million as of December 31, 2002. Average investment securities were 20.5% and 19.1% of average earning assets and average total assets as of December 31, 2003, as compared to 19.0% and 17.8%, respectively one year earlier.

Investment Securities

Our investment portfolio is used both for investment income and liquidity purposes. Funds not used for capital expenditures or lending activities are invested in securities of the U.S. Government and its agencies, mortgage-backed securities, municipal bonds, corporate bonds and restricted equity securities. Obligations of the U.S. Government and its agencies include treasury notes and callable or noncallable agency bonds. Mortgage-backed securities and collateralized mortgage obligations include pools issued by government agencies. Municipal bonds include taxable and tax-exempt general obligation and revenue issues. Corporate bonds are investment grade issue. Equity securities include shares of the Federal Reserve Bank of Richmond, Federal Home Loan Bank of Atlanta, and Community Bankers Bank. We do not invest in derivatives or other types of high-risk securities. Unrealized gains and losses on securities available-for-sale are recognized as direct increases or decreases in shareholders’ equity.

Investment securities (available for sale and held to maturity), including restricted equity securities, at December 31, 2003 were $66.2 million, an increase of $23.8 million or 56.1% from their level of $42.4 million on December 31, 2002. The increase of $23.8 million is primarily due to purchases in the amount of $45.2 million, offset by principal repayments, called proceeds, and sales in the amount of $21.0 million and a decrease in unrealized gains on securities on the available for sale portfolio, which is carried at approximate fair market value, in the amount of $159,000.

Loan Portfolio

The loan portfolio primarily consists of commercial, real estate (including real estate term loans, construction loans and other loans secured by real estate) and loans to individuals for household, family and other consumer purposes. We adjust our mix of lending and the terms of our loan programs according to economic and market conditions, asset/liability management considerations and other factors. Loans typically (in excess of 90%) are made to businesses and individuals located within our primary market area, most of whom maintain deposit accounts with Valley Bank. There is no concentration of loans exceeding 10% of total loans, which is not disclosed in the

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consolidated financial statements and the notes thereto or discussed below. We have not made any loans in excess of 1% of total assets to foreign entities, including governments, banks, businesses or individuals.

Our total gross loans were $222.6 million at December 31, 2003, an increase of $36.9 million or 19.9% from the $185.7 million reported one year earlier. Our ratio of total loans to total funding sources (customer deposits, securities sold under agreements to repurchase, federal funds purchased, Federal Home Loan Bank advances, and trust preferred securities) stood at 77.8% at December 31, 2003 and 81.4% at December 31, 2002. Management seeks to maintain the ratio of loans to funding sources at a maximum of 85%.

Loan Category Analysis

Commercial Loans. Commercial and industrial loans accounted for 23.8% of the loan portfolio as of December 31, 2003 and stood at $53.1 million versus $44.7 million (24.1% of total loans) at December 31, 2002. Such loans generally are made to provide operating lines of credit, to finance the purchase of inventory or equipment, and for other business purposes. The creditworthiness of the borrower is analyzed and re-evaluated on a periodic basis. Most commercial loans are collateralized with business assets such as accounts receivable, inventory and equipment. Even with substantial collateral such as all the assets of the business and personal guarantees, commercial lending involves considerable risk of loss in the event of a business downturn or failure of the business.

Commercial Real Estate Loans. Commercial real estate mortgages represent financing of commercial properties that are secured by real estate, and were 41.6% and 40.6% of total loans at December 31, 2003 and December 31, 2002, respectively. Outstanding loans in this category equaled $92.6 million and $75.4 million at December 31, 2003 and December 31, 2002, respectively. We prefer to make commercial real estate loans secured by owner-occupied properties, and as of December 31, 2003 approximately 47% of these loans are secured in that manner. Such borrowers are generally engaged in business activities other than real estate, and the primary source of repayment is not solely dependent on conditions in the real estate market.

Real Estate Construction Loans. Real estate construction loans represent interim financing on residential and commercial properties under construction, and are secured by real estate. Once construction is completed and the loan becomes permanent, the loans are reclassified as commercial real estate loans, which are secured by commercial property or residential real estate loans, which are secured by first deeds of trust. Outstanding loans in this category totaled $17.6 million (7.9% of total loans) at December 31, 2003 as compared to $15.7 million (8.5% of total loans) at December 31, 2002.

Residential Real Estate Loans. Residential real estate loans are secured by first deeds of trust on 1-4 family residential properties. This category had $30.0 million in loans (13.5% of total loans) at December 31, 2003 and $24.0 million in loans (12.9% of total loans) at December 31, 2002. To mitigate interest rate risk, we usually limit the final maturity of residential real estate loans held for our own portfolio to 15-20 years. Residential real estate lending involves risk elements when there is lack of timely payment and/or a decline in the value of the collateral.

Loans to Individuals. Loans to individuals include installment loans and home equity lines of credit/loans secured by junior liens on residential real estate. The loan proceeds typically are used to purchase vehicles, finance home remodeling or higher education, or for other consumer purposes. Loans to individuals totaled $29.3 million (13.2% of total loans) at December 31, 2003 and $25.9 million (13.9% of total loans) at December 31, 2002.

Summary of Allowance for Loan Losses

Certain credit risks are inherent in making loans. We attempt to assess these risks prudently and to manage them effectively. We also attempt to reduce repayment risks by adhering to our internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review, and follow-up on exceptions to credit policies.

The allowance for loan losses is maintained at a level considered adequate to absorb probable losses. Some of the factors which management considers in determining the appropriate level of the allowance for loans losses are an evaluation of the current loan portfolio, identified loan problems, loan volume outstanding, past loss experience, present and expected industry and economic conditions, and in particular, how such conditions relate to our market area. Bank regulators also periodically review the portfolio and other assets to assess their quality. The provision for loan losses is charged to income in an amount necessary to maintain an allowance for loan losses adequate to

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provide for expected losses in the loan portfolio. Loans deemed uncollectible are charged to the allowance for loan losses and recoveries on loans previously charged off are added to the allowance for loan losses. Management believes the allowance is adequate to provide for any inherent losses in the portfolio.

A provision for loan losses of $966,000 was provided during 2003, an increase of $356,000 or 58.4% over the $610,000 provided during 2002, in recognition of management’s estimate of inherent risks associated with lending activities. This estimate is primarily based on industry practices and consideration of local economic factors. The allowance for loan losses was $2.6 million and $2.0 million as of December 31, 2003 and 2002, respectively, and represented approximately 1.2% and 1.1%, respectively, of net loans outstanding (see Note 4 to the Consolidated Financial Statements). A total of $127,000 in special reserves is included in the balance of the allowance for loan losses as of December 31, 2003. A total of $0 in special reserves is included in the balance of the allowance for loan losses as of December 31, 2002. Additional factors contributing factors to the increase in provision expense are strong year-over-year loan growth in average loans outstanding and management’s concern about perceived continuing economic weakness.

No assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in the future. Additionally, regulatory examiners may require us to recognize additions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations.

During 2003 and 2002, we charged off loans in the amounts of $415,000 and $64,000, respectively. From the inception of operations in 1995 through 1998, we had no history of charge-offs. The $415,000 in loans charged off in 2003 was comprised of $284,000 in commercial loans, $1,000 in credit card loans, and $130,000 in loans to individuals. The $64,000 in loans charged off in 2002 was comprised of $58,000 in commercial loans, $3,000 in credit card loans and $3,000 in loans to individuals.

Nonperforming Assets and Impaired Loans

Nonperforming assets include nonaccrual loans, loans past due 90 days or more, restructured loans, and foreclosed/repossessed property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will automatically be placed on nonaccrual status when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.

A restructured loan is a loan in which the original contract terms have been modified due to a borrower’s financial condition or there has been a transfer of assets in full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not normally consider.

An impaired loan as defined in SFAS 114 is a loan when, based on current information and events, it is likely that a lending institution will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the loan agreement.

Once a quarter the Board of Directors reviews all loans on Valley Bank’s watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review.

If the nonaccrual loans disclosed above had performed in accordance with their original terms, additional interest income in the amount of $18,000 and $15,000, would have been recorded for the years ended December 31, 2003 and 2002, respectively.

The entire balance of restructured loans at December 31, 2003 consists of one commercial loan customer.

The total recorded investment in impaired loans was $1.2 million and $390,000 at December 31, 2003 and 2002, respectively. The special loan loss allowance related to impaired loans was $127,000 and $0, respectively for the above-referenced time periods. Management believes that the above special reserves are adequate for the impaired loans in our portfolio based upon a detailed review of the quality and pledged collateral of each individual loan considered impaired at each of the above-referenced periods.

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Other Assets

We have purchased life insurance contracts on key employees, the tax-exempt income from which is the funding vehicle for our SERP plan. Bank owned life insurance was $5.8 million at December 31, 2003, an increase of $2.6 million over the $3.2 million reported as of December 31, 2002. Additional purchases of split dollar life insurance contracts on key employees in the first and fourth quarters in the amounts of $1.2 million and $1.2 million, respectively, contributed to $2.4 million of the total increase during 2003.

Other assets were $1.5 million at December 31, 2003, an increase of $500,000 over the $1.0 million reported as of December 31, 2002.

Deposits

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 for deposits is intense from other depository institutions and money market funds, some of which offer interest rates higher than those paid by us. Management attempts to identify and implement pricing and marketing strategies designed to control the overall cost of deposits and to maintain a stable deposit mix. The ratio of certificates of deposit to total deposits decreased from 63.4% at December 31, 2002 to 61.0% at December 31, 2003. The cost of funds ratio was 2.2% in 2003, a decrease of 0.5% over the 2002 ratio of 2.7% as Valley Bank continued to work diligently during 2003 to reprice deposits downward in response to Federal Reserve prime rate cuts. Average rates paid on time deposits primarily contributed to the decrease in cost of funds during 2003, as the average rate paid decreased by 0.6% to 2.8% from a level of 3.4% during 2002.

As of December 31, 2003 total deposits were $223.0 million, an increase of $40.8 million or 22.4% from their level of $182.2 million one-year earlier. The major categories of increases were non-interest bearing demand deposits, interest bearing demand deposits, money markets, savings, and time deposits in the amounts of $6.0 million, $4.6 million, $8.7 million, $1.3 million, and $20.2 million, respectively.

At December 31, 2003 noninterest-bearing demand deposits were $36.7 million or 16.4% of total deposits. On December 31, 2002 noninterest-bearing demand deposits were $30.7 million or 16.9% of total deposits. Nonmaturity deposits (noninterest bearing demand deposits, interest bearing demand deposits, money market accounts, and savings accounts) were $87.1 million or 39.0% of total deposits, compared with $66.5 million or 36.6% of total deposits at December 31, 2002. Total interest bearing deposits were $186.3 million at December 31, 2003, an increase of $34.8 million or 23.0% over their level of $151.5 million at December 31, 2002. Total time deposits were $135.9 million or 61.0% of total deposits, compared with $115.7 million or 63.4% of total deposits at December 31, 2002.

For the year ended December 31, 2003 average noninterest bearing demand deposits were $33.4 million or 16.5% of average total deposits. For the prior year, average noninterest bearing demand deposits were $24.1 million or 14.8% of average total deposits. Nonmaturity deposits (noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts) averaged $75.8 million or 37.4% of average total deposits in 2003, up from $56.7 million or 34.9% of average total deposits in 2002. Total interest bearing deposits averaged $169.6 million for the year ended December 31, 2003, an increase of $30.8 million or 22.2% over their level of $138.8 million for the year ended December 31, 2002. Total time deposits averaged $127.2 million in 2003 or 62.6% of average total deposits, up from $106.2 million or 65.1% of average total deposits in 2002.

Short-Term Borrowings

Our short-term borrowings increased by $5.0 million from its level of $10.0 million at December 31, 2002 to a total of $15.0 million as of December 31, 2003. Short-term borrowings at December 31, 2003 consist of a Federal Home Loan Bank of Atlanta daily rate credit in the amount of $5.0 million and a Federal Home Loan Bank of Atlanta adjustable rate credit in the amount of $10.0 million. The increase of $5.0 million is attributable to the Federal Home Loan Bank of Atlanta daily rate credit finalized in September of 2003.

The proceeds of the $5.0 million Federal Home Loan Bank of Atlanta daily rate credit were received in September of 2003. The borrowing matures daily and is rolled over on a daily basis at the stated Federal Home Loan Bank of Atlanta daily rate. There is no stated maturity date. Interest is paid monthly on the daily rate credit.

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The Federal Home Loan Bank of Atlanta adjustable rate credit in the amount of $10.0 million was renewed for another year in December 2003. The new maturity date is December 16, 2004. The advance reprices quarterly on the date of each quarterly interest payment. The current rate is 1.22%. See the liquidity section for further information on the preceding borrowings.

Federal funds purchased increased by $2.6 million from its level of $0 at December 31, 2002.

Valley Bank has in place a commercial sweep account program. The balances in the program decreased by $1.2 million from their level of $5.9 million at December 31, 2002 to a total of $4.7 million as of December 31, 2003. The program consists of establishing a demand deposit account in which Valley Bank invests available balances daily in securities on an overnight basis subject to repurchase. On the following business day, Valley Bank will repurchase from the customer the securities for an amount equal to the amount of available balances invested in the securities. Interest is calculated daily at the rate applicable for each overnight period; however, it is posted to the customer accounts only once per month. The contractual agreement states that the repurchase agreement is not a deposit and therefore is not insured by the Federal Deposit Insurance Corporation. Therefore, these repurchase balances are not reported as deposits but as short-term borrowings.

Long-Term Borrowings

Federal Home Loan Bank advances are relatively cost-effective funding sources and provide us with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity. The increase in advances during the year reflects the funding to support investment growth.

We have outstanding long-term debt with the Federal Home Bank of Atlanta in the amount of $37.0 million as of December 31, 2003, an increase of $7.0 million or 23.3% over the $30.0 million balance as of December 31, 2002. There are four convertible advances in the amount of $5.0 million each, one convertible advance in the amount of $7.0 million, and one convertible advance in the amount of $10.0 million currently drawn. The Federal Home Bank of Atlanta has the option to convert the $37.0 million in convertible advances on the conversion dates below and any interest payment date thereafter with at least two business days notice. If called, the four $5.0 million convertible advances and the one $7.0 million convertible advance will be converted into a 3-month LIBOR-based adjustable rate credit (ARC) at 3-month LIBOR flat. The $10.0 million convertible advance may be converted into a 3-month LIBOR-based floating rate advance (ARC) at 3-month LIBOR flat only if 3-month LIBOR is greater than or equal to 7.0%.

Guaranteed Preferred Beneficial Interests in Valley Financial’s Junior Subordinated Debentures

We created Valley Financial (VA) Statutory Trust I, a statutory business trust (the “Trust”), on June 26, 2003, at which time the Trust issued $4,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature June 26, 2033. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate (“LIBOR”) plus 3.10%, capped at 11.75%, and the securities may be prepaid at par by the Trust at any time after June 26, 2008. The principal assets of the Trust are $4,124 of Valley Financial’s junior subordinated debentures which mature on June 26, 2033, and bear interest at a floating rate equal to the 3-month LIBOR plus 3.10%, capped at 11.75%, and which are callable by Valley Financial after June 26, 2008. All $124 in aggregation liquidation amount of the Trust’s common securities are held by Valley Financial.

The Trust’s preferred securities and common securities may be included in our Tier 1 capital for regulatory capital adequacy purposes to the extent that they do not exceed 25% of our total Tier I capital excluding the securities. Amounts in excess of this ratio will not be considered Tier 1 capital but may be included in the calculation of our total risk-based capital ratio. Our obligations with respect to the issuance of the Trust’s preferred securities and common securities constitute a full and unconditional guarantee by Valley Financial of the Trust’s obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, we may elect from time to time to defer interest payments on its junior subordinated debentures, which would result in a deferral of distribution payments on the Trust’s preferred trust securities and common securities.

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Interest Rate Risk

Interest rate risk is the risk to earnings or capital generated by the effects of changes in interest rates on the Company’s on- and off-balance sheet positions, and can take one or more of several forms. Repricing risk comes from timing mismatches in the ability to alter contractual rates earned on financial assets held or paid on interest-bearing liabilities. Basis risk refers to changes in the underlying relationships between market rates or indices, which result in a narrowing of the spread earned on a loan or investment relative to its cost of funds. Option risk arises from “embedded options” in many financial instruments such as interest rate options, loan prepayment options, deposit early withdrawal options, callable Federal Home Loan Bank advances and potential prepayment of the underlying collateral of asset-backed securities. Embedded options are complex risk positions that are difficult to predict and offset, and are a large component of our overall interest rate risk.

We have established risk measures, limits, policy guidelines and internal control mechanisms for managing the overall asset/liability management (“ALM”) position. The responsibility for interest rate risk control resides with management, with oversight by the Board of Directors and its Investment Committee. We seek to balance the return potential of the ALM position against the desire to limit volatility in earnings.

At least quarterly, we measure the ALM position using earnings simulation modeling to estimate what assets and liabilities would reprice, and to what extent, within a one-year period in response to an immediate 200 and 100 basis point change in the Prime Rate, as well as in response to more gradual interest rate changes. The model also incorporates management’s forecasts for balance sheet growth, noninterest income and noninterest expense. The interest rate scenarios are used for analytical purposes and do not necessarily represent management’s view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may apply to our earnings. Modeling the sensitivity of earnings to interest rate risk is highly dependent on numerous assumptions embedded in the simulation model. While the earnings sensitivity analysis incorporates management’s best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact likely will differ from that projected.

Our objective is to keep the change in net interest income over twelve months at or below 10% under an immediate 200 basis point interest rate shock scenario. At December 31, 2003 it was estimated that an immediate 200 basis point increase in Prime and Federal Funds would change net interest income by +3.39%. At December 31, 2002 it was estimated that an immediate 200 basis point increase in Prime would change net interest income by +3.54%. Because an immediate 200 basis point decline in Prime at current rate levels is considered a practical impossibility (the Federal Funds target rate would become –1.0%), it is estimated that an immediate 100 basis point decrease in Prime would change net interest income by –4.94% at December 31, 2003.

The Company also estimates interest sensitivity by the Economic Value of Equity (EVE), which is an estimate of the net present value of the balance sheet’s cash flows or the residual value of future cash flows ultimately due to shareholders. While EVE does not represent actual market, liquidation or replacement value, it is a useful tool for estimating the balance sheet’s existing earning capacity over the longer term. Management forecasts that an immediate 100 basis point increase in Prime/Federal Funds would change EVE by –0.45%, while an immediate 100 basis point decrease would change EVE by –0.91%.

Capital Adequacy

Our financial position at December 31, 2003 and December 31, 2002 reflects liquidity and capital levels currently adequate to fund anticipated short-term business expansion. Capital ratios are in excess of required regulatory minimums for a well-capitalized institution. The adequacy of our capital is reviewed by management on an ongoing basis. Management seeks to maintain a capital structure adequate to support anticipated asset growth and serve as a cushion to absorb potential losses.

Major capital expenditures completed in 2003 include the construction of Valley Bank’s seventh full-service branch in the Lewis-Gale Hospital area and extensive leasehold improvements to Valley Bank’s headquarters facility.

Total shareholders’ equity was $21.6 million at December 31, 2003 compared with $19.0 million at December 31, 2002, an increase of $2.6 million or 13.7%. This $2.6 million increase is primarily attributable to 2003 net income of $2.6 million. Other components of the increase include a $105,000 decrease over the level at December 31, 2002 in accumulated other comprehensive income (loss), comprised exclusively of unrealized gains (losses) on

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available-for-sale investment securities, and $43,000 in proceeds from the exercise of stock options during 2003. Excluding accumulated other comprehensive income (loss), which is comprised exclusively of the unrealized gains (losses) on available-for-sale securities, total shareholders’ equity would have been $21.4 million and $18.7 million at December 31, 2003 and 2002, respectively, an increase of $2.7 million or 14.4% in 2003.

Liquidity

Asset/liability management activities are designed to ensure that adequate liquidity is available to meet loan demand or deposit outflows and, through the management of our interest sensitivity position, to manage the impact of interest rate fluctuations on net interest income.

Liquidity measures our ability to meet our maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund our operations and to provide for customers’ credit needs. Liquidity represents a financial institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds from alternative funding sources.

Our asset liquidity is provided by cash and due from banks, money market investments, investments available for sale including restricted equity securities, and through the management of investment maturities/prepayments and loan repayments.

The level of deposits may fluctuate, perhaps significantly so, due to seasonal cycles of depositing customers and the promotional activities of competitor financial institutions. Similarly, the level of demand for loans may vary significantly and at any given time may increase or decrease substantially. However, unlike the level of deposits, management has more direct control over lending activities and if necessary can adjust the level of those activities according to the amounts of available funds.

In addition to asset liquidity, liquidity would be available to us through increasing certain categories of liabilities. We could purchase overnight federal funds, borrow from correspondent banks, sell securities under a repurchase agreement or obtain advances from the Federal Home Loan Bank. Valley Bank has established a credit line though the discount window of the Federal Reserve Bank of Richmond as an additional source of liquidity. As a result of our management of liquid assets and the ability to generate liquidity through alternative funding sources, management believes we maintain overall liquidity sufficient to meet our depositors’ requirements and satisfy our customers’ credit needs.

Our ratio of liquid assets to deposits and short-term borrowings was 20.9% and 17.6% at December 31, 2003 and 2002, respectively. We sell excess funds as overnight federal funds sold to provide an immediate source of liquidity. We had federal funds sold of $0 and $4.1 million at December 31, 2003 and 2002, respectively. During 2003 deposit growth, offset by a decrease in securities sold under agreements to repurchase in the amounts of $40.8 million and $1.2 million, respectively, a total of $39.6 million, surpassed loan growth in the amount of $36.9 million. The excess $2.7 million coupled with $12.0 million in Federal Home Loan Bank advances ($5.0 million short-term and $7.0 million long-term), $4.0 million in guaranteed preferred beneficial interests in Valley Financial’s junior subordinated debentures, $4.1 in returned federal funds sold, and $2.6 million in federal funds purchased, was used to fund investment purchases in excess of sales, calls, and principal paydowns in the amount of $24.2 million and split dollar life insurance on key employees in the amount of $2.6 million.

As of December 31, 2003 we had pledged approximately $16.0 million of our investment portfolio as collateral for a line of credit from the Federal Home Loan Bank. As of that date, we had approximately $25.2 million in remaining credit availability from the Federal Home Loan Bank.

Recent and Future Accounting Considerations

In December 2003 the Financial Accounting Standards Board (FASB) revised Statement No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits – an amendment of FASB Statements No. 87, 88, and 106”, which revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, 88, and 106. This Statement requires additional disclosures to those in the original Statement No, 132 about assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. Additional information should include the types of plan assets, investment strategy, and measurement(s) dates. The

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required information should be provided separately for pension plans and for other postretirement benefit plans. The provisions of this Statement are effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by this Statement are effective for interim periods beginning after December 15, 2003.

In May 2003 the Financial Accounting Standards Board (FASB) issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement dictates certain instruments be classified as liabilities such as 1) a financial instrument issued in the form of shares that is mandatorily redeemable – that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date or upon an event that is certain to occur, 2) a financial instrument, other than an outstanding share, that, at inception, embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets, and 3) a financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares. This Statement does not apply to features that are embedded in a financial instrument that is not a derivative in its entirety. It also does not affect the classification or measurement of convertible bonds, putable stock, or other outstanding shares that are conditionally redeemable. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. Restatement is not permitted.

In April 2003 the Financial Accounting Standards Board (FASB) issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”, which amends FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” to amend and clarify financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts. This Statement improves financial reporting by requiring that contracts with comparable characteristics be accounted for in a similar manner. This Statement more clearly defines under what circumstances a contract meets the characteristic of a derivative and clarifies when a derivative contains a financing component. The changes in this Statement will result in more consistent reporting of contracts as either derivatives or hybrid instruments. The provisions of this Statement are effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The provisions of this Statement that relate to Statement 133 Implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates.

In December 2002 the Financial Accounting Standards Board (FASB) issued Statement No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123”, which amends FASB Statement No. 123, “Accounting for Stock-Based Compensation” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of this Statement are effective for interim periods beginning after December 15, 2002 and for fiscal years ending after December 15, 2002.

In October 2002 the Financial Accounting Standards Board (FASB) issued Statement No. 147, “Acquisitions of Certain Financial Institutions-an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9,” which removes acquisitions of financial institutions from the scope of both Statement 72 and Interpretation 9. The Statement requires that acquisitions of financial institutions be accounted for under the purchase method of accounting in accordance with Statement 141, “Business Combinations” and Statement 142, “Goodwill and Other Intangible Assets.” Thus, the requirement in paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess of the fair market value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of this Statement. The provisions of this Statement relating to the application of the purchase method of accounting are effective for acquisitions initiated on or after October 1, 2002. The provisions of this Statement relating to accounting for intangible assets are effective on October 1, 2002.

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In June 2002 the Financial Accounting Standards Board (FASB) issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, not at the date of an entity’s commitment to an exit plan. This Statement also establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002.

Changes in Financial Condition June 30, 2004 Compared with December 31, 2003.

Total assets at June 30, 2004 were $347.0 million, up 12.3% from $309.0 million at December 31, 2003. The principal components of our assets at the end of the period were $51.4 million in securities available-for-sale, including restricted equity securities, $23.1 million in securities held to maturity, and $251.5 million in gross loans.

Total liabilities at June 30, 2004 were $324.3 million, up 12.8% from $287.4 million at December 31, 2003 with the increase represented by $30.0 million growth in deposits, $1.2 million growth in securities sold under agreements to repurchase and a $5.6 million increase in overnight borrowings.

Total shareholders’ equity at June 30, 2004 was $22.7 million consisting of $9.1 million in net proceeds from our initial public offering, $3.2 million in net proceeds from our secondary offering, $565,000 in proceeds from the exercise of stock options and $287,000 deferred tax benefit from the exercise of stock options, all increased by accumulated retained earnings of $10.0 million and reduced by $479,000 of unrealized depreciation on securities available-for-sale, net of related deferred tax liability. Total shareholders’ equity was $22.7 million at June 30, 2004 compared with $21.6 million at December 31, 2003, an increase of $1.1 million or 5.3%. Exclusive of unrealized gains (losses) on investment securities, shareholders’ equity was $23.2 million at June 30, 2004 and $21.4 million at December 31, 2003.

Investment Securities

See discussion at p.17, “Investment Securities”, for a description of our investment portfolio.

Investment securities (available for sale and held to maturity), including restricted equity securities, at June 30, 2004 were $74.5 million, an increase of $8.3 million or 12.6% from their level of $66.2 million on December 31, 2003. The increase is primarily due to purchases in the amount of $21.1 million, offset by principal repayments, sale proceeds, and called proceeds in the amounts of $5.3 million, $5.5 million and $1.0 million, respectively. An increase in unrealized losses on securities in the available for sale portfolio, which is carried at approximate fair market value, offset a portion of the increase. See Note 3 to the Consolidated Financial Statements.

Loan Portfolio

See discussion at p.17, “Loan Portfolio” for a description of our loan portfolio and loan categories.

Our total loans were $251.5 million at June 30, 2004, an increase of $28.9 million or 13.0% from the $222.6 million reported at December 31, 2003. Our ratio of total loans to total funding sources (customer deposits, securities sold under agreements to repurchase, federal funds purchased, Federal Home Loan Bank advances and guaranteed preferred beneficial interests in Valley Financial’s junior subordinated debentures) stood at 77.8% at June 30, 2004 and 77.8% at December 31, 2003. Management seeks to maintain the ratio of loans to funding sources at less than 85%.

Loan Category Analysis

Commercial Loans. Commercial and industrial loans accounted for 24.4% of the loan portfolio as of June 30, 2004 and stood at $61.5 million versus $53.1 million six months earlier.

Commercial Real Estate Loans. Commercial real estate construction and commercial real estate mortgages were 40.7% of total loans at June 30, 2004. Outstanding loans in this category equaled $102.3 million and $92.6 million at June 30, 2004 and December 31, 2003, respectively.

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Real Estate Construction Loans. Outstanding loans in this category totaled $20.6 million (8.2% of total loans) at June 30, 2004 as compared to $17.6 million at December 31, 2003.

Residential Real Estate Loans. We had $35.6 million in residential real estate loans (14.1% of total loans) at June 30, 2004 and $30.0 million in such loans at December 31, 2003.

Loans to Individuals. Loans to individuals totaled $31.7 million (12.6% of total loans) at June 30, 2004 compared to $29.3 million at December 31, 2003.

Summary of Allowance for Loan Losses

See discussion at p.18, “Summary of Allowance for Loan Losses”, for a description of our allowance for loan losses.

The allowance for loan losses was $2.8 million as of June 30, 2004 and represented approximately 1.13% of net loans outstanding versus 1.17% of net loans at December 31, 2003.

Nonperforming Assets and Impaired Loans

See discussion at p.19, “Nonperforming Assets and Impaired Loans”, for a description of nonperforming assets, and restructured and impaired loans.

The total recorded investment in impaired loans was $438,000, $1,390,000 and $218,000, respectively for the six month period ended June 30, 2004, the year ended December 31, 2003 and the six-month period ended June 30, 2003. The loan loss allowance related to impaired loans was $120,000, $30,000 and $137,000, respectively for the above-referenced time periods. To cover potential declines in the value of foreclosed property, $0 was included in the loan loss allowance at June 30, 2004, $0 at December 31, 2003 and $40,000 at June 30, 2003. Management believes that the above allocated reserves are adequate for the impaired loans in our portfolio based upon a detailed review of the quality and pledged collateral of each individual loan considered impaired at each of the above-referenced periods.

If nonaccrual loans had performed in accordance with their original terms, additional interest income in the amount of $22,000, $18,000 and $7,000, respectively would have been recorded for the six-month period ended June 30, 2004, the year ended December 31, 2003 and the six-month period ended June 30, 2003.

Other Assets

We have purchased life insurance contracts on key employees, the tax-exempt income from which is the funding vehicle for our SERP plan. Bank owned life insurance was $6.0 million at June 30, 2004, an increase of $149,000 over the $5.8 million reported as of December 31, 2003.

Other assets were $1.8 million at June 30, 2004, an increase of $305,000 over the $1.5 million reported as of December 31, 2003.

Deposits

See discussion at p.20, “Deposits”, for a description of matters affecting the level and mix of deposits and competitive factors.

As of June 30, 2004 total deposits were $253.0 million, an increase of $30.0 million or 13.4% from their level of $223.0 million at December 31, 2003. Certificates of deposit increased by $18.9 million to a total of $154.8 million (61.2% of total deposits) at June 30, 2004, up from $135.9 million (60.9% of total deposits) at December 31, 2003. Compared with year-end 2003, non-interest bearing demand deposits and money market accounts increased by $6.8 million and $4.9 million, respectively, while interest bearing demand deposits declined $421,000 and savings deposits declined $149,000. We would prefer to have transaction accounts comprise a larger percentage of total deposits but in order to fund double-digit loan growth, often have to rely on higher-cost certificates of deposit. Within the certificate of deposit category, we have subscribed this year to an Internet-based rate posting service that allows it to market

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CDs nationally to institutional depositors, primarily banks, thrift institutions and credit unions. National market CDs at June 30, 2004 were $13.6 million, representing 8.8% of total CDs and 5.2% of total deposits.

At June 30, 2004 noninterest-bearing demand deposits were $43.5 million or 17.2% of total deposits. On December 31, 2003 noninterest-bearing demand deposits were $36.7 million or 16.4% of total deposits. Nonmaturity deposits (noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts) were $98.2 million or 38.8% of total deposits at June 30, 2004 compared with $87.1 million or 39.1% of total deposits at December 31, 2003. Total interest bearing deposits stood at $209.5 million at June 30, 2004, an increase of $23.2 million or 12.4% over their level of $186.4 million at December 31, 2003.

Short-Term Borrowings

The balance in our commercial sweep account program grew by $1.2 million from its level of $4.7 million at December 31, 2003 to a total of $6.0 million as of June 30, 2004. See discussion at p. 20, “Short Term Borrowings”, for a description of this program.

In addition to the commercial sweep accounts, at June 30, 2004 and December 31, 2003, we had $10 million in a term FHLB advance with a maturity under one year. We also had at June 30, 2004 $13.2 million in overnight borrowings, up $5.6 million or 74.7% from their level of $7.6 million at December 31, 2003. The increase in overnight borrowings at June 30, 2004 was primarily attributable to exceptionally strong loan growth in the month of June, and was subsequently offset by deposit growth. See the Liquidity section at p. 23 for further information on these preceding borrowings.

Other Debt

Federal Home Loan Bank advances are relatively cost-effective funding sources and provide us with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity. Long-term Federal Home Loan Bank advances totaled $37.0 million at June 30, the same amount outstanding as of December 31, 2003.

Guaranteed preferred beneficial interests in Valley Financial’s junior subordinated debentures are hybrid securities, commonly called Trust Preferred Securities, which are considered equity for regulatory purposes and debt for financial statement and tax purposes. See discussion at p. 21, “Guaranteed Preferred Beneficial Interests in Valley Financial’s Junior Subordinated Debentures”. Guaranteed preferred beneficial interests in Valley Financial’s junior subordinated debentures offer the benefit of an attractive floating or fixed rate interest payment which is tax deductible, making the after-tax cost to the issuer less than traditional forms of capital. The $4.0 million debt was incurred effective June 26, 2003 with a stated term of 30 years. Quarterly interest payments began September 26, 2003. The debt carries an interest rate of 3-Month LIBOR plus 3.10%, or 4.68625%, which adjust quarterly on each interest payment date.

Capital Adequacy

Our financial position at June 30, 2004 reflects liquidity and capital levels currently adequate to fund anticipated near-term business expansion. Capital ratios remain in excess of required regulatory minimums for a well-capitalized institution.

Total shareholders’ equity increased by $1.1 million during the first six months of 2004. The increase is attributable to net income for the first six months of $1,304,000 and $743,000 in proceeds from the exercise of stock options, partially offset by $227,000 in cash dividends declared and a $676,000 decrease in accumulated other comprehensive income. Exclusive of unrealized gains (losses) on investment securities, shareholders’ equity was $23.2 million at June 30, 2004 and $21.4 million at December 31, 2003.

Liquidity

See discussion at p. 23, “Liquidity”, for a description of liquidity and our asset/liability management objectives.

Our ratio of liquid assets to deposits and short-term borrowings was 21.2% at June 30, 2004 and 20.9% at December 31, 2003. The Company had no federal funds sold at either June 30, 2004 or December 31, 2003. During the first six months of 2004, deposit growth in the amount of $30.0 million surpassed the $28.9 million loan growth

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experienced. The excess $1.1 million coupled with a $5.6 million increase in federal funds purchased was used to fund investment purchases in excess of principal paydowns, sales and calls proceeds of approximately $9.5 million. The increase in securities sold under agreements to repurchase in the amount of $1.2 million alleviated somewhat the need to increase federal funds purchased during the period.

Results of Operations for the Three-Month Periods Ended June 30, 2004 and 2003

The following is management’s discussion and analysis of the results of our operations for the three months ended June 30, 2004 and 2003. The discussion should be read in conjunction with Valley Financial’s Consolidated Financial Statements and Notes thereto.

Net income for the three months ended June 30, 2004 was $674,000, a 7.9% decrease from the $732,000 recorded for the second quarter of 2003. The biggest factor contributing to the decline in net income for the period was shrinkage in the net interest margin as yields on earning assets declined faster than costs could be reduced, and increases in noninterest expense in virtually all categories.

Return on average assets for the second quarter of 2004 was 0.81% versus 1.07% for the second quarter of 2003.

Return on equity for the second quarter of 2004 was 12.03% as compared to 14.84% for the second quarter of 2003. The calculation of return on equity excludes the effect of any unrealized gains or losses on investment securities.

For the three months ended June 30, 2004 net interest income was $2.6 million, an increase of 15.1% from the $2.3 million reported for the three months ended June 30, 2003. The net interest margin on a fully taxable equivalent basis was 3.44% and 3.70% for the three month periods ended June 30, 2004 and 2003, respectively.

For the three months ended June 30, 2004 noninterest income was $340,000, a decrease of $1,000 or 0.3% from the $341,000 reported for the second quarter of 2003. Securities gains of $13,000 and $0 are included in the total noninterest income totals for the quarters ended June 30, 2004 and 2003, respectively.

Noninterest expense for the quarter ended June 30, 2004 was $1.9 million, an increase of $341,000 or 21.7% over the $1.6 million reported for the second quarter of 2003. Substantially all major categories of noninterest expense increased in the second quarter due to growth and expansion.

The provision for income taxes for the second quarter of 2004 and 2003 was $237,000 and $227,000 at an effective tax rate of 26.0% and 23.7%, respectively.

For the three months ended June 30, 2004 a provision for loan losses of $149,000 was made versus $98,000 during the same period in 2003, a 52.0% increase of $51,000. The increase in the quarterly provision expense is due to rapid growth in outstanding loan balances.

Results of Operations for the Six-Month Periods Ended June 30, 2004 and 2003

The following is management’s discussion and analysis of the results of our operations for the six months ended June 30, 2004 and June 30, 2003. The discussion should be read in conjunction with Valley Financial’s Consolidated Financial Statements and Notes thereto.

We had net income of $1,304,000 for the six months ended June 30, 2004, a decrease of $10,000 or 0.8% from the six months ended June 30, 2003. The biggest factor contributing to the decline in net income for the period was increases in noninterest expense in virtually all categories.

Profitability as measured by our return on average assets was 0.80% for the six months ended June 30, 2004 compared to 1.00% for the same period in 2003. Return on average equity was 11.86% for the six months ended June 30, 2004 compared to 13.62% for the same period in 2003. The calculation of return on equity excludes the effect of any unrealized gains or losses on investment securities.

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Net Interest Income

Net interest income was $5.1 million for the six months ended June 30, 2004. Net interest income for the first six months of 2004 increased 11.1% from $4.6 million for the same period in 2003. The net interest margin on a fully taxable equivalent basis was 3.43% for the first six months of 2004, a decrease of 47 basis points from the 3.90% reported for the same period in 2003. Yields on earning assets decreased faster than funding costs could be reduced. Our cost of funds ratio was 2.10% for the six months ended June 30, 2004, down 21 basis points from the 2.31% reported for the first six months of 2003. Our yield on earning assets was 5.49% for the six months ended June 30, 2004, down 68 basis points from the 6.17% reported for the six months ended June 30, 2003. Management is working to maintain the net interest margin by reducing the cost of funds ratio, a task made more difficult by the fact that deposit rates have almost reached a practical floor and Valley Bank’s relative reliance on higher-cost certificates of deposit to fund rapid growth in earning assets.

Allowance for Loan Losses

A provision for loan losses of $247,000 was made during the six months ended June 30, 2004, a decrease of $109,000 or 30.6% over the same period in 2003, in recognition of management’s estimate of inherent risks associated with lending activities. A total of $120,000 in specific reserves is included in the balance of the allowance for loan losses as of June 30, 2004.

Noninterest Income

Noninterest income for the six months ended June 30, 2004 was $660,000, an increase of $16,000 or 2.5% over the $644,000 reported for the same period one year earlier. The largest components of the increase are service charges on deposit accounts in the amount of $38,000 and a $17,000 increase in income on bank-owned life insurance, offset by a $55,000 decline in other income on real estate loans. Securities gains and losses totaled $17,000 during the first six months of 2004 as compared to $7,000 for the first six months of 2003. Future levels of noninterest income are expected to increase as a direct result of business growth and expansion.

Noninterest Expense

Noninterest expense for the first six months of 2004 was $3.8 million, an increase of $500,000 or 15.4% over the $3.3 million reported for the same period in 2003. Compensation expense was the largest contributor to the increase in the amount of $249,000. The second largest contributor to the increase was data processing and equipment expense in the amount of $103,000. For all of 2003 and a portion of 2004 the Bank owned and wrote off certain purchased tax credits. As a result, franchise tax expense increased by $78,000 in the first half of 2004, which was more than offset by a reduction in purchased tax credit expense. Certain operating expenses associated with the opening of the Bank’s seventh full-service branch in December 2003 are included in the six months ended June 30, 2004. Substantially all major categories of noninterest expense increased in the first six months due to growth and expansion. Noninterest expenses are expected to increase in future years as a direct result of business growth and expansion.

Income Taxes

To reflect our anticipated federal income tax liability, an expense of $459,000 and $315,000 at an effective tax rate of 26.0% and 19.3% was recognized for the six months ended June 30, 2004 and June 30, 2003, respectively. During the first quarter of 2003, the Bank purchased federal and state tax credits in the amounts of $174,000 and $217,000, respectively. The federal and state tax credits were purchased at a total cost of $156,000 and $151,000, respectively. The credits were expensed in the amount of $214,000 during the first six months of 2003, comprised of $156,000 federal and $58,000 state, as purchased tax credit expense (a noninterest expense). The federal tax credits partially offset federal income tax expense in 2003, while the state tax credits partially offset Virginia bank franchise tax expense in 2003 and 2004 and will do so for several years beyond. Other factors contributing to the difference between the effective tax rate and the statutory rate of 34% include tax-exempt interest income on municipal securities, net of disallowance, and tax-exempt income earned on bank-owned life insurance.

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The following table presents the major categories of interest-earning assets, interest-bearing liabilities and shareholders’ equity with corresponding average balances, related interest income or expense, and resulting yields and rates for the periods indicated. Where appropriate, income categories and yields have been adjusted in the table to their fully taxable equivalent basis.

NET INTEREST INCOME AND AVERAGE BALANCES ⁽¹⁾

(dollars in thousands)

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Legends for the table are as follows:

31

RATE/VOLUME ANALYSIS

(dollars in thousands)

32

A summary of average assets as of December 31, 2003 and 2002 is shown in the following table.

AVERAGE ASSET MIX

(dollars in thousands )