**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

###### **FORM 10-QSB**

 

**ý****                      ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30,2004**

 

**o****                        ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Commission File Number: 333-112325**

 

**Treaty Oak Bancorp, Inc.**

(Exact name of registrant as specified in itscharter)

 

**Texas**

(State or other jurisdiction ofcorporation or organization)

 

**20-0413144**

(I.R.S. Employer Identification Number)

 

| **101 Westlake Drive, Austin, Texas**    |   | **78746**  |
|------------------------------------------|--------|------------|
| (Address of Principal Executive Offices) |   | (Zip Code) |

 

**(512) 617-3600**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the issuer (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file****such reports),and (2) has been subject to such filing requirements for the past 90 days.

 

**Yes ****ý****                                                         No****o**

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

**Yes****o****            No****ý**

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock asof the close of business of August 10, 2004.

 

| $0.01 Par Value Common  Stock |   | 1,419,781 shares |
|-------------------------------|--------|------------------|

 

Transitional Small Business Disclosure Format (Check one):                                                                   **Yes****o****            No****ý**

 

 

----

 

**QUARTERLY REPORT ON FORM 10-QSBFOR THE PERIOD ENDED JUNE 30, 2004**

 

**TABLE OF CONTENTS**

 
| **Part I.**  | **Financial Information** | ** **                                                                                                                                                                                                                           |
|--------------|---------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** **                | ** **                                                                                                                                                                                                                           | ** ** |
| ** **   | **Item 1.**               | *Financial  Statements*                                                                                                                                                                                                              | ** ** |
| ** **   | ** **                | ** **                                                                                                                                                                                                                           | ** ** |
|         |                      | Consolidated Balance Sheets at June 30, 2004 and  September 30, 2003 (unaudited)                                                                                                                                           |   |
|         |                      |                                                                                                                                                                                                                                 |   |
|         |                      | Consolidated Statements of Operations for  the Three-Month Periods ended June 30, 2003, and 2004; the Period from  November 1, 2002 to June 30, 2003; and the Nine-Month Period ended  June 30, 2004 (unaudited) |   |
|         |                      |                                                                                                                                                                                                                                 |   |
|         |                      | Consolidated Statements of Changes in  Shareholders’ Equity for the Period from November 1, 2002 to  June 30, 2003; and the Nine-Month Period ended June 30, 2004  (unaudited)                                   |   |
|         |                      |                                                                                                                                                                                                                                 |   |
|         |                      | Consolidated Statements of Cash Flows for  the Period from November 1, 2002 to June 30, 2003, and the Nine-Month  Period ended June 30, 2004 (unaudited)                                                              |   |
|         |                      |                                                                                                                                                                                                                                 |   |
|         |                      | Notes to Consolidated Financial Statements                                                                                                                                                                                           |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 2.**               | *Management’s Discussion and Analysis of  Financial Condition and Results of Operations*                                                                                                                                        | * * |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 3.**               | *Controls and Procedures*                                                                                                                                                                                                            | * * |
| * *     | * *                  | * *                                                                                                                                                                                                                             | * * |
| **Part II.** | **Other Information**     |                                                                                                                                                                                                                                 |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 1.**               | *Legal Proceedings*                                                                                                                                                                                                                  |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 2.**               | *Changes in Securities and Use of Proceeds*                                                                                                                                                                                          |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 3.**               | *Defaults Upon Senior Securities*                                                                                                                                                                                                    |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 4.**               | *Submission of Matters to a Vote of Security  Holders*                                                                                                                                                                               |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 5.**               | *Other Information*                                                                                                                                                                                                                  |   |
|         |                      |                                                                                                                                                                                                                                 |   |
| ** **   | **Item 6.**               | *Exhibits and Reports on Form 8-K*                                                                                                                                                                                                   |   |
|         |                      |                                                                                                                                                                                                                                 |   |
|         |                      | Signatures                                                                                                                                                                                                                           |   |

 

This Form 10-QSB contains forward-looking statements consisting ofestimates with respect to the financial condition, results of operations andother business of Treaty Oak Bancorp, Inc. that are subject to various factors,which could cause actual results to differ materially from thoseestimates.  Factors that could influencethe estimates include changes in the national, regional and local marketconditions, legislative and regulatory conditions, and an adverse interest rateenvironment.

 

i

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**Part I****                                                                 Financial Information**

 

**Treaty Oak Bancorp, Inc., and Subsidiaries**

**(A Development Stage Enterprise)**

**Consolidated Balance Sheets**

**(Dollars in Thousands, except share amounts)**

 
| ** **                                                              | ** ** | **June 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                                              | ** ** | **(Unaudited)**         | ** ** | ** **                   | ** ** |
| **ASSETS**                                                              |       |                    |       |                         |       |
| Cash and due from banks                                                 |       | $                       | 590        |                         | $          | — |   |
| Interest bearing deposits in banks                                      |       | 2                       |       | —                       |       |
| Federal funds sold                                                      |       | 400                     |       | —                       |       |
| Total cash and cash equivalents                                         |       | 992                     |       | —                       |       |
|                                                                    |       |                    |       |                         |       |
| Securities available for sale, at fair  value                           |       | 72                      |       | —                       |       |
| Securities held to maturity                                             |       | 408                     |       | —                       |       |
| Investment in Federal Home Loan Bank stock                              |       | 209                     |       | —                       |       |
| Loans receviable, net of allowance for loan  losses                     |       | 8,003                   |       | —                       |       |
| Premises and equipment, net                                             |       | 719                     |       | —                       |       |
| Accrued interest receivable                                             |       | 181                     |       | —                       |       |
| Other real estate owned                                                 |       | 44                      |       | —                       |       |
| Deferred stock issuance costs                                           |       | 905                     |       | —                       |       |
| Goodwill                                                                |       | 1,161                   |       | —                       |       |
| Other assets                                                            |       | 354                     |       | —                       |       |
|                                                                    |       |                    |       |                         |       |
| Total Assets                                                            |       | $                       | 13,048     |                         | $          | — |   |
|                                                                    |       |                    |       |                         |       |
| **LIABILITIES AND  SHAREHOLDERS’ EQUITY**                          |       |                    |       |                         |       |
| Non-interest bearing deposits                                           |       | $                       | 1,968      |                         | $          | — |   |
| NOW, money market and savings deposits                                  |       | 1,516                   |       | —                       |       |
| Time deposits                                                           |       | 5,324                   |       | —                       |       |
| Total Deposits                                                          |       | 8,808                   |       | —                       |       |
|                                                                    |       |                    |       |                         |       |
| Federal Home Loan Bank borrowings                                       |       | 700                     |       | —                       |       |
| Accrued interest payable                                                |       | 25                      |       | —                       |       |
| Due to related party                                                    |       | 1,041                   |       | —                       |       |
| Note payable on stock purchase                                          |       | 1,019                   |       | —                       |       |
| Note payable to related party                                           |       | 500                     |       | —                       |       |
| Other liabilities                                                       |       | 73                      |       | —                       |       |
| Total Liabilities                                                       |       | 12,166                  |       | —                       |       |
|                                                                    |       |                    |       |                         |       |
| **SHAREHOLDERS’  EQUITY**                                          |       |                    |       |                         |       |
|                                                                    |       |                    |       |                         |       |
| Common stock, $0.01 par value; 20,000,000  shares authorized; 1,040,000 |       |                    |       |                         |       |
| issued and outstanding                                                  |       | 10                      |       | —                       |       |
| Additional paid-in capital                                              |       | 2,352                   |       | 218                          |       |
| Deficit accumulated during development  stage                           |       | (1,478                  | )          | (218                         | )          |
| Accumulated other comprehensive loss                                    |       | (2                      | )          | —                       |       |
| Total shareholders’ equity                                         |       | 882                     |       | —                       |       |
|                                                                    |       |                    |       |                         |       |
| Total liabilities and shareholders’ equity                         |       | $                       | 13,048     |                         | $          | — |   |

 

1

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**Treaty Oak Bancorp, Inc.**

**(A Development Stage Enterprise)**

**ConsolidatedStatements of Operations**

**(Dollars in Thousands, except per share amounts)**

 
| ** **                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months  Ended  June 30,** | ** ** | **Period from  November 1,  2002 to  June 30,** | ** ** | ** **      | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|-----------------------------------------------------------|------------|-----------------|------------|
| ** **                                                      | ** ** | **2004**                              | ** ** | **2003**                              | ** ** | **2004**                                                  | ** ** | **2003**        | ** ** | **Cumulative** | ** ** |
| ** **                                                      | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                                           | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
| **Interest Income:**                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Interest and fees on loans                                      |       | $                                     | 203        |                                  | $          | —                                                    |       | $               | 251        |   | $ | — |   | $ | 251 |   |
| Interest on securities:                                         |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| U.S. government and agencies                                    |       | 2                                     |       | —                                |       | 3                                                         |       | —          |       | 3 |   |
| State and political subdivisions                                |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Interest on federal funds sold                                  |       | 2                                     |       | —                                |       | 2                                                         |       | —          |       | 2 |   |
| Interest on deposits in other financial  institutions and other |       | 2                                     |       | —                                |       | 2                                                         |       | —          |       | 2 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Total interest income                                           |       | 209                                   |       | —                                |       | 258                                                       |       | —          |       | 258 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| **Interest Expense:**                                           |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Savings and interest-bearing demand  deposits                   |       | 2                                     |       | —                                |       | 3                                                         |       | —          |       | 3 |   |
| Time deposits                                                   |       | 28                                    |       | —                                |       | 37                                                        |       | —          |       | 37 |   |
| Federal funds purchased and other  borrowings                   |       | 18                                    |       | —                                |       | 20                                                        |       | —          |       | 20 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Total interest expense                                          |       | 48                                    |       | —                                |       | 60                                                        |       | —          |       | 60 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Net interest income after provision for  loan losses            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
|                                                            |       | 161                                   |       | —                                |       | 198                                                       |       | —          |       | 198 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| **Noninterest Income**                                          |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Service charges on deposit accounts                             |       | 14                                    |       | —                                |       | 19                                                        |       | —          |       | 19 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| **Noninterest Expense**                                         |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Salaries and benefits                                           |       | 302                                   |       | —                                |       | 745                                                       |       | —          |       | 745 |   |
| Occupancy expense                                               |       | 38                                    |       | —                                |       | 41                                                        |       | —          |       | 41 |   |
| Acquisition related costs                                       |       | —                                |       | 47                                    |       | 156                                                       |       | 147             |       | 345 |   |
| Other operating expense                                         |       | 336                                   |       | —                                |       | 535                                                       |       | —          |       | 564 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Total noninterest expense                                       |       | 676                                   |       | 47                                    |       | 1,477                                                     |       | 147             |       | 1,695 |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| **Net Loss**                                                    |       | $                                     | (501       | )                                     | $          | (47                                                       | )          | $               | (1,260     | ) | $ | (147 | ) | $ | (1,478 | ) |
|                                                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| **Earnings Per Share**                                          |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Net income (loss) per share - basic and  diluted                |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Basic                                                           |       | $                                     | (0.48      | )                                     | $          | (0.05                                                     | )          | $               | (1.22      | ) | $ | (0.15 | ) | $ | (1.48 | ) |
| Diluted                                                         |       | $                                     | (0.45      | )                                     | $          | (0.05                                                     | )          | $               | (1.19      | ) | $ | (0.15 | ) | $ | (1.48 | ) |
| Weighted average shares outstanding:                            |       |                                  |       |                                  |       |                                                      |       |            |       |   |   |
| Basic                                                           |       | 1,040,000                             |       | 1,000,000                             |       | 1,029,927                                                 |       | 1,000,000       |       | 1,000,000 |   |
| Diluted                                                         |       | 1,118,000                             |       | 1,000,000                             |       | 1,055,927                                                 |       | 1,000,000       |       | 1,000,000 |   |

 

2

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**Treaty Oak Bancorp, Inc.**

**(A Development Stage Enterprise)**

**Statementof Changes in Shareholders’ Equity**

**(Dollars in Thousands, except share amounts)**

 
| ** **                                                                                                    | ** ** | **Common Stock** | ** ** | **Additional  paid-in  capital** | ** ** | **Deficit  accumulated  during  development stage** | ** ** | **Accumulated  other  comprehensive** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------------|------------|----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **                                                                                                    | ** ** | **Shares**       | ** ** | **Amount**                       | ** ** | ** **                                          | ** ** | **loss**                              | ** ** | **Total**  | ** ** |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       |   |   |
| Contribution of pre-opening expenses  incurred by organizing shareholder on behalf of the Company             |       | —           |       | $                                | —     |                                                | $          | 218                                   |       | $          | —     |   | $ | — |   | $ | 218 |   |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       | — |   |
| Net loss                                                                                                      |       |             |       |                             |       |                                                |       | (218                                  | )          | —     |       | (218 | ) |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       | — |   |
| Balances at September 30, 2003                                                                           |       | —           |       | $                                | —     |                                                | $          | 218                                   |       | $          | (218       | ) | $ | — |   | $ | — |   |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       | — |   |
| Initial capital contribution from  organizing shareholder - unaudited                                         |       | 1,000,000        |       | 10                               |       | 1,677                                               |       | —                                |       | —     |       | 1,687 |   |
| Sale of Common stock - unaudited                                                                              |       | 40,000           |       | —                           |       | —                                              |       |                                  |       |       |       | — |   |
| Contribution of pre-opening expenses  incurred by organizing shareholder on behalf of the Company - unaudited |       |             |       |                             |       | 124                                                 |       |                                  |       |       |       | 124 |   |
| Non-cash stock-based compensation                                                                             |       |             |       |                             |       | 333                                                 |       |                                  |       |       |       | 333 |   |
| Net loss - unaudited                                                                                          |       |             |       |                             |       |                                                |       | (1,260                                | )          | —     |       | (1,260 | ) |
| Change in unrealized loss on securities  available for sale                                                   |       |             |       |                             |       |                                                |       |                                  |       | (2         | )          | (2 | ) |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       |   |   |
| Comprehensive loss                                                                                            |       |             |       |                             |       |                                                |       | —                                |       |       |       | (1,262 | ) |
|                                                                                                          |       |             |       |                             |       |                                                |       |                                  |       |       |       |   |   |
| Balances   at June 30, 2004 (unaudited)                                                             |       | 1,040,000        |       | $                                | 10         |                                                | $          | 2,352                                 |       | $          | (1,478     | ) | $ | (2 | ) | $ | 882 |   |

 

SeeNotes to Financial Statements.

 

 

3

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**Treaty Oak Bancorp, Inc.**

**(A Development Stage Enterprise)**

**Consolidated Statements Of Cash Flows**

**(Dollars In Thousands)**

 
| ** **                                                                                 | ** ** | **Nine months ended  June 30, 2004** | ** ** | **Period from  November 1, 2002 to  June 30, 2003** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------------------------|------------|
|                                                                                       |       |                                      |       |                                                          |       |
| Cash flows from operating activities:                                                      |       |                                      |       |                                                          |       |
| Net loss                                                                                   |       | $                                         | (1,260     | )                                                             | $          | (147 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                      |       |                                                          |       |
| Non-cash stock based compensation                                                          |       | 333                                       |       |                                                          |       |
| Non-cash pre-opening expenses incurred by  majority shareholder on behalf of the Company   |       | 520                                       |       | 147                                                           |       |
| Depreciation and amortization                                                              |       | 15                                        |       |                                                          |       |
| Net amortization on securities                                                             |       | 6                                         |       |                                                          |       |
| Changes in other operating assets and  liabilities, net of acquisition:                    |       |                                      |       |                                                          |       |
| Accrued interest receivable                                                                |       | 5                                         |       |                                                          |       |
| Other assets                                                                               |       | (309                                      | )          |                                                          |       |
| Accrued interest payable                                                                   |       | 12                                        |       |                                                          |       |
| Other liabilities                                                                          |       | 64                                        |       |                                                          |       |
|                                                                                       |       |                                      |       |                                                          |       |
| **Net cash used in  operating activities**                                                 |       | (614                                      | )          | —                                                        |       |
|                                                                                       |       |                                      |       |                                                          |       |
| Cash flows from investing activities:                                                      |       |                                      |       |                                                          |       |
| Initial capital contribution of majority  shareholder                                      |       | 1,200                                     |       |                                                          |       |
| Principal repayments on securities  available for sale                                     |       | 17                                        |       |                                                          |       |
| Proceeds from sale of common stock                                                         |       | 1                                         |       |                                                          |       |
| Cash purchase of subsidiary, net of cash  received                                         |       | (324                                      | )          |                                                          |       |
| Proceeds from sale of other real estate                                                    |       | 10                                        |       |                                                          |       |
| Net decrease in loans                                                                      |       | 537                                       |       |                                                          |       |
| Purchases of premises and equipment                                                        |       | (260                                      | )          |                                                          |       |
| Purchase of Federal Home Loan Bank stock                                                   |       | (1                                        | )          |                                                          |       |
|                                                                                       |       |                                      |       |                                                          |       |
| **Net cash provided  by investing activities**                                             |       | 1,180                                     |       | —                                                        |       |
|                                                                                       |       |                                      |       |                                                          |       |
| Cash flows from financing activities:                                                      |       |                                      |       |                                                          |       |
| Net decrease in deposits                                                                   |       | (74                                       | )          |                                                          |       |
| Net increase in notes payable                                                              |       | 500                                       |       |                                                          |       |
|                                                                                       |       |                                      |       |                                                          |       |
| **Net cash provided  by financing activities**                                             |       | 426                                       |       | —                                                        |       |
|                                                                                       |       |                                      |       |                                                          |       |
| Net increase in cash and cash equivalents                                                  |       | 992                                       |       | —                                                        |       |
|                                                                                       |       |                                      |       |                                                          |       |
| Cash and cash equivalents at beginning of  period                                          |       | —                                    |       | —                                                        |       |
|                                                                                       |       |                                      |       |                                                          |       |
| Cash and cash equivalents at end of period                                                 |       | $                                         | 992        |                                                          | $          | — |   |
|                                                                                       |       |                                      |       |                                                          |       |
| Supplemental dislclosures of cash flow  information:                                       |       |                                      |       |                                                          |       |
| Contribution of deferred stock issuance  costs                                             |       | $                                         | 905        |                                                          | $          | — |   |
| Contribution of Direct acquisition costs -  Texline State Bank                             |       | $                                         | 217        |                                                          | $          | — |   |
| Contribution of Deposit on Texline State  Bank                                             |       | $                                         | 50         |                                                          | $          | — |   |
| Cash interest paid                                                                         |       | $                                         | 74         |                                                          | $          | — |   |
|                                                                                       |       |                                      |       |                                                          |       |
| Acquisition of Texline State Bank                                                          |       |                                      |       |                                                          |       |
| Assets acquired                                                                            |       | $                                         | 10,940     |                                                          |       |   |
| Liabilities assumed                                                                        |       | (9,597                                    | )          |                                                          |       |
| Notes payable on acquisition                                                               |       | (1,019                                    | )          |                                                          |       |
| Cash paid, net of cash received                                                            |       | $                                         | 324        |                                                          |       |   |

 

4

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**Treaty Oak Bancorp, Inc.Notes to the Consolidated FinancialStatements (Unaudited)**

 

**Note 1: Description of Business and Summary of Significant AccountingPolicies**

 

Treaty Oak Bancorp, Inc., (the “Company”) is a bank holding companythat owns 99.94% of the outstanding stock of Texline State Bank (the “Bank”),which was acquired on March 9, 2004. The Bank is a state-chartered commercial bank, and its deposits areinsured by the Federal Deposit Insurance Corporation.  The Bank provides a variety of bankingservices to individuals and business located primarily in Dalham County,Texas.  The Company’s primary businessactivity is the operation of the Bank. The Company currently operates only one reportable industry segment:banking.

 

The Company’s fiscal year end is September 30.

 

**Note 2:  Basis of Presentation**

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with the instructions to Form 10-QSB and, therefore, donot include all of the disclosures and notes required by generally acceptedaccounting principles.  In the opinion ofmanagement, all material adjustments (which are of a normal recurring nature)considered necessary for a fair presentation have been made.  The results for the interim period are notnecessarily indicative of the results to be expected for the entire year or anyother interim period.

 

**Note3.  Initial Capitalization**

 

On December 8, 2003, Treaty Oak Holdings, Inc. contributed cash of$250,000, a receivable of $950,000 (which was paid on December 22, 2003)and other assets of $486,688 in exchange for 1,000,000 shares of the Company’scommon stock, which represented 96% of the issued and outstanding shares of theCompany’s common stock.

 

Prior to the formation of the Company, certain pre-opening expenseswere incurred by its organizing shareholder for the Company’s benefit.  These costs, which amounted to $123,896 and$218,350 for the period from October 1, 2003, to December 8, 2003,and the year ended September 30, 2003, respectively, and have beenreflected in the Company’s statements of operations for the respective periodsand as contributions to additional paid-in capital.

 

On December 8, 2003, the Company issued 40,000 shares of itscommon stock to four individuals for $0.02 per share, in cash, and otherconsideration and recognized compensation expense in the amount of $332,400during the period from October 1, 2003, to December 8, 2003.

 

**Note4.  Summary of Significant AccountingPolicies**

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents include cash onhand and held in banks, money-market funds and other investments withmaturities of three months or less, when purchased.

 

*Income Taxes*

 

The Company utilizes the liability method of accounting for deferredincome taxes.  Under the liabilitymethod, deferred income tax assets and liabilities are calculated based on thedifference between the financial statements and tax basis of assets andliabilities as measured by the currently enacted tax rates in effect for theyears in which these differences are expected to reverse.  Deferred tax expense or benefit is the resultof changes in deferred tax assets and liabilities.  An allowance against deferred tax assets isrecorded in whole or in part when it is more likely than not that such taxbenefits will not be realized.

 

5

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*Use of Estimates*

 

The preparation of the financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

 

*Stock-Based Compensation*

 

The Company accounts for stock-based compensation to employees usingthe intrinsic value method.  Accordingly,compensation costs for employee stock options is measured as the excess, ifany, of the fair value of the Company’s common stock at data of grant over theexercise price.

 

The Company accounts for stock-based compensation to non-employees atfair value.

 

*Deferred Stock Issuance Costs*

 

Deferred stock issuance costs represent costs incurred in connectionwith the Company’s proposed offering. Proceeds from the offering will be reduced by these costs.  In the event the offering is not consummated,these costs will be reflected as expenses.

 

*Securities Available for Sale*

 

Securities classified as available for sale are those that the Companyintends to hold for an indefinite period of time, but not necessarily tomaturity.  Any decision to sell a security classified as available forsale would be based on various factors, including significant movements ininterest rates, changes in the maturity mix of the Company’s assets andliabilities, liquidity needs, regulatory capital considerations, and othersimilar factors.

 

Securities available for sale are reported at fair value withunrealized gains or losses reported as a separate component of othercomprehensive income, net of income taxes.

 

Realized gains or losses, determined on the basis of the cost ofspecific securities sold, are included in earnings.

 

*Securities Held to Maturity*

 

Securities classified as hold to maturity are those that the Companyintends to hold until the instrument matures under the terms of its issuanceand are reported at amortized cost.  The amortization of premiums andaccretion of discounts, computed by the interest method over their contractuallives, is recognized in interest income.

 

*Loans*

 

Loans that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off are reported at theiroutstanding principal balance adjusted for the allowance for loan losses.Interest is accrued daily on the outstanding balances.

 

A loan is considered impaired when it is probable, based upon currentinformation and events, the Company will be unable to collect all contractualprincipal and interest payments due in accordance with the terms of the loanagreement.  Impaired loans are accounted for at the net present value ofexpected future cash flows, discounted at the loan’s effective interest rate,the observable market price of the loan or at the fair value of the collateralif the loan is collateral dependent.

 

6

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The accrual of interest on impaired loans is discontinued when, inmanagement’s opinion, the borrower may be unable to meet payments as theybecome due.  When interest accrual is discontinued, all unpaid accruedinterest is reversed.  Interest income is subsequently recognized only tothe extent cash payments are received.

 

Loan fees and direct loan origination costs are immaterial.

 

*Allowance for Loan Losses*

 

The allowance for loan losses is established through a provision forloan losses charged to expense.  Loans are charged against the allowancefor loan losses when management believes that collectibility of the principalis unlikely.  The allowance is an amount that management believes will beadequate to absorb estimated losses on existing loans, based on an evaluationof the collectibility of loans and prior loss experience.  This evaluationalso takes into consideration such factors as changes in the nature and volumeof the loan portfolio, overall portfolio quality, review of specific problemloans, and current economic conditions that may affect the borrower’s abilityto pay.  While management uses the best information available to make itsevaluation, future adjustments to the allowance may be necessary if there aresignificant changes in economic conditions.  In addition, regulatoryagencies, as an integral part of their examination process, periodically reviewthe Company’s allowance for loan losses, and may require the Company to makeadditions to the allowance based on their judgment about information availableto them at the time of their examinations.

 

*Premises and Equipment*

 

Land is carried at cost.  Premises and equipment are carried atcost, less accumulated depreciation which is computed on the straight linemethod over the following estimated useful lives:

 

| Building and improvements |   | 10 – 25 years |
|---------------------------|--------|--------------------|
| Furniture and equipment   |   | 3 – 10 years  |

 

*Other Real Estate and Repossessed Assets*

 

Assets acquired through or instead of loan foreclosures are initiallyrecorded at fair value when acquired, establishing a new cost basis.  Iffair value declines, an impairment charge is recorded through expense. Costs after acquisition are expensed.

 

*Off-Balance Sheet Financial Instruments*

 

In the ordinary course of business, the Company has entered intooff-balance sheet financial instruments consisting of commitments to extendcredit and standby letters of credit.  Such financial instruments arerecorded in the financial statements when they are funded or related fees areincurred or received.

 

*Goodwill*

 

Management periodically reviews goodwill (and other similar intangibles)to determine whether a decline in value exists which requires a charge toearnings and a reduction to the net goodwill reflected on the statement offinancial condition of the Company. An intangible asset with an indefiniteuseful life is tested for impairment at least annually and more frequently ifcircumstances indicate that the asset could be impaired. To test forimpairment, the fair value of the asset is compared to its carrying amount andif the fair value is less than its carrying value, the company will recognizean impairment loss. If the fair value exceeds the carrying amount, no increasein the carrying amount is recorded. In addition, if following the recognitionof an impairment loss, the fair value increases back to or in excess of thecarrying amount prior to the recognition of the loss, no reversal of theimpairment is recorded.

 

**Note 5.  Acquisition of Texline StateBank**

 

On March 9, 2004, the Company purchased, 99.92% of the outstandingshares of the Bank’s common stock, the only stock currently outstanding, for atotal purchase price of approximately $2,225,000.  The Bank was acquired 

 

7

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as the first phase of the Company’s business plan to acquire a smallTexas chartered bank, and the second phase being to relocate the charter toAustin, Texas.  This second phase is currently in process.  Thepurchase price was paid approximately $1,206,000 in cash and notes payable of$1,019,000.  The notes bear interest at 5% per annum and are currentlyamortized over 10 years.  These notes accelerate and become immediatelypayable when and if the Company sells at least $7,000,000 of its common stockin a public offering.  The Company intends to relocate the charter andbegin operations in Austin, Texas as a significant element of its businessplan.  The operating results of the Bank are included in the Company’sFinancial Statements since the date of acquisition.

 

The purchase price and preliminary allocation of the purchase price forthe Bank, was as follows (in thousands):

 
| Contract price    |   | $   | 2,225  |   |
|-------------------|--------|-----|--------|--------|
| Acquisition costs |   | 218 |   |
| Total purchase    |   | $   | 2,443  |   |

 

Immediately following the acquisition, Texline condensed balance sheetwas as follows:

 
| Cash and cash equivalents                       |   | $      | 869    |   |
|-------------------------------------------------|--------|--------|--------|--------|
| Securities                                      |   | 503    |   |
| Loans, net                                      |   | 8,540  |   |
| Core deposit intangibles                        |   | 70     |   |
| Goodwill                                        |   | 1,161  |   |
| Other assets                                    |   | 897    |   |
| Total Assets                                    |   | $      | 12,040 |   |
|                                            |   |   |   |
| Deposits                                        |   | $      | 8,882  |   |
| Other liabilities                               |   | 715    |   |
| Shareholders’ equity                       |   | 2,443  |   |
| Total Liabilities and Shareholders’ Equity |   | $      | 12,040 |   |

 

The table below shows the pro forma results of operations assuming theacquisition of Texline State Bank as of the first day of each period.  Theresults of actual operations over the same period could materially differ fromthose reported here.

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------|------------|------------------------|------------|------------------------|------------|
| ** **          | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| Interest income     |       | $                      | 206        |                   | $          | 211 |   | $ | 634 |   | $ | 644 |   |
| Net interest income |       | $                      | 174        |                   | $          | 153 |   | $ | 503 |   | $ | 452 |   |
| Net loss            |       | $                      | (414       | )                      | $          | (4 | ) | $ | (1,102 | ) | $ | (108 | ) |
| Loss per share      |       | $                      | (0.40      | )                      | (0.00      | ) | $ | (1.07 | ) | $ | (0.10 | ) |

 

**Note 6.  Earnings Per Share**

 

Basic earnings (loss) per share is computed by dividing net earnings(loss) by the weighted average number of common shares outstanding for theperiod.  Diluted earnings per share is computed using the weighted-averagenumber of common shares outstanding plus the number of additional common sharesthat would have been outstanding if dilutive common shares had beenissued.  For all periods presented all potentially dilutive securitiesoutstanding were anti-dilutive.

 

For purposes of calculating weighted-average shares outstanding, the1,000,000 common shares issued to Treaty Oak Holdings in the Company’s initialcapitalization are assumed to be outstanding for all periods presented.

 

8

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**Note 7.  Common Stock Offering**

 

The Company is offering for sale up to 1,440,000 shares of its commonstock at an offering price of $8.33 per share.  In addition, the Companywill issue one stock purchase warrant for every five shares of common stockpurchased, up to a maximum of 288,000 warrants.  The warrants areexercisable at a price of $10.00 per share and will remain exercisable untilJune 30, 2007.  The Company’s registration statement on Form SB-2 wasdeclared effective by the Securities and Exchange Commission on May 7,2004.  379, 781 shares have been soldunder the offering as of the date of filing of this report.

 

**Note 8.  Advances from Organizers**

 

Treaty Oak Holdings has and will continue to advance funds fororganizational, acquisition, offering and other pre-operating expenses. These advances are being made under an expense reimbursement agreement pursuantto which our organizing shareholder has advanced funds on behalf of the Companysubsequent to December 8, 2003, up to an aggregate of $775,000. Unless and until the Company raises at least $4,000,000 from the issuance ofits common stock, the Company will not be obligated to reimburse these costs.

 

The Company will record the payment or accrual of these costs as aliability as incurred and such amounts will be reflected in the appropriatebalance sheet or expense accounts.  In the event the Company does notraise at least $4,000,000 from the issuance of common stock, they will be accountedfor by the Company as a contribution to capital.

 

When the Company has raised the required $4,000,000 from the issuanceof common stock, the Company will reimburse Treaty Oak Holdings based uponinvoices or other support submitted to the Company for reimbursement.

 

**Note 9.  2004 Stock Incentive Plan**

 

On January 19, 2004, the Company and its shareholders approved theCompany’s 2004 Stock Incentive Plan (the “Plan”).  The Plan authorizesincentive stock option grants, non-statutory stock option grants, direct stockissuances, stock appreciation rights, salary investment option grants, anddirector fee option grants.  Eligible participants are employees,non-employee board members, and independent consultants or advisors. 500,000 shares of common stock have been initially reserved under the Plan, andthe share reserve increases on the 1st business day inJanuary each year (beginning in 2005) by an amount equal to 2% of thenumber of outstanding shares of the Company on the last business day inDecember of the preceding year, subject to a maximum annual increase of100,000 shares.  No person may receive stock option grants, stockissuances, or stock appreciation rights for more than 100,000 shares in theaggregate in any calendar year under the Plan.

 

As of July 31, 2004, there were outstanding options to purchase anaggregate of 175,500 shares of the Company’s common stock.  Each option has an exercise price of $8.33per share and may be exercised in three equal annual installments for each yearof service measured from the grant date.

 

Accordingly, the expense related to stock option compensation includedin the determination of net income for the three months and nine months endedJune 30, 2004, is less than that which would have been recognized if thefair value method had been applied.  TheCompany’s net income and earnings per share would have been adjusted to theproforma amounts indicated below:

 

The weighted average fair value of the options granted during the threemonths and nine months ended June 30, 2004, has been estimated using theBlack-Scholes option pricing model with the following assumptions:

 
| Dividend yield          |   | 0    | %      |
|-------------------------|--------|------|--------|
| Risk-free interest rate |   | 4.75 | %      |
| Expected volatility     |   | 22   | %      |
| Expected life in years  |   | 10   |   |

 

9

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| ** **                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2004**                             | ** ** |
|                             |       |                                  |       |                                 |       |
| Net loss - as reported           |       | $                                     | (501       | )                                    | $          | (1,260 | ) |
| Net loss - Pro Forma             |       | (519                                  | )          | (1,278                               | )          |
|                             |       |                                  |       |                                 |       |
| Earnings per share - as reported |       |                                  |       |                                 |       |
| basic                            |       | $                                     | (0.48      | )                                    | $          | (1.22 | ) |
| diluted                          |       | $                                     | (0.45      | )                                    | $          | (1.19 | ) |
|                             |       |                                  |       |                                 |       |
| Earnings per share - Pro Forma   |       |                                  |       |                                 |       |
| basic                            |       | (0.50                                 | )          | (1.24                                | )          |
| diluted                          |       | (0.46                                 | )          | (1.21                                | )          |

 

**Note 10.  Related Party Transactions**

 

The Company engages the services of certain affiliated companies toprovide management, administrative and other support services.  These feesincurred by the Company’s majority shareholder through September 30, 2003totaled $218,350, related to the acquisition of the Bank and to the proposedoffering of the Company’s common stock.

 

The Company receives certain accounting services from a firm in whichone of the firm’s partners is also a director of the Company.  The feesincurred by the Company’s organizing shareholder through September 30,2003 amounted to approximately $20,700.

 

The Company leases its office premises from a partnership in which ourorganizing shareholder owns a 15% interest and in which, as of the completionof the proposed offering, the Company’s directors and officers willcollectively own a 62.5% interest.  However, in connection with theCompany’s approval from the Federal Deposit Insurance Corporation (“FDIC”) torelocate the main office of the Bank, the Company’s directors and officers willdivest themselves of this ownership  interest.  Annual minimum leasepayments under the lease are anticipated to be approximately $150,000 per yearover the 15-year lease term.

 

Treaty Oak Holdings is entitled to certain registration rightsrequiring the Company to register the sale of its shares under the SecuritiesAct of 1933, as amended.  Treaty Oak Holdings may make two demands forregistration and has piggyback rights, subject to limitations.  Theseregistration rights may be exercised beginning January 1, 2005, and ending10 years from the completion of the Company’s proposed stock offering.

 

In March 2004, the organizing shareholder, Treaty Oak Holdings,advanced $500,000 to the Company in connection with the acquisition of theBank.  The $500,000 was advanced  to make a contribution to thecapital of the Bank in addition to the new capital we intend to contribute fromthe proceeds of this offering.  This obligation is currently representedby a promissory note bearing interest at 2.00% and payable in 12 months, withno penalty for prepayment.  This note, including accrued interest, willautomatically convert to 61,342 shares of common stock on March 9, 2005,based upon a conversion price of $8.33 per share.

 

**Note 11.  Commitments**

 

In connection with its capital raising activities, the Company receivescertain services from an unrelated party.  These services are providedunder an agreement entered into by Treaty Oak Holdings.  These servicesare subject to an Expense Reimbursement Agreement (Note 8) and will not bepayable by the Company unless and until it has raised at least $4,000,000 fromthe sale of common stock under the proposed offering.  Certain costs underthis 

 

10

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agreement have already been incurred by Treaty Oak Holdings and areincluded in the initial capital contribution to the Company as accumulateddeficit.  Costs included in the capitalized costs of funding wereapproximately $210,000 and costs currently expensed as pre-operating costs wereapproximately $33,000.  Additional costs to be incurred under thisagreement in the fiscal year ending September 30, 2004, are expected to beapproximately $300,000.

 

**Note 12.  Loansand Allowance for Loan Losses**

 

The Company grants agribusiness, real estate, and commercial loans tocustomers located primarily in Northwest Texas.  The Company has adiversified loan portfolio; however, a significant number of loans made by theCompany are agriculture in nature.  As a result, the ability of many ofthe Company’s borrowers will, to a certain extent, be dependant on the generaleconomic conditions of the Company’s geographic location.

 

Loans at June 30, 2004 were as follows (in thousands):

 
| ** **                      | ** ** | **June 30,  2004 (unaudited)** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|
|                            |       |                                |       |
| Agriculture                     |       | **$**                               | **2,771**  | ** ** |
| Real estate                     |       | **3,921**                           | ** ** |
| Commercial                      |       | **929**                             | ** ** |
| Consumer                        |       | **553**                             | ** ** |
|                            |       | ** **                          | ** ** |
|                            |       | **8,174**                           | ** ** |
|                            |       | ** **                          | ** ** |
| Less: allowance for loan losses |       | **(171**                            | **)**      |
|                            |       | ** **                          | ** ** |
|                            |       | **$**                               | **8 ,003** | ** ** |

 

**Note 13.  Financial Instruments WithOff-Balance Sheet Risk**

 

In the normal course of business, the Company is a party to financialinstruments with off-balance sheet risk to meet the financing needs of itscustomers, through the use of commitments to extend credit.  Thoseinstruments involve, to varying degrees, elements of credit and interest-raterisk in excess of the amount recognized in the consolidated balancesheet.  The contract or notional amounts of those instruments reflect theextent of the Company’s involvement in particular classes of financialinstruments.

 

The Company’s exposure to credit loss in the event of nonperformance bythe other party to the financial instrument for commitments to extend credit isrepresented by the contractual amount of those instruments.  The Companyuses the same credit policies in making commitments and conditional obligationsas they do for on-balance sheet instruments.

 

The following table summarizes the Company’s off-balance sheetfinancial instruments (in thousands):

 
| ** **                   | ** ** | **June 30,  2004 (unaudited)** | ** **    |
|------------------------------|------------|-------------------------------------|---------------|
|                         |       |                                |          |
| Commitments to extend credit |       | **$**                               | **1,919,000** | ** ** |
| Standby letters of credit    |       | **97,000**                          | ** **    |
|                              |            |                                     |               |  |

 

Commitments to extend credit are agreements to lend to a customer aslong as there is no violation of any condition established in thecontract.  Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee.  Since many of thecommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-casebasis.  The amount of collateral obtained if deemed 

 

11

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necessary by the Company upon extension of credit is based onmanagement’s credit evaluation of the counterparty.  Collateral heldvaries but may include accounts receivable, inventory, property, plant andequipment and income-producing commercial properties.

 

Standby letters of credit are written conditional commitments used bythe Company to guarantee the performance of a customer to a third party. The Company’s policies generally require that letter of credit arrangementscontain security and debt covenants similar to those contained in loanarrangements.  In the event the customer does not perform in accordancewith the terms of the agreement with the third party, the Company would berequired to fund the commitment.  The maximum potential amount of futurepayments the Company could be required to make is represented by thecontractual amount shown in the table above.  If the commitment is funded,the Company would be entitled to seek recovery from the customer.

 

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**Item 2.****                                                           *Management’s Discussion and Analysis of FinancialCondition and Results Of Operations***

 

**Executive Overview**

 

Treaty Oak Bancorp, Inc., (the “Company”), a Texas corporation, is abank holding company headquartered in Austin, Texas.  The Company serves the marketplace primarilythrough its 99.94% owned banking subsidiary, Texline State Bank (the “Bank”), aTexas chartered commercial bank.  TheBank’s deposits are insured by the Federal Deposit Insurance Corporation (the“FDIC”) to the extent provided by law. The Bank is supervised and examined by the Texas Department ofBanking.  At June 30, 2004, the Bankoperated a single branch located in Texline, Dalham County, Texas.

 

Through the Bank, the Company offers a variety of commercial bankingservices to individuals and business located in the area surrounding Texline,Texas, which is a primarily agricultural area. The services offered includeagricultural, real estate and commercial lending services, checking and savingsdeposits, time deposits and other customary banking services.  The Bank does not offer trust services.

 

The Company acquired the Bank on March 9, 2004, by purchasing99.92% of the then outstanding common stock of the Bank and currently has noother operating history.  The Companyreceived notification from the Securities and Exchange Commission on May 7,2004, as to the effectiveness of its registration to sell shares of commonstock, at $8.33 per share, to raise up to approximately $12,000,000.  The proceeds of the offering are intendedprimarily to increase the capital of the Bank to permit the relocation of theBank’s charter to Austin, Texas.  As aresult, the Company is currently incurring substantial pre-opening costs relatedto the future relocation.

 

The following discussion provides information about the majorcomponents of the financial condition, results of operations, asset quality,liquidity and capital resources of Treaty Oak Bancorp.  The discussion and analysis should be read inconjunction with the Consolidated Financial Statements.

 

**Plan of Operation**

 

***General***

 

We intend to support the existing and remaining management team inTexline in continuing the improvement of that branch’s financial performance.Additionally, given the greater growth potential in Austin, we expect to focusour efforts on establishing a community-oriented effort out of our headquartersin the leased facility that we will occupy at 101 Westlake Drive (at Bee CaveRoad), Austin, Texas, 78746. The Bank will occupy approximately 7,000 squarefeet in a building that has been renovated and has executed a 15-year lease.The Bank’s budget for leasehold improvements, furniture, fixtures, andtechnology infrastructure and equipment is approximately $400,000. Weanticipate that the Bank will open with 10 full-time employees in Austin andwill retain a staff of approximately seven in Texline.

 

To mitigate the inconvenience and potential competitive disadvantage ofa single location in Austin, we intend to offer a courier service to pick-upnon-cash deposits from our customers and will reimburse customers for a setnumber of ATM transactions per month. Our proposed plan anticipates theestablishment of a second branch late in our second year of operation, twobranches in the third year, and a fifth branch in the fourth year. Alldecisions to add branches will be dependent upon the demands of our market, thegrowth and profitability of the Bank, and our capital adequacy.

 

Assuming we raise the maximum funds under our public offering, weintend to immediately infuse an additional $5,500,000 into the Bank from theproceeds of the offering, the majority of which will be used for bank customerloans, investments, and other general business purposes. The remainder of thecapital raised in our public offering will be retained at the holding companyfor later infusion into the Bank as capital requirements necessitate. We havenot fully developed the products and services that the Bank will initiallyoffer its customers and do anticipate engaging in additional product researchand development during the 12-month period following the offering, but webelieve that the initial offering proceeds will adequately fund our businessoperations for at least the first three years of operations. Accordingly, we donot anticipate raising additional capital in the next three years. However, wecannot assure you that we will not need to raise additional capital in the nextthree years.

 

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Where required in the preparation of the Company’s financial statementsin accordance with generally accepted accounting principles, estimates are madeby management to present fairly the financial condition of the Company. Thenotes to the Consolidated Financial Statements describe the Company’ssignificant accounting policies including the use of estimates by noting that“the preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect certain reportedamounts of assets and liabilities and disclosures of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses for the period. Accordingly, actual results could differfrom those estimates.”

 

Some of the estimates made in preparation of the financial statementsincluded herein are the estimates of the former management of the Bank and theCompany’s current management. Although we believe that the estimates used leadto the fair presentation, in all material respects, of the financial statementsfor the Company, accounting estimates could have a material effect on thefinancial results of the Bank. While management uses estimates to record itemssuch as prepaid expenses, accrued expenses, accrued taxes and similar items, wedo not believe that any of these estimates are material, or that they couldlead to a material misstatement in the financial statements.

 

The critical estimates of the Bank are centered in three areas: thetreatment of certain loans, the allowance for loan losses, and goodwill.

 

*Estimates as they relate to loans*

 

When a loan is considered to be “impaired,” management has concludedthat based upon current information and events, the Bank will be unable tocollect all contractual principal and interest payments due in accordance withthe terms of the loan agreement. Management’s conclusions regarding the statusof a loan are estimates. Management then chooses the method by which this loanwill be accounted for from one of three methods: (1) The loan is accountedfor at the net present value of expected future cash flows, discounted at theloan’s effective interest rate, (2) the observable market price of theloan or (3) at the fair value of the collateral if the loan is collateraldependent. The impact of such method and the underlying estimate ofclassification, varies dependent upon which of these approaches is deemed to beappropriate for the loan. Each of these methods essentially revalues theunderlying loan and the difference between the carrying value and thecalculated loan value is reflected as a charge to the Allowance for LoanLosses. Depending upon the number of loans subject to revaluing and the amountcharged-off, this could create a material additional charge to the Provisionfor Loan Loss expense. In each case, management uses its best efforts toevaluate problem loans and provide adequately for their collectibility based onall the facts available. However, the under or over valuing of loans couldmaterially affect the performance and financial condition of the Bank. Theactual results of collection efforts, regardless of the method selected, couldvary significantly, thereby impacting reported earnings, reserves and asset values.

 

*Estimates as they relate to the allowance forloan losses*

 

The “allowance for loan losses” for the Bank is established through aprovision for loan losses charged to expense. Loans are charged against theallowance for loan losses when management believes that collectibility of theprincipal is unlikely. The allowance is an amount that management, in its bestestimate, believes will be adequate to absorb estimated losses on existingloans. There are generally two components utilized to determine the allowancefor loan losses; the first is a charge determined in the evaluation of specificloans identified by management and deemed to be “impaired” or “troubled,” withthe second being an estimate generally based upon the overall size of the loanportfolio and the Bank’s recent loan loss experience. If for example, as aresult of changes in economic conditions, collateral valuations or otherfactors that could impact a borrower’s ability to repay or the underlying valueof collateral securing loans, actual losses that occur could be greater or lessthan the allowance for losses established by management, in turn resulting inadditional charges against earnings or a recovery that would positively impactearnings.

 

Failure of management to adequately reserve against future losses couldmaterially affect the Bank’s condition and performance. Likewise, an excessivereserve could also materially affect the Bank’s performance and condition.Management does not believe that they have selected any methods that wouldresult in a material difference in the presentation of the financial statementsover the methods employed in the current periods. Further, management does not 

 

14

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believe that the use of any alternative estimates in the financialstatements would have differed materially from financial statements aspresented.

 

*Estimates as they relate to goodwill*

 

In addition to the two critical estimates discussed above, the Bankalso used estimates in evaluating certain intangible assets including thegoodwill recorded as part of the acquisition transaction. Goodwill is no longeramortizable under generally accepted accounting principles, instead managementperiodically reviews goodwill (and other similar intangibles) to determinewhether a decline in value exists which requires a charge to earnings and areduction to the net goodwill reflected on the statement of financial conditionof the Bank. Under SFAS 142, an intangible asset with an indefinite usefullife is tested for impairment at least annually and more frequently ifcircumstances indicate that the asset could be impaired. To test forimpairment, the fair value of the asset is compared to its carrying amount andif the fair value is less than its carrying value, the company will recognizean impairment loss. If the fair value exceeds the carrying amount, no increasein the carrying amount is recorded. In addition, if following the recognitionof an impairment loss, the fair value increases back to or in excess of thecarrying amount prior to the recognition of the loss, no reversal of theimpairment is recorded.

 

*Other Estimates*

 

In addition to the three critical estimates discussed above, the Bankalso uses estimates in the valuation of Other Real Estate Owned (“OREO”) andother repossessed assets. While in larger banks this estimate could besignificant, the Bank does not generally have material amounts of these assets.When the Bank forecloses on real estate, it seeks a third party assessment ofthe asset value, and if available, an appraisal, generally from a real estatebroker familiar with the area. In addition, the Bank uses its best efforts tovalue other foreclosed assets. While the Bank has experienced write-downs ofthese values, these adjustments have not been material and do not materiallyimpact the Bank’s financial performance. As of December 31, 2003, and2002, the Bank held $18,000 and $10,000, respectively, in OREO, whichrepresented 0.14% and 0.08% of gross assets, respectively.

 

**Financial Condition**

 

Total assets as of June 30, 2004, were $13 million up from $0 fromthe year ended September 30, 2003. Total loans decreased between the date of acquisition and June 30,2004, by $532,000 to $8.2 million due to normal principal payments and adecrease in lending activity in conjunction with the Bank’s transition to newmanagement. The Bank’s investment securities decrease by $22,000 due toprincipal payments received between the date of acquisition and June 30,2004.  The Bank decreased its FederalFunds sold from $1,100,000 to $400,000 between March 31, 2004 andJune 30, 2004, due to the maturity of above market rate certificates ofdeposit.

 

15

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Net loans were $8,003,000 as of June 30, 2004.  The following tables set forth thecomposition of the loan portfolio:

 
| ** **                | ** ** | **June 30, 2004** | ** ** |
|---------------------------|------------|------------------------|------------|
| ** **                | ** ** | **Amount**             | ** ** | **Percent** | ** ** |
|                      |       |                   |       |   |   |
| Agriculture               |       | $                      | 2,771,000  |   | 33.9 | % |
| Commercial                |       | 929,000                |       | 11.4 | % |
| Commercial real estate    |       | 1,032,000              |       | 12.6 | % |
| Residential real estate   |       | 2,856,000              |       | 34.9 | % |
| Construction real estate  |       | 33,000                 |       | 0.4 | % |
| Installment and other     |       | 553,000                |       | 6.8 | % |
| Total Loans               |       | 8,174,000              |       | 100 | % |
| Allowance for Loan Losses |       | (171,000               | )          |   |   |
| Net Loans                 |       | $                      | 8,003,000  |   |   |   |

 

Loan concentrations are considered to exist when there are amountsloaned to a multiple number of borrowers engaged in similar activities thatwould cause them to be similarly impacted by economic or other conditions.

 

Given its location in a heavily agricultural section of the state,the Bank has been predominantly an agricultural lender. Accordingly, atpresent, a concentration in agricultural loans exists in the Bank’s portfolio.Recent years have produced increasing trends in agricultural lending as areafarmers have enjoyed several years of adequate rainfall and growing conditionsand as more land has come under irrigation. Despite the increased prevalence ofirrigation farming, weather can have a significant impact on farming yields,and accordingly no assurances can be offered regarding future farmingproduction.

 

When the Bank opened its branch office in Houston, Texas, a secondportfolio concentration developed with loans of one-to-four family residentialreal estate. Approximately $2,100,000 of the Bank’s residential real estateportfolio is comprised of single family residences in Houston. The majority ofthese loans originated between 1996 and 1998 for 15-year terms with fixed ratesof 8.75% or greater. These loans additionally have five-year call provisionsexercisable at the Bank’s discretion.

 

This “book of business” is expected to remain flat or possibly trenddown slightly. The majority of new loan growth is expected to originate fromthe Austin market and reflect a broader, more diverse mix of industries andborrowers. As new loans are generated for non-agricultural and non residentialreal estate purposes, the percentage of the total loan portfolio creating theconcentrations described above will be reduced thereby diminishing undue riskassociated with industry concentration.

 

Management may renew loans at maturity when requested by a customerwhose financial strength appears to support such a renewal or when such arenewal appears to be in the best interest of the Bank. The Bank requirespayment of accrued interest in such instances and may adjust the rate ofinterest, require a principal reduction, or modify other terms of the loan atthe time of renewal.

 

***Loan Maturities***

 

As of June 30, 2004, 41.7% of the loan portfolio consisting ofagricultural, commercial, and real estate loans, or $3,178,000 matures orreprices within one year or less. $4,113,000 of the represented loan portfolio,or 54% are variable rate loans. The following table presents the contractualmaturity ranges for agricultural, commercial, and real estate loans outstandingat June 30, 2004, and also presents for each maturity range the portion ofloans that have fixed 

 

16

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interest rates or interest rates that fluctuate over the life of theloan in accordance with changes in the interest rate environment as representedby the base rate:

 
| ** **              | ** ** | **Due in One Year  or Less** | ** ** | **Due after One Year  Through  Five Years** | ** ** | **Due after  Five Years** | ** ** | ** **         | ** ** |
|-------------------------|------------|------------------------------|------------|---------------------------------------------|------------|---------------------------|------------|--------------------|------------|
| **June 30,  2004** | ** ** | **Fixed  Rate**              | ** ** | **Floating  Rate**                          | ** ** | **Fixed  Rate**           | ** ** | **Floating  Rate** | ** ** | **Fixed  Rate** | ** ** | **Floating  Rate** | ** ** | **Total** | ** ** |
|                    |       |                         |       |                                        |       |                      |       |               |       |   |   |   |   |   |   |
| Agricultural            |       | 64,000                       |       | 1,832,000                                   |       | 8,000                     |       | 660,000            |       | — |   | 207,000 |   | $ | 2,771,000 |   |
| Commercial              |       | 325,000                      |       | 325,000                                     |       | 50,000                    |       | 229,000            |       | — |   | — |   | 929,000 |   |
| Real Estate             |       | 337,000                      |       | 295,000                                     |       | 1,476,000                 |       | 232,000            |       | 1,249,000 |   | 333,000 |   | 3,922,000 |   |
|                         |            |                              |            |                                             |            |                           |            |                    |            |  |  |  |  |  |  |  |

 

As of June 30, 2004, total deposits were $8.8 million whichreflected a net decrease of $309,000 from March 31, 2004. Non-interestbearing deposits decreased by $289,000 while time deposits and other interestbearing deposits decreased by $20,000, accounting for the change.  The Company incurred debt associated with thepurchase of the Bank in the amount of approximately $1,019,000.  These notes, payable to the two largestformer shareholders of the Bank, bear interest at 5% and accelerate to becomedue and payable if and when the Company sells at least $7 million in shares ofits common stock under the public offering.

 

The Bank offers a variety of deposit accounts with a range of interestrates and terms. Core deposits consist of checking accounts (non-interestbearing), “NOW” accounts, savings accounts, and non-public certificates ofdeposit. These deposits, along with public fund deposits and short-termborrowings, are used to support the Bank’s asset base. Deposits are obtainedpredominantly from the geographic trade areas surrounding the Bank’s officelocation. The Bank relies primarily on customer service and long-standingrelationships with customers to attract and retain deposits; however, marketinterest rates and rates offered by competing financial institutionssignificantly affect the Bank’s ability to attract and retain deposits.

 

The following table sets forth the maturities of time deposits $100,000and over at June 30, 2004:

 
| ** **                               | ** ** | **At June 30, 2004** | ** ** |
|------------------------------------------|------------|---------------------------|------------|
|                                     |       |                      |       |
| Time deposits $100,000 and over:         |       |                      |       |
| Maturing within three months             |       | $                         | 504,000    |   |
| After three months but within six months |       | 256,000                   |       |
| After six months but within 12 months    |       | 236,000                   |       |
| Total time deposits $100,000 and over:   |       | $                         | 996,000    |   |

 

The Company borrowed $500,000 from its organizing shareholder onMarch 9, 2004, in conjunction with the acquisition of the Bank.  This amount is represented by a promissorynote bearing interest at a rate of 2.00% per annum.  Any unpaid principal and interest on thisnote will automatically convert to shares of common stock at a price of $8.33per share on March 9, 2005.  Thecash proceeds of this note were used as a capital injection, in cash, to theBank.

 

The Company entered into an Expense Reimbursement Agreement onDecember 8, 2004, with its organizing shareholder with respect to theanticipated costs of the public offering and the pre-opening expenses for theAustin location of the Bank.  Under thisagreement, the organizing shareholder has agreed to pay up to $775,000 of thecosts of the public offering and certain pre-opening expenses incurred afterDecember 8, 2003, and until the termination of the offering.  If and when the Company sells 480,000 sharesof its common stock, the balance incurred under the Agreement will becomepayable.  As of June 30, 2004, costsincurred subject to this agreement were $631,000.

 

Shareholders’ equity was $882,000 on June 30, 2004, compared to $0on September 30, 2003.  The increasein equity is due to the initial capitalization of the Company of approximately$2.3 million net of the cumulative deficit since inception of $1,478,000.  Of the $1,478,000 accumulated deficit,$332,400 was non-cash, 

 

17

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stock-based compensation recognized in conjunction with theorganization of the Company.  Anadditional, $342,000 was incurred prior to organization of the Company by itsorganizing shareholder, primarily in conjunction with the acquisition of theBank.  These costs were included in theinitial capital contribution of the organizing shareholder to the Company.

 

**Results of Operations**

 

The Company acquired the Bank on March 9, 2004, by purchasing 99.92%of the then outstanding common stock of the Bank.  The Company then purchased an additional13,945 shares of the $4.00 par value stock of the Bank, raising its ownershippercentage to 99.94%.  The Companycurrently has no other operating history. The Company received notification from the Securities and Exchange Commissionon May 7, 2004, as to the effectiveness of its registration to sell shares ofcommon stock, at $8.33 per share, to raise up to $12,000,000.  The proceeds of the public offering areintended primarily to increase the capital of the Bank to permit the relocationof the Bank’s charter to Austin, Texas. As a result, the Company is currently incurring substantial pre-openingcosts related to the future relocation.

 

The following discussion provides information about the majorcomponents of the financial condition, results of operations, asset quality,liquidity and capital resources of Treaty Oak Bancorp.  The discussion and analysis should be read inconjunction with the Consolidated Financial Statements.

 

Net loss for the three months ended June 30, 2004, was $501,000compared to $47,000 for the three months ended June 30, 2003.  Net loss for the nine months endedJune 30, 2004, was $1,260,000 compared to $147,000 for the nine monthsended June 30, 2003.  These lossesare directly attributable to various phases of development.

 

Total interest income for the three and nine months ended June 30,2004, was $209,000 and $258,000 respectively, which is primarily attributableto the acquisition of the Bank and its operations since acquisition onMarch 9, 2004.  Interest expense forthe same periods was $48,000  and $60,000respectively, resulting in net interest income for the three months endedJune 30, 2004 of $161,000 (or 77% of total interest income), and $198,000(or 76.7% of total interest income) for the nine months ended June 30,2004.  There was no interest incomeearned or interest expense incurred for the three and nine months endedJune 30, 2003.

 

Non-interest income for the three and nine months ended June 30,2004, was $14,000 and $19,000 and resulted primarily from services fees andcharges on deposit accounts.  Noninterestexpenses for the three months ended June 30, 2004, were $676,000 andincluded salaries and payroll related expenses of $302,000.  Pre-opening costs, in addition to certainpre-opening salaries, were $336,000.  Forthe nine months ended June 30, 2004, the non-cash stock based compensationexpense of $332,000 and internally generated acquisition costs of $156,000accounted for substantially all of the additional loss incurred over that ninemonth period ended June 30, 2004. For the three and nine months ended June 30, 2003, the Companyincurred $47,000 and $147,000 of acquisition related costs accounting for thenet losses for those periods.

 

The provision for loan losses is an expense determined by management asthe amount necessary to increase the allowance for loan losses after netcharge-offs have been deducted to a level that, in management’s best estimate,is necessary to absorb probable losses in the loan portfolio. The amount of theprovision is based on management’s review of the loan portfolio and considerationof such factors as historical loss experience, general prevailing economicconditions, changes in the size and composition of the loan portfolio andspecific borrower considerations, including the ability of the borrower torepay the loan and the estimated value of the underlying collateral. Theprovision is calculated monthly and a charge to expense is made, as required,to increase the allowance to the calculated level. For any particular month, inthe event the required allowance is less than or equal to the currentallowance, no expense is charged or reversed.

 

Our management does not have specific experience with the loanportfolio of the Bank, although we have thoroughly analyzed such loan portfolioin connection with the acquisition of the Bank. Further, given that we will beestablishing the primary location of the Bank in Austin, rather than Texline,we anticipate the majority of new loan growth to come from this new marketwhere the Bank does not have the benefit of specific loan performance fromwhich 

 

18

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to base future forecasts or projections. Management will continue tocalculate the monthly provision to the loan loss reserve using current methodsemployed by the Bank.

 

**Asset Quality**

 

The allowance for loan losses is a reserve against losses in the loanportfolio that is calculated monthly based upon a specific reserve and ageneral allocation as described herein. Increases to the allowance are made bycharging the expense, Provision for Loan Losses.  We believe the accounting policies governingthe allowance for loan losses are critical to the portrayal and understandingof the Bank’s financial condition and its results of operations.

 

Loans subject to specific allocations to the allowance for loan lossesare loans that have generally first been placed on the Bank’s “WatchList.”  The fact that a loan is placed onthe Watch List does not necessarily indicate that the Bank has experienced aproblem with the loan but indicates that the Bank has had some indication thatthe loan may become a problem loan.  TheBank and the regulators each, independently, perform review of the Bank’sloans.  The regulators (the TexasDepartment of Banking and the FDIC) will generally specifically review eachloan on the Bank’s Watch List and a random sampling of other loans aswell.  As a result of these examinations,the regulators may place additional loans on the Watch List.  There are a variety of factors influencingthe Bank’s decision to place a loan on the Watch List. Factors other than afailure to make one or more payments, which may result in a loan being includedon the Watch List include a general economic trend impacting a concentration ofloans such as adverse trends in agriculture, a declining trend in a particular banking customer’s deposits, negativetrends in financial statements which are provided on a routine basis forbusiness loans, and in a rural community such as Texline, Texas, personalknowledge of the existence of a financial hardship to a customer by one of theBank’s officers is not uncommon.  Thus tosome degree, a category of loans, such as agricultural loans, may be separatelyreviewed based upon known additional risks to which the category may besubject.  Placement of a loan on theWatch List from any of these factors may be the result of a determination bythe board of directors, bank management, the servicing officer, or by thebanking regulators during their periodic examinations of the Bank.

 

Through this process the Bank addresses the particular risks inherentin different concentrations of loans. Historically, the Bank’s allowance has been adequate to absorb thelosses experienced by the Bank.

 

Once a loan is placed on the Watch List it may be classified as“Watch,” “Substandard,” “Doubtful,” or “Loss.” These classifications are also based on numerous factors but these aregeneral groupings of the loans that receive different levels of scrutiny andhave different methods for determining whether a specific reserve should bemade for each loan applied to them. If a loan is classified as a “Watch,” thenit merely indicates that circumstances exist that may, but have not yet,jeopardized the collection of the loan. These loans generally do not have a specific reserve charged againstthem but are instead subject to the historical loss percentage discussed below.

 

Substandard loans are those loans that are considered to have somedeficiency relative to loans generally considered to be of acceptable loanquality (be it cash flow, collateral value, or otherwise) but that are notspecifically considered to have loss exposure. Each such loan is considered separately, and allocations range from 15%to 0% on some loans within the classification. Factors such as collectibility,collateral values, borrower strength, and past due status may influence theamount of reserve to be specifically allocated. A 0% specific reserve may occurwhen a loan is classified as substandard but is fully collateralized withcollateral such as a certificate of deposit held by the Bank.

 

As of June 30, 2004, and September 30, 2003, the Bank had$535,000 and $997,000, respectively, in Substandard or Doubtful loans withspecific reserves of $56,000 and $93,000, respectively.  Loss loans totaled $0 and $2,934 as ofJune 30, 2004, and September 30, 2003, respectively. Loans classifiedas “loss” also have specific allocations of 100% of loan principal balance.

 

A historical loss percentage is applied to the balance of the loanportfolio, including those loans on the Watch List for which there has been nospecific reserve and excluding loans secured by cash on deposit and loans thatare guaranteed by governmental agencies. At September 30, 2003, thispercentage was 1.208% which is based upon the actual historical loss experienceof the Bank over the past five (5) years and was mandated by the regulators.This 

 

19

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percentage was 1.0% as of June 30, 2004 and was based uponcalculations performed during the last Texas Department of Banking examination.

 

After the required reserve has been calculated by adding together thespecific reserves and the general allocation discussed above, the currentbalance in the allowance for loan losses is compared to the calculated requiredallowance and to the extent an addition is necessary, the allowance isincreased by a charge to expense through the provision for loan losses.

 

The amount of the allowance represents the cumulative total of theprovisions made from time to time, reduced by loan charge-offs and increased byrecoveries of loans previously charged-off.

 

Credit and loan decisions are made by management and the board ofdirectors in conformity with loan policies established by the board ofdirectors. The Bank’s practice is to charge-off any loan or portion of a loanwhen the loan is determined by management to be uncollectible due to theborrower’s failure to meet repayment terms, the borrower’s deteriorating ordeteriorated financial condition, the depreciation of the underlyingcollateral, the loan’s classification as a loss by regulatory examiners, orother reasons

 

The allowance for loan losses as of June 30, 2004, was $171,000 or2.09% of outstanding loans.  There wereno net charge-offs for the period from March 31, 2004 to June 30,2004.  While management uses allavailable information to recognize losses on loans, future additions to theallowance may be necessary based on changes in economic conditions.  The regulatory agencies (the FDIC and theTexas Department of Banking), as part of their regular examinations of theBank, periodically review the allowance for loan losses and the Bank’s loanportfolio in general.  These agencies mayrequire the Company to recognize additions to the allowance based upon theirjudgments about information available at the time of their examinations.

 

Nonperforming assets, which consist of nonaccrual loans, loans 90 daysor more past due, and other real estate owned, were 457,000 as of June 30,2004.  Management does not expect toincur any material mosses related to nonperforming assets.

 

The following table sets forth the amount of non-performing loans andnon-performing assets at the dates indicated:

 
| ** **                                               | ** ** | **At June 30,** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **2004**             | ** ** | **2003** | ** ** |
| Non-accruing loans                                       |       | $                    | 64,000     |   | 483,000 |   |
| Loans 90 days or more past due, still  accruing interest |       | 343,000              |       | 1,000 |   |
| Total non-performing loans                               |       | 407,000              |       | 484,000 |   |
| Other real estate owned                                  |       | 43,000               |       | 15,000 |   |
| Other repossessed assets                                 |       | 7,000                |       | 11,000 |   |
| Total non-performing assets                              |       | $                    | 457,000    |   | 510,000 |   |
|                                                     |       |                 |       |   |   |
| Total non-performing loans to total loans                |       | 4.97                 | %          | 5.22 | % |
| Allowance for loan losses to non-performing  loans       |       | 42.01                | %          | 45.45 | % |
| Total non-performing assets to total assets              |       | 3.78                 | %          | 4.37 | % |

 

**Liquidity**

 

In determining the Company’s liquidity requirements, management reviewsboth sides of the balance sheet to ensure that adequate funding sources areavailable to support loan growth, deposit withdrawals and unanticipated needsfor funds.

 

20

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The Bank’s liquidity management will be monitored by theAsset/Liability Management Committee and the Board of Directors, who willreview historical funding requirements, current liquidity position, sources andstability of funding, marketability of assets, options for attractingadditional funds, and anticipated future funding needs, including the level ofunfunded commitments.

 

The Bank’s primary sources of funds will be retail and commercialdeposits, loan and securities repayments, other short-term borrowings, andother funds provided by operations. While scheduled loan repayments andmaturing investments are relatively predictable, deposit flows and early loanprepayments are more influenced by interest rates, general economic conditions,and competition. The Bank will maintain investments in liquid assets based uponmanagement’s assessment of (1) the need for funds, (2) expecteddeposit flows, (3) yields available on short-term liquid assets, and(4) objectives of the asset/liability management program. We anticipateeliminating the need for borrowed funds upon infusion of additional cash andcash equivalents.

 

In the event that additional short-term liquidity is needed, the Bankwill retain established relationships created by the Bank with several largeregional banks. For example, the Bank has an existing correspondent bankingrelationship with Plains Capital Bank in Lubbock, Texas. Texline has utilizedthis relationship as a source of liquidity in the past, and we expect toutilize the facility going forward if needed. Also, the Bank has been afrequent borrower from the Federal Home Loan Bank in the past and at present.In the current rate environment where rates on these funds are at historicallows, the Bank has relied upon this source as an alternative to attracting moreexpensive deposit funds that would carry a slightly higher interest cost. Whilewe do not intend to rely as heavily on Fed Funds as has the Bank (we intend torepay these funds from the capital raised from the public offering assuming weraise at least $6,000,000), the source will remain available to the Bank goingforward.

 

Through Treaty Oak Holdings, Inc., the Company’s organizingshareholder, the Bank has an existing line of credit with The IndependentBanker’sBank (TIB) in the amount of $950,000, which was fully drawn as ofJune 30, 2004.

 

**Capital Resources**

 

The Company’s capital position provides support for anticipate assetgrowth and for the absorption of the anticipated losses.

 

The Bank’s Tier 1 capital position as of June 30, 2004, was$1,332,000 or 19.1% of risk weighted assets. Total risk based capital was $1,420,000 or 20.4% of risk weightedassets.

 

Tier 1 capital consists primarily of common shareholders’ equity, whilerisk-based capital includes the allowance for loan losses.  Risk weighted assets are determined byassigning various levels of risk to different categories of assets andoff-balance sheet activities.  Undercurrent risk-based capital standards, all banks are required to have Tier 1capital of at least 4% and total capital of 8%.

 

In addition, to the risk based capital guidelines, banking regulatoryagencies have adopted leverage capital ratio requirements.  The leverage ratio – or core capital toassets ratio – works in conjunction with the risk capital guidelines.  The minimum leverage ratios range from threeto five percent.  At June 30, 2004,the Bank’s leverage capital ratio was 12.11%.

 

21

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**A Warning About Forward-Looking Statements**

 

This Form 10-QSB contains forward-looking statements.  The Company may also make writtenforward-looking statements in periodic reports to the Securities and ExchangeCommission, proxy statements, offering circulars and prospectuses, pressreleases and other written materials and oral statements made by Treaty OakBancorp’s officers, directors or employees to third parties.  Statements that are not historical facts,including statements about the companies beliefs and expectations, areforward-looking statements.  Thesestatements are based on beliefs and assumptions of the Company’s management andupon the information currently available to management.  Forward-looking statements include statementspreceded or followed by, or that include, the words “believes,” “expects,”“estimates,” “anticipates,” “plans,” or other similar words orexpressions.  Forward-looking statementsspeak only as of the date they are made and the Company does not actively seekto update these statements for new information or future events.

 

Forward-looking statements involve inherent risks anduncertainties.  Management cautionsreaders that many factors could cause actual results to materially differ fromthose contained in any forward-looking statement.  Such factors include, but are not limited to,the following: changes in the interest rate environment may reduce interestmargins; general economic or business conditions can cause fluctuations incredit demand or a deterioration in credit quality; legislative or regulatorychanges, including changes in accounting standards can adversely affect thebanking industry; competition in the banking industry or in the market in whichthe Company does now or intends to operate may increase significantly;competitors may have greater financial resources to develop new products or servicesthan the Company.

 

Management believes that these forward looking statements arereasonable; however, undue reliance should not be placed on theseforward-looking statements, which are based upon current expectation.

 

Forward-looking statements are not guarantees of performance.  They involve risks, uncertainties andassumptions.  The future results andshareholder values may differ materially from those expressed in forward-lookingstatements.  Many of the factors thatwill determine these results and values are beyond the Company’s ability tocontrol or predict.

 

**Item 3.****                                                           *Controls and Procedures***

 

With the participation of management, theCompany’s chief executive officer and chief financial officer reviewed andevaluated the Company’s disclosure controls and procedures as defined in Rules13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”), as of a date within 90 days prior to the filing of thisreport.  Based on this evaluation, thechief executive officer and chief financial officer concluded that thedisclosure controls and procedures are effective in bringing to their attentionon a timely basis information relating to the Company and its consolidatedsubsidiaries in connection with the Company’s filing of its quarterly report onForm 10-QSB for the period ended June 30, 2004.  There have been no significant changes in theCompany’s internal controls for financial reporting or in other factors thatcould significantly affect these controls, including any significantdeficiencies or material weaknesses of internal controls that would requirecorrective action.  In connection withthe new rules, the Company is currently in the process of further reviewing anddocumenting its disclosure controls and procedures, including its internalaccounting controls, and may from time to time make changes aimed at enhancingtheir effectiveness and ensuring that the Company’s systems evolve with itsbusiness.

 

**PART II.****                                                Other Information**

 

**Item 1.****                                                           *Legal Proceedings***

 

The Company has no pending legal proceedings as ofJune 30, 2004.  From time to time,the Company’s subsidiary is involved in various legal proceedings arising inthe ordinary course of business.  Theseactions are not believed to be material either individually or collectively tothe consolidated financial condition of the Company or its subsidiary.

 

22

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**Item 2.****                                                           *Changes in Securities and Use of Proceeds***

 

On May 7, 2004, the Securities and Exchange Commission declared theCompany’s Registration Statement on Form SB-2 (File No. 333-112325) effectiveunder the Securities Act of 1933, as amended, and the Company commenced itspublic stock offering at such time.  TheCompany is offering (on a best efforts basis with no underwriters) to sell upto a maximum of 1,440,000 shares of its Common Stock at a purchase price of$8.33 per share with a minimum offering of 360,000 shares.  For every five shares an investor purchases,such investor receives a warrant to purchase an additional share of theCompany’s common stock for a purchase price of $10.00 per share.  The warrants will be exercisable untilJune 30, 2007.  The offering willexpire on September 30, 2004.

 

On August 9, 2004, the Company received $3,163,576 in grossproceeds released from escrow under the offering with respect to the sale of379,781 shares of the Company’s common stock. For the period from May 7, 2004, to June 30, 2004, expenses inconnection with the issuance and distribution of the common stock were insignificant.

 

## **Item 3.**                                                           *Defaults Upon Senior Securities*

 

## **None.**

## ** **

## **Item 4.**                                                           *Submission of Matters to a Voteof Security Holders*

 

## **On May20, 2004, the Company**held its annual meeting of shareholders.  Holdersof 1,030,000 of the 1,040,000 outstanding shares of Common Stock were inattendance at the meeting and voted unanimously to elect the followingdirectors.

## ** **

Class I (terms expire at 2005 annualmeeting):  Charles T. Meeks, Marvin L.Schrager, and Arthur                   H.Coleman

 

Class II (terms expire at 2006 annual meeting):  Jeffrey L. Nash, Toni A. Neal, and Hayden D.Watson

 

Class III (terms expire at 2007 annual meeting):  Terry W. Hamann, William J. McLellan, andCarl J. Stolle

 

There were no abstentions or broker non-votes.

 

**Item 5.****                                                           *Other Information***

 

The Company had anticipated that Hayden D. Watson, a member of the Audit Committee of the Company’s board of directors, would qualify as an “independent audit committee financial expert.”  The Company has since determined that Mr. Watson will not so qualify.  As a result, the Audit Committee does not have a designated audit committee financial expert. The Board of Directors and each of the members of the Audit Committee believe that the Audit Committee as presently comprised thoroughly and adequately performs its primary functions without a member designated as an audit committee financial expert. However, as the Company’s operations expand in the future, the Board and the Audit Committee will seek to add a member that is qualified to serve as an audit committee financial expert.

 

**Item 6.****                                                           *Exhibits and Reports on Form 8-K***

 

a.               Exhibits

 
| 3.1*   |   | Amended and Restated Articles of Incorporation              |
|--------|--------|-------------------------------------------------------------|
|   |   |                                                        |
| 3.2*   |   | By-laws                                                     |
|   |   |                                                        |
| 4.1*   |   | Specimen Common Stock Certificate, $.01 par value per share |

 

23

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| 4.2*   |   | See Exhibits 3.1 and 3.2 for provisions of the Articles of  Incorporation and By-laws defining rights of holders of Common Stock                                                                                                                                    |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                |
| 10.1*  |   | Building Lease between PGI Equity Partners, L.P., and Treaty Oak Bank  (Opening Soon)                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                |
| 10.2*  |   | Expense Reimbursement Agreement between Treaty Oak Holdings, Inc.,  and Treaty Oak Bancorp, Inc.                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                |
| 10.3*  |   | Form of Promotional Shares Lock—In Agreement                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                |
| 10.4*  |   | Form of Escrow Agreement between Treaty Oak Bancorp, Inc., and  TIB–The Independent BankersBank                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                |
| 10.5*  |   | Form of Treaty Oak Bancorp Shareholders’ Warrant Agreement                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                |
| 10.6*  |   | Treaty Oak Bancorp, Inc., 2004 Stock Incentive Plan (Amended and  Restated as of April 12, 2004)                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                |
| 10.7*  |   | Form of Indemnification Agreement between Treaty Oak Bancorp, Inc.,  and its Directors and Officers, and those of the Bank                                                                                                                                          |
| 10.8*  |   | Registration Rights Agreement between Treaty Oak Bancorp, Inc., and  Treaty Oak Holdings, Inc.                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                |
| 10.9*  |   | Stock Purchase Agreement dated June 20, 2003 (as amended on  November 26, 2003), by and among Texline State Bank, Charles T. Meeks,  certain shareholders of Texline State Bank, and Treaty Oak Bancorp, Inc. (as  assignee of Treaty Oak Holdings, Inc.) |
|   |   |                                                                                                                                                                                                                                                                |
| 10.10  |   | Amended and Restated Promissory Note dated March 9, 2004,  between Treaty Oak Holdings, Inc., and Treaty Oak Bancorp, Inc.                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                |
| 31.1   |   | Certification of Chief Executive Officer required by Rule  13a-14(a)/15d-14(a) under the Exchange Act                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                |
| 31.2   |   | Certification of Chief Financial Officer required by Rule  13a-14(a)/15d-14(a) under the Exchange Act                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                |
| 32.1   |   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley  Act of 2002                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                |
| 32.2   |   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley  Act of 2002                                                                                                           |

 

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*                                         Incorporatedby reference to the same numbered exhibit to the Company’s RegistrationStatement on Form SB-2 (File No. 333-112325).

 

b.              Current Reports on Form 8-K

 

There were no reports on Form 8-K filed during the three months endedJune 30, 2004.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 
|                        | **TREATY OAK BANCORP, INC.** |
|-----------------------------|------------------------------|
|                        |                         |
|                        |                         |
| Dated: August 13, 2004 | By:                          | /s/ Terry W. Hamann |   |
|                        |                         | Terry W. Hamann, President and Chief Executive Officer |
|                        |                         |   |
|                        |                         |   |
|                        | By:                          | /s/ Sandra L. Ellsworth |   |
|                        |                         | Sandra L. Ellsworth, Chief Financial Officer |

 

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