Business Combinations

During the year ended December 31, 2014, the Company completed the merger of Washington Banking Company, referred to as the "Washington Banking Merger". During the year ended December 31, 2013, the Company completed the acquisitions of Northwest Commercial Bank and Valley Community Bancshares, referred to jointly as the "NCB and Valley Acquisitions." During the year ended December 31, 2013, the Company also completed the merger of its wholly-owned bank subsidiary Central Valley Bank with and into Heritage Bank. The merger of Central Valley Bank with an into Heritage Bank was a common control merger which had no accounting impact on the consolidated Company. There were no acquisitions or mergers completed during the year ended December 31, 2012.

Washington Banking Merger

On October 23, 2013, the Company, along with the Bank, and Washington Banking and its wholly owned subsidiary bank, Whidbey, jointly announced the signing of a merger agreement for the Washington Banking Merger. The Washington Banking Merger was effective on May 1, 2014. Pursuant to the terms of the Washington Banking Merger, Washington Banking branches adopted the Heritage Bank name in all markets, with the exception of six branches in the Whidbey Island markets which have continued to operate using the Whidbey Island Bank name. The primary reasons for the merger were to expand the Company's geographic footprint consistent with its ongoing growth strategy and to achieve operational scale and realize efficiencies of a larger combined organization.

Under the terms of the merger agreement, Washington Banking shareholders received 0.89000 shares of Heritage common stock and $2.75 in cash for each share of Washington Banking common stock. The terms of the merger agreement also stipulated immediate vesting of the Washington Banking options and restricted stock awards units. At April 30, 2014, the number of Washington Banking common shares outstanding was 15,587,154. The closing price of Heritage common stock was $16.16 as of April 30, 2014. The total consideration transferred by the Company in conjunction with the Washington Banking Merger was $269.6 million and the total number of Heritage shares of common stock issued were 14,000,178. The Company also incurred $489,000 in capitalized stock issuance costs.

The total consideration transferred in the Washington Banking Merger consisted of the following:



	Washington Banking
	(In thousands)
Consideration transferred
Cash paid (1)	$	42,895
Fair value of common shares issued (2)	224,151
Fair value of restricted stock unit awards (3)	2,092
Fair value of common stock options	481
Total consideration transferred	$	269,619


(1)	Includes $3,000 of cash paid due to fractional shares and $27,000 of cash paid from dissenters.


(2)	Total of 13,870,716 shares issued. Excludes 1,686 shares dissented and paid in cash and 165 fractional shares paid in cash.


(3)	Total number of converted shares was 129,462. Fair value includes 26,783 shares which were forfeited by the Washington Banking stockholder to pay applicable taxes, totaling fair value of $433,000.

The transaction qualified as a tax-free reorganization for U.S. federal income tax purposes and Washington Banking shareholders did not recognize any taxable gain or loss in connection with the share exchange and the stock consideration received.

The Washington Banking Merger resulted in $89.7 million of goodwill. This goodwill is not deductible for tax purposes. Subsequent to the goodwill amounts reported in the Form 10-Q for the quarter ended June 30, 2014, the Company recorded adjustments to goodwill totaling $722,000 related to a $489,000 correction of the fair value of consumer loans, a $233,000 correction in the FDIC indemnification asset, a $252,000 correction of the net receivable from the FDIC for losses on covered assets and a $252,000 change in deferred taxes related to correction of tax liabilities. Subsequent to the goodwill amounts reported in the Form 10-Q for the quarter ended September 30, 2014, the Company recorded adjustments to goodwill totaling $118,000 related to a $265,000 correction in the BOLI split-dollar obligation, a $342,000 correction of deferred taxes, and a $489,000 correction in stock issuance costs.

During the years ended December 31, 2014 and 2013, the Company incurred Washington Banking merger-related costs (including system conversion costs) of approximately $9.1 million and $890,000, respectively.

The Company expects to finalize the purchase price allocation by March 31, 2015 when the valuation of acquired noncovered and covered loans, related indemnification asset and deferred taxes is completed.

Valley Community Bancshares

On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares ("Valley") and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington. The Valley Acquisition was completed on July 15, 2013. Valley operated eight branches prior to acquisition, of which only four were maintained by Heritage Bank. Of the four other branches, three leases were terminated during the fourth quarter of 2013 and one owned branch building was considered held for sale at the time of acquisition.

Pursuant to the terms of the merger agreement, the shareholders of Valley common stock received $19.50 per share in cash and 1.3611 shares of Heritage common stock per Valley share. The merger consideration for Valley consisted of cash and stock, with $22.0 million paid in cash by the Company and 1,533,267 shares of the Company’s common stock being issued with fair value of $24.2 million. The Company also recognized $157,000 in capitalized costs related to the issuance of its securities.

The Valley Acquisition resulted in $16.4 million of goodwill. This goodwill is not deductible for tax purposes.

During the years ended December 31, 2014 and 2013, the Company incurred Valley Acquisition-related costs (including system conversion costs) of approximately $443,000 and $2.1 million, respectively.

Northwest Commercial Bank

On September 14, 2012, the Company and Heritage Bank entered into a definitive agreement to acquire Northwest Commercial Bank ("NCB") headquartered in Lakewood, Washington. NCB was a full service commercial bank that operated two branch locations in Lakewood and Auburn, Washington. Prior to the closing of the transaction, NCB redeemed its outstanding preferred stock of approximately $2.0 million issued to the U.S. Department of Treasury in connection with its participation in the Troubled Asset Relief Program Capital Purchase Plan. The NCB Acquisition was completed on January 9, 2013 with the merger of NCB with and into Heritage Bank. After the NCB Acquisition, the NCB Lakewood branch was consolidated into one of Heritage Bank’s full service banking offices in Lakewood, Washington.

In connection with the NCB Acquisition, the Company paid cash consideration of $3.0 million, or $5.50 per NCB share, to NCB shareholders on January 9, 2013. In addition, pursuant to the merger agreement, the NCB shareholders had the ability to potentially receive an additional cash payment based on an earn-out structure from the sale of a NCB asset included in “other real estate owned.” This contingent payment was factored into the NCB liabilities assumed by Heritage Bank as of the January 9, 2013 acquisition date. This asset was sold by Heritage Bank in June 2013, and the $491,000 of proceeds from the sale were paid to the NCB shareholders in July 2013. The payment of these proceeds did not impact the recorded bargain purchase gain on bank acquisition of $399,000.

During the years ended December 31, 2013 and 2012, the Company incurred NCB Acquisition-related costs (including system conversion costs) of approximately $794,000 and $616,000. There were no NCB Acquisition-related costs incurred during the year ended December 31, 2014.

Business Combination Accounting

The Washington Banking Merger and the NCB and Valley Acquisitions constitute business acquisitions as defined by FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed. Heritage was considered the acquirer in the referenced mergers and acquisitions. Accordingly, the preliminary estimates of fair values of the acquired banks' assets, including the identifiable intangible assets, and the assumed liabilities in the merger and acquisitions were measured and recorded as of the respective effective dates of the merger and acquisitions.

The fair value estimates of the assets acquired and liabilities assumed in the indicated merger and acquisitions were as follows:



	Washington Banking		Valley		NCB
	May 1, 2014		July 15, 2013		January 9, 2013
	(In thousands)
Assets
Cash and cash equivalents	$	74,947	$	40,643	$	2,712
Other interest earning deposits	—		13,866		1,003
Investment securities available for sale	458,312		31,444		2,753
Investment securities held to maturity	—		22,908		—
Loans held for sale	3,923		—		—
Noncovered loans receivable	895,978		117,071		51,509
Covered loans receivable	107,050		—		—
FDIC indemnification asset	7,174		—		—
Other real estate owned ($5,122, $0, and $0 covered by FDIC shared-loss agreements, respectively)	7,121		—		2,279
Premises and equipment	31,776		6,558		214
Federal Home Loan Bank stock	7,064		366		88
Bank owned life insurance	32,519		—		—
Accrued Interest Receivable	4,943		465		232
Other intangible assets	11,194		916		156
Prepaid expenses and other assets	14,852		3,087		4,048
Total assets acquired	1,656,853		237,324		64,994
Liabilities
Deposits	1,433,894		207,013		60,442
Junior subordinated debentures	18,937		—		—
Accrued expenses and other liabilities	24,067		342		1,186
Total liabilities assumed	1,476,898		207,355		61,628
Net assets acquired	$	179,955	$	29,969	$	3,366

A summary of the net assets purchased, the fair value adjustments and resulting goodwill recognized from the Washington Banking Merger and Valley Acquisition and the resulting bargain purchase gain recognized on the NCB Acquisition are presented in the following table. Goodwill on mergers and acquisitions represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed. A bargain purchase gain on bank acquisition represents the excess of the estimated fair value of the net assets acquired and liabilities assumed over the value of the consideration paid. The bargain purchase gain in the NCB Acquisition was influenced significantly by the net deferred tax asset acquired. NCB had significant net operating losses and as a result of its estimate of whether or not it was more likely than not that the net deferred tax asset would be realized, had recorded a full valuation allowance on the net deferred tax asset. The Company, however, has reviewed the net deferred tax asset and determined it is more likely than not that the net deferred tax asset would be realized by the Company.



	Washington Banking			Valley			NCB
	May 1, 2014			July 15, 2013			January 9, 2013
	(In thousands)
Cost basis of net assets on merger date	$	181,782		$	29,720		$	6,113
Less: Consideration transferred	(269,619		)	(46,323		)	(2,967		)
Fair value adjustments:
Other interest earning deposits	—			162			7
Investment securities	—			—			(2		)
Loans held for sale	86			—			—
Noncovered loans receivable	(12,811		)	(3,003		)	(3,299		)
Covered loans receivable	6,384			—			—
FDIC indemnification asset	357			—			—
Other real estate owned	387			—			(1,301		)
Premises and equipment	(1,540		)	1,837			(69		)
Other intangible assets	10,216			916			156
Prepaid expenses and other assets	(6,416		)	198			2,394
Deposits	(1,737		)	(9		)	(11		)
Junior subordinated debentures	6,837			—			—
Accrued expenses and other liabilities	(3,590		)	149			(622		)
(Goodwill) bargain purchase gain recognized	$	(89,664	)	$	(16,353	)	$	399

The operating results of the Company for the years ended December 31, 2014 and 2013 include the operating results produced by the net assets acquired in the merger and acquisitions since the respective effective dates. Disclosure of the amount of revenue and net income (excluding acquisition-related costs) of Washington Banking, Valley and NCB since the effective dates included in the Company's Consolidated Statements of Income is impracticable due to the integration of the operations and accounting for the merger and acquisitions.

The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard for the NCB and Valley Acquisitions as they were not material to the Company. The Company believes that the historical NCB and Valley operating results are not considered of enough significance to be meaningful to the Company’s results of operations.

The pro forma requirements of FASB ASC 805 were necessary for the Washington Banking Merger. The following table presents certain pro forma information, for illustrative purposes only, for the years ended December 31, 2014 and 2013 as if the Washington Banking Merger had occurred on January 1, 2013. The estimated pro forma information combines the historical results of Washington Banking with the Company's consolidated historical results and includes certain adjustments reflecting the estimated impact of certain fair value adjustments for the respective periods. The pro forma information is not indicative of what would have occurred had the Washington Banking Merger occurred on January 1, 2013. In particular, no adjustments have been made to eliminate the impact of the Washington Banking loans previously accounted for under ASC 310-30 that may have been necessary if these loans had been recorded at fair value at January 1, 2013. The pro forma information also does not consider any changes to the provision for loan losses resulting from recorded loans at fair value. Additionally, Heritage expects to achieve further operating savings and other business synergies, including interest income growth, as a result of the Washington Banking Merger which are not reflected in the pro forma amounts in the following table. As a result, actual amounts will differ from the pro forma information presented.



	Pro Forma for the Year Ended December 31,
	2014		2013
	(Dollars In Thousands, except per share amounts)
Net interest income	$	144,470	$	147,267
Net income	35,758		30,718
Basic earnings per common share	$	1.19	$	1.04
Diluted earnings per common share	1.18		1.04