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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the Quarterly Period Ended June 30, 2006



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 000-28342



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VALLEY FINANCIAL CORPORATION



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|                         |  |                                    
|------------------------ |  | -----------------------------------
|VIRGINIA                 |  | 54-1702380                         
|(State of Incorporation) |  | (I.R.S. EmployerIdentification No.)

36 Church Avenue, S.W.

Roanoke, Virginia 24011

(Address of principal executive offices)

(540) 342-2265

(Issuers telephone number, including area code)



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Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months
(or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated and large accelerated filer in Rule 12b-2 of the
Exchange Act. (Check one):

Large accelerated filer ̈Accelerated filer ̈Non-accelerated
filer  x

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

Transitional small business disclosure format:    Yes ̈No  x.

At August 14, 2006, 4,108,493 shares of common stock, no par value, of the registrant were outstanding.



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

FORM 10-Q

June 30, 2006

TABLE OF CONTENTS



|                                                                    |  |    |  | 
|------------------------------------------------------------------- |  | -- |  | 
|Part I. FINANCIAL INFORMATION                                       |  |   
|                                                                    | 
|Item 1.
Financial Statements                                        |  |   
|                                                                    | 
|Consolidated Balance Sheets                                         |  | 4 
|                                                                    | 
|Consolidated Statements of Income                                   |  | 5 
|                                                                    | 
|Consolidated Statements of Cash Flows                               |  | 6 
|                                                                    | 
|Notes to Consolidated Financial Statements                          |  | 7 
|                                                                    | 
|Item 2.
Managements Discussion and Analysis                        |  | 17
|                                                                    | 
|Item 3.
Quantitative and Qualitative Disclosures about Market Risk  |  | 33
|                                                                    | 
|Item 4.
Controls and Procedures                                     |  | 34
|                                                                    | 
|Part II. OTHER INFORMATION                                          |  |   
|                                                                    | 
|Item 1.
Legal Proceedings                                           |  | 34
|                                                                    | 
|Item 1A.
Risk Factors                                               |  | 34
|                                                                    | 
|Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds |  | 35
|                                                                    | 
|Item 3.
Defaults Upon Senior Securities                             |  | 35
|                                                                    | 
|Item 4.
Submission of Matters to a Vote of Security Holders         |  | 35
|                                                                    | 
|Item 5.
Other Information                                           |  | 35
|                                                                    | 
|Item 6.
Index to Exhibits                                           |  | 36
|                                                                    | 
|SIGNATURES                                                          |  | 39
|                                                                    | 
|CERTIFICATIONS                                                      |  |   



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Cautionary Statement Regarding Forward-Looking Statements

This report contains statements concerning the Companys expectations, plans, objectives, future financial performance and other statements that are
not historical facts. These statements may constitute forward-looking statements as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management and risks and
uncertainties. Actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not
limited to, changes in:



| | 1. | interest rates
| | -- | --------------



| | 2. | general economic conditions, either nationally or regionally
| | -- | ------------------------------------------------------------



| | 3. | the legislative/regulatory climate
| | -- | ----------------------------------



| | 4. | monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board
| | -- | --------------------------------------------------------------------------------------------------------------------------



| | 5. | demand for loan products
| | -- | ------------------------



| | 6. | deposit flows
| | -- | -------------



| | 7. | competitive pressures among depository and other financial institutions
| | -- | -----------------------------------------------------------------------



| | 8. | demand for financial services in our market area
| | -- | ------------------------------------------------



| | 9. | technology and
| | -- | --------------



| | 10. | accounting principles, policies and guidelines.
| | --- | -----------------------------------------------

These risks and
uncertainties should be considered in evaluating the forward-looking statements contained herein. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.



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##### Table of Contents

PART 1  FINANCIAL INFORMATION

Item 1. Financial Statements.

VALLEY FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                             |  | (Unaudited)6/30/06 |         |   | (Audited)12/31/05 |  
|Assets                                                                                                                                                       |  |                    |         |   |                   |   |         |  
|Cash and due from banks                                                                                                                                      |  | $                  | 9,956   |   |                   | $ | 9,746   |  
|Interest-bearing deposits in banks                                                                                                                           |  |                    | 123     |   |                   |   | 336     |  
|Securities available-for-sale                                                                                                                                |  |                    | 35,200  |   |                   |   | 33,206  |  
|Securities held-to-maturity (approximate market values of $19,745 at June 30, 2006 and $20,524 at December 31, 2005)                                         |  |                    | 20,443  |   |                   |   | 20,796  |  
|Restricted equity securities                                                                                                                                 |  |                    | 5,046   |   |                   |   | 3,987   |  
|Loans, net of allowance for loan losses of $4,832 at June 30, 2006 and $4,124 at December 31, 2005                                                           |  |                    | 444,507 |   |                   |   | 410,253 |  
|Premises and equipment, net                                                                                                                                  |  |                    | 6,976   |   |                   |   | 6,590   |  
|Bank owned life insurance                                                                                                                                    |  |                    | 10,894  |   |                   |   | 8,950   |  
|Accrued interest receivable                                                                                                                                  |  |                    | 2,433   |   |                   |   | 2,073   |  
|Other assets                                                                                                                                                 |  |                    | 3,672   |   |                   |   | 3,012   |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Total assets                                                                                                                                                 |  | $                  | 539,250 |   |                   | $ | 498,949 |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Liabilities and Shareholders Equity                                                                                                                         |  |                    |         |   |                   |   |         |  
|Liabilities:                                                                                                                                                 |  |                    |         |   |                   |   |         |  
|Noninterest- bearing deposits                                                                                                                                |  | $                  | 22,475  |   |                   | $ | 19,466  |  
|Interest-bearing deposits                                                                                                                                    |  |                    | 372,235 |   |                   |   | 345,850 |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Total deposits                                                                                                                                               |  |                    | 394,710 |   |                   |   | 365,316 |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Federal funds purchased and securities sold under agreements to repurchase                                                                                   |  |                    | 23,698  |   |                   |   | 27,829  |  
|Short-term borrowings                                                                                                                                        |  |                    | 15,000  |   |                   |   | 23,000  |  
|Long-term borrowings                                                                                                                                         |  |                    | 58,000  |   |                   |   | 37,000  |  
|Guaranteed preferred beneficial interests in the Companys junior subordinated debentures                                                                    |  |                    | 11,341  |   |                   |   | 11,341  |  
|Accrued interest payable                                                                                                                                     |  |                    | 3,033   |   |                   |   | 2,129   |  
|Other liabilities                                                                                                                                            |  |                    | 1,724   |   |                   |   | 1,619   |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Total liabilities                                                                                                                                            |  |                    | 507,506 |   |                   |   | 468,234 |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Commitments and other contingencies                                                                                                                          |  |                    |        |   |                   |   |        |  
|                                                                                                                                                             |  |                   
|Shareholders equity:                                                                                                                                        |  |                    |         |   |                   |   |         |  
|Preferred stock, no par value. Authorized 10,000,000 shares; none issued and outstanding                                                                     |  |                    |        |   |                   |   |        |  
|Common stock, no par value. Authorized 10,000,000 shares; issued and outstanding 4,108,493 at June 30,2006, and 4,076,993 at
December 31, 2005, respectively |  |                    | 17,193  |   |                   |   | 16,981  |  
|Retained earnings                                                                                                                                            |  |                    | 15,633  |   |                   |   | 14,181  |  
|Accumulated other comprehensive income (loss)                                                                                                                |  |                    | (1,082  | ) |                   |   | (447    | )
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Total shareholders equity                                                                                                                                   |  |                    | 31,744  |   |                   |   | 30,715  |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  
|Total liabilities and shareholders equity                                                                                                                   |  | $                  | 539,250 |   |                   | $ | 498,949 |  
|                                                                                                                                                             |  |                    |         |   |                   |   |         |  

See accompanying notes to consolidated financial statements.



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VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except
share and per share data)



|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|------------------------------------------------------------ |  | -------------- | --------- | -------------- | - | --------- |  | - | --------- | - |  | - | ---------
|                                                             |  | 3 Months Ended |           | 6 Months Ended
|                                                             |  | 6/30/06        |           | 6/30/05        |   | 6/30/06   |  |   | 6/30/05  
|Interest Income:                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Interest and fees on loans                                   |  | $              | 7,779     |                | $ | 5,002     |  | $ | 14,983    |   |  | $ | 9,281    
|Interest on securities - taxable                             |  |                | 518       |                |   | 540       |  |   | 1,002     |   |  |   | 1,124    
|Interest on securities - nontaxable                          |  |                | 137       |                |   | 150       |  |   | 275       |   |  |   | 309      
|Interest on deposits in banks                                |  |                | 2         |                |   | 37        |  |   | 7         |   |  |   | 59       
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Total interest income                                        |  |                | 8,436     |                |   | 5,729     |  |   | 16,267    |   |  |   | 10,773   
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Interest Expense:                                            |  |                |           |                |   |           |  |   |           |   |  |   |          
|Interest on deposits                                         |  |                | 3,270     |                |   | 1,840     |  |   | 6,193     |   |  |   | 3,338    
|Interest on short-term borrowings                            |  |                | 333       |                |   | 113       |  |   | 632       |   |  |   | 225      
|Interest on long-term borrowings                             |  |                | 402       |                |   | 392       |  |   | 790       |   |  |   | 781      
|Interest on guaranteed preferred beneficial interests in the |  |                |           |                |   |           |  |   |           |   |  |   |          
|Companys junior subordinated debentures                     |  |                | 196       |                |   | 63        |  |   | 379       |   |  |   | 120      
|Interest on federal funds purchased and securities sold      |  |                |           |                |   |           |  |   |           |   |  |   | 42       
|under agreements to repurchase                               |  |                | 304       |                |   | 60        |  |   | 545       |   |  |   | 102      
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Total interest expense                                       |  |                | 4,505     |                |   | 2,468     |  |   | 8,539     |   |  |   | 4,566    
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Net interest income                                          |  |                | 3,931     |                |   | 3,261     |  |   | 7,728     |   |  |   | 6,207    
|                                                             |  |                |           |               
|Provision for loan losses                                    |  |                | 119       |                |   | 401       |  |   | 706       |   |  |   | 725      
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Net interest income after provision for loan losses          |  |                | 3,812     |                |   | 2,860     |  |   | 7,022     |   |  |   | 5,482    
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Noninterest Income:                                          |  |                |           |                |   |           |  |   |           |   |  |   |          
|Service charges on deposit accounts                          |  |                | 234       |                |   | 235       |  |   | 447       |   |  |   | 445      
|Realized gains (losses) on sale of securities                |  |                |          |                |   | 52        |  |   | (1        | ) |  |   | 53       
|Income earned on bank owned life insurance                   |  |                | 129       |                |   | 76        |  |   | 244       |   |  |   | 152      
|Other income on real estate loans                            |  |                | 29        |                |   | 30        |  |   | 58        |   |  |   | 46       
|Other income                                                 |  |                | 134       |                |   | 47        |  |   | 234       |   |  |   | 76       
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Total noninterest income                                     |  |                | 526       |                |   | 440       |  |   | 982       |   |  |   | 772      
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Noninterest Expense:                                         |  |                |           |                |   |           |  |   |           |   |  |   |          
|Compensation expense                                         |  |                | 1,531     |                |   | 1,169     |  |   | 3,016     |   |  |   | 2,213    
|Occupancy expense                                            |  |                | 170       |                |   | 148       |  |   | 327       |   |  |   | 296      
|Equipment expense                                            |  |                | 129       |                |   | 112       |  |   | 264       |   |  |   | 224      
|Data processing expense                                      |  |                | 155       |                |   | 145       |  |   | 307       |   |  |   | 275      
|Advertising and marketing expense                            |  |                | 71        |                |   | 60        |  |   | 155       |   |  |   | 124      
|Audit fees                                                   |  |                | 73        |                |   | 78        |  |   | 146       |   |  |   | 151      
|Franchise and purchased tax credit expense                   |  |                | 67        |                |   | 46        |  |   | 134       |   |  |   | 93       
|Business manager                                             |  |                | 67        |                |   | 69        |  |   | 128       |   |  |   | 140      
|Deposit expense                                              |  |                | 62        |                |   | 49        |  |   | 161       |   |  |   | 102      
|Loan expenses                                                |  |                | 56        |                |   | 64        |  |   | 111       |   |  |   | 107      
|Computer software                                            |  |                | 105       |                |   | 69        |  |   | 188       |   |  |   | 137      
|Other expense                                                |  |                | 366       |                |   | 302       |  |   | 636       |   |  |   | 500      
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Total noninterest expense                                    |  |                | 2,852     |                |   | 2,311     |  |   | 5,573     |   |  |   | 4,362    
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Income before income taxes                                   |  |                | 1,486     |                |   | 989       |  |   | 2,431     |   |  |   | 1,892    
|                                                             |  |                |           |               
|Income tax expense                                           |  |                | 446       |                |   | 267       |  |   | 691       |   |  |   | 500      
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Net income                                                   |  | $              | 1,040     |                | $ | 722       |  | $ | 1,740     |   |  | $ | 1,392    
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Earnings per share                                           |  |                |           |                |   |           |  |   |           |   |  |   |          
|Basic earnings per share                                     |  | $              | 0.25      |                | $ | 0.18      |  | $ | 0.43      |   |  | $ | 0.34     
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Diluted earnings per share                                   |  | $              | 0.25      |                | $ | 0.17      |  | $ | 0.41      |   |  | $ | 0.33     
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Weighted average shares                                      |  |                | 4,107,593 |                |   | 4,074,630 |  |   | 4,093,413 |   |  |   | 4,074,630
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          
|Diluted average shares                                       |  |                | 4,216,423 |                |   | 4,261,471 |  |   | 4,199,448 |   |  |   | 4,266,276
|                                                             |  |                |           |                |   |           |  |   |           |   |  |   |          

See accompanying notes to consolidated financial statements.



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VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands, except
share and per share data)



|                                                                                                  |  |                |         |   |         |   |         |  
|------------------------------------------------------------------------------------------------- |  | -------------- | ------- | - | ------- | - | ------- | -
|                                                                                                  |  | 6 Months Ended |        
|                                                                                                  |  | 6/30/06        |         |   | 6/30/05 |  
|Cash flows from operating activities                                                              |  |                |         |   |         |   |         |  
|Net income                                                                                        |  | $              | 1,740   |   |         | $ | 1,392   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                 |  |                |         |   |         |   |         |  
|Provision for loan losses                                                                         |  |                | 706     |   |         |   | 725     |  
|Depreciation and amortization                                                                     |  |                | 369     |   |         |   | 336     |  
|Stock option expense                                                                              |  |                | 80      |   |         |   |        |  
|Deferred income tax                                                                               |  |                | (449    | ) |         |   |        |  
|Net (gains)/ losses on sale of securities                                                         |  |                | 1       |   |         |   | (53     | )
|Amortization (accretion) of bond premiums/discounts                                               |  |                | 88      |   |         |   | 101     |  
|Increase in interest receivable                                                                   |  |                | (360    | ) |         |   | (264    | )
|Increase in other assets                                                                          |  |                | (234    | ) |         |   | (338    | )
|Increase in value of life insurance contracts                                                     |  |                | (244    | ) |         |   | (152    | )
|Increase (decrease) in accrued interest payable                                                   |  |                | 904     |   |         |   | 257     |  
|Increase (decrease) in other liabilities                                                          |  |                | (67     | ) |         |   | (178    | )
|                                                                                                  |  |                |         |   |         |   |         |  
|Net cash provided by operating activities                                                         |  |                | 2,534   |   |         |   | 1,826   |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Cash flows from investing activities                                                              |  |                |         |   |         |   |         |  
|(Increase) decrease in interest- bearing deposits in banks                                        |  |                | 213     |   |         |   | (3,248  | )
|Purchases of premises and equipment                                                               |  |                | (733    | ) |         |   | (702    | )
|Purchases of securities available-for-sale                                                        |  |                | (5,694  | ) |         |   | (216    | )
|Purchases of securities held-to-maturity                                                          |  |                |        |   |         |   | (215    | )
|Purchases of restricted equity securities                                                         |  |                | (1,284  | ) |         |   | (216    | )
|Proceeds from sales/calls/paydowns/maturities of securities available-for-sale                    |  |                | 3,191   |   |         |   | 10,155  |  
|Proceeds from paydowns on securities held-to-maturity                                             |  |                | 308     |   |         |   | 562     |  
|Principal repayments of restricted equity securities                                              |  |                | 225     |   |         |   | 315     |  
|Purchase of bank owned life insurance                                                             |  |                | (1,700  | ) |         |   |        |  
|Increase in loans, net                                                                            |  |                | (34,960 | ) |         |   | (54,886 | )
|                                                                                                  |  |                |         |   |         |   |         |  
|Net cash used in investing activities                                                             |  |                | (40,434 | ) |         |   | (48,451 | )
|                                                                                                  |  |                |         |   |         |   |         |  
|Cash flows from financing activities                                                              |  |                |         |   |         |   |         |  
|Increase in noninterest-bearing deposits                                                          |  |                | 3,009   |   |         |   | 6,816   |  
|Increase in interest-bearing deposits                                                             |  |                | 26,385  |   |         |   | 47,260  |  
|(Decrease) in short-term borrowings                                                               |  |                | (8,000  | ) |         |   | (5,000  | )
|Increase (decrease) in federal funds purchased and securities sold under agreements to repurchase |  |                | (4,131  | ) |         |   | 850     |  
|Increase in long-term borrowings                                                                  |  |                | 21,000  |   |         |   |        |  
|Cash dividends paid                                                                               |  |                | (285    | ) |         |   | (244    | )
|Proceeds from issuance of common stock                                                            |  |                | 132     |   |         |   |        |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Net cash provided by financing activities                                                         |  |                | 38,110  |   |         |   | 49,682  |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Net Increase (decrease) in cash and due from banks                                                |  |                | 210     |   |         |   | 3,057   |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Cash and due from banks at beginning of year                                                      |  |                | 9,746   |   |         |   | 7,119   |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Cash and due from banks at end of year                                                            |  | $              | 9,956   |   |         | $ | 10,176  |  
|                                                                                                  |  |               
|Supplemental disclosure of cash flow information:                                                 |  |                |         |   |         |   |         |  
|Cash paid during the period for interest                                                          |  | $              | 7,635   |   |         | $ | 4,309   |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Cash paid during the period for taxes                                                             |  | $              | 948     |   |         | $ | 793     |  
|                                                                                                  |  |                |         |   |         |   |         |  
|Noncash financing and investing activities:                                                       |  |                |         |   |         |   |         |  
|Transfer of loans to foreclosed property                                                          |  | $              |        |   |         | $ | 1,142   |  
|                                                                                                  |  |                |         |   |         |   |         |  

See accompanying notes to consolidated financial statements.



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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2006 (Unaudited)

(In thousands,
except share and per share data)

(1) Organization and Summary of Significant Accounting Policies

Valley Financial Corporation (the Company) was incorporated under the laws of the Commonwealth of Virginia on March 15, 1994, primarily
to serve as a holding company for Valley Bank (the Bank), which opened for business on May 15, 1995. The Companys fiscal year end is December 31.

The consolidated financial statements of the Company conform to generally accepted accounting principles and to general banking industry practices. The
interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments of a normal recurring nature which are necessary for a fair presentation of the consolidated financial statements herein have been
included. The consolidated financial statements herein should be read in conjunction with the Companys 2005 Annual Report on Form 10-K.

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

During the first quarter of fiscal 2006, we adopted the provisions
of, and account for stock-based compensation in accordance with, the Financial Accounting Standards Boards (FASB) Statement of Financial Accounting Standards No 123  revised 2004 (SFAS 123R), Share-Based
Payment, (SFAS No. 123R) which replaced SFAS No. 123, Accounting for Stock Based Compensation, and supersedes APB No. 25, Accounting for Stock Issued to Employees, and its related
interpretations. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite
service period, which is the vesting period. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new grants and to grants that were
outstanding as of the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the
SFAS 123 pro forma disclosures. See Note 11 for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded stock-based compensation expense.

(2) Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks. To comply with Federal Reserve regulations, the Bank is required to maintain certain average reserve balances. The daily
cash reserve requirement for the two weeks including June 30, 2006 was $161, less cash on hand in the amount of $1,097, or a net of $0.

As a condition of our correspondent bank agreement, the Bank is also required to maintain a target balance. The target balance as of June 30, 2006 was $250.



7



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##### Table of Contents

(3) Securities

The carrying values, unrealized gains, unrealized losses and approximate fair values of available-for-sale and held-to-maturity investment securities at
June 30, 2006 are shown in the tables below. As of June 30, 2006, investments (including both available for sale and held to maturity) and restricted equity securities with amortized costs and fair values of $49,166 and $48,474,
respectively, were pledged as collateral for public deposits, a line of credit available from the Federal Home Loan Bank, customer sweep accounts, and for other purposes as required or permitted by law. At June 30, 2006 we evaluated our
investment portfolio and determined all unrealized losses presented in the table below are not related to an issuers financial condition but are due to changes in the level of interest rates and no declines are deemed to be other than
temporary in nature.

The following table sets forth the composition of securities available for sale at June 30, 2006. Securities
available for sale are carried at approximate market value.

Available for Sale Investment Portfolio  Category Distribution

(dollars in thousands)



|                                    |  |                |        |                 |   |                  |  |                        |       |  |   |       
|----------------------------------- |  | -------------- | ------ | --------------- | - | ---------------- |  | ---------------------- | ----- |  | - | ------
|                                    |  | AmortizedCosts |        | UnrealizedGains |   | UnrealizedLosses |  | ApproximateFair Values
|U. S. Treasury                      |  | $              | 199    |                 | $ |                 |  | $                      | 3     |  | $ | 196   
|U.S. Government agencies            |  |                | 11,440 |                 |   |                 |  |                        | 331   |  |   | 11,109
|Mortgage-backed securities          |  |                | 4,863  |                 |   |                 |  |                        | 313   |  |   | 4,550 
|Collateralized mortgage obligations |  |                | 13,466 |                 |   |                 |  |                        | 690   |  |   | 12,776
|States and political subdivisions   |  |                | 6,416  |                 |   | 45               |  |                        | 88    |  |   | 6,373 
|Corporate debt securities           |  |                | 200    |                 |   |                 |  |                        | 4     |  |   | 196   
|                                    |  |                |        |                 |   |                  |  |                        |       |  |   |       
|Total securities available for sale |  | $              | 36,584 |                 | $ | 45               |  | $                      | 1,429 |  | $ | 35,200
|                                    |  |                |        |                 |   |                  |  |                        |       |  |   |       

The following table sets forth the composition of securities held to maturity at June 30,
2006. Securities held to maturity are carried at amortized cost.

Held to Maturity Investment Portfolio  Category Distribution

(dollars in thousands)



|                                    |  |                |        |                 |   |                  |  |                        |     |  |   |       
|----------------------------------- |  | -------------- | ------ | --------------- | - | ---------------- |  | ---------------------- | --- |  | - | ------
|                                    |  | AmortizedCosts |        | UnrealizedGains |   | UnrealizedLosses |  | ApproximateFair Values
|U.S. Government agencies            |  | $              | 9,942  |                 | $ |                 |  | $                      | 422 |  | $ | 9,520 
|Mortgage-backed securities          |  |                | 2,612  |                 |   |                 |  |                        | 128 |  |   | 2,484 
|Collateralized mortgage obligations |  |                | 571    |                 |   |                 |  |                        | 48  |  |   | 523   
|States and political subdivisions   |  |                | 7,318  |                 |   | 14               |  |                        | 114 |  |   | 7,218 
|                                    |  |                |        |                 |   |                  |  |                        |     |  |   |       
|Total securities held to maturity   |  | $              | 20,443 |                 | $ | 14               |  | $                      | 712 |  | $ | 19,745
|                                    |  |                |        |                 |   |                  |  |                        |     |  |   |       



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##### Table of Contents

(4) Allowance for Loan Losses

The following table summarizes the loan loss experience for the six-month periods ended June 30, 2006 and 2005.

Allowance for Loan Losses

(dollars in
thousands)



|                          |  |      |       |   |      |   |       |  
|------------------------- |  | ---- | ----- | - | ---- | - | ----- | -
|                          |  | 2006 |       |   | 2005 |  
|Balance at January 1      |  | $    | 4,124 |   |      | $ | 2,989 |  
|Provision for loan losses |  |      | 706   |   |      |   | 725   |  
|Recoveries:               |  |      |       |   |      |   |       |  
|Commercial                |  |      | 4     |   |      |   |      |  
|Loans to individuals      |  |      |      |   |      |   | 2     |  
|Charged off loans:        |  |      |       |   |      |   |       |  
|Commercial                |  |      | (2    | ) |      |   |      |  
|Credit Cards              |  |      |       |   |      |   | (5    | )
|Loans to individuals      |  |      |       |   |      |   |      |  
|                          |  |      |       |   |      |   |       |  
|Balance at June 30        |  | $    | 4,832 |   |      | $ | 3,711 |  
|                          |  |      |       |   |      |   |       |  

(5) Earnings Per Share

Basic earnings per share is based upon the weighted average number of common shares outstanding during the period. The weighted average shares outstanding
for the diluted earnings per share computations were adjusted to reflect the assumed conversion of shares available under stock options. The following tables summarize earnings per share and the shares utilized in the computations:



|        |  |                                     |           |                 |   |           |  |         |           |  |   |          
|------- |  | ----------------------------------- | --------- | --------------- | - | --------- |  | ------- | --------- |  | - | ---------
|        |  | Earnings Per Share                 
|        |  | 6 Months Ending                     |           | 3 Months Ending
|        |  | 6/30//06                            |           | 6/30/05         |   | 6/30//06  |  | 6/30/05
|Basic   |  | $                                   | 0.43      |                 | $ | 0.34      |  | $       | 0.25      |  | $ | 0.18     
|Diluted |  | $                                   | 0.41      |                 | $ | 0.33      |  | $       | 0.25      |  | $ | 0.17     
|        | 
|        |  | Weighted Average Shares Outstanding
|        |  | 6 Months Ending                     |           | 3 Months Ending
|        |  | 6/30//06                            |           | 6/30/05         |   | 6/30//06  |  | 6/30/05
|Basic   |  |                                     | 4,093,413 |                 |   | 4,074,630 |  |         | 4,107,593 |  |   | 4,074,630
|Diluted |  |                                     | 4,199,448 |                 |   | 4,266,276 |  |         | 4,216,423 |  |   | 4,261,471

(6) Comprehensive Income

On January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. This Statement
establishes standards for reporting and presentation of comprehensive income and its components in a full set of general purpose financial statements. This Statement was issued to address concerns over the practice of reporting elements of
comprehensive income directly in equity.



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##### Table of Contents

The Company is required to classify items of Other Comprehensive Income (such as net
unrealized gains on securities available for sale) by their nature in a financial statement. It does not require a specific format for that financial statement but requires the Company to display an amount representing comprehensive income for the
period in that financial statement. The Company is required to present the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital in the equity section of a statement of financial position.
It does not require per share amounts of comprehensive income to be disclosed.

The adoption of Statement 130 on January 1, 1998 did
not have any effect on the consolidated financial position, results of operations or liquidity of the Company. However, Statement 130 does have an effect on financial statement displays presented by the Company since the Company has net unrealized
gains (losses) on available for sale securities, an item of other comprehensive income (loss). For the six months ended June 30, 2006 and 2005, total comprehensive income (loss) was $1,106 and $1,343 respectively.

The information that follows discloses the reclassification adjustments and the income taxes related to the net unrealized gains (losses) on securities
available-for-sale and net unrealized gains (losses) on derivatives not held for trading that are included in other comprehensive income (loss), net of income taxes for the six and three month periods ended June 30, 2006 and 2005.



|                                                                                        |  |                                      |      |   |                                      |   |     |         |  |   |         |   |  |   |      |  
|--------------------------------------------------------------------------------------- |  | ------------------------------------ | ---- | - | ------------------------------------ | - | --- | ------- |  | - | ------- | - |  | - | ---- | -
|                                                                                        |  | 6 Months Ended(dollars in thousands) |      |   | 3 Months Ended(dollars in thousands) |  
|                                                                                        |  | 6/30/06                              |      |   | 6/30/05                              |   |     | 6/30/06 |  |   | 6/30/05 |  
|Net unrealized gains (losses) on securities available for sale:                         |  |                                      |      |   |                                      |   |     |         |  |   |         |   |  |   |      |  
|Net unrealized holding gains (losses) during the year                                   |  | $                                    | (707 | ) |                                      | $ | (22 | )       |  | $ | (406    | ) |  | $ | 580  |  
|Less reclassification adjustments for realized gains included in net income, net of tax |  |                                      |     |   |                                      |   | (34 | )       |  |   |        |   |  |   | (1   | )
|Net unrealized gains (losses) on derivatives not held for trading                       |  |                                      | (256 | ) |                                      |   |    |         |  |   | (256    | ) |  |   |     |  
|Income tax benefit (expense)                                                            |  |                                      | 328  |   |                                      |   | 7   |         |  |   | 225     |   |  |   | (197 | )
|                                                                                        |  |                                      |      |   |                                      |   |     |         |  |   |         |   |  |   |      |  
|Other comprehensive income (loss), net of income taxes                                  |  | $                                    | (635 | ) |                                      | $ | (49 | )       |  | $ | (437    | ) |  | $ | 382  |  
|                                                                                        |  |                                      |      |   |                                      |   |     |         |  |   |         |   |  |   |      |  

(7) Financial Instruments With Off-Balance Sheet Risk

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

The Companys exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend
credit is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk. At June 30, 2006 outstanding commitments to extend credit were $148,403 as compared
to $136,371 at December 31, 2005.

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



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##### Table of Contents

(8) Related Party Transactions

The Bank has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in
the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of
management, involve more than normal credit risk or present other unfavorable features. As of June 30, 2006 aggregate loans to directors, executive officers, and principal shareholders totaled $17,483. An analysis of loan activity to directors,
executive officers and principal shareholders is as follows:

Loans to Related Parties

(dollars in thousands)



|                                    |  |   |         |  
|----------------------------------- |  | - | ------- | -
|Balances as of January 1, 2005      |  | $ | 10,449  |  
|Addition of new director/officer(s) |  |   | 3,209   |  
|Advances                            |  |   | 14,091  |  
|Repayments                          |  |   | (10,659 | )
|                                    |  |   |         |  
|Balances as of December 31, 2005    |  | $ | 17,090  |  
|                                    |  |   |         |  
|Addition of new director/officer(s) |  |   | 14      |  
|Advances                            |  |   | 8,079   |  
|Repayments                          |  |   | (7,700  | )
|                                    |  |   |         |  
|Balances as of June 30, 2006        |  | $ | 17,483  |  
|                                    |  |   |         |  

(9) Long-Term Federal Home Loan Bank Advances

The Company has outstanding long-term debt with the Federal Home Loan Bank of Atlanta in the amount of $58.0 million as of June 30, 2006. There are
four convertible advances in the amount of $5.0 million each, one convertible advance in the amount of $7.0 million, and one convertible advance in the amount of $10.0 million currently drawn. The Federal Home Loan Bank of Atlanta has the option to
convert the $37.0 million in convertible advances on the conversion dates below, and on any quarterly interest payment date thereafter, with at least two business days notice. If called, the four $5.0 million convertible advances and the one $7.0
million convertible advance will be converted into a 3-month London Interbank Offered Rate (LIBOR) based adjustable rate credit (ARC) at 3-month LIBOR. The $10.0 million convertible advance may be converted into a 3-month LIBOR-based
floating rate advance (ARC) at 3-month LIBOR only if 3-month LIBOR is greater than or equal to 7.0%.

During the second quarter of 2006,
the Bank entered into two new structured advances with the Federal Home Loan Bank of Atlanta. The first advance is a variable rate advance in the amount of $8.0 million, the proceeds of which were used to offset overnight borrowings. It is priced at
the Prime Rate minus 2.855% per annum. It has a 2-year maturity date. The second advance is convertible advance in the amount of $13.0 million at 3-month LIBOR minus 0.50% per annum. The advance may be called on the two-year anniversary
date by the issuer. If it is not called, it will automatically convert to a fixed rate of 5.03% for the remaining eight year maturity. The proceeds of these advances were used to pay off the $11 million short-term daily rate credit and to offset
overnight borrowings.



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##### Table of Contents

The following table provides more information on the outstanding advances as of June 30, 2006:

LONG-TERM FEDERAL HOME LOAN BANK ADVANCES

(dollars in thousands)



|               |  |                   |  |                   |  |             |   |  |                             
|-------------- |  | ----------------- |  | ----------------- |  | ----------- | - |  | ----------------------------
|AdvanceBalance |  | AdvanceDate       |  | MaturityDate      |  | CurrentRate |   |  | First OptionalConversionDate
|$5,000         |  | December 2, 1999  |  | December 2, 2009  |  | 5.46        | % |  | December 4, 2000            
|$5,000         |  | May 24, 2000      |  | May 24, 2010      |  | 6.49        | % |  | May 24, 2001                
|$5,000         |  | February 9, 2001  |  | February 9, 2011  |  | 4.97        | % |  | February 9, 2005            
|$5,000         |  | November 7, 2001  |  | November 7, 2011  |  | 3.91        | % |  | November 7, 2006            
|$10,000        |  | September 4, 2002 |  | September 4, 2007 |  | 3.09        | % |  | September 4, 2004           
|$7,000         |  | March 11, 2003    |  | March 11, 2013    |  | 2.91        | % |  | March 11, 2008              
|$8,000         |  | June 27, 2006     |  | June 27, 2008     |  | 5.395       | % |  | None                        
|$13,000        |  | June 29, 2006     |  | June 29, 2016     |  | 4.85        | % |  | June 29, 2008               

(10) Guaranteed Preferred Beneficial Interests in the Companys Junior
Subordinated Debentures

Valley Financial (VA) Statutory Trust II, a statutory business trust (Trust II), was created by the
Company on September 26, 2005, at which time Trust II issued $7,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature December 15, 2035. Distributions are payable on the securities at a
floating rate equal to the 3-month LIBOR plus 1.49%, and the securities may be prepaid at par by Trust II at any time after December 15, 2010. The principal assets of Trust II are $7,217 of the Companys junior subordinated debentures
which mature on December 15, 2035, and bear interest at a floating rate equal to the 3-month LIBOR plus 1.49%, and which are callable by the Company after December 15, 2010. All $217 in aggregation liquidation amount of Trust IIs
common securities are held by the Company.

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

The debenture proceeds from Trust I and Trust II are included in the
Companys Tier 1 capital for regulatory capital adequacy purposes to the extent that they do not exceed 25% of the Companys total Tier I capital including the securities. This amount totaled $10,944 (of the $11,000 outstanding) at
June 30, 2006. The remaining $56 is included in the calculation of our total risk based capital ratio as Tier 2 capital. Our obligations with respect to the issuance of Trust I and Trust IIs preferred securities and common securities
constitute a full and unconditional guarantee by the Company of the Trust I and Trust IIs obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, the Company may elect from
time to time to defer interest payments on its junior subordinated debentures, which would result in a deferral of distribution payments on Trust I and Trust IIs preferred trust securities and common securities.



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##### Table of Contents

(11) Stock Based Compensation

Beginning with our first quarter of fiscal 2006, we adopted SFAS 123R. See Note 1 for a description of our adoption of SFAS 123R. We currently use the
Black-Scholes option pricing model to determine the fair value of stock options and restricted stock grants. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our
stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors,
risk-free interest rate and expected dividends.

Prior to the adoption of SFAS No. 123R, the Company used the intrinsic value method
as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), and thus recognized no compensation expense for options granted with exercise prices equal to the fair market value of the
Companys common stock on the date of grant.

The Company has two share-based compensation plans, which are described below. The
compensation cost that has been charged against income for those plans was approximately $80 for the six-month period ended June 30, 2006. The Company currently has 82,098 nonqualified stock options outstanding at June 30, 2006, which were
fully vested as of January 1, 2006; therefore, there are no income tax implications for share-based compensation for the six-month period ended June 30, 2006.

Stock Option Plans

The Company has a 2005 Key Employee Equity Award Plan (the 2005 Plan). The 2005 Plan gives the Company flexibility in tailoring equity-based compensation awards for employees from time to time to the continuing objective of aligning
employee incentives with the interests of shareholders as the Company grows and develops. In addition to incentive and nonqualified stock options, the 2005 Plan permits the grant of restricted stock, stock appreciation rights and stock units to
persons designated as Key Employees. The 2005 Plan will remain in effect for ten years, subject to the right of the Board of Directors to terminate the 2005 Plan earlier, except with respect to awards made prior to and outstanding on
that date which remain valid in accordance with their terms. The maximum aggregate number of shares of the Companys common stock (no par value) that may be issued pursuant to awards made under the Plan may not exceed 250,000. Accordingly,
250,000 shares of authorized but unissued common stock are reserved for use in the 2005 Plan. Within the maximum limits, the Plan specifies that stock appreciation rights may not be granted with respect to more than 500 shares per recipient (2,000
shares for a new employee recipient) per year; and restricted shares and stock units, respectively, may not be granted for more than 5,000 shares per year per recipient.

Additionally, the Company has a 1995 Incentive Stock Plan (the 1995 Plan) pursuant to which the Human Resources Committee of the Companys Board of Directors may grant stock options to officers and key employees.
The 1995 Plan authorizes grants of options to purchase up to 311,850 shares (adjusted for stock splits) of the Companys authorized but unissued common stock. Accordingly, 311,850 shares of authorized but unissued common stock are reserved for
use in the Plan.

Under the 2005 Plan, there are options for 46,400 shares granted to officers and key employees currently outstanding as
of June 30, 2006. Under the 1995 Plan, there are options for 209,382 shares granted to officers and key employees currently outstanding as of June 30, 2006. All stock options (for both plans) have been granted with an exercise price equal
to the stocks fair market value at the date of the grant. Stock options under the Plan generally have 10-year terms, vest at the rate of 20 percent per year, and become fully exercisable five years from the date of the grant. Additionally
under the 2005 Plan, there are 15,075 restricted stock grants



13



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##### Table of Contents

(RSGs) that have been granted to officers and key employees currently outstanding as of June 30,
2006. These RSGs will vest 100% on January 31, 2008 (Vesting Date) based upon successfully meeting certain performance criteria.

As of June 30, 2006, there are 5,358 shares available for grant under the 1995 Plan and 188,525 shares available for grant under the 2005 Plan. In addition, certain other options for 182,196 shares (adjusted for
stock splits), of which 82,098 are outstanding, based on meeting certain past performance criteria have been granted.

The share-based
awards granted under the aforementioned Plans have similar characteristics, except that some awards have been granted in options and certain awards have been granted in restricted stock. Therefore, the following disclosures have been disaggregated
for the stock option and restricted stock awards of the Plans due to their dissimilar characteristics.

The fair value of each option award
is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is based on the U.S. Treasury rate for the expected life at the time of grant. Volatility is based on the volatilities of our trading
history. The expected life is based on the average life of the options of 10 years and the weighted average vesting period of 5 years, and forfeitures are estimated based on the Companys history. The following table illustrates the
assumptions for the Black-Scholes model used in determining the fair value of options granted to employees for the six months ended June 30, 2006.



|                        |  |                               |  
|----------------------- |  | ----------------------------- | -
|                        |  | Six Months EndedJune 30, 2006 |  
|Dividend yield          |  | 0.03                          | %
|Risk-free interest rate |  | 4.45                          | %
|Volatility              |  | 20.71                         | %
|Expected life           |  | 10 years                      |  

The fair value of each restricted stock grant is equal to the stock price on the date of grant and
assumes the performance goals will be achieved. Total compensation cost is recognized on a pro-rata basis over the remaining vesting period, through July 31, 2008. If such performance goals are not met, any previously recognized compensation
cost will be reversed.

Total stock-based compensation recognized as compensation expense on our consolidated statement of income is as
follows:



|                           |  |                             |    |                            |   |   
|-------------------------- |  | --------------------------- | -- | -------------------------- | - | --
|                           |  | 3 MonthsEnded June 30, 2006 |    | 6 MonthsEndedJune 30, 2006
|Option Grants              |  | $                           | 22 |                            | $ | 41
|Restricted Stock Grants    |  | $                           | 20 |                            | $ | 39
|                           |  |                             |    |                            |   |   
|Total Compensation Expense |  | $                           | 42 |                            | $ | 80
|                           |  |                             |    |                            |   |   



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##### Table of Contents

At June 30, 2005, we accounted for our stock-based compensation using the accounting prescribed by
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. We were not required to adopt the fair value based recognition provisions prescribed under SFAS No. 123, Accounting for Stock-Based
Compensation,but complied with the disclosure requirements set forth in SFAS No. 148, which included disclosing pro forma net income as if the fair value based method of accounting had been applied. This information for the six and three
month periods ended June 30, 2005 is as follows:



|                                                                                                                                     |  |              |       |              |   |     
|------------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | ----- | ------------ | - | ----
|                                                                                                                                     |  | 6MonthsEnded |       | 3MonthsEnded
|                                                                                                                                     |  | 6/30/05      |       | 6/30/05     
|Net income                                                                                                                           |  | $            | 1,392 |              | $ | 722 
|                                                                                                                                     |  |             
|Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
benefits |  | $            | 13    |              | $ | 6   
|                                                                                                                                     |  |             
|Pro forma net income                                                                                                                 |  | $            | 1,379 |              | $ | 716 
|                                                                                                                                     |  |             
|Earnings per share                                                                                                                   |  |              |       |              |   |     
|Basic, reported                                                                                                                      |  | $            | 0.34  |              | $ | 0.18
|Basic, pro forma                                                                                                                     |  | $            | 0.34  |              | $ | 0.18
|Diluted, reported                                                                                                                    |  | $            | 0.33  |              | $ | 0.17
|Diluted, pro forma                                                                                                                   |  | $            | 0.32  |              | $ | 0.17

As of June 30, 2006, there was $396 of unrecognized compensation cost, adjusted for estimated
forfeitures, related to non-vested stock-based payments granted to employees. A maturity schedule of the unrecognized compensation cost as of June 30, 2006 is as follows:



|                  |  |                |    |      |   |      |  |      |    |      |   |      |  |       |    |  |   |   |  |   |    
|----------------- |  | -------------- | -- | ---- | - | ---- |  | ---- | -- | ---- | - | ---- |  | ----- | -- |  | - | - |  | - | ---
|                  |  | Remaining 2006 |    | 2007 |   | 2008 |  | 2009 |    | 2010 |   | 2011 |  | Total
|Compensation Cost |  | $              | 78 |      | $ | 154  |  | $    | 70 |      | $ | 63   |  | $     | 30 |  | $ | 1 |  | $ | 396

Total unrecognized compensation cost will be adjusted for future grants and future changes in estimated
forfeitures.

General Stock Option Information

A summary of option activity under the stock option plans during the six month period ended June 30, 2006 is presented below:



|                       |  |                     |   |  |                                    |       |                                   |           
|---------------------- |  | ------------------- | - |  | ---------------------------------- | ----- | --------------------------------- | ----------
|                       |  | Options Outstanding |   |  | WeightedAverage Exercise Price
($) |       | Weighted Average Contractual Term
|Balance, 12/31/05      |  | 365,380             |   |  | $                                  | 6.30  |                                   |           
|                       |  |                     |  
|Exercised              |  | (31,500             | ) |  | $                                  | 4.20  |                                   |           
|Authorized             |  |                    |   |  |                                    |      |                                   |           
|Forfeited              |  |                    |   |  |                                    |      |                                   |           
|Granted                |  | 4,000               |   |  | $                                  | 13.30 |                                   |           
|                       |  |                     |   |  |                                    |       |                                   |           
|Outstanding at 6/30/06 |  | 337,880             |   |  | $                                  | 6.58  |                                   | 4.36 years
|                       |  |                     |   |  |                                    |       |                                   |           
|Exercisable at 6/30/06 |  | 247,120             |   |  | $                                  | 4.78  |                                   | 2.94 years
|                       |  |                     |   |  |                                    |       |                                   |           



15



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##### Table of Contents

There were no options granted during the three month period ended June 30, 2006. The total intrinsic
value of options exercised during the six month period ended June 30, 2006 was $287. The total intrinsic value of options exercised during the three month period ended June 30, 2006 was $68.

Cash received from option exercises under all share-based payment arrangements for the three-month period ended June 30, 2006 was $18. Cash received
from option exercises under all share-based payment arrangements for the six-month period ended June 30, 2006 was $132.

Information
regarding the stock options outstanding at June 30, 2006 is summarized below:



|                        |  |                    |  |                                             |  |                                 |       |                    |         |                                |   |      
|----------------------- |  | ------------------ |  | ------------------------------------------- |  | ------------------------------- | ----- | ------------------ | ------- | ------------------------------ | - | -----
|Range ofExercise Prices |  | Number Outstanding |  | Weighted Average Remaining Contractual Life |  | Weighted Average Exercise Price |       | Number Exercisable |         | Weighted Average ExercisePrice
|$3.18 - $3.81           |  | 108,085            |  | 1.12 years                                  |  | $                               | 3.24  |                    | 108,085 |                                | $ | 3.24 
|$4.25 - $5.94           |  | 132,095            |  | 3.91 years                                  |  | $                               | 5.32  |                    | 120,695 |                                | $ | 5.29 
|$7.14 - $12.85          |  | 71,350             |  | 7.07 years                                  |  | $                               | 11.29 |                    | 14,780  |                                | $ | 9.55 
|$13.00 - $14.23         |  | 26,350             |  | 8.34 years                                  |  | $                               | 13.87 |                    | 3,560   |                                | $ | 14.20
|                        |  |                    |  |                                             |  |                                 |       |                    |         |                                |   |      
|Totals                  |  | 337,880            |  | 4.36 years                                  |  | $                               | 6.58  |                    | 247,120 |                                | $ | 4.78 
|                        |  |                    |  |                                             |  |                                 |       |                    |         |                                |   |      

The aggregate intrinsic value of options outstanding and options exercisable as of June 30,
2006 was $2,311 and $2,135, respectively.

A summary of the status of the Companys non-vested restricted stock as of June 30,
2006, and changes during the six months then ended is presented below:



|                       |  |                                        |  |                                       |      
|---------------------- |  | -------------------------------------- |  | ------------------------------------- | -----
|                       |  | Non-Vested RestrictedStock Outstanding |  | WeightedAverage Grant Date Fair
Value
|Balance, 12/31/05      |  | 14,675                                 |  | $                                     | 12.53
|                       |  |                                       
|Authorized             |  |                                       |  |                                       |     
|Forfeited              |  |                                       |  |                                       |     
|Granted                |  | 400                                    |  | $                                     | 13.34
|                       |  |                                        |  |                                       |      
|Outstanding at 6/30/06 |  | 15,075                                 |  | $                                     | 12.56
|                       |  |                                        |  |                                       |      



16



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##### Table of Contents

(12) Other Items

On April 20, 2006, the Company declared its fifth consecutive semi-annual cash dividend on the Companys stock, in the amount of $0.07 per
share, payable on July 3, 2006 to shareholders of record June 1, 2006.

Item 2. Managements Discussion and Analysis.

Managements discussion and analysis of the
financial condition and results of operations of the Company as of and for the six months ended June 30, 2006 and 2005 is as follows. The discussion should be read in conjunction with the Companys Consolidated Financial Statements and
Notes on the December 31, 2005 Form 10-K.

Critical Accounting Policies

The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies that require our most difficult,
subjective or complex judgments and uncertainties include (1) the allowance for loan losses and (2) impaired loans. Further information about these critical policies is described below.

Allowance for Loan Losses: Certain credit risks are inherent in making loans. We seek to prudently assess these risks and manage them effectively.
We have internal credit policies and procedures in place to reduce repayment risks. These policies and procedures include:



| |  |  | officer and customer limits
| | - |  | ---------------------------



| |  |  | periodic loan documentation review, and
| | - |  | ---------------------------------------



| |  |  | follow-up on exceptions to credit policies.
| | - |  | -------------------------------------------

We establish
the allowance for loan losses through charges to earnings through a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously
charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be appropriate to absorb probable losses on existing loans that may become uncollectible. Some of the factors we consider in
determining the appropriate level of the allowance for loan losses are as follows:



| |  |  | an evaluation of the current loan portfolio
| | - |  | -------------------------------------------



| |  |  | identified loan problems
| | - |  | ------------------------



| |  |  | loan volume outstanding
| | - |  | -----------------------



| |  |  | past loss experience
| | - |  | --------------------



| |  |  | present and expected industry and economic conditions and, in particular, how such conditions relate to our market area.
| | - |  | ------------------------------------------------------------------------------------------------------------------------

The general component of the reserve covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An
unallocated component is maintained to cover uncertainties that could affect our estimate of probable losses. It also reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and
general losses in the portfolio. The allowance for loan losses is evaluated on a regular basis by management. On a quarterly basis, we perform a detailed analysis of the allowance for loan losses to verify the adequacy and appropriateness of the
allowance in meeting possible losses in the loan portfolio.



17



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##### Table of Contents

Our internal loan and credit process review program is intended to reduce and control the risks
associated with the lending process on an ongoing basis. It includes monitoring the lending activities of all bank personnel and an assessment of the effectiveness, with respect to underwriting and processing new loans, preventing insider abuse,
minimizing lender liability risk exposure and ensuring timely follow-up and corrective action for loans showing signs of deterioration in quality. Bank regulators also periodically review the loan portfolio and other assets to assess their quality,
and we employ independent, third party loan reviewers (semi-annually) to complement our internal review as well. This evaluation is inherently subjective because it requires estimates that may be significantly revised as more information becomes
available. We believe the allowance for loan losses is appropriate to provide for expected losses in the loan portfolio, but there are no assurances that it will be.

Impairment of Loans: We consider a loan impaired when it is probable that we will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired
during a period of delay in payment if we expect the ultimate collection of all amounts due. An allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying
value of that loan.

Overview

The
Company was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of the Bank. The Bank opened for business on May 15, 1995. There are currently eight full-service branch
locations, operating in various locations throughout the Cities of Roanoke and Salem, Town of Vinton, and the County of Roanoke. The Bank also has a wealth management subsidiary, Valley Wealth Management Services, Inc. which markets investment and
insurance products. Net income derived for the new subsidiary is not significant at this time.

Performance Summary

The following table shows our key performance ratios for the period ended June 30, 2006 and December 31, 2005 and June 30, 2005:

Key Performance Ratios



|                               |  |                      |       |   |                        |   |       |                      |  |   |      |  
|------------------------------ |  | -------------------- | ----- | - | ---------------------- | - | ----- | -------------------- |  | - | ---- | -
|                               |  | 6 monthsEnded6/30/06 |       |   | 12 monthsEnded12/31/05 |   |       | 6 monthsEnded6/30/05 | 
|Return on average assets       |  |                      | 0.68  | % |                        |   | 0.79  | %                    |  |   | 0.70 | %
|Return on average equity (1)   |  |                      | 10.85 | % |                        |   | 11.42 | %                    |  |   | 9.64 | %
|Net interest margin (2)        |  |                      | 3.26  | % |                        |   | 3.42  | %                    |  |   | 3.40 | %
|Cost of funds                  |  |                      | 3.59  | % |                        |   | 2.76  | %                    |  |   | 2.51 | %
|Yield on earning assets        |  |                      | 6.79  | % |                        |   | 6.13  | %                    |  |   | 5.83 | %
|Basic net earnings per share   |  | $                    | 0.43  |   |                        | $ | 0.83  |                      |  | $ | 0.34 |  
|Diluted net earnings per share |  | $                    | 0.41  |   |                        | $ | 0.80  |                      |  | $ | 0.33 |  

All percentage calculations are on an annualized basis.

---

|(1) | The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities available-for-sale.
|--- | -------------------------------------------------------------------------------------------------------------------------

|(2) | Calculated on a fully taxable equivalent basis (FTE)
|--- | ------------------------------------------------------



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##### Table of Contents

Our performance was adversely affected by two major factors during the first half of 2006. As shown
above, we have continued to see the net interest margin under considerable pressure from the increasing interest rate environment and the relatively flat yield curve. As such, our cost of funds has increased by 83 basis points during the first six
months compared with an increase of only 66 basis points in our yield on earning assets. Additionally, one large commercially-oriented credit relationship slipped into the non-performing category during the first quarter of 2006 and a special loan
loss provision amounting to $325,000 was made in recognition of the workout nature of the credit. Our overall performance for 2006 is largely dependent upon the resolution of this credit and our ability to contain funding costs. Our return on
average assets for the three months ended June 30, 2006 did improve to 0.80% from 0.56% in the first quarter of 2006 and our return on average equity improved to 12.77% for the three months ended June 30, 2006 as compared to 8.87% during
the first quarter.

Growth

The
following table shows our key growth indicators:

Key Growth Indicators

(dollars in thousands)



|                      |  |         |         |          |   |         |  |   |        
|--------------------- |  | ------- | ------- | -------- | - | ------- |  | - | -------
|                      |  | 6/30/06 |         | 12/31/05 |   | 6/30/05
|Investment securities |  | $       | 60,689  |          | $ | 57,989  |  | $ | 60,993 
|Loans, net            |  |         | 444,507 |          |   | 410,253 |  |   | 332,804
|Deposits              |  |         | 394,710 |          |   | 365,316 |  |   | 333,409
|Total assets          |  | $       | 539,250 |          | $ | 498,949 |  | $ | 425,083

We have intentionally slowed the growth of the Bank as compared to 2005. Annualized growth rates
for assets, loans and deposits in the first half of 2006 were substantially less than the growth rates achieved in 2005. However, the rates of growth remained at double-digit levels on an annualized basis. Competition for deposits has heightened
significantly in the last 6 to 9 months and our ability to fund loan growth will be dependent upon our ability to grow our deposit base at a reasonable cost. During the second quarter of 2006, we were successful in reducing our overall reliance on
certificates of deposits by raising $24.7 million of new deposits in our new money market product, which is tied to the WSJ Prime rate. Based upon current market conditions, we do anticipate that the Companys asset, loan and deposit growth
rates will show declines in 2006 when compared to 2005.

Total liabilities at June 30, 2006 were $507.5 million, up 8% from $468.2
million at December 31, 2005 with the increase primarily represented by a $29.4 million growth in deposits, a $13 million increase in Federal Home Bank of Atlanta borrowings, a $4.2 million increase in securities sold under agreements to
purchase, and an $8.4 million decrease in federal funds purchased.

Shareholders Equity

Total shareholders equity at June 30, 2006 was $31.7 million consisting of $9.1 million in net proceeds from the Companys 1995 initial
public offering, $3.2 million in net proceeds from the Companys 2000 secondary offering, $3.8 million in net proceeds from a private stock placement in 2004, $1,012,000 in proceeds from the exercise of stock options, $80,000 from the expensing
of restricted stock grants and incentive stock options, increased by accumulated retained earnings of $15.6 million and decreased by $913,000 of net unrealized losses on securities available for sale and $169,000 of net unrealized losses on
derivatives not held for



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##### Table of Contents

trading, net of related deferred tax liability. Total shareholders equity (exclusive of unrealized gains (losses)
on investment securities and derivatives) was $32.8 million at June 30, 2006 compared with $31.1 million at December 31, 2005, an increase of $1.7 million or 5%.

Net Income

We earned net income of $1,740,000 for the six months ended June 30, 2006, an
increase of $348,000 or 25% over the $1,392,000 reported for the same period in 2005. We earned net income of $1,040,000 for the three month period ended June 30, 2006, an increase of $318,000 or 44% over the $722,000 reported for the same
period in 2005. The increase in net earnings for both periods is largely attributable to the substantial volume of loan growth during 2005 and the elimination of the year-end performance bonus accruals for the current year. Despite the increases
over prior year earnings, earnings were adversely affected by two major factors during the first half of 2006. As discussed above, we have continued to see the net interest margin under considerable pressure from the relatively flat yield curve.
Additionally, one large commercially-oriented credit relationship slipped into the non-performing category during the first quarter of 2006, and a special loan loss reserve provision amounting to $325,000 was made in recognition of the workout
nature of the credit. Our overall performance for 2006 is largely dependent upon the resolution of this credit as well as our ability to contain funding costs.

Net Interest Income

Net interest income is our principal source of earnings and is calculated as the amount which loan and
investment (earning assets) income exceeds the interest expense on deposits and borrowings (interest-bearing liabilities). Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and
rates, have a significant impact on the level of net interest income.

Net interest income was $7,728,000 for the six months ended
June 30, 2006, an increase of 25% from the $6,207,000 reported for the same period in 2005. Net interest income was $3,931,000 for the three months ended June 30, 2006, an increase of 21% from the $3,261,000 reported for the same period in
2005. Our net interest margin was 3.26% for the six months ended June 30, 2006, down 14 basis points compared to the 3.40% reported for the same period last year. This decrease is primarily attributable to the relatively flat yield curve which
is causing our cost of funds to rise at a greater pace than our yield on earning assets.

Interest Rate Risk

Interest rate risk is the risk to earnings or capital generated by the effects of changes in interest rates on our on- and off-balance sheet positions,
and can take one or more of several forms:



| |  |  | Repricing risk comes from timing mismatches in the ability to alter contractual rates earned on financial assets held or paid on interest-bearing liabilities.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Basis risk refers to changes in the underlying relationships between market rates or indices, which result in a narrowing of the spread earned on a loan or investment
relative to its cost of funds.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Option risk arises from embedded options in many financial instruments such as:
| | - |  | ---------------------------------------------------------------------------------



| |  |  | interest rate options,
| | - |  | ----------------------



| |  |  | loan prepayment options,
| | - |  | ------------------------



| |  |  | deposit early withdrawal options,
| | - |  | ---------------------------------



| |  |  | callable Federal Home Loan Bank advances, and
| | - |  | ---------------------------------------------



| |  |  | prepayment of the underlying collateral of asset-backed securities.
| | - |  | -------------------------------------------------------------------

Embedded options are complex risk positions that are difficult to predict and offset, and are a large component of our overall interest rate risk.



20



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##### Table of Contents

We have established risk measures, limits, policy guidelines and internal control mechanisms for managing
our overall asset/liability management (ALM) position. The responsibility for interest rate risk control resides with management, with oversight by the board of directors and the ALCO Oversight Committee. We seek to balance the return
potential of the ALM position against the desire to limit volatility in earnings.

At least quarterly, we measure the ALM position using
earnings simulation modeling to estimate what assets and liabilities would re-price, and to what extent, within a one-year period in response to an immediate 200 and 100 basis point change in the Prime Rate, as well as in response to more gradual
interest rate change. Our objective is to keep the change in net interest income over twelve months at or below 5%, and the change in net income at or below 10%, under an immediate 200 basis point interest rate shock scenario.

The model also incorporates managements forecasts for balance sheet growth, noninterest income and noninterest expense. The interest rate scenarios
are used for analytical purposes and do not necessarily represent managements view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may apply to our earnings.
Modeling the sensitivity of earnings to interest rate risk is highly dependent on numerous assumptions embedded in the simulation model. While the earnings sensitivity analysis incorporates managements best estimate of interest rate and
balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact likely will differ from that projected. Our cumulative repricing gap for the 90-day time period indicates an asset-sensitive position as of
March 31, 2006 (the most recent date for which information is currently available).

We also estimate interest sensitivity by
calculating the net present value of the balance sheets cash flows or the residual value of future cash flows ultimately due to shareholders. This calculation is known as Economic Value of Equity or EVE and is generally considered
a better measure of long-term interest sensitivity than is IRS. Our objective is for the result to change 25% or less in an immediate 300 basis point interest rate shock scenario; 20% or less in an immediate 200 basis point interest rate shock
scenario; and 15% or less in an immediate 100 basis point interest rate shock scenario.

Derivative Financial Instruments

For asset/liability management purposes, we may use interest rate swap agreements to hedge interest rate risk exposure to declining rates. Such
derivatives are used as part of the asset/liability management process and are linked to specific assets, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.

Interest rate swaps are contracts in which a series of cash flows from interest are exchanged over a prescribed period, based upon a
notional amount. The notional amount on which the interest payments are based is not exchanged. The Company entered into its first such derivative instrument in April 2006 when it entered into a forward-start interest rate swap agreement
(Agreement) to convert a portion of its variable rate loans to a fixed rate (cash flow hedge). We entered into this agreement to protect the Bank from interest rate exposure during a period of declining rates. The effective period of the
Agreement is April 19, 2007 through April 19, 2009.

Under SFAS 133, the effective portion of the gain or loss on a
derivative designated and qualifying as a cash flow hedging instrument is initially reported as a component of other comprehensive income and subsequently reclassified into earnings in the same period or periods during which cash flows are
exchanged. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized currently in earnings. As of June 30, 2006, the mark-to-market adjustment, net of taxes, included in other comprehensive
income for this Agreement was ($169,000).



21



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##### Table of Contents

Interest rate derivative financial instruments receive hedge accounting treatment only if they are
designated as a hedge and are expected to be, and are, effective in substantially reducing interest rate risk arising from assets and liabilities identified as exposing the Company to risk. Those derivative financial instruments that do not
meet the hedging criteria discussed below would be classified as trading activities and would be recorded at fair value with changes in fair value recorded in income. Derivative hedge contracts must meet specific effectiveness tests ( i.e., over
time the change in their fair values due to the designated hedge risk must be within 80 to 125 percent of the opposite change in the fair values of the hedged assets or liabilities). Changes in the fair value of the derivative financial instruments
must be effective at offsetting changes in the fair value of the hedged items due to the designated hedge risk during the term of the hedge.

Further, if the underlying financial instrument differs from the hedged asset or liability, there must be a clear economic relationship between the two prices of the two financial instruments. If periodic assessment indicates derivatives no
longer provide an effective hedge, the derivative contracts would be closed out and settled or classified as a trading activity.

In
accordance with SFAS No. 133, hedges of variable-rate loans are accounted for as cash flow hedges, with changes in fair values recorded in derivative assets or liabilities and other comprehensive income. The net settlement (upon close or
termination) that offsets changes in the value of the hedged asset or liability is recognized immediately in non-interest income.

Cash
flows resulting from the derivative financial instruments that are accounted for as hedges of assets and liabilities are classified in the cash flow statement in the same category as the cash flow of the items being hedged.

Noninterest Income

Noninterest income for the three
months ended June 30, 2006 and 2005 is shown in the following table:

Noninterest Income

(dollars in thousands)



|                                 |  |                      |     |                      |   |                       |  |      |   
|-------------------------------- |  | -------------------- | --- | -------------------- | - | --------------------- |  | ---- | --
|                                 |  | 3 monthsEnded6/30/06 |     | 3 monthsEnded6/30/05 |   | % Increase/(Decrease) | 
|Service charges on deposits      |  | $                    | 234 |                      | $ | 235                   |  | 0    | % 
|Other income                     |  |                      | 292 |                      |   | 153                   |  | 92   | % 
|Realized securities gains/losses |  |                      |    |                      |   | 52                    |  | (100 | )%
|                                 |  |                      |     |                      |   |                       |  |      |   
|Total noninterest income         |  | $                    | 526 |                      | $ | 440                   |  | 20   | % 
|                                 |  |                      |     |                      |   |                       |  |      |   

Noninterest income for the six months ended June 30, 2006 and 2005 is as follows:

Noninterest Income

(dollars in
thousands)



|                                 |  |                      |     |   |                      |   |                       |  |      |   
|-------------------------------- |  | -------------------- | --- | - | -------------------- | - | --------------------- |  | ---- | --
|                                 |  | 6 monthsEnded6/30/06 |     |   | 6 monthsEnded6/30/05 |   | % Increase/(Decrease) | 
|Service charges on deposits      |  | $                    | 447 |   |                      | $ | 445                   |  | 0    | % 
|Other income                     |  |                      | 536 |   |                      |   | 274                   |  | 96   | % 
|Realized securities gains/losses |  |                      | (1  | ) |                      |   | 53                    |  | (101 | )%
|                                 |  |                      |     |   |                      |   |                       |  |      |   
|Total noninterest income         |  | $                    | 982 |   |                      | $ | 772                   |  | 27   | % 
|                                 |  |                      |     |   |                      |   |                       |  |      |   



22



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##### Table of Contents

For both periods above, the increase in other income is primarily attributable to income earned on bank
owned life insurance, increase in income earned on letter of credit fees, and the gross income earned from our investment subsidiary, Valley Wealth Management Services, Inc. Expenses for Valley Wealth Management Services, Inc. are included in other
expenses in the noninterest expense category. Net income for the subsidiary is not significant at this time.

Service charges on deposit
accounts consist of a variety of charges imposed on demand deposits, interest-bearing deposits and savings deposit accounts. These include, but are not limited to, the following:



| |  |  | Demand deposit monthly activity fees
| | - |  | ------------------------------------



| |  |  | Service charges for checks for which there are non-sufficient funds or overdraft charges
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | ATM transaction fees
| | - |  | --------------------



| |  |  | Debit card transaction fees
| | - |  | ---------------------------

The principal factors that may affect
current or future income for service charges on deposit accounts are:



| |  |  | Internally generated growth
| | - |  | ---------------------------



| |  |  | Acquisitions of other banks/branches or de novo branches
| | - |  | --------------------------------------------------------



| |  |  | Adjustments to service charge structures
| | - |  | ----------------------------------------

Other fee
income consists of several categories, primarily the following:



| |  |  | Income earned on insurance policies owned by the bank on key executives
| | - |  | -----------------------------------------------------------------------



| |  |  | Fees for the issuance of official checks
| | - |  | ----------------------------------------



| |  |  | Fees for wire transfers
| | - |  | -----------------------



| |  |  | Safe deposit box rent
| | - |  | ---------------------



| |  |  | Income from the sale of customer checks
| | - |  | ---------------------------------------



| |  |  | Income on real estate loans
| | - |  | ---------------------------



| |  |  | Extension fees, insurance premiums, and letter of credit fees
| | - |  | -------------------------------------------------------------



| |  |  | Income earned from Valley Wealth Management, Inc.
| | - |  | -------------------------------------------------

Levels
of income derived from these categories vary. For example, general market conditions and new insurance premiums purchased affect the income earned on bank owned life insurance. Fees for the issuance of official checks and customer check sales tend
to grow as new branches are added. Fee schedules, while subject to change, generally do not alone yield a significant or discernable increase in income when they change. Additionally, with rising interest rates, mortgage originations and
re-financings have slowed down, which decreases the fee income earned on real estate loans.



23



---

##### Table of Contents

Noninterest Expense

Noninterest expense for the three month period ended June 30, 2006 and 2005 is shown in the following table:

Noninterest Expense

(dollars in thousands)



|                                           |  |                      |       |                      |       |                       |     |   
|------------------------------------------ |  | -------------------- | ----- | -------------------- | ----- | --------------------- | --- | --
|                                           |  | 3 monthsEnded6/30/06 |       | 3 monthsEnded6/30/05 |       | % Increase/(Decrease) |    
|Compensation                               |  | $                    | 1,531 |                      | 1,169 |                       | 31  | % 
|Occupancy                                  |  |                      | 170   |                      | 149   |                       | 14  | % 
|Equipment                                  |  |                      | 129   |                      | 112   |                       | 15  | % 
|Data processing                            |  |                      | 155   |                      | 145   |                       | 7   | % 
|Advertising and marketing                  |  |                      | 71    |                      | 80    |                       | (11 | )%
|Audit fees                                 |  |                      | 73    |                      | 78    |                       | (6  | )%
|Franchise and purchased tax credit expense |  |                      | 67    |                      | 47    |                       | 43  | % 
|Business manager                           |  |                      | 67    |                      | 70    |                       | (4  | )%
|Deposit expense                            |  |                      | 62    |                      | 50    |                       | 24  | % 
|Loan expense                               |  |                      | 56    |                      | 64    |                       | (13 | )%
|Computer software                          |  |                      | 105   |                      | 69    |                       | 52  | % 
|Other expense                              |  |                      | 366   |                      | 278   |                       | 32  | % 
|                                           |  |                      |       |                      |       |                       |     |   
|Total noninterest expense                  |  | $                    | 2,852 |                      | 2,311 |                       | 23  | % 
|                                           |  |                      |       |                      |       |                       |     |   

Noninterest expense for the six months ended June 30, 2006 and 2005 is as follows:

Noninterest Expense

(dollars in thousands)



|                                           |  |                      |       |                      |   |                       |  |    |   
|------------------------------------------ |  | -------------------- | ----- | -------------------- | - | --------------------- |  | -- | --
|                                           |  | 6 monthsEnded6/30/06 |       | 6 monthsEnded6/30/05 |   | % Increase/(Decrease) | 
|Compensation                               |  | $                    | 3,016 |                      | $ | 2,213                 |  | 36 | % 
|Occupancy                                  |  |                      | 327   |                      |   | 296                   |  | 11 | % 
|Equipment                                  |  |                      | 264   |                      |   | 224                   |  | 18 | % 
|Data processing                            |  |                      | 307   |                      |   | 275                   |  | 12 | % 
|Advertising and marketing                  |  |                      | 155   |                      |   | 124                   |  | 25 | % 
|Audit fees                                 |  |                      | 146   |                      |   | 151                   |  | (3 | )%
|Franchise and purchased tax credit expense |  |                      | 134   |                      |   | 93                    |  | 44 | % 
|Business manager                           |  |                      | 128   |                      |   | 140                   |  | (9 | )%
|Deposit expense                            |  |                      | 161   |                      |   | 102                   |  | 58 | % 
|Loan expense                               |  |                      | 111   |                      |   | 107                   |  | 4  | % 
|Computer software                          |  |                      | 188   |                      |   | 137                   |  | 37 | % 
|Other expense                              |  |                      | 636   |                      |   | 500                   |  | 27 | % 
|                                           |  |                      |       |                      |   |                       |  |    |   
|Total noninterest expense                  |  | $                    | 5,573 |                      | $ | 4,362                 |  | 28 | % 
|                                           |  |                      |       |                      |   |                       |  |    |   



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##### Table of Contents

Compensation expense has increased over the prior year due to officer merit increases effective
January 1, 2006; however, it does not include any year-end performance bonus accruals for either period due to the special loan loss provision taken. Occupancy and equipment expense increases are primarily attributable to the new occupancy (and
related equipment purchases) of the 6thand 7thfloors of our main headquarters. Additionally, we have upgraded a number of our computer servers. Advertising and marketing expense increase is primarily
attributable to an increase in advertising for deposits as well as advertising costs associated with Valley Wealth Management, Inc. The large increase in franchise and purchased tax credit expense is a direct result of the significant deposit growth
the Bank has experienced. Deposit expense is up due to the write-off of $30,000 related to a fraudulent check scheme as well as an increase in our courier expenses and other miscellaneous charges. The increase in computer software expense is
attributable to the amortization of new computer software programs installed and in use for regulatory purposes as well as for customer relationship management. Noninterest expenses are expected to continue to increase as a direct result of business
growth and expansion.

Income Taxes

To
reflect our anticipated federal income tax liability, an expense of $691,000 at an effective tax rate of 28.4% was recognized for the six months ended June 30, 2006, compared to an expense of $500,000 at an effective tax rate of 26.4%
recognized for the six months ended June 30, 2005. The provision for income taxes for the second quarter of 2006 was $446,000 at an effective tax rate of 30.0%, as compared to $267,000 at an effective tax rate of 27.0% for the second quarter of
2005. There was a true-up of tax expense during the second quarter of approximately $13,000 related to option and restricted stock grant expense. Factors contributing to the difference between the effective tax rate and the statutory
rate of 34% include provision for loan loss reserves not allowed for tax purposes, tax-exempt interest income on municipal securities (net of disallowance), and tax-exempt income earned on bank-owned life insurance.

Investment Securities

Our investment portfolio is
used both for investment income and liquidity purposes. At this time, we do not invest in derivatives or other types of high-risk securities. Unrealized gains and losses on securities available-for-sale are recognized as direct increases or
decreases in net shareholders equity. Funds not used for capital expenditures or lending activities are invested in the following:



| |  |  | Securities of the U.S. Government and its agencies
| | - |  | --------------------------------------------------



| |  |  | Treasury notes
| | - |  | --------------



| |  |  | Callable agency bonds
| | - |  | ---------------------



| |  |  | Noncallable agency bonds
| | - |  | ------------------------



| |  |  | Mortgage-backed securities and collateralized mortgage obligations
| | - |  | ------------------------------------------------------------------



| |  |  | Pools issued by government agencies
| | - |  | -----------------------------------



| |  |  | AAA rated corporate mortgage pools
| | - |  | ----------------------------------



| |  |  | Municipal bonds
| | - |  | ---------------



| |  |  | Taxable general obligation and revenue issues
| | - |  | ---------------------------------------------



| |  |  | Tax-exempt general obligation and revenue issues
| | - |  | ------------------------------------------------



| |  |  | Investment grade corporate bonds
| | - |  | --------------------------------



| |  |  | Restricted equity securities
| | - |  | ----------------------------



| |  |  | Federal Reserve Bank of Richmond shares
| | - |  | ---------------------------------------



| |  |  | Federal Home Loan Bank of Atlanta shares
| | - |  | ----------------------------------------



| |  |  | Community Bankers Bank shares
| | - |  | -----------------------------



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##### Table of Contents

Investment securities (available for sale and held to maturity), including restricted equity securities,
at June 30, 2006 were $60.7 million, an increase of $2.7 million or 4.7% from their level of $57.9 million on December 31, 2005. The increase is attributable to new investment security purchases of $5.0 million, offset by the principal
prepayments on mortgage-backed securities. See Note 3 to the Consolidated Financial Statements.

Loan Portfolio

Our total loans were $449.3 million at June 30, 2006, an increase of $34.9 million or 8% from the $414.4 million reported at December 31, 2005.
Our ratio of total loans to total funding sources (customer deposits, securities sold under agreements to repurchase, federal funds purchased, Federal Home Loan Bank advances, and guaranteed preferred beneficial interests in the Companys
junior subordinated debentures) stood at 89.4% at June 30, 2006 and 89.2% at December 31, 2005. Management seeks to maintain the ratio of loans to funding sources at a maximum of 85%. The Board of Directors has approved the temporary
overage at June 30, 2006. Management will work diligently to bring the ratio back below the 85% level by the end of the current fiscal year.

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

The following table summarizes the loan portfolio by category, net of deferred fees, as of the
six-month periods ended June 30, 2006 and 2005 and the year ended December 31, 2005:

Loan Portfolio Summary

(dollars in thousands)



|                                                           |  |         |  |          |  |         |  |       |  |         |  |      
|---------------------------------------------------------- |  | ------- |  | -------- |  | ------- |  | ----- |  | ------- |  | -----
|                                                           |  | 6/30/06 |  | 12/31/05 |  | 6/30/05
|                                                           |  | $       |  | %        |  | $       |  | %     |  | $       |  | %    
|Commercial                                                 |  | 97,705  |  | 21.8     |  | 97,904  |  | 23.6  |  | 78,405  |  | 23.3 
|Commercial real estate                                     |  | 167,352 |  | 37.2     |  | 159,962 |  | 38.6  |  | 131,954 |  | 39.2 
|Real estate construction                                   |  | 71,121  |  | 15.8     |  | 55,810  |  | 13.5  |  | 43,046  |  | 12.8 
|Residential real estate                                    |  | 105,011 |  | 23.4     |  | 92,957  |  | 22.4  |  | 75,379  |  | 22.4 
|Loans to individuals (except those secured by real estate) |  | 8,150   |  | 1.8      |  | 7,744   |  | 1.9   |  | 7,731   |  | 2.3  
|                                                           |  |         |  |          |  |         |  |       |  |         |  |      
|Total loans                                                |  | 449,339 |  | 100.0    |  | 414,377 |  | 100.0 |  | 336,515 |  | 100.0
|                                                           |  |         |  |          |  |         |  |       |  |         |  |      

Loan Category Analysis

Commercial Loans. Commercial loans generally are made to provide operating lines of credit, to finance the purchase of inventory or equipment, and for other business purposes. The credit worthiness of the
borrower is analyzed and re-evaluated on a periodic basis. Most commercial loans are collateralized with business assets such as accounts receivable, inventory and equipment. Even with substantial collateral, such as all the assets of the business
and personal guarantees, commercial lending involves considerable risk of loss in the event of a business downturn or failure of the business.



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##### Table of Contents

Commercial Real Estate Loans.Commercial real estate construction and commercial real estate
mortgages represent interim and permanent financing of commercial properties that are secured by real estate. The Company prefers to make commercial real estate loans secured by owner-occupied properties. These borrowers are engaged in business
activities other than real estate, and the primary source of repayment is not solely dependent on conditions in the real estate market.

Real Estate Construction Loans. Real estate construction loans represent interim financing on residential and commercial properties under construction, and are secured by real estate. Once construction is completed and the loan
becomes permanent, the loans are reclassified as either commercial real estate loans, which are secured by commercial property or residential real estate loans, which are secured by first deeds of trust.

Residential Real Estate Loans. Residential real estate loans are secured by first deeds of trust on 1-4 family residential properties. To mitigate
interest rate risk, the Company usually limits the final maturity of residential real estate loans held for its own portfolio to 15-20 years, although exceptions are made for competitive reasons and under special programs. Residential real estate
lending involves risk elements when there is lack of timely payment and/or a decline in the value of the collateral.

Loans to
Individuals.Loans to individuals include installment loans, home equity lines of credit, and loans secured by junior liens on residential real estate. The loan proceeds typically are used to purchase vehicles, finance home remodeling, higher
education, or for other consumer purposes.

Asset Quality

Summary of Allowance for Loan Losses

The allowance for loan losses represents an amount that, in our judgment, will be
adequate to absorb any losses on existing loans that may become uncollectible, although there can be no assurance that this will be so. The provision for loan losses increases the allowance, and loans charged off (net of recoveries) reduce the
allowance.

In recognition of our estimate of inherent risks associated with lending activities, a provision for loan losses of $706,000
was provided during the six months ended June 30, 2006, a decrease of $19,000 or 3% under the $725,000 reported during the same period in 2005. For the three months ended June 30, 2006, a provision for loan losses of $119,000 was made
versus $401,000 during the same period in 2005, a 70% decrease of $282,000. This large decrease is due to the special provision of $271,000 that was made during the second quarter of 2005 for one large commercially-oriented credit relationship. This
specific credit was subsequently resolved during the third quarter of 2005. As discussed above, we made a similar special provision of $325,000 during the first quarter of 2006 for a commercially-oriented credit relationship that slipped into the
non-performing category as of March 31, 2006.

The ratio of the allowance for loan losses to total loans outstanding was approximately
1.1% at June 30, 2006, which compares to approximately 1.0% of net loans at December 31, 2005 (see Note 4 to the Consolidated Financial Statements). These estimates are primarily based on our historical loss experience, portfolio
concentrations, evaluation of individual loans and economic conditions. A total of $1,420,000 in special reserves is included in the balance of the allowance for loan losses as of June 30, 2006 for impaired loans, which



27



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##### Table of Contents

compares to a total of $344,000 as of December 31, 2005. The $1,420,000 in special reserves is concentrated in two
large relationships within our overall loan portfolio. A total of $495,000 in special reserves was included in the balance of the allowance for loan losses as of June 30, 2005 for impaired loans and was concentrated in one large relationship
within the overall loan portfolio. This credit issue was subsequently resolved during the third quarter of 2005 with a related net charge-off of $163,000.

We regularly review asset quality and re-evaluate the allowance for loan losses. However, no assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased
provisions in the future. Additionally, regulatory examiners may require us to recognize additions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations. (See
Allowance for Loan Losses under Critical Accounting Policies.)

Nonperforming Assets and Impaired Loans

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

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

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

For the six months ended June 30, 2006, our non-performing assets to total assets ratio increased from 0.72% at
December 31, 2005 to 1.46%. Additionally, our loans past due more than 90 days increased from 0.10% at December 31, 2005 to 0.26% at June 30, 2006. The increase in the non-performing asset ratio is primarily attributable to the
commercially-oriented credit relationship mentioned above. All related loans, aggregating approximately $5.0 million, were placed on nonaccrual status during the first quarter. A possible resolution of this problem credit is projected to occur
during the third quarter of 2006 and we believe we have reserved an amount that should be sufficient to cover any potential losses. Although we presently believe any unreserved loan balances are secured by customer assets pledged as collateral, it
is obviously a situation which can change, which we are constantly monitoring. Nonperforming assets at June 30, 2006, December 31, 2005 and June 30, 2005 are presented in the following table:

Nonperforming Assets

(dollars in
thousands)



|                                             |  |         |       |          |   |         |  |   |      
|-------------------------------------------- |  | ------- | ----- | -------- | - | ------- |  | - | -----
|                                             |  | 6/30/06 |       | 12/31/05 |   | 6/30/05
|Nonaccrual loans                             |  | $       | 4,982 |          | $ | 104     |  | $ | 1,295
|Loans past due 90 days or more               |  |         | 193   |          |   | 423     |  |   | 2    
|Restructured loans                           |  |         |      |          |   |        |  |   |     
|Other nonperforming loans (1)                |  |         | 2,666 |          |   | 3,062   |  |   |     
|                                             |  |         |       |          |   |         |  |   |      
|Total nonperforming loans                    |  | $       | 7,841 |          | $ | 3,589   |  | $ | 1,297
|                                             |  |         |       |          |   |         |  |   |      
|Foreclosed, repossessed and idled properties |  |         |      |          |   |        |  |   | 1,142
|                                             |  |         |       |          |   |         |  |   |      
|Total nonperforming assets                   |  | $       | 7,841 |          | $ | 3,589   |  | $ | 2,439
|                                             |  |         |       |          |   |         |  |   |      

---

|(1) | Other nonperforming loans include impaired loans which are not on nonaccrual status or past due 90 days or more.
|--- | ----------------------------------------------------------------------------------------------------------------



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Each quarter, the Directors Loan Committee, composed of eight directors, reviews all loans on our
watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review. We believe that the above allocated reserves are appropriate for the impaired loans in our portfolio based upon a detailed
review of the quality and pledged collateral of each individual loans considered impaired at each of the above-referenced periods. (See Impairment of Loans under Critical Accounting Policies.)

If nonaccrual loans had performed in accordance with their original terms, additional interest income in the amount of $109,000 for the six-month period
ended June 30, 2006; $1,230 for the year ended December 31, 2005; and $24,000 for the six-month period ended June 30, 2005 would have been recorded.

Additionally, the Banks credit risk process provides ongoing assessment of the loan portfolios risk profile in accordance with standard industry practices. Loan assets which do not support satisfactory
risk ratings under this basis are subjected to a well-defined, ongoing management and reporting process. These Watch-List loan assets were as follows as of June 30, 2006, December 31, 2005, and June 30, 2005:

Watch List Credits

(dollars in thousands)



|                   |  |         |        |   |          |   |        |         |  |   |        |  
|------------------ |  | ------- | ------ | - | -------- | - | ------ | ------- |  | - | ------ | -
|                   |  | 6/30/06 |        |   | 12/31/05 |   |        | 6/30/05 | 
|Watch List Credits |  | $       | 20,898 |   |          | $ | 18,192 |         |  | $ | 16,224 |  
|% of Total Loans   |  |         | 4.65   | % |          |   | 4.39   | %       |  |   | 4.82   | %

Other Assets

We have purchased life insurance contracts on key employees, the tax-exempt income from which is the funding vehicle for the Companys Supplemental Executive Retirement Plan (SERP). Bank owned life
insurance was $10.9 million at June 30, 2006, an increase of $2 million over the $8.9 million reported as of December 31, 2005. The increase is due to the $1.1 million purchase of additional life insurance contracts on key employees and a
$900,000 increase in the cash surrender value of the life insurance contracts.

Deposits

The levels and mix of deposits are influenced by such factors as customer service, interest rates paid, service charges and the convenience of banking
locations. Competition for deposits is intense from other depository institutions and money market funds, some of which offer interest rates higher than we pay. We attempt to identify and implement pricing and marketing strategies designed to
control the overall cost of deposits and to maintain a stable deposit mix.



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##### Table of Contents

The following table summarizes our total deposits for the six months ended June 30, 2006 and for the
year ended December 31, 2005:

Deposit Summary

(dollars in thousands)



|                                       |  |         |  |          |  |                     |  |       |  |        |   |  |       |  
|-------------------------------------- |  | ------- |  | -------- |  | ------------------- |  | ----- |  | ------ | - |  | ----- | -
|                                       |  | 6/30/06 |  | 12/31/05 |  | Increase/(Decrease) | 
|                                       |  | $       |  | %        |  | $                   |  | %     |  | $      |   |  | %     |  
|Time deposits                          |  | 253,865 |  | 64.3     |  | 234,809             |  | 64.3  |  | 19,056 |   |  | 8.1   |  
|Interest bearing demand & money market |  | 65,891  |  | 16.7     |  | 50,279              |  | 13.8  |  | 15,612 |   |  | 31.1  |  
|Savings                                |  | 52,479  |  | 13.3     |  | 60,762              |  | 16.6  |  | (8,283 | ) |  | (13.6 | )
|                                       |  |         |  |          |  |                     |  |       |  |        |   |  |       |  
|Total interest bearing deposits        |  | 372,235 |  | 94.3     |  | 345,850             |  | 94.7  |  | 26,385 |   |  | 7.6   |  
|                                       |  |         |  |          |  |                    
|Noninterest demand & official checks   |  | 22,475  |  | 5.7      |  | 19,466              |  | 5.3   |  | 3,009  |   |  | 15.5  |  
|                                       |  |         |  |          |  |                     |  |       |  |        |   |  |       |  
|Total deposits                         |  | 394,710 |  | 100.0    |  | 365,316             |  | 100.0 |  | 29,394 |   |  | 8.0   |  
|                                       |  |         |  |          |  |                     |  |       |  |        |   |  |       |  

We would prefer to have transaction accounts comprise a larger percentage of total deposits, but
in order to fund our loan growth, we often have to rely on higher-cost certificates of deposit. However, during the second quarter of 2006, we were successful in raising $24.7 million with our new money market product. Within the certificate of
deposit category, we have marketed CDs nationally to institutional depositors, primarily banks, thrift institutions and credit unions through an Internet-based rate posting service. National market CDs at June 30, 2006 were $11.2 million, a
decrease of $5.3 million from the $16.5 million reported at December 31, 2005 and represent 4.43% of total CDs and 2.85% of total deposits at June 30, 2006.

Short-Term Borrowings

Total short-term borrowings (including federal funds purchased and securities
sold under agreements to repurchase) decreased by $12.1 million from their level of $50.8 million at December 31, 2005 to a total of $38.7 million as of June 30, 2006. The decrease was primarily attributable to the payoff of the $11
million short term daily rate credit with the Federal Home Loan Bank of Atlanta (FHLB) using the proceeds from the two new long-term FHLB advances. (See Footnote 9 of the Companys Consolidated Financial Statements for more
information on the long-term advances.) Short-term borrowings at June 30, 2006 include federal funds purchased of $8.7 million, Federal Home Loan Bank of Atlanta (FHLB) borrowings in the amount of $15.0 million, and a commercial
sweep account program in the amount of $15 million.

The FHLB borrowings include a $10 million adjustable rate credit which matures on
December 18, 2006 and reprices quarterly on the date of each quarterly interest payment (rate of 5.48% on June 30, 2006). The second FHLB credit of $5 million matures on October 31, 2006 and reprices monthly at 1-month LIBOR + 10
basis points (rate of 5.45% on June 30, 2006).

The commercial sweep program involves balances subject to repurchase agreements which
are reported as short term borrowings rather than deposits since they are not FDIC insured. The balance in the program is $15.0 million at June 30, 2006, an increase of $4.2 million from the $10.8 million level at December 31, 2005. The
program consists of a demand deposit account from which we invest available balances daily in securities on an overnight basis subject to repurchase. On the following business day, we repurchase from the customer the securities for an amount equal
to the amount of available balances invested in the securities. Interest is calculated daily at the rate applicable for each overnight period; however, it is posted to the customer accounts only once per month.



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##### Table of Contents

Long-Term Borrowings

Federal Home Loan Bank advances are relatively cost-effective funding sources and provide us with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity.
Long-term convertible Federal Home Loan Bank advances totaled $58.0 million at June 30, 2006 and $37.0 million at December 31, 2005, an increase of $21 million. This increase is made up of a $13 million convertible advance and an $8.0
million variable rate advance. (See Footnote 9 of the Companys Consolidated Financial Statements for more information on the long-term advances.)

Guaranteed Preferred Beneficial Interests in the Companys Junior Subordinated Debentures

Valley Financial (VA)
Statutory Trust II, a statutory business trust (Trust II), was created on September 26, 2005, at which time Trust II issued $7.0 million in aggregate liquidation amount of $1 par value preferred capital trust securities which mature
December 15, 2035. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate (LIBOR) plus 1.49%, and the securities may be prepaid at par by Trust II at any time after
December 15, 2010. The principal assets of Trust II are $7.2 million of the Companys junior subordinated debentures which mature on December 15, 2035, and bear interest at a floating rate equal to the 3-month LIBOR plus 1.49%, and
which are callable by the Company after December 15, 2010. All $217,000 in aggregation liquidation amount of Trust IIs common securities are held by the Company.

Valley Financial (VA) Statutory Trust I, a statutory business trust (Trust I), was created on June 26, 2003, at which time the Trust
issued $4.0 million in aggregate liquidation amount of $1 par value preferred capital trust securities which mature June 26, 2033. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate
(LIBOR) plus 3.10%, capped at 11.75%, and the securities may be prepaid at par by Trust I at any time after June 26, 2008. The principal assets of Trust I are $4.1 million of the Companys junior subordinated debentures which
mature on June 26, 2033, and bear interest at a floating rate equal to the 3-month LIBOR plus 3.10%, capped at 11.75%, and which are callable by the Company after June 26, 2008. All $124,000 in aggregation liquidation amount of Trust
Is common securities are held by the Company.

The debenture proceeds from Trust I and Trust II are included in our Tier 1 capital
for regulatory capital adequacy purposes to the extent that they do not exceed 25% of our total Tier I capital including the securities. This amount totaled $10,944,000 (of the $11,000,000 outstanding) at June 30, 2006. The remaining $56,000 is
included in the calculation of our total risk-based capital ratio as Tier 2 capital. Our obligations with respect to the issuance of Trust I and Trust IIs preferred securities and common securities constitute a full and unconditional guarantee
of Trust I and Trust IIs obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, we may elect from time to time to defer interest payments on its junior subordinated
debentures, which would result in a deferral of distribution payments on Trust I and Trust IIs preferred trust securities and common securities.

Capital Adequacy

We seek to maintain a capital structure adequate to support anticipated asset growth and serve as a
cushion to absorb potential losses. Our financial position at June 30, 2006 reflects liquidity and capital levels currently adequate to fund anticipated near-term business expansion. We review the adequacy of our capital on an ongoing basis at
the Company and Bank level and are committed to maintaining a total risk based capital ratio of 10% or greater at the Bank level, as is required for a well capitalized institution. We will be monitoring the



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##### Table of Contents

Bank capital ratios very closely throughout the remainder of the year due to the strain of the one large non-performing
commercially-oriented relationship, as the current years performance is substantially dependent upon the outcome of this credit.

For
the periods indicated, the Company had the following risk-based capital and leverage ratios:

Valley Financial Corporation



|         |  |         |   |  |          |   |  |         |  
|-------- |  | ------- | - |  | -------- | - |  | ------- | -
|Ratio    |  | 6/30/06 |   |  | 12/31/05 |   |  | 6/30/05 |  
|Tier 1   |  | 9.4     | % |  | 9.7      | % |  | 9.4     | %
|Total    |  | 10.4    | % |  | 10.8     | % |  | 10.4    | %
|Leverage |  | 8.4     | % |  | 8.8      | % |  | 8.1     | %

For the periods indicated, the Bank had the following risk-based capital and leverage ratios:

Valley Bank



|         |  |         |   |  |          |   |  |         |  
|-------- |  | ------- | - |  | -------- | - |  | ------- | -
|Ratio    |  | 6/30/06 |   |  | 12/31/05 |   |  | 6/30/05 |  
|Tier 1   |  | 9.0     | % |  | 9.2      | % |  | 9.2     | %
|Total    |  | 10.0    | % |  | 10.1     | % |  | 10.2    | %
|Leverage |  | 8.1     | % |  | 8.0      | % |  | 7.7     | %

Total shareholders equity grew by $1,029,000 from December 31, 2005 to June 30,
2006. Earnings, proceeds from the exercise of incentive stock options, the change in unrealized gains and losses for securities available for sale, and the change in unrealized gains and losses for derivatives not held for trading accounted for the
net increase. The Company paid its fifth consecutive semi-annual cash dividend on the Companys common stock, in the amount of $0.07 per share on July 3, 2006 to shareholders of record June 1, 2006.

Liquidity

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

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

Liquid assets, which include cash and due from banks, interest-bearing deposits at
other banks and non-pledged securities available-for-sale, at June 30, 2006 totaled $15.3 million. Our funding sources consist of an established federal funds lines with a regional correspondent bank totaling $12 million that had a
$682,000 balance as of June 30, 2006, three established federal funds lines with third party banks totaling $21 million that had outstanding balances totaling $7,984,000 as of June 30, 2006, and an established line with the
FHLB that had $73 million outstanding under a total line of $112.6 million as of June 30, 2006. We believe these arrangements will be renewed at maturity.



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We sell excess funds as overnight federal funds sold to provide an immediate source of liquidity. We had
federal funds sold of $0 at June 30, 2006 and December 31, 2005.

As a result of our management of liquid assets and our ability
to generate liquidity through alternative funding sources, we believe we maintain overall liquidity sufficient to meet our depositors requirements and satisfy our customers credit needs.

Impact of Inflation

The Consolidated Financial
Statements and Notes presented have been prepared in accordance with generally accepted accounting principles, which requires the measurement of financial position and operating results in terms of historical dollars without considering changes in
the relative purchasing power of money over time due to inflation. Unlike most industrial companies, nearly all the assets and liabilities of the Company and the Bank are monetary in nature. As a result, interest rates have a greater impact on our
performance than do the effects of changes in the general rate of inflation and changes in prices. In addition, interest rates do not necessarily move in the same direction, or in the same magnitude, as do the prices of goods and services. We seek
to manage the relationship between interest-sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations, including those resulting from inflation.

Recent and Future Accounting Considerations

In May
2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 establishes retrospective application as the required method
for reporting a change in accounting principle, unless it is impracticable, in which case the changes should be applied to the latest practicable date presented. SFAS No. 154 also requires that a correction of an error be reported as a prior
period adjustment by restating prior period financial statements. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

In December 2005, the FASB issued FSP SOP 94-6-1, Terms of Loan Products that May Give Rise to a Concentration of Credit Risk. The disclosure
guidance in this FSP is effective for interim and annual periods ending after December 19, 2005. The FSP states that the terms of certain loan products may increase a reporting entitys exposure to credit risk and thereby may result in a
concentration of credit risk as that term is used in SFAS No. 107, either as an individual product type or as a group of products with similar features. SFAS No. 107 requires disclosures about each significant concentration, including
information about the (shared) activity, region, or economic characteristic that identifies the concentration. The FSP suggests possible shared characteristics on which significant concentrations may be determined which include, but are
not limited to (1) loans that subject borrowers to significant payment increases, (2) loans with terms that permit negative amortization, and (3) loans with high loan-to-value ratios. This FSP requires entities to provide the
disclosures required by SFAS No. 107 for loan products that are determined to represent a concentration of credit risk in accordance with the guidance of this FSP for all periods presented. The Bank adopted this disclosure standard effective
December 31, 2005.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The principal goals of our asset and
liability management strategy are the maintenance of adequate liquidity and the management of interest rate risk. Liquidity is the ability to convert assets to cash to fund depositors withdrawals or borrowers loans without significant
loss. Interest rate risk management balances the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Bank from wide fluctuations in its net interest income which could result from
interest rate changes.



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We attempt to ensure that adequate funds are available at all times to meet the needs of our customers.
On the asset side of the balance sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity. On the liability side of the balance sheet, liquidity sources
include core deposits, the ability to increase large denomination certificates of deposit, federal fund lines from correspondent banks, borrowings from the FHLB and the Federal Reserve Bank, as well as the ability to generate funds through the
issuance of long-term debt and equity.

Interest rate risk is the effect that changes in interest rates would have on interest income and
interest expense as interest-sensitive assets and interest-sensitive liabilities either re-price or mature. We attempt to maintain the portfolios of interest-earning assets and interest-bearing liabilities with maturities or re-pricing opportunities
at levels that will afford protection from substantial erosion of net interest margin, to the extent practical, from changes in interest rates.

We use a number of tools to manage our interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap
between rate sensitive assets and rate sensitive liabilities over various time periods. (See Interest Rate Risk.)

Item 4. Controls and Procedures.

As of the end of the period covered by the report, an evaluation was
performed under the supervision and with the participation of the Companys management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There have not
been any changes in our internal control over financial reporting that occurred during the last quarter that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

The design of any system of controls is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any
design will succeed in achieving its stated goal under every potential condition, regardless of how remote. In addition, the operation of any system of controls and procedures is dependent upon the employees responsible for executing it. While we
have evaluated the operation of our disclosure controls and procedures and found them effective, there can be no assurance that they will succeed in every instance to achieve their objective.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

There were no pending legal proceedings during the quarter.

Item 1A. Risk Factors.

The only material change to the risk factors disclosed in the Companys
Annual Report Form 10-K



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for the year ended December 31, 2005 is the increase in our nonperforming assets and watch-list credits as discussed
in the Asset Quality section of Managements Discussion and Analysis above. All other risk factors disclosed in the Companys Annual Report Form 10-K for the year ended December 31, 2005 are applicable as of June 30, 2006.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

There were no unregistered sales of
equity securities during the quarter.

Item 3. Defaults Upon Senior Securities.

There were no defaults upon Senior Securities in the quarter.

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

We held our 2006 Annual Meeting of
Shareholders on April 26, 2006, at which meeting five Class C directors were reelected to new three-year terms. The following table indicates the total votes in favor of, and withheld from voting on, the re-election of each nominee, and
provides certain information with respect to those directors not standing for re-election whose term of office continued past the 2006 Annual Meeting of Shareholders:



|                          |  |                |  |                  |  |               
|------------------------- |  | -------------- |  | ---------------- |  | --------------
|DIRECTORNAME              |  | TERM OF OFFICE |  | AFFIRMATIVEVOTES |  | VOTES WITHHELD
|Class A Directors         |  |                |  |                  |  |               
|James S. Frantz, Jr.      |  | 2005-2007      |  | Not applicable   |  | Not applicable
|Eddie F. Hearp            |  | 2004-2007      |  | Not applicable   |  | Not applicable
|Anna L. Lawson            |  | 2004-2007      |  | Not applicable   |  | Not applicable
|John W. Starr, M.D.       |  | 2004-2007      |  | Not applicable   |  | Not applicable
|Michael E. Warner         |  | 2004-2007      |  | Not applicable   |  | Not applicable
|Class B Directors         |  |                |  |                  |  |               
|Abney S. Boxley, III      |  | 2005-2008      |  | Not applicable   |  | Not applicable
|William D. Elliot         |  | 2005-2008      |  | Not applicable   |  | Not applicable
|Barbara B. Lemon          |  | 2005-2008      |  | Not applicable   |  | Not applicable
|Samuel L. Lionberger, Jr. |  | 2005-2008      |  | Not applicable   |  | Not applicable
|Ward W. Stevens, M.D.     |  | 2005-2008      |  | Not applicable   |  | Not applicable
|Class C Directors         |  |                |  |                  |  |               
|Ellis L. Gutshall         |  | 2006-2009      |  | 3,593,723        |  | 614           
|Mason Haynesworth         |  | 2006-2009      |  | 3,592,149        |  | 2,188         
|A. Wayne Lewis            |  | 2006-2009      |  | 3,593,723        |  | 614           
|George W. Logan           |  | 2006-2009      |  | 3,593,723        |  | 614           
|Geoffrey M. Ottaway       |  | 2006-2009      |  | 3,593,345        |  | 992           

Item 5. Other Information.

None.



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Item 6. Index to Exhibits

(a) We filed the following exhibits for the quarter ended June 30, 2006:



|               |  |                                                                                                                                                                                                                                   
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                       
|3.1            |  | Articles of Incorporation (incorporated herein by reference to Exhibit No. 3.1 of Registration Statement No. 33-77568, on Form S-1, as amended).                                                                                  
|               | 
|3.2            |  | Bylaws (incorporated herein by reference to Exhibit No. 3.2 of Registration Statement No. 33-77568, on Form S-1, as amended).                                                                                                     
|               | 
|3.3            |  | Bylaws as amended July 19, 2003 (incorporated herein by reference to Exhibit 3.3 of Form 10-KSB filed March 30, 2005, File No. 000-28342).                                                                                        
|               | 
|10.2*          |  | Stock Option Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.4 of Form 10-KSB filed March 27,
1997, File No. 33-77568).                   
|               | 
|10.3*          |  | Severance Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.3 of Form 10-KSB filed March 27,
1997, File No. 33-77568).                      
|               | 
|10.4*          |  | Stock Option Agreement dated January 29, 2001 by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.4 of Form 10-K filed March 28,
2006, File No. 33-77568).                       
|               | 
|10.5*          |  | Stock Option Agreement dated January 10, 2002, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.5 of Form 10-K filed March 28,
2006, File No. 33-77568).                      
|               | 
|10.6*          |  | Stock Option Agreement dated July 5, 2005, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.6 of Form 10-K filed March 28, 2006,
File No. 33-77568).                          
|               | 
|10.7*          |  | Restricted Stock Agreement dated July 5, 2005, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.7 of Form 10-K filed March 28,
2006, File No. 33-77568).                      
|               | 
|10.8*          |  | Employment agreement dated September 21, 2000, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit 10.2 of Form SB-2, filed September 27,
2000, and Form SB-2/A filed October 25, 2000).
|               | 
|10.9*          |  | Valley Bank Supplemental Retirement Plan effective January 1, 2002 (incorporated herein by reference to Exhibit 10.14 of Form 10-QSB filed May 15, 2002, File No.
33-77568).                                                      



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|       |  |                                                                                                                                                                                                                                                
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.10* |  | Employment agreement dated August 26, 2002, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit 10.15 of Form 10-QSB filed November 14,
2002, File No. 33-77568).                                   
|       | 
|10.11  |  | Split-Dollar Insurance Agreement dated August 20, 2003, by and between Valley Bank and Ellis L. Gutshall (incorporated herein by reference to Exhibit 10.16 of Form 10-QSB filed
November 14, 2003, File No. 33-77568).                        
|       | 
|10.12* |  | Stock Option Agreement dated February 9, 1998, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.12 of Form 10-K filed March 28,
2006, File No. 33-77568).                                 
|       | 
|10.13  |  | Split-Dollar Insurance Agreement dated August 20, 2003, by and between Valley Bank and J. Randy Woodson (incorporated herein by reference to Exhibit 10.18 of Form 10-QSB filed
November 14, 2003, File No. 33-77568).                         
|       | 
|10.14* |  | Stock Option Agreement dated January 21, 1999, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.14 of Form 10-K filed March 28,
2006, File No. 33-77568).                                 
|       | 
|10.15* |  | Stock Option Agreement dated December 16, 1999, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.15 of Form 10-K filed March 28,
2006, File No. 33-77568).                                
|       | 
|10.16* |  | Stock Option Agreement dated January 29, 2001, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.16 of Form 10-K filed March 28,
2006, File No. 33-77568).                                 
|       | 
|10.17* |  | Stock Option Agreement dated January 10, 2002, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.17 of Form 10-K filed March 28,
2006, File No. 33-77568).                                 
|       | 
|10.18* |  | Stock Option Agreement dated August 26, 2002, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.18 of Form 10-K filed March 28,
2006, File No. 33-77568).                                  
|       | 
|10.19  |  | Insurance Transfer Agreement dated December 31, 2003 by and among Valley Financial Corporation, Valley Bank, and Ellis L. Gutshall (incorporated herein by reference to Exhibit 10.20 of
Form 10-KSB filed March 30, 2004, File No. 000-28342).
|       | 
|10.20* |  | Stock Option Agreement dated July 5, 2005, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.20 of Form 10-K filed March 28,
2006, File No. 33-77568).                                     
|       | 
|10.21* |  | Restricted Stock Agreement dated July 5, 2005, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.21 of Form 10-K filed March 28,
2006, File No. 33-77568).                                 



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|       |  |                                                                                                                                                                                                             
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.22* |  | Stock Option Agreement dated November 11, 2004, by and between the Company and John T. McCaleb (incorporated herein by reference to Exhibit No. 10.22 of Form 10-K filed March 28,
2006, File No. 33-77568).
|       | 
|10.23* |  | Restricted Stock Agreement dated July 5, 2005, by and between the Company and John T. McCaleb (incorporated herein by reference to Exhibit No. 10.23 of Form 10-K filed March 28,
2006, File No. 33-77568). 
|       | 
|10.24* |  | Stock Option Agreement dated November 11, 2004, by and between the Company and Andrew B. Agee (incorporated herein by reference to Exhibit No. 10.24 of Form 10-K filed March 28,
2006, File No. 33-77568). 
|       | 
|10.25* |  | Restricted Stock Agreement dated July 5, 2005, by and between the Company and Andrew Agee (incorporated herein by reference to Exhibit No. 10.25 of Form 10-K filed March 28, 2006,
File No. 33-77568).     
|       | 
|11     |  | Statement re Computation of Earnings per Share (filed herewith as Note 5).                                                                                                                                  
|       | 
|31.1   |  | Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                           
|       | 
|31.2   |  | Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                           
|       | 
|32.1   |  | Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                            
|       | 
|32.2   |  | Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                            

---

|* | Management contract or compensatory plan or agreement required to be filed as an Exhibit to this Form 10-Q pursuant to Item 13(a).
|- | ----------------------------------------------------------------------------------------------------------------------------------



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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 the undersigned thereunto duly authorized.



|                |  |                                                         
|--------------- |  | --------------------------------------------------------
|                |  | VALLEY FINANCIAL CORPORATION                            
|                | 
|August 14, 2006 |  | /s/ Ellis L. Gutshall                                   
|Date            |  | Ellis L. Gutshall, President and Chief Executive Officer
|                | 
|August 14, 2006 |  | /s/ Kimberly B. Snyder                                  
|Date            |  | Kimberly B. Snyder, Senior Vice President and           
|                |  | Chief Financial Officer                                 



39