**Exhibit 13.1**

**COASTAL BANKINGCOMPANY, INC.**

**2005 ANNUAL REPORT**

**Contents**

| To Our Shareholders                                                                         |   | 2  |   |
|---------------------------------------------------------------------------------------------|--------|----|--------|
| Financial  Highlights                                                                       |   | 3  |   |
| Selected  Financial Data                                                                    |   | 4  |   |
| Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 5  |   |
| Report of  Independent Registered Public Accounting Firm                                    |   | 21 |   |
| Consolidated Financial  Statements                                                          |   | 22 |   |
| Notes to  Consolidated Financial Statements                                                 |   | 27 |   |
| Corporate and  Shareholder Information                                                      |   | 51 |   |

 

**About the Company**

Coastal Banking Company, Inc.(the “Company”), headquartered in Beaufort, South Carolina, is a bank holdingcompany organized as a South Carolina corporation with two wholly-ownedsubsidiary banks, Lowcountry National Bank (“Lowcountry”), and First NationalBank of Nassau County (“First National”). Collectively, Lowcountry and FirstNational are referred to as the “Banks.” Through the Banks, the Companyprovides a full range of commercial and consumer banking services to domesticmarkets, principally in Beaufort County, South Carolina, and Nassau County,Florida. The Company also has an investment in Coastal Banking CompanyStatutory Trust I (the “Trust”). The Trust is a special purposenon-consolidated subsidiary organized for the sole purpose of issuing trustpreferred securities. The Company attributes its success to localdecision-making and a commitment to deliver superior, personal, friendly, andresponsive service to its customers. The Company first commenced its bankingoperations on May 10, 2000. FirstNational became a subsidiary of Coastal through merger on October 1, 2005.

**Our Vision**

*“Coastal Banking Company is the leader in the deliveryof comprehensive financial services responsive to the communities we serve.”*

**Our Values**

*“The values ofCoastal Banking Company shape our relationships with customers, employees, andshareholders while capturing the spirit of our business practices anddecisions.”*

*“Our directors,officers, and staff will always act with Integrity, guided by what isethical and right for our customers.”*

*“We are Customer-Centered:readily available, responsive to customers’ needs, and accountable for ouractions. We will provide unparalleled service and support.”*

*“As the financialservices industry changes, we will be Innovative to deliver the productsand services that exceed our customers’ expectations while producing a fairreturn to our shareholders.”*

*“These values will be the foundation of our operatingphilosophy in our daily environment.”*

**Locations**
| **Coastal Banking Company, Inc.** | ** ** | **Lowcountry National Bank**            | ** ** | **First National Bank of  Nassau County** |
|----------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------|
| **Lowcountry  National Bank**          | ** ** | **Bluffton, South Carolina Office**     | ** ** | **Fernandina Beach, Florida Office**      |
| 36 Sea Island  Parkway                 | ** ** | 1533 Fording Island Road Suite 300 | ** ** | 1891 South 14th Street                    |
| Beaufort, South  Carolina 29902        |       | Hilton Head Island,                     |       | Fernandina Beach, FL 32034                |
| (843) 522-1228                         |       | South Carolina 29926                    |       | (904) 321-0400                            |
| Website:  coastalbanking.com           |       | (843) 837-7977                          |       |                                      |

 

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**Coastal BankingCompany, Inc.**

Dear Shareholder:

Coastal Banking Company took a major step forward in2005 with the announcement and completion of its merger with First Capital BankHolding Company, parent company for First National Bank of Nassau County, Florida.The Company now operates through its two wholly-owned bank subsidiaries and iswell positioned to develop its coastal franchise with banks in Florida andSouth Carolina. This merger represents a strategic step forward that will allowus to expand our loan and deposit product services, streamline our operationsand expand our market presence.

The effective merger date of our two companies was October 1,2005. The balance sheet data that follows reflects the combined balance sheetsof the merged company at year-end December 31, 2005. Income statement andrelated performance data include the earnings for the twelve months of 2005with the inclusion of the merged companies from October 1 through the endof the year. All earnings per share figures are adjusted for a 5% stockdividend paid to shareholders on December 15, 2005.

At October 1, 2005, the assets of First Capitalwere merged into Coastal, effectively doubling our size. Those assets of FirstCapital included loans of $114,052,000, allowance for loan losses of$1,396,000, investment securities of $34,735,000 and deposits of $137,933,000.

Net income for the year-ended December 31, 2005was $1,509,000, compared to $1,111,000 for the year ended December 31,2004. Basic earnings per share were $1.09 as compared to $1.06 in 2004, whilediluted earnings per share were $0.97 in 2005 compared to $0.94 in 2004. Ourweighted average shares outstanding used for earnings per share calculationsinclude the addition of converted First Capital shares from October 1through December 31, 2005.

Outside of the merger, total assets of the Companygrew by $23,274,000 primarily as a result of continued growth in our loanportfolio which increased by $25,366,000, offset by small declines in ourinvestment portfolio and cash-related accounts. Total deposits grew by$19,014,000. Excluding the merger, our total allowance for loan lossesincreased by $330,000 as we provided an additional $380,000 through ourprovision. As a percent of total loans outstanding, our allowance was 1.18% at December 31,2005 compared to 1.11% at December 31, 2004.

At year-end 2005, total tangible capital was $28,479,198compared to $10,792,000 at year-end 2004. Both banks and the Company continueto meet the regulatory “well capitalized” definitions.

Each of our two community banks has expansion plansduring 2006. Lowcountry National has started construction on its Port RoyalBranch with completion scheduled for late 2006. First National is in theinitial planning stages for its new Concourse office in neighboring Yulee,Florida. Construction of this office should begin later this year.

We areexcited about the prospects of our business combination with First Capital. Wenow operate in two dynamic coastal markets and our combination approximatelydoubles our Company shareholder base. Transaction activity in our stock can befollowed through our market symbol CBCO.OB. We thank you for your support in2005 and look forward to meeting both your investment objectives and bankingneeds in 2006.
| Suellen Rodeffer Garner | Randolph C. Kohn        |
|-------------------------|-------------------------|
| Chairman of the Board   | Chief Executive Officer |

 

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**Financial Highlights**

| ** **                              | ** ** | **2005**    | ** **  | **2004**    | ** ** | **Percent  Change** | ** ** |
|-----------------------------------------|------------|-------------|-------------|-------------|------------|---------------------|------------|
| **Balance Sheet**                       | ** ** | ** **  | ** **  | ** **  | ** ** |                | ** ** | ** ** |   |
| Total assets                            |       | $           | 355,168,137 |        | $          | 146,071,670         |       |   | 143.2 | % |   |
| Net loans                               |       | 239,505,778 |        | 100,397,246 |       |                | 138.6      | % |   |
| Securities                              |       | 67,106,074  |        | 34,046,381  |       |                | 97.1       | % |   |
| Deposits                                |       | 286,395,980 |        | 129,431,713 |       |                | 121.3      | % |   |
| Shareholders’  equity              |       | 39,315,168  |        | 10,792,050  |       |                | 264.3      | % |   |
| **For the  Year**                       | ** ** | ** **  | ** **  | ** **  | ** ** |                | ** ** | ** ** |   |
| Net interest  income                    |       | 6,777,223   |        | $           | 4,474,894  |                |       | 51.4 | % |   |
| Provision for  loan losses              |       | 380,000     |        | 463,200     |       |                | (18.0      | )% |   |
| Non-interest  income                    |       | 1,097,561   |        | 764,426     |       |                | 43.6       | % |   |
| Non-interest  expense                   |       | 5,189,354   |        | 3,269,332   |       |                | 58.7       | % |   |
| Income tax  expense                     |       | 796,060     |        | 396,186     |       |                | 100.9      | % |   |
| Net income                              |       | 1,509,370   |        | 1,110,602   |       |                | 35.9       | % |   |
| **Per  Share**                          | ** ** | ** **  | ** **  | ** **  | ** ** |                | ** ** | ** ** |   |
| Net income—Diluted                 |       | 0.97        |        | $           | 0.94       |                |       | 2.8 | % |   |
| Tangible book  value at year end        |       | 12.02       |        | 10.17       |       |                | 16.1       | % |   |
| **Financial  Performance Ratios**       | ** ** | ** **  | ** **  | ** **  | ** ** |                | ** ** | ** ** |   |
| Return on average  tangible assets      |       | 0.75        | %           | 0.86        | %          |                |       |   |   |
| Return on average  tangible equity      |       | 8.75        | %           | 10.85       | %          |                |       |   |   |
| **Asset  Quality Ratios**               | ** ** | ** **  | ** **  | ** **  | ** ** |                | ** ** | ** ** |   |
| Non-performing  loans to total loans    |       | 0.05        | %           | 0.31        | %          |                |       |   |   |
| Net charge-offs to  average total loans |       | 0.03        | %           | 0.22        | %          |                |       |   |   |
|                                         |            |             |             |             |            |                     |            |  |  |  |  |

 

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**COASTAL BANKING COMPANY, INC.SELECTED FINANCIAL DATA**

| ** **                                                 | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2003**                               | ** ** | **2002**                   | ** ** | **2001**                              | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|----------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| **FOR THE YEAR**                                           | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                 | ** ** | ** **                            | ** ** |
| Net interest  income                                       |       | $  6,777,223 |       | $  4,474,894 |       | $  3,328,024                 |       | $ 2,344,944           |       | $ 1,304,596                      |       |
| Provision for loan  losses                                 |       | 380,000                |       | 463,200                |       | 253,500                                |       | 232,200                    |       | 265,800                               |       |
| Non-interest  income                                       |       | 1,097,561              |       | 764,426                |       | 790,667                                |       | 507,029                    |       | 387,928                               |       |
| Non-interest  expense                                      |       | 5,189,353              |       | 3,269,332              |       | 2,541,808                              |       | 1,835,721                  |       | 1,374,986                             |       |
| Income taxes  (benefit)                                    |       | 796,060                |       | 396,186                |       | 458,933                                |       | 268,119                    |       | 13,635                                |       |
| Net earnings  (loss)                                       |       | $  1,509,370 |       | $  1,110,602 |       | $     864,450 |       | $   515,933 |       | $     38,103 |       |
| **PER  COMMON SHARE***                                     | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                 | ** ** | ** **                            | ** ** |
| Basic earnings  (loss)                                     |       | 1.09                   |       | 1.06                   |       | 0.83                                   |       | 0.52                       |       | 0.04                                  |       |
| Diluted earnings  (loss)                                   |       | 0.97                   |       | 0.94                   |       | 0.78                                   |       | 0.52                       |       | 0.04                                  |       |
| Cash dividends  declared                                   |       | —                 |       | —                 |       | —                                 |       | —                     |       | —                                |       |
| Book value—tangible                                   |       | 12.02                  |       | 10.17                  |       | 9.33                                   |       | 8.65                       |       | 7.95                                  |       |
| **AT YEAR  END**                                           | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                 | ** ** | ** **                            | ** ** |
| Loans, net                                                 |       | $ 239,505,778     |       | $ 100,397,246     |       | $ 67,488,128                      |       | $ 49,065,800          |       | $ 32,566,026                     |       |
| Earning assets                                             |       | 309,765,812            |       | 137,904,751            |       | 104,034,196                            |       | 70,470,548                 |       | 45,288,309                            |       |
| Goodwill and other  intangibles                            |       | 10,855,970             |       | —                 |       | —                                 |       | —                     |       | —                                |       |
| Assets                                                     |       | 355,168,137            |       | 146,071,670            |       | 107,874,055                            |       | 75,696,898                 |       | 48,692,697                            |       |
| Deposits                                                   |       | 286,395,980            |       | 129,431,713            |       | 96,435,587                             |       | 65,947,791                 |       | 39,478,014                            |       |
| Shareholders’  equity                                 |       | $ 39,315,168      |       | $ 10,792,050      |       | $  9,753,467                 |       | $ 9,036,692           |       | $ 8,314,352                      |       |
| Common shares outstanding                                  |       | 2,369,263              |       | 1,010,379              |       | 995,695                                |       | 995,695                    |       | 995,695                               |       |
| **AVERAGE  BALANCES**                                      | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                 | ** ** | ** **                            | ** ** |
| Loans                                                      |       | $ 141,988,973     |       | $ 86,580,511      |       | $ 60,860,974                      |       | $ 41,842,080          |       | $ 24,490,000                     |       |
| Earning assets                                             |       | 188,539,361            |       | 124,586,573            |       | 87,772,570                             |       | 58,103,534                 |       | 32,350,000                            |       |
| Assets                                                     |       | 203,287,131            |       | 128,884,584            |       | 91,417,046                             |       | 61,240,904                 |       | 35,489,000                            |       |
| Deposits                                                   |       | 170,982,888            |       | 116,757,374            |       | 81,427,295                             |       | 51,972,457                 |       | 26,755,000                            |       |
| Shareholders’  equity                                 |       | $ 17,245,815      |       | $ 10,239,847      |       | $  9,375,405                 |       | $ 8,630,130           |       | $ 8,265,000                      |       |
| Weighted average shares outstanding*                       |       | 1,390,751              |       | 1,054,130              |       | 1,045,480                              |       | 1,045,480                  |       | 1,045,480                             |       |
| **KEY  PERFORMANCE RATIOS**                                | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                 | ** ** | ** **                            | ** ** |
| Return on average  assets                                  |       | 0.75                   | %          | 0.86                   | %          | 0.95                                   | %          | 0.84                       | %          | 0.11                                  | %          |
| Return on average  shareholders’ equity—tangible |       | 8.75                   | %          | 10.85                  | %          | 9.22                                   | %          | 5.98                       | %          | 0.46                                  | %          |
| Net interest  margin                                       |       | 3.66                   | %          | 3.65                   | %          | 3.79                                   | %          | 4.04                       | %          | 4.03                                  | %          |
| Dividend payout  ratio                                     |       | —                 |       | —                 |       | —                                 |       | —                     |       | —                                |       |
| Average tangible equity  to average tangible assets        |       | 8.61                   | %          | 7.94                   | %          | 10.26                                  | %          | 14.09                      | %          | 23.29                                 | %          |

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*******                   **2005 and prior years have been restated for two 5%stock dividends.

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**MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

**General**

Coastal Banking Company, Inc. (the “Company”) isa bank holding company headquartered in Beaufort, South Carolina organized toown all of the common stock of its subsidiaries, Lowcountry National Bank (“Lowcountry”)and First National Bank of Nassau County, Florida (“First National”). Theprincipal activity of the Banks is to provide banking services for theirdomestic markets. Lowcountry’s primary market is Beaufort County, SouthCarolina. First National’s primary market is Nassau County, Florida. The Banksare primarily regulated by the Office of the Comptroller of the Currency (“OCC”)and undergo periodic examinations by this regulatory agency. The holding companyis regulated by the Federal Reserve Board of Governors and also is subject toperiodic examinations. Lowcountry opened for business on May 10, 2000 at36 Sea Island Parkway, Beaufort, South Carolina 29902. First National openedfor business July 26, 1999 and was acquired by Coastal through the mergerwith its holding company, First Capital Bank Holding Corporation (“FirstCapital”) on October 1, 2005. The Company also has an investment inCoastal Banking Company Statutory Trust I (the “Trust”). The Trust is a specialpurpose non-consolidated subsidiary organized for the sole purpose of issuingtrust-preferred securities.

In the merger with First Capital, each outstandingshare of First Capital common stock was converted into 1.054 shares of Coastalstock at the time of the merger. Each outstanding share of Coastal common stockprior to the merger remained outstanding as a share of common stock after themerger.

The following discussion describes our results ofoperations for 2005 as compared to 2004 and also analyzes our financialcondition as of December 31, 2005 as compared to December 31, 2004.Like most community banks, we derive most of our income from interest wereceive on our loans and investments. Our primary source of funds for makingthese loans and investments is our deposits, on which we pay interest.Consequently, one of the key measures of our success is our amount of netinterest income, or the difference between the income on our interest-earningassets, such as loans and investments, and the expense on our interest-bearingliabilities, such as deposits. Another key measure is the spread between theyield we earn on these interest-earning assets and the rate we pay on ourinterest-bearing liabilities.

We have included a number of tables to assist in ourdescription of these measures. For example, the “Average Balances” table showsthe average balance during 2005 and 2004 of each category of our assets andliabilities, as well as the yield we earned or the rate we paid with respect toeach category. A review of this table shows that our loans typically providehigher interest yields than do other types of interest earning assets, which iswhy we intend to continue to direct a substantial percentage of our earningassets into our loan portfolio. Similarly, the “Rate/Volume Analysis” tablehelps demonstrate the impact of changing interest rates and changing volume ofassets and liabilities during the years shown. We also track the sensitivity ofour various categories of assets and liabilities to changes in interest rates,and we have included a “Sensitivity Analysis Table” to help explain this.Finally, we have included a number of tables that provide detail about ourinvestment securities, our loans, and our deposits.

Of course, there are risks inherent in all loans, sowe maintain an allowance for loan losses to absorb possible losses on existingloans that may become uncollectible. We establish and maintain this allowanceby charging a provision for loan losses against our operating earnings. In thefollowing section we have included a detailed discussion of this process,as well as several tables describing our allowance for loan losses. See comments in thesection entitled “Provision and Allowance for Loan Losses.”

In addition to earning interest on our loans andinvestments, we earn income through fees and other expenses we charge to ourcustomers. We describe the various components of this non-interest income, aswell as our non-interest expense, in the following discussion.

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The following discussionand analysis also identifies significant factors that have affected ourfinancial position and operating results during the periods included in theaccompanying financial statements. We encourage you to read this discussion andanalysis in conjunction with the financial statements and the related notes andthe other statistical information also included in this report.

**Forward-LookingStatements**

This report contains “forward-lookingstatements” relating to, without limitation, future economic performance, plansand objectives of management for future operations, and projections of revenuesand other financial items that are based on the beliefs of management, as wellas assumptions made by and information currently available to management. Thewords “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,”“expect,” “estimate,” “continue,” “may,” and “intend,” as well as other similarwords and expressions of the future, are intended to identify forward-lookingstatements. Potential risks and uncertainties include, but are not limited tothose described under the heading “Risk Factors” in our Form 10-KSBfor the year ended December 31, 2005.

**Critical AccountingPolicies**

We have adopted various accounting policies, whichgovern the application of accounting principles generally accepted in theUnited States of America in the preparation of our financial statements. Oursignificant accounting policies are described in Note 1 in the footnotes to theconsolidated financial statements at December 31, 2005 included elsewherein this annual report.

We believe that the allowance for loan losses is acritical accounting policy that requires the most significant judgments andestimates used in preparation of our consolidated financial statements. Pleaserefer to the portion of management’s discussion and analysis of financialcondition and results of operations that addresses the allowance for loanlosses for a description of our processes and methodology for determining theallowance for loan losses.

Intangible assets,included in Other Assets on the Consolidated Balance Sheets, include goodwilland other identifiable assets, such as core deposits, resulting fromacquisitions. Goodwill, in this context, is the excess of the purchase price inan acquisition transaction over the fair market value of the net assetsacquired. Core deposit intangibles are amortized on a straight-line basis oversuch assets’ estimated expected life. In accordance with SFAS No. 142, “Goodwilland Other Intangible Asset,” goodwill is not amortized but is tested annuallyfor impairment or at any time an event occurs, or circumstances change, thatmay trigger a decline in the value of the reporting unit. Such impairmenttesting calculations include estimates. Furthermore, the determination of whichintangible assets have finite lives is subjective as is the determination ofthe amortization period for such intangible assets. The Company tests forgoodwill impairment by determining the fair market value for each reportingunit and comparing the fair market value to the carrying amount of theapplicable reporting unit. If the carrying amount exceeds fair market value thepotential for the impairment exists, and a second step of impairment testing isperformed. In the second step, the fair market value of the reporting units’goodwill is determined by allocating the reporting unit’s fair market value toall of its assets (recognized and unrecognized) and liabilities as if thereporting unit had been acquired in a business combination at the date of theimpairment test. If the implied fair market value of reporting unit goodwill isless than its carrying amount, goodwill is impaired and is written-down to itsfair market value. The loss recognized is limited to the carrying amount ofgoodwill. Once an impairment loss is recognized, future increases in fairmarket value will not result in the reversal of previously recognized losses.The Company will perform its annual impairment testing annually by applying theabove process to its reportable operating segment of banking. No previousimpairment testing has been performed since the first instance of intangibleswas October 1, 2005 with the merger of First Capital.

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**Results ofOperations**

**Overview**

Net income for 2005 was $1,509,370 or $1.09 per basiccommon share compared to $1,111,602, or $1.06 per basic common share, in 2004.Our operational results were impacted in part by our merger with First Capitalon October 1, 2005, which resulted in the inclusion of net income fromthat operation for the fourth quarter of 2005. In total, our operationalresults depend to a large degree on net interest income, which is thedifference between the interest income received from our investments (such asloans, investment securities, and federal funds sold) and interest expense,which is paid on deposit liabilities and other borrowings. Net interest incomewas $6,777,223 for the year ended December 31, 2005 compared to netinterest income of $4,475,000 for the year ended December 31, 2004.

The provision for loan losses in 2005 was $380,000compared to $463,000 in 2004. The decrease in the provision for loan losses wasattributable to the decrease in our loan growth during 2005 other thanadditional loans acquired through the merger with First Capital. The provisionfor loan losses continues to reflect our estimate of potential losses inherentin the loan portfolio and the creation of an allowance for loan losses adequateto absorb such losses.

Non-interest income for the year ended December 31,2005 totaled $1,098,000, representing a $333,000 increase from December 31,2004. This increase was primarily associated the additional income contributedby First National, which added $327,000 in the fourth quarter. Non-interestexpenses in 2005 were $5,189,000, a $1,920,000 increase compared with the 2004amount, primarily due to the addition of First National effective October 1,2005, which contributed $1,198,000 to non-interest expense.

In 2005, we recognized$796,060 of income tax expense compared to an income tax expense of $396,000 in2004. Our effective tax rate was 34.5% in 2005 and 26% in 2004. Our income taxexpense increased in 2005 because we concluded that the valuation allowances in2004 were no longer needed after an analysis of certain valuation allowancesrelated to our deferred tax assets. The elimination of these tax valuationallowances reduced tax expense in 2004 by approximately $115,000.

**Net Interest Income**

For the year ended December 31,2005, net interest income totaled approximately $6,777,000, as compared toapproximately $4,475,000 for the same period in 2004. Interest income fromloans, including fees, increased approximately $4,542,000 to $10,107,000 forthe year ended December 31, 2005. This increase in income was partiallyoffset by increased interest expense, which totaled approximately $5,185,000for the year ended December 31, 2005, compared to $2,482,000 in 2004. Theincrease in net interest income is due to the overall growth in the volume ofinterest earning assets and by increases in overall weighted average interestrates. The net interest margin realized on earning assets and the interest ratespread were 3.66% and 3.35%, respectively, for the year ended December 31,2005. For the year ended December 31, 2004, the net interest margin was3.65% and the interest rate spread was 3.42%. Yields on interest earning assetsincreased during the year by .77% compared to an increase in interest bearing liabilities of .84% during theprior year.

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**Average Balancesand Interest Rates**

Thetable below shows the average balance outstanding for each category ofinterest-earning assets and interest-bearing liabilities for 2005 and 2004, andthe average rate of interest earned or paid thereon. Average balances have beenderived from the daily balances throughout the period indicated.

| ** **                                                           | ** ** | **For the Years Ended December 31** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
| ** **                                                           | ** ** | **Average  Balance**                                         | ** ** | **Interest** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/  Rate** | ** ** |
| ** **                                                           | ** ** | **(In Thousands)**                                      | ** ** |
| Assets:                                                              |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                             |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (including  loan fees)                                         |       | $                                                            | 141,989    |   | $ | 10,106 |   |   | 7.12 | % |   | $ | 86,581 |   | $ | 5,565 |   |   | 6.43 | % |   |
| Taxable  investments                                                 |       | 34,377                                                       |       | 1,400 |   |   | 4.07 | % |   | 30,561 |   | 1,163 |   |   | 3.81 | % |   |
| Tax-free  investments                                                |       | 6,735                                                        |       | 369 |   |   | 5.48 | % |   | 5,561 |   | 271 |   |   | 4.88 | % |   |
| Interest-bearing  deposits in other banks                       |       | 125                                                          |       | 3 |   |   | 2.74 | % |   |   |   | 0 |   |   | 0 | % |   |
| Federal funds  sold                                                  |       | 5,313                                                        |       | 209 |   |   | 3.93 | % |   | 1,884 |   | 28 |   |   | 1.47 | % |   |
| Total  interest-earning assets                                       |       | 188,539                                                      |       | 12,087 |   |   | 6.41 | % |   | 124,587 |   | 7,027 |   |   | 5.64 | % |   |
| Other  non-interest earning assets                                   |       | 14,748                                                       |       |   |   |   |   |   |   | 4,298 |   |   |   |   |   |   |   |
| Total assets                                                         |       | $                                                            | 203,287    |   |   |   |   |   |   |   | $ | 128,885 |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                          |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                                       |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand and savings                                 |       | $                                                            | 69,958     |   | 1,876 |   |   | 2.68 | % |   | $ | 55,909 |   | $ | 994 |   |   | 1.78 | % |   |
| Time                                                                 |       | 86,736                                                       |       | 2,757 |   |   | 3.18 | % |   | 52,088 |   | 1,376 |   |   | 2.64 | % |   |
| Other                                                                |       | 12,814                                                       |       | 552 |   |   | 4.31 | % |   | 3,706 |   | 112 |   |   | 3.01 | % |   |
| Total  interest-bearing liabilities                                  |       | 169,508                                                      |       | 5,185 |   |   | 3.06 | % |   | 111,703 |   | 2,482 |   |   | 2.22 | % |   |
| Other  non-interest bearing liabilities                              |       | 16,533                                                       |       |   |   |   |   |   |   | 6,942 |   |   |   |   |   |   |   |
| Shareholders’  equity                                           |       | 17,246                                                       |       |   |   |   |   |   |   | 10,240 |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity                     |       | $                                                            | 203,287    |   |   |   |   |   |   |   | $ | 128,885 |   |   |   |   |   |   |   |
| Excess of  interest-earning assets over interest bearing liabilities | ** ** | **$**                                                        | **19,032** | ** ** | ** ** | ** ** |   |   |   | ** ** | **$** | **12,884** | ** ** | ** ** | ** ** |   |   |   |   |
| Ratio of  interest-earning assets to interest-bearing liabilities    |       | 111                                                          | %          |   |   |   |   |   |   | 112 | % |   |   |   |   |   |   |
| Tax equivalent  adjustment                                           |       |                                                         |       | (125 | ) |   |   |   |   |   |   | (70 | ) |   |   |   |   |
| Net interest  income                                                 |       |                                                         |       | $ | 6,777 |   |   |   |   |   |   |   | $ | 4,475 |   |   |   |   |   |
| Net interest  spread                                                 |       |                                                         |       |   |   |   | 3.35 | % |   |   |   |   |   |   | 3.42 | % |   |
| Net interest margin                                                  |       |                                                         |       |   |   |   | 3.66 | % |   |   |   |   |   |   | 3.65 | % |   |

 

Non-accrual loans and the interest income, which wasrecorded on these loans, if any, are included in the yield calculation forloans in all periods reported.

Amounts are presented on atax equivalent basis.

**Volume/RateAnalysis**

Netinterest income can also be analyzed in terms of the impact of changing ratesand changing volume. The following table describes the extent to which changesin interest rates and changes in the volume of interest-earning assets andinterest-bearing liabilities have affected our interest income and 

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interest expense during the periods indicated. Theeffect of a change in average balance has been determined by applying theaverage rate in the earlier year to the change in average balance in the lateryear, as compared with the earlier year. The effect of a change in the averagerate has been determined by applying the average balance in the earlier year tothe change in the average rate in the later year, as compared with the earlieryear. (Dollars in thousands)

| ** **                                    | ** ** | **2005 Compared to 2004  Increase (decrease) due to changes in** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Volume**                                                                                               | ** ** | **Rate** | ** ** | **Net Change** | ** ** |
| Interest income on:                           |       |                                                                                                     |       |   |   |   |   |   |   |
| Loans (including  loan fees)                  |       | $                                                                                                        | 3,888      |   | $ | 654 |   |   | $ | 4,542 |   |   |
| Taxable investments                           |       | 152                                                                                                      |       | 84 |   |   | 236 |   |   |
| Non-taxable  investments                      |       | 62                                                                                                       |       | 36 |   |   | 98 |   |   |
| Interest bearing  deposits in other banks     |       | 3                                                                                                        |       |   |   |   | 3 |   |   |
| Federal funds  sold                           |       | 95                                                                                                       |       | 86 |   |   | 181 |   |   |
| Total interest  income (tax equivalent basis) |       | 4,200                                                                                                    |       | 860 |   |   | 5,060 |   |   |
| Interest expense on:                          |       |                                                                                                     |       |   |   |   |   |   |   |
| Interest-bearing  demand and savings          |       | 292                                                                                                      |       | 591 |   |   | 883 |   |   |
| Time                                          |       | 1,057                                                                                                    |       | 322 |   |   | 1,379 |   |   |
| Other                                         |       | 375                                                                                                      |       | 66 |   |   | 441 |   |   |
| Total interest  expense                       |       | 1,724                                                                                                    |       | 979 |   |   | 2,703 |   |   |
| Net interest income (tax  equivalent basis)   |       | $                                                                                                        | 2,476      |   | $ | (119 | ) |   | $ | 2,357 |   |   |

 

**Interest RateSensitivity and Asset Liability Management**

Interest rate sensitivity measures the timing andmagnitude of the repricing of assets compared with the repricing of liabilitiesand is an important part of asset/liability management of a financialinstitution. The objective of interest rate sensitivity management is togenerate stable growth in net interest income, and to control the risksassociated with interest rate movements. Management constantly reviews interestrate risk exposure and the expected interest rate environment so thatadjustments in interest rate sensitivity can be timely made. Since the assetsand liabilities of a bank are primarily monetary in nature (payable in fixed,determinable amounts), the performance of a bank is affected more by changes ininterest rates than by inflation. Interest rates generally increase as the rateof inflation increases, but the magnitude of the change in rates may not be thesame.

Net interest income is the primary component of netincome for financial institutions. The timing and magnitude of repricing aswell as the mix of interest sensitive and non-interest sensitive assets andliabilities affect net interest income. “Gap” is a static measurement of thedifference between the contractual maturities or repricing dates of interestsensitive assets and interest sensitive liabilities within the following twelvemonths. Gap is an attempt to predict the behavior of the Banks’ net interestincome in general terms during periods of movement in interest rates. Ingeneral, if the bank is asset sensitive, more of its interest sensitive assetsare expected to reprice within twelve months than its interest sensitiveliabilities over the same period. In a rising interest rate environment, assetsrepricing more quickly are expected to enhance net interest income.Alternatively, decreasing interest rates would be expected to have the oppositeeffect on net interest income since assets would theoretically be repricing atlower interest rates more quickly than interest sensitive liabilities. Althoughit can be used as a general predictor, gap as a predictor of movements in netinterest income has limitations due to the static nature of its definition anddue to its inherent assumption that all assets will reprice immediately andfully at the contractually designated time. At December 31, 2005, theCompany, as measured by gap, is in a liability sensitive position. Managementhas several tools available to it to evaluate and affect interest rate risk,including deposit pricing policies and changes in the mix of various types ofassets and liabilities.

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The following tablesummarizes the amounts of interest-earning assets and interest-bearingliabilities outstanding at December 31, 2005, that are expected to mature,prepay, or reprice in each of the future time periods shown. Except as statedbelow, the amount of assets or liabilities that mature or reprice during aparticular period was determined in accordance with the contractual terms ofthe asset or liability. Adjustable rate loans are included in the period inwhich interest rates are next scheduled to adjust rather than in the period inwhich they are due, and fixed-rate loans and mortgage-backed securities areincluded in the periods in which they are anticipated to be repaid based onscheduled maturities. The Banks’ savings accounts and interest-bearing demandaccounts (NOW and money market deposit accounts), which are generally subjectto immediate withdrawal, are included in the “Three Months or Less” category.Many of these money market accounts are tied to a Treasury index and repricemonthly.

**AtDecember 31, 2005Maturing or Repricing in(Dollars in thousands)**

| ** **                                  | ** ** | **3 Months  or Less** | ** ** | **4 Months to  12 Months** | ** ** | **1 to 5  Years** | ** ** | **Over 5  Years** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|-------------------------------------------|------------|-----------------------------|------------|------------------------|------------|-----------|------------|
| Interest-earning  assets:                   |       |                            |       |                                      |       |                        |       |                   |       |      |       |   |   |
| Federal funds  sold                         |       | $                               | 13,598     |                                      |       | —                      |       |                   | —     |      | —     |   | 13,598 |   |
| Deposits In other  banks                    |       | 500                             |       |                                      | —     |                        |       | —                 |       | —    |       | 500 |   |
| Investment  securities                      |       | 182                             |       |                                      | 7,277      |                        |       | 21,727                 |       | 35,185    |       | 64,371 |   |
| Loans held for  sale                        |       | 2,450                           |       |                                      | —     |                        |       | —                 |       | —    |       | 2,450 |   |
| Loans                                       |       | 61,393                          |       |                                      | 64,498     |                        |       | 79,512                 |       | 36,967    |       | 242,370 |   |
| Total  interest-earning assets              |       | 78,123                          |       |                                      | 71,775     |                        |       | 101,239                |       | 72,152    |       | 323,289 |   |
| Interest-bearing liabilities:               |       |                            |       |                                      |       |                        |       |                   |       |      |       |   |   |
| Deposits:                                   |       |                            |       |                                      |       |                        |       |                   |       |      |       |   |   |
| Savings and  demand                         |       | 49,988                          |       |                                      | 31,643     |                        |       | 48,519                 |       | —    |       | 130,150 |   |
| Time deposits                               |       | 49,753                          |       |                                      | 61,583     |                        |       | 44,910                 |       | —    |       | 156,246 |   |
| FHLB advances                               |       | —                          |       |                                      | 3,000      |                        |       | 19,963                 |       | —    |       | 22,963 |   |
| Junior subordinated  debentures             |       | 3,093                           |       |                                      | —     |                        |       | —                 |       | —    |       | 3,093 |   |
| Total  interest-bearing liabilities         |       | 102,834                         |       |                                      | 96,226     |                        |       | 113,392                |       | —    |       | 312,452 |   |
| Interest sensitive difference per period    |       | $                               | (24,711    | )                                         |       | (24,451                     | )          |                   | (12,153    | )         | 72,152     |   | 10,837 |   |
| Cumulative  interest sensitivity difference |       | $                               | (24,711    | )                                         |       | (49,162                     | )          |                   | (61,315    | )         | 10,837     |   |   |   |
| Cumulative difference to  total assets      |       | (7.0                            | )%         |                                      | (13.9      | )%                          |       | (17.3                  | )%         | 3.1       | %          |   |   |

 

At December 31, 2005, the difference between theBanks’ liabilities and assets repricing or maturing within one year was $49,162,000or 15.2% of total assets. Due to an excess of liabilities repricing or maturingwithin one year, a rise in interest rates would cause the Banks’ net interestincome to decline.

Certain shortcomings areinherent in the method of analysis presented in the foregoing table. Forexample, although certain assets and liabilities may have similar maturities orperiods of repricing, they may reflect changes in market interest ratesdifferently. Additionally, certain assets, such as adjustable-rate mortgages,have features that restrict changes in interest rates, both on a short-termbasis and over the life of the asset. Other factors, which may affect theassumptions made in the table, include changes in interest rates, pre-paymentrates, early withdrawal levels, and the ability of borrowers to service theirdebt.

**Impaired Loans**

A loan is considered to be impaired when, inmanagement’s judgment based on current information and events, it is probablethat the loan’s principal or interest is not collectible in accordance with theterms 

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of the original loanagreement. Impaired loans, when not material, will be carried in the balancesheet at a value not to exceed their observable market price or the fair valueof the collateral if the repayment of the loan is expected to be providedsolely by the underlying collateral. The carrying values of any materialimpaired loans are measured based on the present value of expected future cashflows discounted at the loan’s effective interest rate, which is thecontractual interest rate adjusted for any deferred loan fees or costs, premiumor discount existing at the inception or acquisition of the loan.

Loans which management identifies as impairedgenerally will be non-performing loans. Non-performing loans include non-accrualloans or loans which are 90 days or more delinquent as to principal or interestpayments. At December 31, 2005, First National had $130,000 of loans thatwere impaired and non-performing, and Lowcountry had no impaired ornon-performing loans. None of the Company’s loans were impaired ornon-performing at December 31, 2004.

The accrual of interest isdiscontinued on non-accrual loans and any previously accrued interest on suchloans will be reversed against current income. Any subsequent interest income isrecognized on a cash basis when received unless collectibility of a significantamount of principal is in serious doubt. In such cases, collections arecredited first to the remaining principal balance on a cost recovery basis. Animpaired loan is not returned to accrual status unless principal and interestare current and the borrower has demonstrated the ability to continue makingpayments as agreed.

**Potential ProblemLoans**

Management identifies andmaintains a list of potential problem loans. These are loans that are notincluded in non-accrual status, or loans that are past due 90 days or more andstill accruing interest. A loan is added to the potential problem list whenmanagement becomes aware of information about possible credit problems of borrowersthat causes serious doubts as to the ability of such borrowers to comply withthe current loan repayment terms. These loans are designated as such in orderto be monitored more closely than other credits in the Banks’ portfolios.

**Provision andAllowance for Loan Losses**

The provision for loan losses is the charge tooperating earnings that management believes is necessary to maintain theallowance for loan losses at an adequate level. The provision charged toexpense was approximately $380,000 for the year ended December 31, 2005 ascompared to $463,000 for the year ended December 31, 2004. The change inthe provision was the result of our loan portfolio, excluding additions to theportfolio from First National, growing slower in 2005 than in 2004. The loanportfolio increased by approximately $139,109,000 during the year ended December 31,2005, of which approximately $114,052,000 was added by First National. Net loangrowth outside the merger during the year totaled $25.0 million as compared togrowth of $33.2 million in 2004. The allowance for loan losses was 1.18% ofgross loans at December 31, 2005 as compared to 1.11% at December 31,2004. There are risks inherent in making all loans, including risks withrespect to the period of time over which loans may be repaid, risks resultingfrom changes in economic and industry conditions, risks inherent in dealingwith individual borrowers, and, in the case of a collateralized loan, risksresulting from uncertainties about the future value of the collateral.

We have established an allowance for loan lossesthrough a provision for loan losses charged to expense on our statement ofearnings. Additions to the allowance for loan losses, which are expenses to theprovision for loan losses on our income statement, are made periodically tomaintain the allowance at an appropriate level based on management’s analysisof the potential risk in the loan portfolio. The allowance for loan lossesrepresents an amount, which we believe will be adequate to absorb probablelosses on existing loans that may become uncollectible. Our judgment as to theadequacy of the allowance for loan losses is based upon a number of assumptionsabout future events, which we believe to be reasonable, but 

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which may or may not proveto be accurate. Our losses will undoubtedly vary from our estimates, and thereis a possibility that charge-offs can reduce this allowance.  Our determination of the allowance for loanlosses is based on evaluations of the collectibility of loans, includingconsideration of factors such as the balance of impaired loans, the quality,mix, and size of our overall loan portfolio, economic conditions that mayaffect the borrower’s ability to repay, the amount and quality of collateralsecuring the loans, our historical loan loss experience, and a review ofspecific problem loans. We also consider subjective issues such as changes inthe lending policies and procedures, changes in the local/national economy,changes in volume or type of credits, changes in volume/severity of problemloans, quality of loan review and board of director oversight, concentrationsof credit, and peer group comparisons.

Weallocate the allowance for loan losses to specific categories of loans in ourportfolio. See the table below for the allocation of loan losses and for ahistory of charge-offs by loan category, which may or may not be indicative offuture charge-offs by category.

**Allocation of the Allowance for Loan Losses**

| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **(In Thousands)**                 | ** ** | ** **            | ** ** | **Amount** | ** ** | **% of Loans in  Category** | ** ** | **Amount** | ** ** | **% of Loans in  Category** | ** ** |
| Commercial,  Financial and Agricultural |       |                  | 226        |   |   |   | 5 |   |   |   | 65 |   |   |   | 6 |   |   |
| Real  Estate—Construction          |       |                  | 760        |   |   |   | 39 |   |   |   | 337 |   |   |   | 33 |   |   |
| Real  Estate—Mortgage              |       |                  | 342        |   |   |   | 54 |   |   |   | 590 |   |   |   | 58 |   |   |
| Consumer                                |       |                  | 50         |   |   |   | 2 |   |   |   | 33 |   |   |   | 3 |   |   |
| Unallocated                             |       |                  | 1,485      |   |   |   | — |   |   |   | 112 |   |   |   | — |   |   |
| **Total**                               | ** ** | ** **            | **2,863**  |   | ** ** | ** ** | **100** | **%** | ** ** | ** ** | **1,137** |   | ** ** | ** ** | **100** | **%** | ** ** |
|                                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Due to our limited operating history, our policy hasbeen to review the allowance for loan losses using a reserve factor based onrisk-rated categories of loans because there has been relatively littlecharge-off activity since the Banks’ respective inceptions. The overallobjective is to apply percentages to the loans based on the relative inherentrisk for that loan type and grade. Reserve factors are based on peer groupdata, information from regulatory agencies, and on the experience of the Banks’lenders. The reserve factors will change depending on trends in national andlocal economic conditions, the depth of experience of the Banks’ lenders,delinquency trends, and other factors. Our general strategy is to maintain aminimum coverage of a certain percentage of gross loans until we havesufficient historical data and trends available. Periodically, we adjust theamount of the allowance based on changing circumstances. We charge recognizedlosses to the allowance and add subsequent recoveries back to the allowance forloan losses. There can be no assurance that charge-offs of loans in futureperiods will not exceed the allowance for loan losses as estimated at any pointin time or that provisions for loan losses will not be significant to aparticular accounting period. Thus, there is a risk that substantial additionalincreases in the allowance for loan losses could be required. Additions to theallowance for loan losses would result in a decrease of our net income and,possibly, our capital.

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Thefollowing table summarizes information concerning the allowance for loanlosses:

| ** **                                                                                 | ** ** | **December 31,**                                   | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                                | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | **(Amounts are presented in thousands)** | ** ** |
| Loans  outstanding, end of year                                                            |       | $                                                       | 242,369    |   | $ | 101,534 |   |
| Average loans  outstanding                                                                 |       | $                                                       | 141,989    |   | $ | 86,581 |   |
| Allowance,  beginning of year                                                              |       | 1,137                                                   |       | 866 |   |
| Charge-offs:                                                                               |       |                                                    |       |   |   |
| Commercial,  financial and industrial                                                      |       | —                                                  |       | — |   |
| Real  estate—construction                                                             |       | —                                                  |       | — |   |
| Real  estate—mortgage                                                                 |       | —                                                  |       | 102 |   |
| Consumer                                                                                   |       | 56                                                      |       | 93 |   |
| Total charge-offs                                                                          |       | 56                                                      |       | 195 |   |
| Recoveries:                                                                                |       |                                                    |       |   |   |
| Commercial,  financial and industrial                                                      |       | 6                                                       |       | 3 |   |
| Real  estate—construction                                                             |       | —                                                  |       | — |   |
| Real  estate—mortgage                                                                 |       | —                                                  |       | — |   |
| Consumer                                                                                   |       | —                                                  |       | — |   |
| Total recoveries                                                                           |       | 6                                                       |       | 3 |   |
| Net charge-offs                                                                            |       | 50                                                      |       | 192 |   |
| Allowance brought  forward in merger                                                       |       | 1,396                                                   |       | — |   |
| Additions charged  to operations                                                           |       | 380                                                     |       | 463 |   |
| Allowance, end of  year                                                                    |       | $                                                       | 2,863      |   | $ | 1,137 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | 0.04                                                    | %          | 0.22 | % |
| Allowance for loan  losses to loans, end of year                                           |       | 1.18                                                    | %          | 1.11 | % |

 

Thefollowing table summarizes past due and non-accrual loans, other real estateand repossessions, and income that would have been reported on non-accrualloans as of December 31, 2005 and 2004 (amounts are presented in thousands):

| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Other real estate  and repossessions                          |       | $                     | 0          |   | $ | 55 |   |
| Accruing loans 90  days or more past due                      |       | 0                     |       | 313 |   |
| Non-accrual loans                                             |       | 130                   |       | — |   |
| Interest on non-accrual  loans which would have been reported |       | 6                     |       | — |   |
|                                                               |            |                       |            |  |  |  |  |

 

**Non-interest Incomeand Expense**

Non-interest income for the year ended December 31,2005 totaled $1,098,000 as compared to $764,000 for the year ended December 31,2004. This increase in non-interest income was primarily due to the addition offourth quarter earnings of First National. Residential mortgage originationfees totaled $676,000 and $391,000 in 2005 and 2004, respectively. The increaseresulted from a combination of the fee income added by First National andLowcountry’s Bluffton office increasing its presence in that market. Refinancingvolume slowed in 2005 as interest rates continued to increase at a measuredpace. Both Banks own bank-owned life insurance policies covering certain of ourexecutives and directors. The cash value of these policies increases over timeand, accordingly, we recognized $124,000 in income related to these policies in2005. We recognized losses on the call of certain investment securitiesavailable for sale totaling 

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$8,000 during the yearended December 31, 2005 as compared to gains on sales of securitiestotaling $85,000 in 2004.

Total non-interest expensefor the year ended December 31, 2005 was $5,189,000 as compared to$3,270,000 for 2004. Salaries and benefits, the largest component ofnon-interest expense, totaled $2,934,000 for the year ended December 31,2005, compared to $1,766,000 for the same period a year ago. The mergerincreased our full-time equivalent employees from 31 to 66 employees. Otheroperating expenses were $1,764,000 for the year ended December 31, 2005 ascompared to $1,209,000 for the year ended December 31, 2004. These otheroperating expenses included increases in audit and professional fees, from$223,487 in 2004 to $371,179 in 2005 related to costs associated with themerger, advertising expenses, which increased from $133,955 in 2004 to $193,185in 2005, and data processing expenses which increased from $312,762 in 2004 to$420,744 in 2005 as our account base continued to rise.

**Financial Condition**

Total assets increasedfrom $146,072,000 at December 31, 2004 to $355,168,000 at December 31,2005, primarily as a result of the merger, which added $186,288,000. The netincrease in asset growth outside the merger was $22,808,000 or 15.6% (see note2 of Notes to Consolidated Financial Statements for detail of acquisitionamounts). The primary source of growth in assets was net loans, which increased$139,109,000 during 2005, which included $114,052,000 from First National.Total deposits increased $156,964,000 from the December 31, 2004 amount of$129,432,000 to $286,396,000 at December 31, 2005 of which $137,933 werecontributed by First National. Net deposit growth outside the merger was$19,031,000 or 15%.

**Interest-EarningAssets**

**Loans**

Grossloans totaled $242,369,000 at December 31, 2005, an increase of $140,835,000or 139%, since December 31, 2004. At year-end 2005 the mix of the loanportfolio remained approximately consistent with the mix at the end of 2004. Inabsolute dollars, the largest increase in loans was in Real estate—mortgageloans, which increased $70,666,000, or 120%, to $129,645,000 at December 31,2005. Real estate—construction loans increased $61,731,000 or 183%, during 2005.Both South Carolina and Florida coastal markets have experienced strongresidential loan demand. Balances and percentages within the major loansreceivable categories as of December 31, 2005 and December 31, 2004are as follows (amounts in thousands):

| ** **                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Real estate—construction         |       | $        | 95,458     |     | 39         | % | $ | 33,727 |   | 33 | % |
| Real estate—mortgage             |       | 129,645  |       | 54       | %          | 58,979 |   | 58 | % |
| Commercial,  financial and industrial |       | 11,459   |       | 5        | %          | 5,561 |   | 6 | % |
| Consumer and  other                   |       | 5,807    |       | 2        | %          | 3,267 |   | 3 | % |
|                                  |       | $        | 242,369    |     |       |   | $ | 101,534 |   |   |   |

 

As of December 31,2005, maturities of loans in the indicated classifications were as follows(amounts are presented in thousands):

| ** **    | ** ** | **Commercial** | ** ** | **Real Estate  Construction** | ** ** | **Total** | ** ** |
|---------------|------------|----------------|------------|------------------------------------|------------|-----------|------------|
| *Maturity*    | * *   |           | * *   | * *                           |       |      | * *   | * * |   | * * | * * |
| Within 1 year |       |           | $          | 7,063                              | * *   |      |       | 80,485 | * * |   | 87,548 |   |
| 1 to 5 years  |       |           | 4,156      | * *                           |       |      | 14,003     | * * |   | 18,159 |   |
| Over 5 years  |       |           | 240        | * *                           |       |      | 970        | * * |   | 1,210 |   |
| Totals        |       |           | $          | 11,459                             | * *   |      |       | 95,458 | * * |   | 106,917 |   |

 

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As of December 31,2005, the interest terms of loans in the indicated classification for theindicated maturity ranges are as follows (amounts are presented in thousands):

| ** **                    | ** ** | **Fixed  Interest  Rates** | ** ** | **Variable  Interest  Rates** | ** ** | **Total** | ** ** |
|-------------------------------|------------|----------------------------|------------|-------------------------------|------------|-----------|------------|
| Commercial                    |       |                       |       |                          |       |      |       |
| 1 to 5 years                  |       | $                          | 3,702      |                          | $          | 972       |       | $ | 4,674 |   |
| Over 5 years                  |       | 214                        |       | 1,141                         |       | 1,355     |       |
| Real estate—construction |       |                       |       |                          |       |      |       |
| 1 to 5 years                  |       | 12,056                     |       | 14,401                        |       | 26,457    |       |
| Over 5 years                  |       | 810                        |       | 1,695                         |       | 2,505     |       |
|                          |       | $                          | 16,782     |                          | $          | 18,209    |       | $ | 34,991 |   |

 

**InvestmentSecurities**

Investment securities available for sale increased to$46,151,000 at December 31, 2005 from $27,366,000 at December 31,2004. Investment securities held to maturity increased from $5,643,000 at December 31,2004 to $18,221,000 at December 31, 2005. Total securities added from themerger were $34,735,000, and there was a net decrease in the securitiesportfolio outside merger of $3,372,000. The demand for funds to support loangrowth caused this decline.

Thefollowing table presents the investments by category at December 31, 2005and 2004:

| ** **                    | ** ** | **2005**                                                     | ** ** | **2004**                       | ** ** |
|-------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **Amortized Cost**                                      | ** ** | **Estimated  Fair Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                    | ** ** | **(Amounts are presented in thousands)** | ** ** |
| *Available for sale*          | * *   |                                                         | * *   | * *                       |       |   | * * | * * |   |   | * * | * * |   |   | * * | * * |   |
| Federal agencies              |       |                                                         | $          | 23,047                         | * *   |   |   | $ | 22,692 | * * |   |   | $ | 15,010 | * * |   |   | $ | 14,916 | * * |   |
| Mortgage-backed               |       |                                                         | 22,463     | * *                       |       |   | 22,074 | * * |   |   | 12,290 | * * |   |   | 12,182 | * * |   |
| State, county and  municipals |       |                                                         | 1,409      | * *                       |       |   | 1,385 | * * |   |   | 268 | * * |   |   | 268 | * * |   |
| Totals                        |       |                                                         | $          | 46,919                         | * *   |   |   | $ | 46,151 | * * |   |   | $ | 27,568 | * * |   |   | $ | 27,366 | * * |   |
| *Held to Maturity*            | * *   |                                                         | * *   | * *                       |       |   | * * | * * |   |   | * * | * * |   |   | * * | * * |   |
| Mortgage backed  securities   |       |                                                         | 9,749      | * *                       |       |   | 9,590 | * * |   |   | — | * * |   |   | — | * * |   |
| State, county and  municipals |       |                                                         | $          | 8,472                          | * *   |   |   | $ | 8,294 | * * |   |   | $ | 5,643 | * * |   |   | $ | 5,555 | * * |   |
| Totals                        |       |                                                         | $          | 18,221                         | * *   |   |   | $ | 17,884 | * * |   |   | $ | 5,643 | * * |   |   | $ | 5,555 | * * |   |

 

Thefollowing table presents the maturities of investment securities at carryingvalue and the weighted average yields for each range of maturities presented.Yields are based on amortized cost of securities. (Amounts are presented inthousands)

| **Maturities at  December 31, 2005** | ** ** | ** ** | ** ** | **State,  County and  Municipals** | ** ** | **Weighted  Average  Yields** | ** ** | **Federal  Agencies** | ** ** | **Weighted  Average  Yields** | ** ** | **Mortgage-  backed** | ** ** | **Weighted  Average  Yields** | ** ** |
|-----------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|-------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------------------|------------|-------------------------------|------------|
| Within 1 year                                       |       |       | $          | 103                                     |       |                          |       | 3.23                  | %          |                          |       | 7,356                 |       |                          |       | 3.82 | % |   |   | — |   |   |   | — | % |   |
| After 1 through 5  years                            |       |       | 2,446      |                                    |       |                          | 4.21       | %                     |       |                          | 14,020     |                  |       |                          | 4.06       | % |   |   | 5,262 |   |   |   | 3.99 | % |   |
| After 5 through  10 years                           |       |       | 4,468      |                                    |       |                          | 5.65       | %                     |       |                          | 1,316      |                  |       |                          | 4.69       | % |   |   | 2,156 |   |   |   | 3.76 | % |   |
| After 10 years                                      |       |       | 2,836      |                                    |       |                          | 6.14       | %                     |       |                          | —     |                  |       |                          | —     |   |   |   | 24,409 |   |   |   | 4.73 | % |   |
| Totals                                              |       |       | $          | 9,853                                   |       |                          |       | 5.37                  | %          |                          |       | 22,692                |       |                          |       | 4.02 | % |   |   | 31,827 |   |   |   | 4.54 | % |   |

 

Mortgage-backed securitiesare included in the maturities categories in which they are anticipated to berepaid based on scheduled maturities.

15

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**Deposits**

At December 31, 2005, total deposits increased by$156,964,000, or 121%, to a total of $286,396,000 at December 31, 2005from $129,432,000 at December 31, 2004. First National contributed$137,933,000 in deposits to the Company leaving a net growth outside the mergerof $19,031,000 or 15%. Non-interest-bearing demand deposits increased$11,239,000, or 104%, while interest-bearing deposits increased $145,726,000,or 124%.

Balancesand percentages within the major deposit categories as of December 31,2005 and December 31, 2004 are as follows (amounts in thousands):

| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Noninterest-bearing  demand |       | $        | 22,474     |     | 8          | % | $ | 11,235 |   | 9 | % |
| Interest-bearing  demand    |       | 105,142  |       | 37       | %          | 57,239 |   | 44 | % |
| Savings                     |       | 2,534    |       | 1        | %          | 961 |   | 1 | % |
| Time over  $100,000         |       | 91,330   |       | 30       | %          | 30,185 |   | 23 | % |
| Time                        |       | 64,916   |       | 24       | %          | 29,812 |   | 23 | % |
|                        |       | $        | 286,396    |     |       |   | $ | 129,432 |   |   |   |

 

Theaverage balance of deposits and the average rates paid on such deposits aresummarized for the periods indicated in the following table.

| ** **                   | ** ** | **December 31,**                                        | ** ** |
|------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **Amount**                                                   | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                   | ** ** | **(Amounts are presented in thousands)** | ** ** |
| Non-interest-bearing  demand |       | $                                                            | 14,288     |   | — | % | $ | 8,760 |   | — | % |
| Interest-bearing  demand     |       | 68,497                                                       |       | 2.73 | % | 54,931 |   | 1.80 | % |
| Savings                      |       | 1,462                                                        |       | .68 | % | 978 |   | .72 | % |
| Time                         |       | 86,736                                                       |       | 3.18 | % | 52,088 |   | 2.64 | % |
| Total                        |       | $                                                            | 170,982    |   |   |   | $ | 116,757 |   |   |   |

 

Maturitiesof time certificates of deposit of $100,000 or more outstanding at December 31,2005 are summarized as follows (amounts are presented in thousands):

| Within 3 months            |   | $      | 37,830 |   |
|----------------------------|--------|--------|--------|--------|
| After 3 through  12 months |   | 32,437 |   |
| 1 through 3 years          |   | 16,925 |   |
| After 3 years              |   | 4,138  |   |
| Total                      |   | $      | 91,330 |   |

 

**Junior SubordinatedDebentures**

In May 2004, CoastalBanking Company Statutory Trust I issued $3.0 million of trust preferredsecurities with a maturity of May 18, 2034. In accordance with FASBInterpretation Number (“FIN”) 46(R), the Trust has not been consolidatedin the Company’s financial statements. The proceeds from the issuance of thetrust preferred securities were used by the Trust to purchase $3.0 million ofthe Company’s junior subordinated debentures, which pay interest at a floatingrate equal to 3 month LIBOR plus 275 basis points. The Company used theproceeds from the sale of the junior subordinated debentures for generalpurposes, primarily to provide capital to the Bank. The debentures representthe sole asset of the Trust.

16

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**Capital Resources**

Total shareholders’ equity increased from $10,792,000at December 31, 2004 to $39,315,000 at December 31, 2005. Thisincrease was attributable to the merger with First Capital, which added$17,616,000 in tangible equity and $10,935,000 in net intangibles at the mergerdate. Net earnings for the period added $1,509,000, which was partially offsetby a decrease of $370,000 in the fair value of securities available for sale,net of tax.

Bank holding companies, such as ours, and theirbanking subsidiaries are required by banking regulators to meet particularminimum levels of capital adequacy, which are expressed in the form of certainratios. Capital is separated into Tier 1 capital (essentially commonshareholders’ equity less intangible assets) and Tier 2 capital (essentiallythe allowance for loan losses limited to 1.25% of risk-weighted assets). Thefirst two ratios, which are based on the degree of credit risk in our assets, providethe weighting of assets based on assigned risk factors and include off-balancesheet items such as loan commitments and stand-by letters of credit. The ratioof Tier 1 capital to risk-weighted assets must be at least 4.0% and the ratioof total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assetsmust be at least 8.0%. The capital leverage ratio supplements the risk-basedcapital guidelines.

Banks and bank holding companies are required tomaintain a minimum ratio of Tier 1 capital to adjusted quarterly average totalassets of 3.0%.

Thefollowing table summarizes the Company’s risk-based capital ratios at December 31,2005:

| Tier 1 capital  (to risk-weighted assets) |   | 10.93 | % |
|-------------------------------------------|--------|-------|---|
| Total capital (to  risk-weighted assets)  |   | 12.55 | % |
| Tier 1 capital (to total  average assets) |   | 9.99  | % |

 

See note 17 of notes toconsolidated financial statements for a detail of the Banks and Company.

**Liquidity**

The Banks must maintain, on a daily basis, sufficientfunds to cover the withdrawals from depositors’ accounts and to supply newborrowers with funds. To meet these obligations, the Banks keep cash on hand,maintain account balances with their correspondent banks, and purchase and sellfederal funds and other short-term investments. Asset and liability maturitiesare monitored in an attempt to match the maturities to meet liquidity needs. Itis the policy of the Banks to monitor their liquidity to meet regulatoryrequirements and their local funding requirements.

We are a party to financial instruments with off-balance-sheetrisk in the normal course of business to meet the financing needs of ourcustomers. These financial instruments consist of commitments to extend credit,standby letters of credit and loans sold with limited recourse. Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Standby letters ofcredit are written conditional commitments issued by the Banks to guarantee theperformance of a customer to a third party. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.A commitment involves, to varying degrees, elements of credit and interest raterisk in excess of the amount recognized in the balance sheets. Our exposure tocredit loss in the event of non-performance by the other party to theinstrument is represented by the contractual notional amount of the instrument.

Since certain commitments are expected to expirewithout being drawn upon, the total commitment amounts do not necessarilyrepresent future cash requirements. We use the same credit policies in makingcommitments to extend credit as we do for on-balance sheet instruments.Collateral held for commitments 

17

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to extend credit variesbut may include accounts receivable, inventory, property, plant, equipment, andincome-producing commercial properties.

Loans sold with limited recourse are 1-4 familyresidential mortgages originated by us and sold to various other financialinstitutions. These loans are sold with the agreement that a loan may bereturned to us within 90 days of any one of the loan’s first four paymentsbeing missed. Our exposure to credit loss in the event of non-performance bythe other party to the loan is represented by the contractual notional amountof the loan. Since none of the loans sold have ever been returned to us, thetotal loans sold with limited recourse amount do not represent future cashrequirements. We use the same credit policies in making loans held for sale as wedo for on-balance sheet instruments. First National, prior to merger, operateda mortgage wholesale operation, which it sold prior to merger. It maintains areserve of $144,000 at December 31, 2005 to cover against potential losses.Management considers the reserve to be adequate.

Thefollowing table summarizes our off-balance sheet financial instruments whosecontract amounts represent credit risk as of December 31, 2005:

| Commitments to  extend credit     |   | $ | 70,577,000 |   |
|-----------------------------------|--------|---|------------|--------|
| Standby letters  of credit        |   | $ | 1,068,000  |   |
| Loans sold with limited  recourse |   | $ | 26,072,000 |   |

 

Management is not aware of any significantconcentrations of loans to classes of borrowers or industries that would beaffected similarly by economic conditions. Although the Banks’ loan portfoliosare diversified, a substantial portion of their borrowers’ ability to honor theterms of their loans is dependent on the economic conditions in BeaufortCounty, South Carolina and Nassau County, Florida and surrounding areas. Inaddition, a substantial portion of our loan portfolio is collateralized byimproved and unimproved real estate and is therefore dependent on the localreal estate markets.

The Banks maintain relationships with correspondentbanks that can provide funds on short notice, if needed. Presently, the Bankshave arrangements with commercial banks for short term unsecured advances up to$15,850,000.

Cash and cash equivalents as of December 31, 2005increased $15,434,000 from December 31, 2004. Cash provided by operatingactivities totaled $1,912,000 in 2005, while inflows from financing activitiestotaled $22,014,000, which was attributable to an increase in deposits of$19,014,000 and a net increase in FHLB advances of $3,000,000.

During 2005, we had a netcash outflow of $8,492,000 from investing activities. Investing activitiesincluded net loans made to customers of approximately $25,366,000 partiallyoffset by cash inflows from the merger with First Capital of $16,490,000.

**Inflation**

Inflation impacts thegrowth in total assets in the banking industry and causes a need to increaseequity capital at higher than normal rates to meet capital adequacyrequirements. We cope with the effects of inflation through the management ofinterest rate sensitivity gap position, by periodically reviewing and adjustingour pricing of services to consider current costs and through managing ourlevel of net income relative to our dividend payout policy.

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**Selected Ratios**

Thefollowing table sets out certain ratios for the years indicated.

| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Net income to:                                |       |     |       |     |       |
| Average  shareholders’ equity (tangible) |       | 8.75     | %          | 10.85    | %          |
| Average assets  (tangible)                    |       | .75      | %          | 0.86     | %          |
| Dividends to net  income                      |       | —   | %          | —   | %          |
| Average equity to  average assets (tangible)  |       | 8.61     | %          | 7.94     | %          |

 

**Recent AccountingPronouncements**

In May 2003, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 150,*Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity*, which establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. SFAS No. 150 requires anissuer to classify certain financial instruments that include certainobligations, such as mandatory redemption, repurchase of the issuer’s equity,or settlement by issuing equity, previously classified as equity, asliabilities or assets in some circumstances. SFAS No. 150 was generallyeffective for financial instruments entered into or modified after May 31,2003, and otherwise was effective at the beginning of the first interim periodbeginning after June 15, 2003, except for mandatory redeemable financialinstruments of non-public entities which are subject to the provisions of SFAS No. 150for the first fiscal period beginning after December 15, 2003. Theadoption of SFAS No. 150 did not have any impact on the financialcondition or operating results of the Company.

In December 2004, the FASB issued SFAS No. 153,*Exchange of Non-monetary Assets, an amendment of APBOpinion No. 29, Accounting for Non-monetary Transactions.* Theamendments made by SFAS No. 153 are based on the principle that exchangesof non-monetary assets should be measured on the fair value of the assetsexchanged. Further, the amendments eliminate the narrow exception fornon-monetary exchanges of similar productive assets and replace it with abroader exception for exchanges of non-monetary assets that do not havecommercial substance. Previously, Accounting Principles Board (“APB”) Opinion No. 29required that the accounting for an exchange of a productive asset for asimilar productive asset or an equivalent interest in the same productive assetshould be based on the recorded amount of the asset relinquished. APB Opinion No. 29provided for an exception to its basic measurement principle (fair value) forexchanges of similar productive assets. SFAS No. 153 is effective fornon-monetary asset exchanges occurring in fiscal periods beginning after June 15,2005. Earlier application is permitted for non-monetary asset exchangesoccurring in fiscal periods beginning after the date of issuance. Theprovisions of this statement shall be applied prospectively. The adoption ofthis statement is not expected to have any impact on the financial condition oroperating results of the Company.

In December 2004, the FASB issued SFAS No. 123(revised 2004),*Share-Based Payment*(“SFAS No. 123 (R)”). SFAS No. 123(R) will require companies tomeasure all employee stock-based compensation awards using a fair value methodand to record such expense in its financial statements. In addition, theadoption of SFAS No. 123(R) requires additional accounting and disclosurerelated to the income tax and cash flow effects resulting from share-basedpayment arrangements. SFAS No. 123(R) is effective beginning as of thefirst interim or annual reporting period beginning after December 15,2005. The adoption of SFAS No. 123(R) will not have a material impact uponthe financial statements of the Company.

In December 2003, the FASB issued FIN No. 46(revised),*Consolidation of VariableInterest Entities* (“FIN No. 46(R)”), which addressesconsolidation by business enterprises of variable interest entities. FIN No. 46(R)requires a variable interest entity to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the variable interestentity’s activities or entitled to receive a majority of 

19

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the entity’s residualreturns, or both. FIN No. 46(R) also requires disclosure about variableinterest entities that a company is not required to consolidate, but in whichit has a significant variable interest. FIN No. 46(R) provides guidancefor determining whether an entity qualifies as a variable interest entity byconsidering, among other considerations, whether the entity lacks sufficientequity or its equity holders lack adequate decision-making ability. Theconsolidation requirements of FIN No. 46(R) applied immediately tovariable interest entities created after January 31, 2003. Theconsolidation requirements applied to the Company’s existing variable interestentities in the first reporting period ending March 31, 2004. Certain ofthe disclosure requirements applied to all financial statements issued after December 31,2003, regardless of when the variable interest entity was established. Theadoption of FIN No. 46(R) did not have a material impact on the Company’sfinancial position or results of operations.

In November 2003, the Emerging Issues Task Force(“EITF”) reached a consensus that certain quantitative and qualitativedisclosures should be required for debt and marketable equity securitiesclassified as available for sale or held to maturity under SFAS No. 115and SFAS No. 124 that are in an unrealized loss position at the balancesheet date but which other-than-temporary impairments has not been recognized.Accordingly the EITF issued EITF No. 03-1,*The Meaning of Other-Than-Temporary Impairments and Its Application toCertain Investments.* This issue addresses the meaning ofother-than-temporary impairments and its application to investments classifiedas either available for sale or held to maturity under SFAS No. 115 andprovides guidance on quantitative and qualitative disclosures. The disclosurerequirement of EITF No. 03-1 are effective for annual financial statementsfor fiscal years ending after June 15, 2004. The effective date for themeasurement and recognition of EITF No. 03-1 had been delayed. TheFASB staff has issued a proposed Board-directed FASB Staff Position (“FSP”),FSP EITF 03-1-a,*ImplementationGuidance for the Application of Paragraph 16 of Issue No. 03-1*.The proposed FSP would provide implementation guidance with respect to debtsecurities that are impaired solely due to interest rates and/or sector spreadsand analyzed for other-than-temporary impairments under the measurement andrecognition requirements of EITF No. 03-1. The delay of theeffective date for the measurement and recognition requirements of EITF No. 03-1will be superseded with the final issuance of FSP EITF 03-1-a.Adopting the disclosure provisions of EITF No. 03-1 did not have anyimpact on the Company’s financial position or results of operations.

In March 2004, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 105,*Application of Accounting Principles to LoanCommitments*, to inform registrants of the Staff’s view that the fairvalue of the recorded loan commitments should not consider the expected futurecash flows related to the associated servicing of the future loan. Theprovisions of SAB No. 105 must be applied to loan commitments accountedfor as derivatives that are entered into after March 31, 2004. The Staffwill not object to the application of existing accounting practices to loancommitments accounted for as derivatives that are entered into on or before March 31,2004, with appropriate disclosures. The Company adopted the provision of SAB No. 105on April 1, 2004. The adoption of SAB No. 105 did not have any impacton the Company’s financial condition or results of operations.

Other accounting standards that have been issued orproposed by the FASB or other standards-setting bodies that do not requireadoption until a future date are not expected to have a material impact on theconsolidated financial statements upon adoption.

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Board of Directors***Coastal Banking Company, Inc.***Beaufort, South Carolina

We have audited the accompanying consolidated balancesheets of***CoastalBanking Company, Inc. and Subsidiaries*** (the “Company”) asof December 31, 2005 and 2004 and the related consolidated statements ofearnings, comprehensive income, changes in shareholders’ equity and cash flowsfor the years ended December 31, 2005 and 2004. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

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

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position of***Coastal Banking Company, Inc.and Subsidiaries*** at December 31, 2005 and 2004 and theresults of their operations and cash flows for the years then ended, inconformity with accounting principles generally accepted in the United Statesof America.
| /s/  ELLIOTT DAVIS, LLC    |   |
|----------------------------|--------|
| Elliott Davis, LLC         |   |
| Greenville, South Carolina |   |
| March 24, 2006        |   |

 

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**COASTAL BANKING COMPANY, INC. AND SUBSIDIARIESConsolidated Balance Sheets**

| ** **                                                                                                                                         | ** ** | **December 31,** | ** **  |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                                                                         | ** ** | **2005**              | ** **  | **2004** | ** ** |
| **Assets**                                                                                                                                         | * *   | * *              | * *    | * * | * * |
| Cash and due from  banks                                                                                                                           |       | $                     | 5,932,444   |   | 1,513,726 |   |
| Federal funds  sold                                                                                                                                |       | 13,598,435            |        | 2,583,000 |   |
| Cash and cash equivalents                                                                                                                          |       | 19,530,879            |        | 4,096,726 |   |
| Certificate of  deposit                                                                                                                            |       | 500,000               |        | — |   |
| Investment  securities available for sale                                                                                                          |       | 46,150,641            |        | 27,366,390 |   |
| Investment  securities held to maturity                                                                                                            |       | 18,220,867            |        | 5,642,841 |   |
| Other  investments, at cost                                                                                                                        |       | 2,734,567             |        | 1,037,150 |   |
| Loans held for  sale                                                                                                                               |       | 2,449,651             |        | 878,124 |   |
| Loans, net                                                                                                                                         |       | 239,505,778           |        | 100,397,246 |   |
| Premises and  equipment, net                                                                                                                       |       | 6,620,652             |        | 2,871,908 |   |
| Cash value of  life insurance                                                                                                                      |       | 5,322,247             |        | 2,082,333 |   |
| Goodwill and  other intangibles                                                                                                                    |       | 10,835,970            |        | — |   |
| Accrued interest  receivable and other assets                                                                                                      |       | 3,296,885             |        | 1,698,952 |   |
| Total assets                                                                                                                                       |       | $                     | 355,168,137 |   | 146,071,670 |   |
| **Liabilities and Shareholders’ Equity**                                                                                                      | * *   | * *              | * *    | * * | * * |
| Deposits:                                                                                                                                          |       |                  |        |   |   |
| Demand                                                                                                                                             |       | $                     | 22,473,524  |   | 11,234,972 |   |
| Money market and  NOW accounts                                                                                                                     |       | 105,141,877           |        | 57,239,217 |   |
| Savings                                                                                                                                            |       | 2,534,306             |        | 960,804 |   |
| Time                                                                                                                                               |       | 64,915,893            |        | 29,811,472 |   |
| Time over  $100,000                                                                                                                                |       | 91,330,380            |        | 30,185,248 |   |
| Total deposits                                                                                                                                     |       | 286,395,980           |        | 129,431,713 |   |
| FHLB advances                                                                                                                                      |       | 22,962,934            |        | 2,000,000 |   |
| Junior  subordinated debentures                                                                                                                    |       | 3,093,000             |        | 3,093,000 |   |
| Accrued interest  payable and other liabilities                                                                                                    |       | 3,401,055             |        | 754,907 |   |
| Total liabilities                                                                                                                                  |       | 315,852,969           |        | 135,279,620 |   |
| Commitments and  contingencies—Notes 6, 12 and 14                                                                                             |       |                  |        |   |   |
| Shareholders’  Equity:                                                                                                                        |       |                  |        |   |   |
| Preferred stock,  $.01 par value; 10,000,000 shares authorized; no shares issued and outstanding                                                   |       | —                |        | — |   |
| Common stock, par  value $.01; 10,000,000 shares authorized; 2,369,263 and 1,010,379 shares  issued and outstanding in 2005 and 2004, respectively |       | 23,693                |        | 10,104 |   |
| Additional  paid-in capital                                                                                                                        |       | 39,317,286            |        | 9,626,976 |   |
| Retained earnings                                                                                                                                  |       | 476,593               |        | 1,287,727 |   |
| Accumulated other  comprehensive income (loss)                                                                                                     |       | (502,404              | )           | (132,757 | ) |
| Total shareholders’ equity                                                                                                                    |       | 39,315,168            |        | 10,792,050 |   |
| Total liabilities  and shareholders’ equity                                                                                                   |       | $                     | 355,168,137 |   | 146,071,670 |   |

 

See accompanying notes to consolidated financial statements.

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**COASTAL BANKINGCOMPANY, INC. AND SUBSIDIARIESConsolidated Statements of Earnings**

| ** **                                            | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                                      | ** ** | **2004** | ** ** |
| Interest income:                                      |       |                                                          |       |   |   |
| Interest and fees  on loans                           |       | $                                                             | 10,106,654 |   | 5,564,820 |   |
| Taxable  investments                                  |       | 1,399,547                                                     |       | 1,161,586 |   |
| Non-taxable  investments                              |       | 243,594                                                       |       | 200,899 |   |
| Federal funds  sold                                   |       | 208,650                                                       |       | 27,767 |   |
| Interest on  deposits                                 |       | 3,428                                                         |       | 1,752 |   |
| Total interest income                                 |       | 11,961,873                                                    |       | 6,956,824 |   |
| Interest expense:                                     |       |                                                          |       |   |   |
| Deposits                                              |       | 4,632,264                                                     |       | 2,370,358 |   |
| Junior  subordinated debentures                       |       | 188,660                                                       |       | 82,882 |   |
| Advances from  FHLB and Federal funds purchased       |       | 363,726                                                       |       | 28,690 |   |
| Total interest expense                                |       | 5,184,650                                                     |       | 2,481,930 |   |
| Net interest income                                   |       | 6,777,223                                                     |       | 4,474,894 |   |
| Provision for loan losses                             |       | 380,000                                                       |       | 463,200 |   |
| Net interest income after provision for loan losses   |       | 6,397,223                                                     |       | 4,011,694 |   |
| Non-interest  income:                                 |       |                                                          |       |   |   |
| Service charges  on deposit accounts                  |       | 264,770                                                       |       | 188,838 |   |
| Residential  mortgage origination fees                |       | 676,248                                                       |       | 390,814 |   |
| Gain (loss) on  sale of securities available for sale |       | (7,503                                                        | )          | 85,181 |   |
| Income from  investment in life insurance contracts   |       | 124,086                                                       |       | 82,333 |   |
| Other income                                          |       | 39,960                                                        |       | 17,260 |   |
| Total other income                                    |       | 1,097,561                                                     |       | 764,426 |   |
| Non-interest  expenses:                               | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Salaries and  employee benefits                       |       | 2,933,592                                                     |       | 1,766,124 |   |
| Occupancy and  equipment                              |       | 491,913                                                       |       | 294,499 |   |
| Other operating                                       |       | 1,763,849                                                     |       | 1,208,709 |   |
| Total other expenses                                  |       | 5,189,354                                                     |       | 3,269,332 |   |
| Earnings before income taxes                          |       | 2,305,430                                                     |       | 1,506,788 |   |
| Income tax expense                                    |       | 796,060                                                       |       | 396,186 |   |
| Net earnings                                          |       | $                                                             | 1,509,370  |   | 1,110,602 |   |
| Basic earnings per share                              |       | $                                                             | 1.09       |   | 1.06 |   |
| Diluted earnings  per share                           |       | $                                                             | 0.97       |   | 0.94 |   |

 

See accompanying notes to consolidated financial statements.

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**COASTAL BANKINGCOMPANY, INC. AND SUBSIDIARIESConsolidated Statements of Comprehensive Income**

 

| ** **                                                                                                                                            | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                            | ** ** | **2005**                                                      | ** ** | **2004** | ** ** |
| Net earnings                                                                                                                                          |       | $                                                             | 1,509,370  |   | 1,110,602 |   |
| Other  comprehensive income (loss), net of tax:                                                                                                       |       |                                                          |       |   |   |
| Unrealized gains  (losses) on investment securities available for sale arising during the  period, net of tax of $198,058 in 2005 and $79,859 in 2004 |       | (369,647                                                      | )          | (155,021 | ) |
| Reclassification  adjustment for losses (gains) included in net earnings, net of tax of $2,551  in 2005 and $31,595 in 2004                           |       | 4,952                                                         |       | (61,331 | ) |
| Total other comprehensive income (loss), net of tax                                                                                                   |       | (364,695                                                      | )          | (216,352 | ) |
| Comprehensive  income                                                                                                                                 |       | $                                                             | 1,144,675  |   | 894,250 |   |

 

See accompanying notes to consolidated financial statements.

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**COASTAL BANKINGCOMPANY, INC. AND SUBSIDIARIESConsolidated Statements of Changes in Shareholders’ EquityFor the Years Ended December 31, 2005 and 2004**

| ** **                                                              | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------|------------|-----------------------------------------------|------------|------------|------------|
| ** **                                                              | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Earnings** | ** ** | **Earnings**                                  | ** ** | **(Loss)** | ** ** | **Total** | ** ** |
| Balance,  December 31, 2003                                        |       | 995,695               |       | $                       | 9,957      |         | 9,482,517  |                                          | 177,398    |       |       | 83,595 |   |   | 9,753,467 |   |
| Change in unrealized gain on securities  available-for-sale, net of tax |       | —                |       | —                  |       | —       |       | —                                        |       |       | (216,352   | ) |   | (216,352 | ) |
| Proceeds from exercise of stock options                                 |       | 14,700                |       | 147                     |       | 144,459      |       | —                                        |       |       | —     |   |   | 144,606 |   |
| Cash in lieu of fractional shares                                       |       | (16                   | )          | —                  |       | —       |       | (273                                          | )          |       | —     |   |   | (273 | ) |
| Net earnings                                                            |       | —                |       | —                  |       | —       |       | 1,110,602                                     |       |       | —     |   |   | 1,110,602 |   |
| Balance, December 31, 2004                                         |       | 1,010,379             |       | 10,104                  |       | 9,626,976    |       | 1,287,727                                     |       |       | (132,757   | ) |   | 10,792,050 |   |
| Change in unrealized gain on securities  available-for-sale, net of tax |       | —                |       | —                  |       | —       |       | —                                        |       |       | (369,647   | ) |   | (369,647 | ) |
| Stock issued in acquisition                                             |       | 1,246,402             |       | 12,464                  |       | 27,370,931   |       | —                                        |       |       | —     |   |   | 27,383,395 |   |
| Stock Dividend                                                          |       | 112,482               |       | 1,125                   |       | 2,319,379    |       | (2,320,504                                    | )          |       | —     |   |   | — |   |
| Net earnings                                                            |       | —                |       | —                  |       | —       |       | 1,509,370                                     |       |       | —     |   |   | 1,509,370 |   |
| Balance,  December 31, 2005                                        |       | 2,369,263             |       | $                       | 23,693     |         | 39,317,286 |                                          | 476,593    |       |       | (502,404 | ) |   | 39,315,168 |   |

 

See accompanying notes to consolidated financial statements.

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**COASTAL BANKING COMPANY, INC. AND SUBSIDIARIESConsolidated Statements of Cash Flows**

| ** **                                                                              | ** ** | **For the years ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| Cash flows from operating  activities:                                                  |       |                                                      |       |   |   |
| Net earnings                                                                            |       | $                                                         | 1,509,370  |   | 1,110,602 |   |
| Adjustments to reconcile  net earnings to net cash provided by operating activities:    |       |                                                      |       |   |   |
| Depreciation,  amortization and accretion                                               |       | 318,345                                                   |       | 246,113 |   |
| Provision for loan  losses                                                              |       | 380,000                                                   |       | 463,200 |   |
| Provision for  deferred income taxes (benefit)                                          |       | (107,605                                                  | )          | (117,561 | ) |
| (Gain) loss on  sale of securities available for sale                                   |       | 7,503                                                     |       | (85,181 | ) |
| Loss on sale of  premises and equipment                                                 |       | —                                                    |       | 2,257 |   |
| Increase in cash  value of life insurance                                               |       | (116,943                                                  | )          | (82,333 | ) |
| Origination of  loans held for sale                                                     |       | (23,583,156                                               | )          | (28,570,922 | ) |
| Proceeds from sale  of loans held for sale                                              |       | 23,591,373                                                |       | 27,817,000 |   |
| Change in other  assets and other liabilities                                           |       | (87,342                                                   | )          | (119,002 | ) |
| Net cash provided by operating activities                                               |       | 1,911,545                                                 |       | 664,173 |   |
| Cash flows from  investing activities:                                                  |       |                                                      |       |   |   |
| Proceeds from  calls and maturities of investment securities available for sale         |       | 6,199,475                                                 |       | 5,800,837 |   |
| Proceeds from  sales of investment securities available for sale                        |       | —                                                    |       | 11,399,870 |   |
| Purchases of  investment securities available for sale                                  |       | (5,389,918                                                | )          | (13,603,479 | ) |
| Proceeds from maturity  of securities held to maturity                                  |       | 552,625                                                   |       | 534,612 |   |
| Purchases of  investment securities held to maturity                                    |       | (498,617                                                  | )          | (2,765,360 | ) |
| Proceeds from  sales of other investments                                               |       | 1,255,500                                                 |       | 180,000 |   |
| Purchases of other  investments                                                         |       | (1,619,317                                                | )          | (357,200 | ) |
| Investment in  Coastal Banking Company Statutory Trust I                                |       | —                                                    |       | (93,000 | ) |
| Net change in  loans                                                                    |       | (25,365,665                                               | )          | (33,427,318 | ) |
| Purchase of life  insurance contracts                                                   |       | —                                                    |       | (2,000,000 | ) |
| Proceeds from the  sale of premises and equipment                                       |       | —                                                    |       | 10,453 |   |
| Cash equivalents  acquired in merger with First Capital                                 |       | 16,490,497                                                |       | — |   |
| Purchase of  premises and equipment                                                     |       | (116,222                                                  | )          | (85,403 | ) |
| Net cash used by investing activities                                                   |       | (8,491,642                                                | )          | (34,405,988 | ) |
| Cash flows from  financing activities:                                                  |       |                                                      |       |   |   |
| Net change in  deposits                                                                 |       | 19,014,250                                                |       | 32,996,126 |   |
| Net change in  federal funds purchased                                                  |       | —                                                    |       | (600,000 | ) |
| Proceeds from FHLB  advances                                                            |       | 23,900,000                                                |       | 17,000,000 |   |
| Repayments of FHLB  advances                                                            |       | (20,900,000                                               | )          | (15,000,000 | ) |
| Proceeds from  junior subordinated debt                                                 |       | —                                                    |       | 3,093,000 |   |
| Proceeds from  exercise of stock options                                                |       | —                                                    |       | 144,606 |   |
| Cash in lieu of  fractional shares                                                      |       | —                                                    |       | (273 | ) |
| Net cash provided by financing activities                                               |       | 22,014,250                                                |       | 37,633,459 |   |
| Net change in cash and cash equivalents                                                 |       | 15,434,153                                                |       | 3,891,644 |   |
| Cash and cash  equivalents at beginning of year                                         |       | 4,096,726                                                 |       | 205,082 |   |
| Cash and cash  equivalents at end of year                                               |       | $                                                         | 19,530,879 |   | 4,096,726 |   |
| Supplemental  schedule of non-cash investing and financing activities:             |       |                                                      |       |   |   |
| Change in  unrealized gain/loss on investment securities available for sale, net of tax |       | $                                                         | (369,647   | ) | (216,352 | ) |
| Loan transferred  to repossessed assets                                                 |       | $                                                         | —     |   | 55,000 |   |
| Purchase of First  Capital:                                                             |       |                                                      |       |   |   |
| Fair value of net  assets acquired                                                      |       | $                                                         | 28,651,321 |   | — |   |
| Goodwill and other  intangibles acquired                                                |       | $                                                         | 10,935,207 |   | — |   |
| Supplemental  disclosures of cash flow information:                                     |       |                                                      |       |   |   |
| Cash paid during  the year for interest                                                 |       | $                                                         | 4,744,209  |   | 2,428,379 |   |
| Cash paid during the year  for income taxes                                             |       | $                                                         | 605,780    |   | 637,000 |   |

 

See accompanying notes to consolidated financial statements.

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**COASTAL BANKING COMPANY, INC. AND SUBSIDIARIESNotes to Consolidated Financial Statements**

**(1)**                                              Summaryof Significant Accounting Policies

*Basis ofPresentation and Nature of Operations*

Coastal Banking Company, Inc. (the “Company”) isorganized under the laws of the State of South Carolina for the purpose ofoperating as a bank holding company for Lowcountry National Bank and FirstNational Bank of Nassau County, Florida (the “Banks”). Lowcountry National Bankcommenced business on May 10, 2000. First National Bank of Nassau Countybegan operations in 1999 and was acquired through merger on October 1,2005 (See Note 2). The Banks provide full commercial banking services tocustomers throughout Beaufort County, South Carolina and Nassau County, Floridaand are subject to regulation by the Office of the Comptroller of the Currency(the “OCC”) and the Federal Deposit Insurance Corporation. The Company issubject to regulation by the Federal Reserve Board of Governors. The Companyalso has an investment in Coastal Banking Company Statutory Trust I (the “Trust”)(a non-consolidated subsidiary). The Trust is a special purpose subsidiaryorganized for the sole purpose of issuing trust preferred securities.

The consolidated financialstatements include the accounts of the Company and the Banks. All significantintercompany transactions have been eliminated in consolidation. The accountingand reporting policies of the Company conform to accounting principlesgenerally accepted in the United States of America and to general practices inthe banking industry. The Company uses the accrual basis of accounting.

*Estimates*

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the consolidated financial statements and the reported amount of income andexpenses during the reporting periods. Actual results could differ from thoseestimates.

*Cash and CashEquivalents*

Cash equivalents includeamounts due from banks, interest-bearing demand deposits with banks and federalfunds sold. Generally, federal funds are sold for one-day periods.

*Segments*

The Company, through itssubsidiaries, provides a broad range of financial services to individuals andcompanies. These services include demand, time and savings deposits, lending,and ATM processing and are substantially the same across subsidiaries.  While the Company’s decision-makers monitorthe revenue streams of the various financial products and services by productline and by subsidiary, the operations and the allocation of resources aremanaged, and financial performance is evaluated, on an organization-wide basis.Accordingly, the Company’s banking operation is considered by management to beone reportable operating segment.

*Intangible assets*

Intangible assets includegoodwill and other identifiable assets, such as core deposit intangibles,resulting from acquisitions. Goodwill, in this context, is the excess of thepurchase price in an acquisition 

27

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transactionover the fair market value of the net assets acquired. Core deposit intangiblesare amortized on a straight-line basis over such assets’ estimated expectedlife. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,”goodwill is not amortized but is tested annually for impairment or at any timean event occurs, or circumstances change, that may trigger a decline in thevalue of the reporting unit. Such impairment testing calculations includeestimates. Furthermore, the determination of which intangible assets havefinite lives is subjective as is the determination of the amortization periodfor such intangible assets. The Company tests for goodwill impairment bydetermining the fair market value for each reporting unit and comparing thefair market value to the carrying amount of the applicable reporting unit. Ifthe carrying amount exceeds fair market value the potential for the impairmentexists, and a second step of impairment testing is performed. In the secondstep, the fair market value of the reporting units’ goodwill is determined byallocating the reporting unit’s fair market value to all of its assets(recognized and unrecognized) and liabilities as if the reporting unit had beenacquired in a business combination at the date of the impairment test. If theimplied fair market value of reporting unit goodwill is less than its carryingamount, goodwill is impaired and is written-down to its fair market value. Theloss recognized is limited to the carrying amount of goodwill. Once animpairment loss is recognized, future increases in fair market value will notresult in the reversal of previously recognized losses. The Company willperform its impairment testing annually by applying the above process to itsreportable operating segment of banking. No previous impairment testing hasbeen performed since the first instance of intangibles was October 1, 2005 withthe merger of First Capital. 

*InvestmentSecurities*

The Company classifies its securities in one of threecategories: trading, available for sale, or held to maturity. Tradingsecurities are bought and held principally for the purpose of selling them inthe near term. Held to maturity securities are those securities for which theCompany has the ability and intent to hold until maturity. All securities notincluded in trading or held to maturity are classified as available for sale.The Company has no trading securities.

Trading and available for sale securities are recordedat fair value. Held to maturity securities are recorded at cost, adjusted forthe amortization or accretion of premiums or discounts. Unrealized gains andlosses on trading securities are recognized in earnings. Unrealized holdinggains and losses, net of the related tax effect, on securities available forsale are excluded from earnings and are reported as a separate component ofshareholders’ equity until realized. Transfers of securities between categoriesare recorded at fair value at the date of transfer.

A decline in the market value of any available forsale or held to maturity security below cost that is deemed other thantemporary is charged to earnings and establishes a new cost basis for thesecurity.

Premiums and discounts areamortized or accreted over the life of the related securities as adjustments tothe yield. Realized gains and losses for securities classified as available forsale and held to maturity are included in earnings and are derived using thespecific identification method for determining the cost of securities sold.

*Other Investments*

Other investments includeequity securities with no readily determinable fair value. These investmentsare carried at cost. The Bank, as a member institution, is required to owncertain stock investments in the Federal Home Loan Bank of Atlanta (“FHLB”) andthe Federal Reserve Bank (“FRB”). The stock is generally pledged against anyborrowings from these institutions. No ready market exists for the stock and ithas no quoted market price. However, redemption of these stocks hashistorically been at par value.

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*Loans Held for Sale*

Loans originated and intendedfor sale in the secondary market are carried at the lower of aggregate cost ormarket value. The amount by which cost exceeds market value is accounted for asa valuation allowance. Changes, if any, in the valuation allowance are includedin the determination of net earnings in the period in which the change occurs.The Company has recorded no valuation allowance related to its loans held forsale as their cost approximates market value.

*Loans and Allowancefor Loan Losses*

Loans are stated at principal amount outstanding, netof the allowance for loan losses. Interest on loans is calculated by using theinterest method based upon the principal amount outstanding. Loan originationand commitment fees and direct loan origination costs are deferred and amortizedover the contractual life of the related loan or commitments as an adjustmentof the related loan yields.

A loan is considered impaired when, based on currentinformation and events, it is probable that all amounts due according to thecontractual terms of the loan agreement will not be collected. Impaired loansare measured based on the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, at the loan’s observablemarket price, or at the fair value of the collateral of the loan if the loan iscollateral dependent. Accrual of interest is discontinued on a loan whenmanagement believes, after considering economic and business conditions andcollection efforts that the borrower’s financial condition is such thatcollection of interest is doubtful. When the ultimate collectibility of animpaired loan’s principal is in doubt, wholly or partially, all cash receiptsare applied to principal.

The allowance for loan losses is established through aprovision for loan losses charged to expense. Loans are charged against theallowance for loan losses when management believes that the collectibility ofthe principal is unlikely. The allowance represents an amount, which, inmanagement’s judgment, will be adequate to absorb probable losses on existingloans that may become uncollectible.

Management’s judgment in determining the adequacy ofthe allowance is based on evaluations of the collectibility of loans. Theseevaluations take into consideration such factors as changes in the nature andvolume of the loan portfolio, current economic conditions that may affect theborrower’s ability to pay, overall portfolio quality and review of specificproblem loans. In determining the adequacy of the allowance for loan lossesmanagement uses four different methods as indicators of the reasonableness ofthe allowance. The methods used include a risk method (using internalclassifications along with regulatory classifications), historical charge-offs,comparison to a peer group, and current classifications based on the loangrading system. The combination of these results are compared quarterly to therecorded allowance for loan losses for reasonableness and material differencesare adjusted by increasing or decreasing the provision for loan losses.Management uses an external loan review program to challenge and corroboratethe internal loan grading system and provide additional analysis in determiningthe adequacy of the allowance and the future provisions for estimated loanlosses.

Management believes thatthe allowance for loan losses is adequate. While management uses availableinformation to recognize losses on loans, future additions to the allowance maybe necessary based on changes in economic conditions. In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the Banks’ allowance for loan losses. Such agencies mayrequire the Banks to recognize additions to the allowance based on judgmentsdifferent than those of management.

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*Non-performingAssets*

Loans are placed in anon-accrual status when, in the opinion of management, the collection ofadditional interest is questionable. Thereafter, no interest is taken intoincome unless received in cash or until such time as the borrower demonstratesthe ability to pay principal and interest.

*Premises andEquipment*

Premises and equipment are stated at cost lessaccumulated depreciation. Costs incurred for maintenance and repairs that donot extend the useful life of the asset are expensed as incurred.

Depreciationexpense is computed using the straight-line method over the following estimateduseful lives:

| Building and  improvements |   | 10 - 40 years |   |
|----------------------------|--------|---------------|--------|
| Furniture and equipment    |   | 3 - 10 years  |   |

 

*Advertising Costs*

The Company expenses alladvertising costs as incurred. Advertising costs for the Company wereapproximately $193,000 and $134,000 for the years ended December 31, 2005and 2004.

*Income Taxes*

Deferred tax assets and liabilities are recognized forthe future tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin income in the period that includes the enactment date.

In the event the futuretax consequences of differences between the financial reporting bases and thetax bases of the assets and liabilities result in deferred tax assets, anevaluation of the probability of being able to realize the future benefitsindicated by such asset is required. A valuation allowance is provided for someportion or all of the deferred tax asset when it is more likely than not thatsome portion or all of the deferred tax asset will not be realized. Inassessing the realizability of the deferred tax assets, management considersthe scheduled reversals of deferred tax liabilities, projected future taxableincome, and tax planning strategies.

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*Stock-BasedCompensation*

At December 31,2005, the Company sponsors stock-based compensation plans, which are describedmore fully in Note 15. The Company accounts for these plans under therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25,*Accounting for StockIssued to Employees,* and related Interpretations. No stock-basedemployee compensation cost is reflected in net earnings, as all options grantedunder those plans had an exercise price equal to the market value of theunderlying common stock on the date of grant. The following table illustratesthe effect on net earnings and earnings per share if the Company had appliedthe fair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123,*Accountingfor Stock-Based Compensation,* to stock-based employee compensationfor the years ended December 31, 2005 and 2004.

| ** **                                                                                                        | ** ** | **For the Year Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                                                 | ** ** | **2004** | ** ** |
| Net earnings as  reported                                                                                         |       | $                                                        | 1,509,370  |   | 1,110,602 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair-value based  method for all awards |       | (172,121                                                 | )          | (63,342 | ) |
| Pro forma net  earnings                                                                                           |       | $                                                        | 1,337,249  |   | 1,047,260 |   |
| Basic earnings per  share:                                                                                        |       |                                                     |       |   |   |
| As reported                                                                                                       |       | $                                                        | 1.09       |   | 1.06 |   |
| Pro forma                                                                                                         |       | $                                                        | .96        |   | .98 |   |
| Diluted earnings per  share:                                                                                      |       |                                                     |       |   |   |
| As reported                                                                                                       |       | $                                                        | .97        |   | 0.94 |   |
| Pro forma                                                                                                         |       | $                                                        | .86        |   | 0.88 |   |

 

*Net Earnings PerCommon Share*

TheCompany is required to report earnings per common share with and without thedilutive effects of potential common stock issuances from instruments such asoptions, convertible securities and warrants on the face of the statements ofearnings. Basic earnings per common share are based on the weighted averagenumber of common shares outstanding during the period, which was 1,390,751 in2005 and 1,054,130 in 2004, while the effects of potential common sharesoutstanding during the period are included in diluted earnings per share.Additionally, the Company must reconcile the amounts used in the computation ofboth “basic earnings per share” and “diluted earnings per share”. There were noantidilutive potential common shares at December 31, 2005. All shareamounts have been adjusted for the five percent stock dividend recorded in 2005.Earnings per common share amounts for the years ended December 31, 2005and 2004 are as follows:

| **For the year ended December 31, 2005** | ** ** | ** ** | ** ** | **Net Earnings  (Numerator)** | ** ** | **Common  Share  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| Basic earnings  per share                                              |       |       | $          | 1,509,370                          |       |                             |       | 1,390,751                  |       |   |   | $ | 1.09 |   |   |
| Effect of  dilutive securities—stock options and warrants         |       |       | —     |                               |       |                             | 170,539    |                       |       |   | (.12 | ) |   |
| Diluted earnings per  share                                            |       |       | $          | 1,509,370                          |       |                             |       | 1,561,290                  |       |   |   | $ | .97 |   |   |

 

| **For the year ended December 31, 2004** | ** ** | ** ** | ** ** | **Net Earnings  (Numerator)** | ** ** | **Common  Share  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| Basic earnings  per share                                              |       |       | $          | 1,110,602                          |       |                             |       | 1,054,130                  |       |   |   | $ | 1.06 |   |   |
| Effect of  dilutive securities—stock options and warrants         |       |       | —     |                               |       |                             | 121,472    |                       |       |   | (0.12 | ) |   |
| Diluted earnings per  share                                            |       |       | $          | 1,110,602                          |       |                             |       | 1,175,602                  |       |   |   | $ | 0.94 |   |   |

 

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*Recent AccountingPronouncements*

In May 2003, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 150,*Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity*, which establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity. SFAS No. 150 requires an issuer to classifycertain financial instruments that include certain obligations, such asmandatory redemption, repurchase of the issuer’s equity, or settlement byissuing equity, previously classified as equity, as liabilities or assets insome circumstances. SFAS No. 150 was generally effective for financialinstruments entered into or modified after May 31, 2003, and otherwise waseffective at the beginning of the first interim period beginning afterJune 15, 2003, except for mandatorily redeemable financial instruments ofnon-public entities which are subject to the provisions of SFAS No. 150for the first fiscal period beginning after December 15, 2003. Theadoption of SFAS No. 150 did not have any impact on the financialcondition or operating results of the Company.

In December 2004, the FASB issued SFASNo. 153,*Exchange of Non-monetaryAssets, an amendment of APB Opinion No. 29, Accounting for Non-monetaryTransactions.* The amendments made by SFAS No. 153 are based onthe principle that exchanges of non-monetary assets should be measured on thefair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for non-monetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of non-monetary assets thatdo not have commercial substance. Previously, APB Opinion No. 29 requiredthat the accounting for an exchange of a productive asset for a similarproductive asset or an equivalent interest in the same productive asset shouldbe based on the recorded amount of the asset relinquished. APB OpinionNo. 29 provided for an exception to its basic measurement principle (fairvalue) for exchanges of similar productive assets. SFAS No. 153 iseffective for non-monetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. Earlier application is permitted fornon-monetary asset exchanges occurring in fiscal periods beginning after thedate of issuance. The provisions of this statement are to be appliedprospectively. The adoption of this statement is not expected to have anyimpact on the financial condition or operating results of the Company.

In December 2004, the FASB issued SFASNo. 123 (revised 2004),*Share-BasedPayment* (“SFAS No. 123 (R)”). SFAS No. 123(R) will requirecompanies to measure all employee stock-based compensation awards using a fairvalue method and record such expense in its financial statements. In addition,the adoption of SFAS No. 123(R) requires additional accounting anddisclosure related to the income tax and cash flow effects resulting fromshare-based payment arrangements. SFAS No. 123(R) is effective beginningas of the first interim or annual reporting period beginning after December 15,2005. The adoption of SFAS No. 123(R) will not have a material impact uponthe financial statements.

In December 2003, the FASB issued FASBInterpretation No. 46 (revised),*Consolidation of Variable Interest Entities* (“FIN No. 46(R)”),which addresses consolidation by business enterprises of variable interestentities. FIN No. 46(R) requires a variable interest entity to beconsolidated by a company if that company is subject to a majority of the riskof loss from the variable interest entity’s activities or entitled to receive amajority of the entity’s residual returns, or both. FIN No. 46(R) alsorequires disclosure about variable interest entities that a company is notrequired to consolidate, but in which it has a significant variable interest.FIN No. 46(R) provides guidance for determining whether an entityqualifies as a variable interest entity by considering, among otherconsiderations, whether the entity lacks sufficient equity or its equityholders lack adequate decision-making ability. The consolidation requirementsof FIN No. 46(R) applied immediately to variable interest entities createdafter January 31, 2003. The consolidation requirements applied to theCompany’s existing variable interest entities in the first reporting periodending March 31, 2004. Certain of the disclosure requirements applied toall financial statements issued after December 31, 2003, regardless ofwhen the variable interest entity was established. The adoption of FINNo. 46(R) did not have a material impact on the Company’s financialposition or results of operations.

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In November 2003, the Emerging Issues Task Force(“EITF”) reached a consensus that certain quantitative and qualitativedisclosures should be required for debt and marketable equity securitiesclassified as available for sale or held to maturity under SFAS No. 115and SFAS No. 124 that are in an unrealized loss position at the balancesheet date but which other-than-temporary impairments has not been recognized.Accordingly, the EITF issued EITF No. 03-1,*The Meaning of Other-Than-Temporary Impairments andIts Application to Certain Investments*. This issue addresses themeaning of other-than-temporary impairments and its application to investmentsclassified as either available for sale or held to maturity under SFAS No. 115and provides guidance on quantitative and qualitative disclosures. Thedisclosure requirement of EITF No. 03-1 are effective for annualfinancial statements for fiscal years ending after June 15, 2004. Theeffective date for the measurement and recognition of EITF No. 03-1had been delayed. The FASB staff has issued a proposed Board-directed FASBStaff Position (“FSP”), FSP EITF 03-1-a,*Implementation Guidance for the Application ofParagraph 16 of Issue No. 03-1*. The proposed FSP wouldprovide implementation guidance with respect to debt securities that areimpaired solely due to interest rates and/or sector spreads and analyzed forother-than-temporary impairments under the measurement and recognitionrequirements of EITF No. 03-1. The delay of the effective date forthe measurement and recognition requirements of EITF No. 03-1 willbe superseded with the final issuance of FSP EITF 03-1-a. Adoptingthe disclosure provisions of EITF No. 03-1 did not have any impacton the Company’s financial position or results of operations.

In March 2004, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 105,*Application of Accounting Principles to LoanCommitments*, to inform registrants of the Staff’s view that the fairvalue of the recorded loan commitments should not consider the expected futurecash flows related to the associated servicing of the future loan. Theprovisions of SAB No. 105 must be applied to loan commitments accountedfor as derivatives that are entered into after March 31, 2004. The Staffwill not object to the application of existing accounting practices to loancommitments accounted for as derivatives that are entered into on or before March 31,2004, with appropriate disclosures. The Company adopted the provision of SAB No. 105on April 1, 2004. The adoption of SAB No. 105 did not have any impacton the Company’s financial condition or results of operations.

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.”This FSP concluded that the terms of certain loan products may increase areporting entity’s exposure to credit risk and, therefore, may result in aconcentration of credit risk as the term is used in SFAS No. 107, “Disclosuresabout Fair Value of Financial Instruments,” either as an individual producttype or as a group of products with similar features. SFAS No. 107 requiresdisclosures about each significant concentration, including information aboutthe (shared) activity, region, or economic characteristic that identifies theconcentration. Possible share characteristics on which significant concentrationsmay be determined include, but are not limited to borrowers subject tosignificant payment increases, loans with terms that permit negativeamortization, and loan with high loan-to-value ratios. This FSP requiresentities to provide the disclosures required by SFAS No. 107 for loan productsthat are determined to represent a concentration of credit risk in accordancewith the guidance of this FSP for all periods presented. Such disclosures arerequired to be applied for interim and annual periods ending after the date theFSP was posted to the FASB website (December 19, 2005). The adoption of thisdisclosure statement had no effect on the financial statements.

Other accounting standardsthat have been issued or proposed by the FASB or other standards-setting bodiesthat do not require adoption until a future date are not expected to have amaterial impact on the consolidated financial statements upon adoption.

*Risks andUncertainties*

In the normal course of its business, the Companyencounters two significant types of risk: economic and regulatory. There arethree main components of economic risk: interest rate risk, credit risk and 

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market risk. The Companyis subject to interest rate risk to the degree that its interest-bearingliabilities mature or reprice at different speeds, or on different bases, thanits interest-earning assets. Credit risk is the risk of default on the Company’sloan portfolio that results from borrowers’ inability or unwillingness to makecontractually required payments. Market risk reflects changes in the value ofcollateral underlying loans receivable, the valuation of real estate held bythe Company, and the valuation of loans held for sale and mortgage-backedsecurities available for sale.

The Company is subject tothe regulations of various government agencies. These regulations can and dochange significantly from period to period. The Company also undergoes periodicexaminations by the regulatory agencies, which may subject it to furtherchanges with respect to asset valuations, amounts of required loss allowances,and operating restrictions, resulting from the regulators’ judgments based oninformation available to them at the time of their examination.

*Concentrations ofCredit Risk*

The Company, through its subsidiaries, makes loans toindividuals and businesses in and around Beaufort County, South Carolina andNassau County, Florida for various personal and commercial purposes. TheCompany has a diversified loan portfolio and the borrowers’ ability to repaytheir loans is not dependent upon any specific economic sector.

The Company makes loans to individual and smallbusinesses for various personal and commercial purposes primarily through ourfull-service offices in Beaufort County, South Carolina and Nassau County,Florida and through our loan production office in Savannah, Georgia. TheCompany’s loan portfolio is not concentrated in loans to any single borrower orin a relatively small number of borrowers. Our loan portfolio has a significantnumber of construction loans that if subjected to a real estate marketdown-turn could adversely affect the earnings of the Company.

In addition to monitoring potential concentrations ofloans to particular borrowers or groups of borrowers, industries and geographicregions, management monitors exposure to credit risk that could arise frompotential concentrations of lending products and practices such as loans thatsubject borrowers to substantial payment increases (e.g. principal deferralperiod, loans with initial interest-only payments, etc), and loans with highloan-to-value ratios. Additionally, there are industry practices that couldsubject the Company to increased credit risk should economic conditions changeover the course of a loan’s life. For example, the Company makes variable rateloans and fixed rate principal-amortizing loans with maturities prior to theloan being fully paid (i.e. balloon payment loans). These loans areunderwritten and monitored to manage the associated risks. Management haddetermined that there is no concentration of credit risk associated with itslending policies or practices.

The Company’s investmentportfolio consists principally of obligations of the United States, itsagencies or its corporations and general obligation municipal securities.  In the opinion of management, there is noconcentration of credit risk in this investment portfolio. The Company placesit deposits and correspondent accounts with and sells its federal funds to highquality institutions. Management believes credit risk associated withcorrespondent accounts is not significant.

*Reclassifications*

Certain reclassificationshave been made to the 2004 financial statements to conform to classificationsused for 2005. All such reclassifications had no effect on the prior year’s netearnings or retained earnings as previously reported.

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**(2)**                                              BusinessCombination

On October 1, 2005, the Company completed itsacquisition of First Capital Bank Holding Corporation, the holding company forFirst National Bank of Nassau County, Florida, located in Fernandina Beach,Florida. The acquisition was approved at a special shareholders’ meetingon August 24, 2005. First Capital shareholders were given 1.054 shares ofthe Company’s common stock in exchange for each share of First Capital commonstock. As a result of the exchange, First Capital shareholders were given atotal of 1,246,402 shares of  the Company’scommon stock valued at $21.24 per share for a total market value of  $27,383,395, which included the value ofstock options assumed and cash paid in lieu of fractional shares. The value ofthe common stock issued was determined based on the average closing price overthe ten days prior to the closing of the transaction. The acquisition wasaccounted for using the purchase method of accounting, with the operatingresults of First Capital from October 1, 2005 forward included in theCompany’s financial statements. A summary of the purchase price of thetransaction is as follows:

Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed at October 1, 2005, the date of acquisition, includingsubsequent adjustments to the allocation of the purchase price.

| Cash and cash  equivalents                |   | $           | 16,490,497 |   |
|-------------------------------------------|--------|-------------|------------|--------|
| Securities                                |   | 34,735,395  |       |
| Loans Held for  sale                      |   | 1,579,744   |       |
| Loans, net of  allowance                  |   | 114,052,253 |       |
| Premises and  equipment                   |   | 3,815,530   |       |
| Cash value of  life insurance             |   | 3,122,971   |       |
| Other assets                              |   | 1,090,433   |       |
| Core deposit  intangible                  |   | 1,212,435   |       |
| Goodwill                                  |   | 9,722,772   |       |
| Total assets acquired                     |   | 185,822,030 |       |
| Deposits                                  |   | 137,933,242 |       |
| Advances from the  Federal Home Loan Bank |   | 17,958,741  |       |
| Other liabilities                         |   | 1,278,726   |       |
| Total liabilities assumed                 |   | 157,170,709 |       |
| Net assets acquired                       |   | $           | 28,651,321 |   |

 

Goodwill includesmerger-related expenses of  $1,202,318.These fees include professional fees and costs associated with the terminationof data processing contracts related to the combination.

**(3)**                                              Restrictionson Cash and Due From Banks

The Banks are required tomaintain average reserve balances, computed by applying prescribed percentagesto its various types of deposits, either at the Banks or on deposit with theFRB. At December 31, 2005 and 2004, these required reserves were met byvault cash and deposits on hand at the Federal Reserve.

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**(4)**                                              InvestmentSecurities

Investmentsecurities at December 31, 2005 and 2004 are as follows:

| ** **                                 | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| *Available for sale*                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Federal agencies                           |       | $                               | 23,047,120 |   |   | 1,748 |   |   |   | (356,723 | ) |   | 22,692,145 |   |
| Mortgage-backed  securities                |       | 22,463,443                      |       |   | — |   |   |   | (389,357 | ) |   | 22,074,086 |   |
| State, county and  municipals              |       | 1,408,930                       |       |   | — |   |   |   | (24,520 | ) |   | 1,384,410 |   |
| Total AFS                                  |       | $                               | 46,919,493 |   |   | 1,748 |   |   |   | (770,600 | ) |   | 46,150,641 |   |
| *Held to maturity*                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State, county  municipals                  |       | 8,467,980                       |       |   | 2,298 |   |   |   | (178,175 | ) |   | 8,292,103 |   |
| Mortgage backed  securities and CMO’s |       | 9,752,887                       |       |   | — |   |   |   | (158,531 | ) |   | 9,594,356 |   |
| Total HTM                                  |       | $                               | 18,220,867 |   |   | 2,298 |   |   |   | (336,706 | ) |   | 17,886,459 |   |

 

| ** **                    | ** ** | **December 31, 2004** | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| ** **                    | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| *Available for sale*          |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Federal agencies              |       | $                               | 15,009,737 |   |   | 38,715 |   |   |   | (132,802 | ) |   | 14,915,650 |   |
| Mortgage-backed  securities   |       | 12,289,675                      |       |   | 15,295 |   |   |   | (122,355 | ) |   | 12,182,615 |   |
| State, county and  municipals |       | 268,125                         |       |   | — |   |   |   | — |   |   | 268,125 |   |
|                          |       | $                               | 27,567,537 |   |   | 54,010 |   |   |   | (255,157 | ) |   | 27,366,390 |   |
| *Held to maturity*            |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State, county and  municipals |       | $                               | 5,642,841  |   |   | 10,983 |   |   |   | (98,811 | ) |   | 5,555,013 |   |

 

The following table showsgross unrealized losses and fair value, aggregated by investment category, andlength of time that individual securities have been in a continuous unrealizedloss position, at December 31, 2005.

*Investment securities available for sale**:***

| ** **                  | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|-----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| ** **                  | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses**               | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| Federal agencies            |       | $                                      | 3,677,735  |                                 |       | (34,794         | )          |   | 19,014,410 |   |   | (320,181 | ) |   | 22,692,145 |   |   | (356,723 | ) |   |
| Mortgage-backed  securities |       | 6,548,267                              |       |                                 | (43,563    | )               |       | 15,525,819 |   |   | (345,794 | ) |   | 22,074,086 |   |   | (389,357 | ) |   |
| Municipals                  |       | 1,384,410                              |       |                                 | (24,520    | )               |       | — |   |   | — |   |   | 1,384,410 |   |   | (24,520 | ) |   |
| Total                       |       | $                                      | 11,610,412 |                                 |       | (102,877        | )          |   | 34,540,229 |   |   | (665,975 | ) |   | 46,150,641 |   |   | (770,600 | ) |   |

 

Twenty one (21) individualsecurities were in a continuous loss position for twelve months or more. TheCompany has the ability and intent to hold these securities until such time asthe value recovers or the securities mature. The Company believes, based onindustry analyst reports and credit ratings, that the deterioration in value isattributable to changes in market interest rates and not in the credit qualityof the issuer and therefore, these losses are not consideredother-than-temporary.

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*Investment securities held to maturity**:***

| ** **                                        | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses**               | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| State, county and  municipals                     |       | $                                      | 102,492    |                                 |       | (471            | )          |   | 8,189,611 |   |   | (177,704 | ) |   | 8,292,103 |   |   | (178,175 | ) |   |
| Mortgage backed  securities & CMO’s |       | —                                 |       |                                 | —     |            |       | 9,594,356 |   |   | (158,531 | ) |   | 9,594,356 |   |   | (158,531 | ) |   |
| Total                                             |       | $                                      | 102,492    |                                 |       | (471            | )          |   | 17,783,967 |   |   | (333,937 | ) |   | 17,886,459 |   |   | (336,706 | ) |   |

 

Seven (7) individual securities were in a continuousloss position for twelve months or more. The Company has the ability and intentto hold these securities until maturity. The Company believes, based onindustry analyst reports and credit ratings, that the deterioration in value isattributable to changes in market interest rates and not in the credit qualityof the issuer; and therefore, these losses are not consideredother-than-temporary.

Theamortized cost and estimated fair value of investment securities at December 31,2005, by contractual maturity, are shown below. Expected maturities will differfrom contractual maturities because borrowers have the right to call or prepayobligations with or without call or prepayment penalties.

| ** **                                         | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------------------|------------|---------------------|------------|--------------------------------|------------|
| *Available for sale*                               | * *   | * *            | * *   | * *                       | * *   |
| Federal agencies  and state, county and municipals |       |                |       |                           |       |
| Within 1 year                                      |       | $                   | 7,500,833  |                           | 7,355,925  |   |
| 1 to 5 years                                       |       | 15,329,439          |       | 15,145,109                     |       |
| 5 to 10 years                                      |       | 1,625,778           |       | 1,575,518                      |       |
| Mortgage-backed  securities                        |       | 22,463,443          |       | 22,074,089                     |       |
|                                               |       | $                   | 46,919,493 |                           | 46,150,641 |   |
| *Held to maturity*                                 | * *   | * *            | * *   | * *                       | * *   |
| Federal agencies  and state, county and municipals |       |                |       |                           |       |
| Within 1 year                                      |       | 102,963             |       | 102,492                        |       |
| 1 to 5 years                                       |       | 1,725,117           |       | 1,700,072                      |       |
| 5 to 10 years                                      |       | 4,424,995           |       | 4,338,252                      |       |
| More than 10  years                                |       | 2,214,905           |       | 2,151,287                      |       |
| Mortgage-backed  securities                        |       | 9,752,887           |       | 9,594,356                      |       |
|                                               |       | $                   | 18,220,867 |                           | 17,886,459 |   |

 

Proceeds from sales of securities available for saleduring 2005 and 2004 totaled $0 and $11,399,870 respectively. There were nogross gains or losses realized on those sales during 2005 and gross losses of$7,503 were realized on calls of securities during 2005. Gross gains of$121,819 were realized on those sales during 2004 and gross losses of $36,638were realized on sales during 2004.

Securities with anamortized cost and fair value pledged to secure public deposits and for otherpurposes as required by law totaled $20,592,000 and $20,364,000 respectively asof December 31, 2005 and $8,766,000 and $8,011,000 as of December 31,2004, respectively.

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**(5)**                                              Loansand allowance for loan losses

Majorclassifications of loans at December 31, 2005 and 2004 are summarized asfollows:

| ** **                              | ** ** | **2005**    | ** **  | **2004**    | ** **  |
|-----------------------------------------|------------|-------------|-------------|-------------|-------------|
| Commercial,  financial and agricultural |       | $           | 11,458,455  |        | 5,561,639   |   |
| Real  estate—construction          |       | 95,458,183  |        | 33,726,328  |        |
| Real  estate—mortgage              |       | 129,645,136 |        | 58,979,404  |        |
| Consumer and  other                     |       | 5,806,996   |        | 3,266,786   |        |
| Gross loans                             |       | 242,368,770 |        | 101,534,157 |        |
| Less: Allowance for loan losses         |       | 2,862,992   |        | 1,136,911   |        |
| Net loans                               |       | $           | 239,505,778 |        | 100,397,246 |   |

 

The Banks grant loans and extensions of credit toindividuals and a variety of businesses and corporations located in its generaltrade areas Beaufort, Beaufort County, South Carolina and adjoining counties,and Nassau County, Florida. Although the Banks have diversified loanportfolios, a substantial portion of the loan portfolios are collateralized byimproved and unimproved real estate and are dependent upon the real estatemarket.

Ananalysis of the activity in the allowance for loan losses for the years ended December 31,2005 and 2004 is presented below:

| ** **                       | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------------------------------|------------|-----------|------------|----------|------------|
| Balance at  beginning of year    |       | $         | 1,136,911  |     | 866,228    |   |
| Provision charged  to operations |       | 380,000   |       | 463,200  |       |
| Provision added  through merger  |       | 1,395,767 |       | —   |       |
| Loans charged off                |       | (55,990   | )          | (194,948 | )          |
| Recoveries                       |       | 6,304     |       | 2,431    |       |
| Balance at end of  year          |       | $         | 2,862,992  |     | 1,136,911  |   |

 

At December 31, 2005,non-accrual loans totaled $130,000. At December 31, 2004, there were nonon-accrual loans. Foregone interest income on non-accrual loans in 2005 and2004 was an insignificant amount. At December 31, 2005, impaired loanstotaled $130,189. At December 31, 2004, the company had no impaired loans.At December 31, 2005 and 2004, criticized and classified loans amounted to$2,592,251 and $1,254,115, respectively.

**(6)**                                              Premisesand Equipment

Majorclassifications of premises and equipment are summarized as follows:

| ** **                    | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-------------------------------|------------|-----------|------------|-----------|------------|
| Land and  improvements        |       | $         | 3,929,669  |      | 1,514,668  |   |
| Building and  improvements    |       | 2,397,480 |       | 1,150,222 |       |
| Furniture and  equipment      |       | 1,042,879 |       | 771,996   |       |
|                          |       | 7,370,028 |       | 3,436,886 |       |
| Less accumulated depreciation |       | (749,376  | )          | (564,978  | )          |
|                          |       | $         | 6,620,652  |      | 2,871,908  |   |

 

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Depreciation expense amounted to $184,398 and $158,223in 2005 and 2004, respectively.

LowcountryNational Bank has entered into a non-cancelable operating lease related to landand buildings at its Bluffton branch, which expires in 2008. This lease wasmodified in 2005 to include additional space to provide for growth. In 2005,Lowcountry National Bank entered into a short-term lease with a director of theCompany and a director of the Bank on property located in Port Royal, SouthCarolina. The lease begins January 2006 and is for nine months at a rateof $1,500 per month. Total lease expense for 2006 will be $13,500. The officewill be used as a temporary loan production office pending completion of thePort Royal branch. In 2005, First National entered into a three-year lease forrental space for a loan production office in Savannah, Georgia. At December 31,2005, future minimum lease payments under these non-cancelable operating leaseswith initial or remaining terms of one year or more are as follows:

| 2006   |   | $      | 89,198  |   |
|--------|--------|--------|---------|--------|
| 2007   |   | 95,575 |    |
| 2008   |   | 62,276 |    |
| 2009   |   | 24,684 |    |
|   |   | $      | 271,733 |   |

 

Total rental expense amounted to $46,434 and $30,600for the years ended December 31, 2005 and 2004, respectively, under theseoperating leases.

In March 2006,Lowcountry National entered into an agreement to build a new branch in PortRoyal at an approximate cost of $971,000 with an expected completion date oflate 2006.

**(7)**                               Deposits

Maturitiesof time deposits at December 31, 2005 are as follows:

| Maturing in: |   |       |        |
|--------------|--------|------------|-------------|
| 2005         |   | $          | 112,162,183 |   |
| 2006         |   | 29,835,148 |        |
| 2007         |   | 7,698,362  |        |
| 2008         |   | 4,043,940  |        |
| 2009         |   | 2,506,640  |        |
|         |   | $          | 156,246,273 |   |

 

At December 31, 2005 and 2004, $13,860,000 and$18,612,000 of time deposits less than $100,000 consisted of brokered deposits.At December 31, 2005 and 2004, $20,369,000 and $16,963,000 of timedeposits greater than $100,000 consisted of brokered deposits.

Interest expense on timedeposits greater than $100,000 totaled $1,586,000 and $453,325 in 2005 and2004, respectively.

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**(8)**                               FederalHome Loan Bank Advances

At December 31,2005, the Bank had advances outstanding from the FHLB in the amount of$23,000,000, excluding purchase accounting adjustments. Advances outstandingare shown in the following table:
|                                       | ** ** | **FHLB Advances Outstanding  December 31, 2005** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------|------------|
| **Type advance**                 | ** ** | ** **                                                      | ** ** | **Balance** | ** ** | **Interest rate** | ** ** | **Maturity date** | ** ** | **Convertible date** | ** ** |
| Fixed rate                            |       | $                                                               | 2,000,000  |   |   | 4.55 | % |   | October 26, 2006 |   |   |   |
| Fixed rate                            |       | 1,000,000                                                       |       |   | 2.93 | % |   | April 3, 2006 |   |   |   |
| Convertible fixed  rate advance       |       | 10,000,000                                                      |       |   | 4.25 | % |   | May 21, 2014 |   | May 21, 2009 |   |
| Convertible fixed  rate advance       |       | 5,000,000                                                       |       |   | 3.71 | % |   | June 24, 2015 |   | June 24, 2010 |   |
| Convertible fixed  rate advance       |       | 5,000,000                                                       |       |   | 4.01 | % |   | August 16, 2010 |   | August 16, 2007 |   |
| Less purchase  accounting adjustments |       | (37,066                                                         | )          |   |   |   |   |   |   |   |   |
| Total                                 |       | $                                                               | 22,962,934 |   |   | 4.05 | % |   |   |   |   |   |
|                                       |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2004, the Company had$2.0 million in overnight advances outstanding.

**(9)          Junior Subordinated Debentures**

In May 2004, Coastal Banking Company StatutoryTrust I (the “Trust”) (a non-consolidated subsidiary) issued $3,000,000 offloating rate trust preferred securities with a maturity of May 18, 2034.In accordance with FIN No. 46(R), the trust has not been consolidated inthese financial statements. The Company received from the Trust the $3,000,000million proceeds from the issuance of securities and the $93,000 initialproceeds from the capital investment in the Trust, and accordingly has shownthe funds due to the Trust as $3,093,000 junior subordinated debentures.

All of the common securities of the Trust are owned bythe Company. The proceeds from the issuance of the trust preferred securitieswere used by the Trust to purchase $3,093,000 of junior subordinated debenturesof the Company, which carry a floating rate equal to the 3-month LIBORplus 2.75%. At December 31, 2005, this rate was 6.94%. The proceedsreceived by the Company from the sale of the junior subordinated debentureswere used to strengthen the capital position of the Bank and to accommodatecurrent and future growth. The current regulatory rules allow certainamounts of junior subordinated debentures to be included in the calculation ofregulatory capital, and have been included in the Tier I calculationaccordingly. The debentures and related accrued interest represent the soleassets of the Trust.

The trust preferred securities accrue and paydistributions quarterly, equal to 3-month LIBOR plus 2.75% per annum of thestated liquidation value of $1,000 per capital security. The Company hasentered into contractual arrangements which, taken collectively, fully andunconditionally guarantee payment of: (i) accrued and unpaid distributionsrequired to be paid on the trust preferred securities; (ii) the redemptionprice with respect to any trust preferred securities called for redemption bythe Trust, and (iii) payments due upon a voluntary or involuntarydissolution, winding up, or liquidation of the Trust.

The Trust PreferredSecurities are mandatorily redeemable upon maturity of the debentures on May 18,2034, or upon earlier redemption as provided in the indenture. The Company hasthe right to redeem the debentures purchased by the Trust in whole or in part,on or after May 18, 2009. As specified in the indenture, if the debenturesare redeemed prior to maturity, the redemption price will be the unpaidprincipal amount, plus any accrued unpaid interest.

40

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**(10)**                        OtherNon-interest Expenses

Componentsof other non-interest expenses, which are greater than 1% of interest incomeand other operating income for the years ended December 31, 2005 and 2004are as follows:

| ** **        | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Professional fees |       | $        | 371,179    |     | 223,487    |   |
| Insurance         |       | 109,874  |       | 84,884   |       |
| Data processing   |       | 420,744  |       | 312,762  |       |
| Advertising       |       | 193,185  |       | 133,955  |       |
| Office supplies   |       | 71,227   |       | 47,982   |       |
| Other             |       | 597,639  |       | 405,639  |       |
|              |       | $        | 1,763,848  |     | 1,208,709  |   |

 

**(11)**                        IncomeTaxes

Thecomponents of income tax expense (benefit) for the years ended December 31,2005 and 2004 are as follows:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Currently payable               |       | $        | 903,665    |     | 513,747    |   |
| Deferred tax  expense (benefit) |       | (107,605 | )          | (117,561 | )          |
|                            |       | $        | 796,060    |     | 396,186    |   |

 

Thedifferences between income tax expense and income tax expense computed byapplying the statutory federal income tax rate to earnings before taxes for theyears ended December 31, 2005 and 2004 are as follows:

| ** **                                  | ** ** | **2005** | ** ** | **2004** | ** ** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|------------|
| Tax expense at  statutory rate              |       | $        | 783,800    |     | 512,300    |       |   |
| Add (deduct):                               |       |     |       |     |       |       |
| State income  taxes, net of federal benefit |       | 58,200   |       | 35,200   |       |       |
| Non-deductible  expenses                    |       | 3,200    |       | 6,100    |       |       |
| Tax exempt  interest                        |       | (94,300  | )          | (68,300  | )          |       |
| Other                                       |       | 45,160   |       | (89,114  | )          |       |
|                                        |       | $        | 796,060    |     | 396,186    |       |   |

 

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Thefollowing summarizes the components of deferred taxes at December 31, 2005and 2004.

| ** **                                                                                                                                  | ** ** | **2005**  | ** ** | **2004** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------|------------|------------|
| Deferred income  tax assets:                                                                                                                |       |      |       |     |       |       |
| Allowance for loan losses                                                                                                                   |       | $         | 983,940    |     | 423,276    |       |   |
| Deferred compensation expense                                                                                                               |       | 208,687   |       | —   |       |       |
| Unrealized loss on securities available for sale                                                                                            |       | 267,506   |       | 68,390   |       |       |
| Other                                                                                                                                       |       | 132,935   |       | 13,419   |       |       |
| Total deferred tax assets                                                                                                                   |       | 1,593,068 |       | 505,085  |       |       |
| Deferred income  tax liabilities:                                                                                                           |       |      |       |     |       |       |
| Premises and equipment                                                                                                                      |       | 191,985   |       | 67,987   |       |       |
| Purchase accounting adjustments related to  acquisition of First Capital Bank Holding Corporation and First National Bank  of Nassau County |       | 832,457   |       | —   |       |       |
| Other                                                                                                                                       |       | 39,672    |       | —   |       |       |
| Total gross deferred tax liabilities                                                                                                        |       | $         | 1,064,114  |     | 67,987     |       |   |
| Net deferred tax asset                                                                                                                      |       | $         | 528,954    |     | 437,098    |       |   |

 

The net deferred tax assetis included in other assets in the consolidated balance sheets. The future taxconsequences of the differences between the financial reporting and tax basisof the Company’s assets and liabilities resulted in a net deferred tax assetfor 2005. A portion of the change in the net deferred tax asset relates tothe unrealized gains and losses on investment securities available for sale. Acurrent period deferred tax benefit related to the change in unrealized gainsand losses on investment securities available for sale of $119,116 has beenrecorded directly to shareholders’ equity. The rest of the change in the deferredtax asset results from the current period deferred tax benefit of $107,605and deferred taxes related to the differences between financial reporting andtax basis as of the merger date of the net assets of First Capital Bank HoldingCorporation and First National Bank of Nassau County.

**(12)**                        FinancialInstruments with Off-Balance-Sheet Risk

The Banks are a parties to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of its customers. These financial instruments include commitments toextend credit, standby letters of credit and loans sold with limited recourse.These instruments involve, to varying degrees, elements of credit risk inexcess of the amount recognized in the consolidated balance sheets. Thecontractual amounts of those instruments reflect the extent of involvement theBanks have in particular classes of financial instruments.

Commitments to extend credit are agreements to lend toa customer as long as there is no violation of any condition established in thecontract. Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee. Since many of thecommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. TheBanks evaluate each customer’s creditworthiness on a case-by-case basis. Theamount of collateral obtained, if deemed necessary by the Bank upon extensionof credit, is based on management’s credit evaluation of the counterparty. TheBanks’ loans are primarily collateralized by residential and other realproperties, automobiles, savings deposits, accounts receivable, inventory andequipment.

Standby letters of credit are written conditionalcommitments issued by the Banks to guarantee the performance of a customer to athird party. Those guarantees are primarily issued to support public andprivate borrowing arrangements. Most letters of credit extend for less than oneyear. The credit risk 

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involved in issuingletters of credit is essentially the same as that involved in extending loanfacilities to customers.

Loans sold with limited recourse are 1-4 familyresidential mortgages originated by the Banks and sold to various otherfinancial institutions. These loans are sold with the agreement that a loan maybe returned to the Bank within 90 days of any one of the loan’s first fourpayments being missed. The Banks’ exposure to credit loss in the event ofnon-performance by the other party to the loan is represented by thecontractual notional amount of the loan. The Banks use the same credit policiesin making loans held for sale as it does for on-balance-sheet instruments.

TheBanks’ exposure to credit loss in the event of non-performance by the other partyto the financial instrument for commitments to extend credit, standby lettersof credit and loans sold with limited recourse is represented by thecontractual amount of those instruments. The Banks use the same credit policiesin making commitments and conditional obligations as it does foron-balance-sheet instruments. In most cases, the Banks require collateral tosupport financial instruments with credit risk.

| ** **                                                           | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Financial instruments  whose contract amounts represent credit risk: |       |                  |       |   |   |
| Commitments to extend  credit                                        |       |                  |       |   |   |
| Variable rate                                                        |       | $                     | 69,683,000 |   | 17,295,000 |   |
| Fixed rate                                                           |       | 894,000               |       | 695,000 |   |
|                                                                 |       | $                     | 70,577,000 |   | 17,990,000 |   |
| Standby letters  of credit                                           |       | $                     | 1,068,000  |   | 552,000 |   |
| Loans sold with limited  recourse                                    |       | $                     | 26,072,000 |   | 6,157,000 |   |

 

**(13)**                        UnusedLines of Credit

At December 31, 2005,the Banks had $15,850,000 of availability on lines of credit to purchasefederal funds from unrelated banks. These lines of credit are available on aone to seven day basis for general corporate purposes of the Banks. All of thelenders have reserved the right to withdraw these lines at their option.

**(14)**                        LegalContingencies

The Company has, from timeto time, various lawsuits and claims arising from the conduct of its business.Such items are not expected to have any material adverse effect on thefinancial position or results of operations of the Company.

**(15)**                        Employeeand Director Benefit Programs

In connection with the Company’s initial public stockoffering, the directors received warrants to purchase 212,100 shares of theCompany’s common stock at a price of $9.42 per share of which 199,553 sharesare still outstanding. The warrants vested equally over a three-year periodbeginning December 2, 1999 and expire on December 2, 2010 or 120 daysafter the warrant holder ceased to serve as a member of the board of directors.As of December 31, 2005, all of the warrants are exercisable.

The Company adopted a Stock Incentive Plan in 2000covering up to 156,822 shares of the Company’s common stock. The Plan isadministered by a committee of the Board of Directors and provides for thegranting of options to purchase shares of common stock to officers, directors,employees or consultants of the Company and Banks. The exercise price of eachoption granted under the Plan will not be less than the fair market value ofthe shares of common stock subject to the option on the date of grant asdetermined 

43

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by the Board of Directors.Options are exercisable in whole or in part upon such terms as may bedetermined by the committee, and are exercisable no later than ten years afterthe date of grant. As of December 31, 2005, 133,625 shares were availablefor grant under this plan.

On October 1, 2005, 95,619 options at an averageprice of $9.72 were assumed by the Company as a result of its merger with FirstCapital of which 83,711 of those options are vested.

Asummary status of the Company’s stock option plan as of December 31, 2005and 2004, and changes during the years, are presented below:

| ** **                       | ** ** | **2005**   | ** ** | **2004**                                   | ** ** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------|------------|------------|
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | ** ** |
| Outstanding,  beginning of year  |       | 123,082    |       |                                       | $          | 9.07       |   |   | 134,632 |   |   | $ | 9.38 |   |   |   |
| Granted during  the year         |       | 4,200      |       |                                       | 17.02      |       |   | 10,500 |   |   | 15.95 |   |   |   |
| Exercised during  the year       |       | —     |       |                                       |       |       |   | (11,025 | ) |   | 9.50 |   |   |   |
| Shares assumed in  merger        |       | 95,619     |       |                                       | 9.72       |       |   | — |   |   | — |   |   |   |
| Cancelled during  the year       | * *   | (3,308     | )          |                                       | 9.87       |       |   | (11,025 | ) |   | 10.76 |   |   |   |
| Outstanding, end  of year        |       | 219,593    |       |                                       | 9.87       |       |   | 123,082 |   |   | 9.74 |   |   |   |
| Options exercisable at  year end |       | 207,685    |       |                                       | 9.79       |       |   | 74,509 |   |   | 9.07 |   |   |   |

 

The weighted average remaining contractual life ofthese stock options was 5.2 years as of December 31, 2005.

All share numbers and prices are restated for theeffects of a 5% stock dividend paid to shareholders of record on December 1,2005.

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions for grants in 2005 and 2004:

| ** **                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Weighted average  grant date fair value of options granted during the year |       | $        | 5.29       |     | 4.99       |   |
| Assumptions used to  estimate fair value:                                  |       |     |       |     |       |
| Risk-free  interest rate                                                   |       | 4.50     | %          | 4.15     | %          |
| Dividend yield                                                             |       | 0        | %          | 0        | %          |
| Expected  volatility                                                       |       | 15       | %          | 15       | %          |
| Expected life                                                              |       | 7 years  |       | 7 years  |       |
|                                                                            |            |          |            |          |            |  |

 

The Company sponsors the Lowcountry National BankRetirement Savings Plan and the First National Bank Savings Plan (collectivelythe “Plans”) for the benefit of all eligible employees. The Company contributesto the Plan annually upon approval by the Board of Directors. Contributionsmade to the Plan in 2005 and 2004 amounted to $47,753 and $24,314,respectively.

The Company adopted aDirector and Executive Officer Deferred Compensation Plan in 2004 that allowsdirectors and executive officers to defer compensation. Interest accruesquarterly on deferred amounts at a rate, which is equal to 75% of the previousquarter’s return on equity, not to exceed 12%.

**(16)**                        RelatedParty Transactions

In thenormal course of business, officers and directors of the Bank, and certainbusiness organizations and individuals associated with them, maintain a varietyof banking relationships with the Bank. Transactions with officers anddirectors are made on terms comparable to those available to other 

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Bank customers. At December 31, 2005 and 2004,deposits from directors, executive officers, and their related interestsaggregated approximately $2,106,546 and $1,318,000, respectively. The followingsummary reflects related party loan activity for the years ended December 31,2005 and 2004:

| ** **                     | ** ** | **2005**   | ** ** | **2004**   | ** ** | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|------------|
| Beginning balance              |       | $          | 3,083,245  |       | $          | 2,368,245  |   |   |
| New loans                      |       | 1,924,405  |       | 2,220,840  |       |       |
| Loans deleted  through merger  |       | (1,613,297 | )          | —     |       |       |
| Loans acquired  through merger |       | 2,963,154  |       | —     |       |       |
| Repayments                     |       | (1,247,415 | )          | (1,505,840 | )          |       |
| Ending balance                 |       | $          | 5,110,092  |       | $          | 3,083,245  |   |   |

 

**(17)**                        RegulatoryMatters

The Company and the Banks are subject to variousregulatory capital requirements administered by the federal banking agencies.Failure to meet minimum capital requirements can initiate certain mandatory andpossibly additional discretionary actions by regulators that, if undertaken,could have a direct material effect on the financial statements. Under certainadequacy guidelines and the regulatory framework for prompt corrective action,specific capital guidelines that involve quantitative measures of the assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices must be met. The capital amounts and classification arealso subject to qualitative judgments by the regulators about components, riskweightings, and other factors.

Quantitative measures established by regulation toensure capital adequacy require the Company and the Banks to maintain minimumamounts and ratios (set forth in the table below) of Total and Tier 1 Capital(as defined in the regulations) to risk-weighted assets (as defined), and ofTier 1 Capital (as defined) to average assets (as defined). Managementbelieves, as of December 31, 2005, that the Company and the Banks meet allcapital adequacy requirements to which they are subject.

As of December 31, 2005 the most recentnotification from the Federal Deposit Insurance Corporation categorized theBanks as well capitalized under the regulatory framework for prompt correctiveaction. To be categorized as well capitalized the Banks must maintain minimumtotal risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth inthe table. There are no conditions or events since that notification thatmanagement believes have changed the Banks’ category.

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Theactual capital amounts and ratios are also presented in the table below.

| ** **                                                     | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                     | ** ** | **Amount** | ** ** | **Ratio**                               | ** ** | **Amount**                                                                                       | ** ** | **Ratio**  | ** ** | **Amount** | ** ** | **Ratio** | ** ** | ** ** |
| **As of December 31, 2005:**                              |       |       |       |                                    |       |                                                                                             |       |       |   |   |   |   |   |   |   |   |
| Total Capital—Coastal  (to Risk Weighted Assets)          |       | $          | 35,081,827 |                                    | 12.55      | %                                                                                                | 22,365,966 |       |   | 8.00 | % |   | 27,957,458 |   | 10.00 | % |   |
| Total Capital—Lowcountry  (to Risk Weighted Assets)       |       | 14,719,430 |       | 11.01                                   |       | 10,695,360                                                                                       |       |       | 8.00 |   |   | 13,369,200 |   | 10.00 |   |   |
| Total Capital—First  National  (to Risk Weighted Assets)  |       | 17,079,133 |       | 11.74                                   |       | 11,638,080                                                                                       |       |       | 8.00 |   |   | 14,547,600 |   | 10.00 |   |   |
| Tier 1 Capital—Coastal  (to Risk Weighted Assets)         |       | 32,074,602 |       | 10.93                                   | %          | 11,182,983                                                                                       |       |       | 4.00 | % |   | 16,774,475 |   | 6.00 | % |   |
| Tier 1 Capital—Lowcountry  (to Risk Weighted Assets)      |       | 13,616,205 |       | 9.96                                    |       | 5,347,680                                                                                        |       |       | 4.00 |   |   | 8,021,520 |   | 6.00 |   |   |
| Tier 1 Capital—First  National  (to Risk Weighted Assets) |       | 15,475,133 |       | 10.64                                   |       | 5,819,040                                                                                        |       |       | 4.00 |   |   | 8,728,560 |   | 6.00 |   |   |
| Tier 1 Capital—Coastal  (to Average Assets)               |       | 32,074,602 |       | 9.99                                    | %          | 12,839,007                                                                                       |       |       | 4.00 | % |   | 16,048,759 |   | 5.00 | % |   |
| Tier 1 Capital—Lowcountry  (to Average Assets)            |       | 13,616,205 |       | 8.26                                    |       | 6,278,184                                                                                        |       |       | 4.00 |   |   | 7,847,730 |   | 5.00 |   |   |
| Tier 1 Capital—First  National  (to Average Assets)       |       | 15,475,133 |       | 9.46                                    |       | 6,544,560                                                                                        |       |       | 4.00 |   |   | 8,180,700 |   | 5.00 |   |   |
|                                                                |            |            |            |                                         |            |                                                                                                  |            |            |  |  |  |  |  |  |  |  |  |

 

*Cash Dividends—*There are no current plans to initiate payment ofcash dividends and future dividend policy will depend on the Banks’ and theCompany’s earnings, capital requirements, financial condition and other factorsconsidered relevant by the Company’s Board of Directors. The Banks arerestricted in their ability to pay dividends under national banking laws andregulations of the OCC. Generally, these restrictions require the Banks to paydividends derived solely from net profits. Moreover, the OCC’s prior approval isrequired if dividends declared by either Bank in any calendar year exceed thatBank’s net profit for that year combined with its retained net profits for thepreceding two years.

*Stock Dividends—*In November 2005, the Company declared a fivepercent stock dividend to shareholders of record as of December 1, 2005.The dividend was issued on December 15, 2005. All earnings per shareamounts for all periods have been adjusted to reflect the five percent stockdividend.

**(18)**                        Shareholders’Equity

Shares of preferred stockmay be issued from time to time in one or more series as established byresolution of the Board of Directors of the Company, up to a maximum of10,000,000 shares. Each resolution shall include the number of shares issued,preferences, special rights and limitations as determined by the Board.

**(19)**                        FairValue of Financial Instruments

SFAS No. 107,*Disclosures about Fair Value of Financial Instruments,* requiresdisclosure of fair value information about financial instruments, whether ornot recognized on the face of the balance sheets, for which it is practical toestimate that value. The assumptions used in the estimation of the fair valueof financial instruments are detailed below. Where quoted prices are notavailable, fair values are based on estimates using discounted cash flows andother valuation techniques. The use of discounted cash flows can 

46

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be significantly affectedby the assumptions used, including the discount rate and estimates of futurecash flows. The following disclosures should not be considered asrepresentative of the liquidation value of the Banks, but rather represent agood-faith estimate of the increase or decrease in value of financialinstruments held by the Banks since purchase, origination, or issuance. Thisanalysis has not undertaken any steps to value any intangibles, which ispermitted by the provisions of SFAS No. 107.

Certain items are specifically excluded from thedisclosure requirements, including the Company’s common stock, premises andequipment and other assets and liabilities.

The followingmethods and assumptions were used in this analysis in estimating the fair valueof financial instruments:

·       ***Cash and due from banks***:Fair value equals the carrying value of such assets.

·       ***Investment securities***:Fair values for investment securities are based on bond accounting reports.

·       ***Federal funds sold and purchased***:Due to the short-term nature of these assets, the carrying values of theseassets approximate their fair value.

·       ***Loans***: For variablerate loans, those repricing within six months or less, fair values are based oncarrying values. Fixed rate commercial loans, other installment loans, andcertain real estate mortgage loans were valued using discounted cash flows. Thediscount rates used to determine the present value of these loans were based oninterest rates currently being charged by the Banks on comparable loans as tocredit risk and term.

·       ***Deposit liabilities***:The fair values of demand deposits are, as required by SFAS No. 107, equalto the carrying value of such deposits. Demand deposits includenon-interest-bearing demand deposits, savings accounts, NOW accounts, and moneymarket demand accounts. Discounted cash flows are used to value fixed rate termdeposits. The discount rate used is based on interest rates currently beingoffered by the Banks on comparable deposits as to amount and term.

·       ***FHLB, Junior Subordinated Debenturesand other borrowings***: The carrying amount on variable rateborrowings approximates their fair value. Fair Values of fixed rate advancesare based on discounted cash flows. Convertible advances are taken from FederalHome Loan Bank provided reports.

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Theestimated fair values of the Company’s financial instruments are as follows:

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **Carrying  amount**  | ** ** | **Fair  value** | ** ** | **Carrying  amount** | ** ** | **Fair  Value** | ** ** |
| Financial assets:                         |       |                  |       |   |   |   |   |   |   |
| Cash and due from  banks                  |       | $                     | 5,932,444  |   | 5,932,444 |   | 1,513,726 |   | 1,513,726 |   |
| Federal funds  sold                       |       | 13,598,435            |       | 13,598,435 |   | 2,583,000 |   | 2,583,000 |   |
| Certificate of  deposit                   |       | 500,000               |       | 500,000 |   | — |   | — |   |
| Investment  securities available for sale |       | 46,150,641            |       | 46,150,641 |   | 27,366,390 |   | 27,366,390 |   |
| Investment  securities held to maturity   |       | 18,220,867            |       | 17,886,459 |   | 5,642,841 |   | 5,555,013 |   |
| Loans held for  sale                      |       | 2,449,651             |       | 2,449,651 |   | 878,124 |   | 878,124 |   |
| Loans, net                                |       | 239,505,778           |       | 238,372,045 |   | 100,397,246 |   | 99.569,246 |   |
| Other investments                         |       | 2,734,567             |       | 2,734,567 |   | 1,037,150 |   | 1,037,150 |   |
| Cash surrender  value life insurance      |       | 5,322,247             |       | 5,322,247 |   | 2,082,333 |   | 2,082,333 |   |
| Financial  liabilities:                   |       |                  |       |   |   |   |   |   |   |
| Deposits                                  |       | 286,395,980           |       | 287,687,445 |   | 129,431,713 |   | 129,822,713 |   |
| FHLB advances                             |       | 22,962,934            |       | 22,748,580 |   | 2,000,000 |   | 2,000,000 |   |
| Junior subordinated  debentures           |       | 3,093,000             |       | 3,093,000 |   | 3,093,000 |   | 3,093,000 |   |
|                                           |            |                       |            |  |  |  |  |  |  |  |

 

**(20)**                                       IntangibleAssets

The Company added $1,212,000 in core depositintangibles with the merger of First Capital on October 1, 2005. During the 4thquarter of 2005, the Company amortized $99,000 of the total, resulting in abalance remaining of $1,113,000 at December 31, 2005. The Company anticipatesamortization of core deposit intangibles to be $373,000, $290,000 and $199,000for the years 2006, 2007 and 2008 respectively.

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**(21)**                                       CoastalBanking Company, Inc. (Parent Company Only) Financial Information

**CondensedBalance Sheets**

| ** **                                               | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash                                                     |       | $                     | 2,859,874  |   | 937,211 |   |
| Investment securities  held to maturity                  |       | —                |       | 268,125 |   |
| Investment in Coastal  Banking Company Statutory Trust I |       | 93,000                |       | 93,000 |   |
| Investment in Banks                                      |       | 39,124,904            |       | 11,886,443 |   |
| Premises and equipment                                   |       | 414,904               |       | 414,904 |   |
| Other assets                                             |       | 137,135               |       | 309,975 |   |
|                                                     |       | $                     | 42,629,817 |   | 13,909,658 |   |
| **Liabilities and Shareholders’ Equity**            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Junior subordinated debentures                           |       | $                     | 3,093,000  |   | 3,093,000 |   |
| Accrued interest payable                                 |       | 221,649               |       | 24,608 |   |
| Total liabilities                                        |       | 3,314,649             |       | 3,117,608 |   |
| Shareholders’ equity                                |       | 39,315,168            |       | 10,792,050 |   |
|                                                     |       | $                     | 42,629,817 |   | 13,909,658 |   |

 

**CondensedStatements of Earnings**

| ** **                                                                     | ** ** | **For the years ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| Interest and other  income                                                     |       | $                                                         | 32,477     |   | 2,349 |   |
| Expenses                                                                       |       |                                                      |       |   |   |
| Interest expense                                                               |       | 192,680                                                   |       | 82,882 |   |
| Other operating expenses                                                       |       | 109,478                                                   |       | 31,694 |   |
|                                                                           |       | 302,158                                                   |       | 114,576 |   |
| Loss before equity in  undistributed earnings of subsidiaries and income taxes |       | (269,681                                                  | )          | (112,227 | ) |
| Equity in undistributed  earnings of subsdiaries                               |       | 1,687,351                                                 |       | 1,183,829 |   |
| Income tax benefit                                                             |       | 91,700                                                    |       | 39,000 |   |
| Net earnings                                                                   |       | $                                                         | 1,509,370  |   | 1,110,602 |   |

 

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**CondensedStatements of Cash Flows**

| ** **                                                                       | ** ** | **For the years ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                           |       |                                                      |       |   |   |
| Net earnings                                                                     |       | $                                                         | 1,509,370  |   | 1,110,602 |   |
| Adjustments to  reconcile net earnings to net cash used by operating activities: |       |                                                      |       |   |   |
| Equity in  undistributed earnings of Bank                                        |       | (1,687,351                                                | )          | (1,183,829 | ) |
| Amortization                                                                     |       | 4,500                                                     |       | 2,792 |   |
| Change in other  assets and liabilities                                          |       | (875,433                                                  | )          | 42,944 |   |
| Net cash used by operating activities                                            |       | (1,048,914                                                | )          | (27,491 | ) |
| Cash flows from investing activities:                                            |       |                                                      |       |   |   |
| Cash from  acquisition of First Capital                                          |       | 2,703,452                                                 |       | — |   |
| Capital  contribution to Bank                                                    |       | —                                                    |       | (2,932,500 | ) |
| Purchase of  investment security                                                 |       | —                                                    |       | (268,125 | ) |
| Sale of  investment security                                                     |       | 268,125                                                   |       | — |   |
| Investment in  Coastal Banking Company Statutory Trust I                         |       | —                                                    |       | (93,000 | ) |
| Net cash used by investing activities                                            |       | 2,971,577                                                 |       | (3,293,625 | ) |
| Cash flows from financing activities:                                            |       |                                                      |       |   |   |
| Proceeds from  junior subordinated debt                                          |       | —                                                    |       | 3,093,000 |   |
| Proceeds from  exercise of stock options                                         |       | —                                                    |       | 144,606 |   |
| Cash in lieu of  fractional shares                                               |       | —                                                    |       | (273 | ) |
| Net cash provided by financing activities                                        |       | —                                                    |       | 3,237,333 |   |
| Net change in cash and cash equivalents                                          |       | 1,922,663                                                 |       | (83,783 | ) |
| Cash and cash equivalents at beginning of year                                   |       | 937,211                                                   |       | 1,020,994 |   |
| Cash and cash  equivalents at end of year                                        |       | $                                                         | 2,859,874  |   | 937,211 |   |

 

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**COASTAL BANKINGCOMPANY, INC. AND SUBSIDIARIES**

**CORPORATE DATA**

**BOARDOF DIRECTORS**

| Ron Anderson                               |   | Managing General Partner    Marel Enterprises                                                                           |
|--------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------|
| Christina H. Bryan                         |   | Co-Owner of  various businesses                                                                                         |
| Suellen Rodeffer Garner,  Chairman         |   | Orthodontist;  Co-Owner   Suellen Rodeffer and David Garner D.D.S., P.A.                                                |
| Dennis O. Green, CPA                       |   | Managing Member,  Celadon LLC                                                                                           |
| James W.  Holden, Jr., DVM, Secretary |   | Owner, Director   Holly Hall Animal Hospital                                                                            |
| Ladson F. Howell, Vice  Chairman           |   | Retired, Attorney    Howell, Gibson & Hughes, PA                                                               |
| James C. Key                               |   | Partner,  Shenandoah Group, L.L.P                                                                                       |
| Randolph C. Kohn                           |   | CEO  of  Coastal Banking Company, Inc. and   President & CEO of Lowcountry National Bank             |
| Robert L. Peters                           |   | Attorney                                                                                                                |
| Robert B. Pinkerton                        |   | President &  CEO, Athena Corporation                                                                           |
| Michael G. Sanchez                         |   | President of  Coastal Banking Company, Inc. and   President & CEO of First National Bank of Nassau County |
| Edward E. Wilson                           |   | Licensed Insurance Agent                                                                                                |

 

**SENIOR OFFICERS**

Randolph C. Kohn, Chief Executive Officer

Michael G. Sanchez, President

James L. Pate, III, Chief Financial Officer

Timothy S. Ayers,Chief Operating Officer

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**COASTAL BANKINGCOMPANY, INC. AND SUBSIDIARIES**

**CORPORATEDATA**
| CORPORATE OFFICE:               | ** ** | ** **                   | ** ** | GENERAL COUNSEL: | ** ** | ** ** |
|---------------------------------|------------|------------------------------|------------|------------------|------------|------------|
| 36 Sea Island  Parkway          |       | Powell Goldstein  LLP        |
| Beaufort, South Carolina  29907 |       | 1201 West Peachtree St.,  NW |
| Phone (843) 522-1228            |       | 14th Floor              |
| Fax: (843) 524-4510             |       | Atlanta, Georgia 30309       |

 
| STOCK TRANSFER DEPARTMENT:    | ** ** | ** **                       | ** ** | INDEPENDENT REGISTERED  PUBLIC  ACCOUNTING FIRM: | ** ** | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|------------|
| First Citizens  Bank          |       | Elliott Davis,  LLC              |
| Corporate Trust—DAC 61   |       | 200 East Broad Street            |
| 100 East Tryon Road           |       | Post Office Box 6286             |
| Raleigh, North Carolina 27603 |       | Greenville, South Carolina 29606 |

 

**STOCK INFORMATION:**

TheCommon Stock of Coastal Banking Company, Inc. is not listed on anyexchange. However, the stock is quoted on the NASDAQ OTC Bulletin Board underthe symbol “CBCO.OB.” There were approximately 1,498 shareholders of record on December 31,2005. The following table sets forth the high and low bid prices as quoted onthe OTC Bulletin Board during the periods indicated. The quotations reflectinter-dealer prices, without retail mark-up, mark-down, or commissions, and maynot represent actual transactions. All prices are adjusted for the stockdividends paid to shareholders of record on December 1, 2005.

| ** **     | ** ** | **Years Ended December 31,** | ** ** |
|----------------|------------|---------------------------------------------|------------|
| ** **     | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| ** **     | ** ** | **High**                                    | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                           | 18.10      |   | $ | 16.90 |   | $ | 16.90 |   | $ | 14.51 |   |
| Second quarter |       | $                                           | 18.57      |   | $ | 17.14 |   | $ | 16.90 |   | $ | 15.14 |   |
| Third quarter  |       | $                                           | 20.95      |   | $ | 18.10 |   | $ | 15.71 |   | $ | 14.29 |   |
| Fourth quarter |       | $                                           | 22.71      |   | $ | 19.52 |   | $ | 17.14 |   | $ | 14.52 |   |

 

The Company has never declared or paid a cash dividendand does not expect to do so in the foreseeable future. The ability of theCompany to pay cash dividends is dependent upon receiving cash dividends fromthe Banks. However, federal banking regulations restrict the amount of cashdividends that can be paid to the Company from the Banks. All of ouroutstanding shares of common stock are entitled to share equally in dividendsfrom funds legally available when, and if, declared by the board of directors.

**Copies of theCompany’s Annual Report on Form 10-KSB for the fiscal year ended December 31,2005, as filed with the Securities and Exchange Commission, will be furnishedat no charge to shareholders upon written request to:  James L. Pate, III, Chief FinancialOfficer, Coastal Banking Company, Inc., 36 Sea Island Parkway, Beaufort,South Carolina 29907.**

**This Annual Reportserves as the Annual Financial Disclosure Statement furnished pursuant to Part 350of the Federal Deposit Insurance Corporation’s Rules and Regulations. ThisStatement has not been reviewed or confirmed for accuracy or relevance by theOffice of the Comptroller of the Currency.**

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