UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

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

For the transition period from ____________to ____________

Commission file number                          333-86993                     

MainStreet BankShares, Inc.

(Exact name of registrant as specified in its charter)

Virginia	54-1956616
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
1075 Spruce Street, Martinsville, Virginia	24112
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code  (276) 632-8054

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
None	None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, No Par Value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

  Yes ¨No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

  Yes ¨          No S

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

Yes x          No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x          No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one):

Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer ¨	Smaller reporting company x
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨No x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2012. $5,658,161 based on $4.50 per share.

(Applicable only to corporate registrants) Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date 1,713,375 shares outstanding as of March 14, 2013.

Documents incorporated by reference. Portions of the Corporation’s 2013 Proxy Statement have been incorporated by reference into Part III.

MainStreet BankShares, Inc.

Form 10-K

Index

	PART I
Item 1	Business	1-5
Item 1A	Risk Factors	5
Item 1B	Unresolved Staff Comments	5
Item 2	Properties	6
Item 3	Legal Proceedings	6
Item 4	Mine Safety Disclosures	6
	PART II
Item 5	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	6-8
Item 6	Selected Financial Data	8
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations	8-29
Item 7A	Quantitative and Qualitative Disclosures about Market Risk	29
Item 8	Financial Statements and Supplementary Data	30-71
Item 9	Changes In and Disagreements with Accountants on Accounting and Financial Disclosure	72
Item 9A	Controls and Procedures	72
Item 9B	Other Information	72
	PART III
Item 10	Directors, Executive Officers and Corporate Governance	73-75
Item 11	Executive Compensation	75
Item 12	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	75
Item 13	Certain Relationships and Related Transactions, and Director Independence	76
Item 14	Principal Accounting Fees and Services	76
	PART IV
Item 15	Exhibits and Financial Statement Schedules	76

PART I

Item 1. Business

General

MainStreet BankShares, Inc., (the “Corporation”, “MainStreet”, or “BankShares”), was incorporated in the Commonwealth of Virginia on January 14, 1999. MainStreet was primarily formed to serve as a bank holding company. Its first wholly-owned subsidiary was located in Martinsville, Virginia and was sold on March 23, 2005. In 2002, MainStreet organized a second bank subsidiary, Franklin Community Bank, National Association (“Franklin Bank”). On February 8, 2007, MainStreet formed a wholly-owned real estate company, MainStreet RealEstate, Inc., for the sole purpose of owning the real estate of the Corporation.

MainStreet is authorized to engage in any lawful activity for a bank holding company. The holding company structure provides greater flexibility than a bank standing alone because it allows expansion and diversification of business activities through newly formed subsidiaries or through acquisitions. MainStreet’s business is conducted through its subsidiary bank.

Franklin Community Bank, N.A.

Franklin Bank is a nationally chartered commercial bank and member of the Federal Reserve whose deposits are insured by the FDIC. Franklin Bank opened for business on September 16, 2002. Franklin Bank accepts deposits from the general public and makes commercial, consumer, and real estate loans. Franklin Bank operates as a locally-owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. It relies on local advertising and the personal contacts of its directors, employees, and shareholders to attract customers and business to the Bank. Franklin Bank emphasizes a high degree of personalized client service in order to be able to serve each customer. Franklin Bank’s marketing approach emphasizes the advantages of dealing with an independent, locally managed commercial bank to meet the particular needs of individuals, professionals and small to medium-sized businesses. The main office of Franklin Bank is located at 400 Old Franklin Turnpike, Suite 100, Rocky Mount, Virginia. Franklin Bank has banking offices located at 12930 Booker T. Washington Highway, Hardy, Virginia and in Union Hall located at 25 Southlake Drive, Union Hall, Virginia. Franklin Bank’s primary service area is Franklin County, Town of Rocky Mount and surrounding areas. For the most part, Franklin Bank’s business activity is with customers located in its primary market area. Accordingly, operating results are closely correlated with the economic trends within the region and influenced by the significant industries in the region including pre-built housing, real estate development, agriculture, and resort and leisure services. Much of the market area is considered rural; however, the resort surrounding Smith Mountain Lake attracts many tourists to the area.

MainStreet RealEstate, Inc.

MainStreet RealEstate, Inc. was formed effective February 8, 2007 as a subsidiary of MainStreet. It was formed for the sole purpose of owning the real estate of the Corporation. It owns the facility in which Franklin Bank’s Southlake branch operates.

Competition

Franklin Bank experiences competition in attracting and retaining business and personal checking and savings accounts, making commercial, consumer, and real estate loans and providing other services in their primary service area. The principal methods of competition in the banking industry for deposits are service, rates offered, convenience of location, and flexible office hours. The principal methods of competition in the banking industry for loans are interest rates, loan origination fees, and the range of lending services offered. Competition in the service area comes from other commercial banks, savings institutions, brokerage firms, credit unions, and mortgage banking firms. Competition for deposits is particularly intense in Franklin Bank’s market which increases the cost and reduces the availability of local deposits. Because of the nature of Franklin Bank’s market, a substantial portion of the loan opportunities for which banks compete are real estate related. During the present economic downturn, which has been focused on real estate, the number of loan opportunities is reduced and the risk of those loans is increased. Franklin Bank has been able to take advantage of the consolidation in the banking industry in our market area by providing personalized banking services that are desirable to large segments of customers, which has enabled the bank to compete satisfactorily. We intend to continue to provide a high level of service with local decision-making focused solely on our local market. We process daily by branch capture, a method by which checks are processed by tellers rather than item processing, which allows for better efficiencies along with all day banking. We also receive and send our cash letters electronically. We believe these factors more than offset the advantages that larger banks in our markets may have in offering a larger number of banking locations and broader range of services.

Regulation, Supervision and Government Policy

BankShares and Franklin Bank are subject to state and federal banking laws and regulations that provide for general regulatory oversight of all aspects of their operations. As a result of substantial regulatory burdens on banking, financial institutions like MainStreet and Franklin Bank are at a disadvantage to other competitors who are not as highly regulated, and MainStreet and Franklin Bank’s costs of doing business are accordingly higher. A brief summary follows of certain laws, rules and regulations which affect MainStreet and Franklin Bank. Recent and expected changes in the laws and regulations governing banking and financial services could have an adverse effect on the business prospects of MainStreet and Franklin Bank. The current economic environment has created uncertainty in this area, as legislators and regulators attempt to address rapidly changing problems which are likely to lead to new laws and regulations affecting financial institutions.

MainStreet BankShares, Inc.

MainStreet is a bank holding company organized under the Federal Bank Holding Company Act (BHCA), which is administered by the Board of Governors of the Federal Reserve System (the Federal Reserve). MainStreet is required to file an annual report with the Federal Reserve and may be required to furnish additional information pursuant to the BHCA. The Federal Reserve is authorized to examine MainStreet and its subsidiaries. With some limited exceptions, the BHCA requires a bank holding company to obtain prior approval from the Federal Reserve before acquiring or merging with a bank or before acquiring more than 5% of the voting shares of a bank unless it already controls a majority of shares. On June 17, 2009, MainStreet entered into a Memorandum of Understanding (“MOU”) with the Federal Reserve which was amended effective January 26, 2011. Refer to Item 7, Management’s Discussion and Analysis for a detailed discussion.

The Bank Holding Company Act. Under the BHCA, a bank holding company is generally prohibited from engaging in nonbanking activities unless the Federal Reserve has found those activities to be incidental to banking. Bank holding companies also may not acquire more than 5% of the voting shares of any company engaged in nonbanking activities.

The Virginia Banking Act. The Virginia Banking Act requires all Virginia bank holding companies to register with the Virginia State Corporation Commission (the Commission). MainStreet is required to report to the Commission with respect to financial condition, operations and management. The Commission may also make examinations of any bank holding company and its subsidiaries.

The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (GLBA) permits significant combinations among different sectors of the financial services industry, allows for expansion of financial service activities by bank holding companies and offers financial privacy protections to consumers. GLBA preempts most state laws that prohibit financial holding companies from engaging in insurance activities. GLBA permits affiliations between banks and securities firms in the same holding company structure, and it permits financial holding companies to directly engage in a broad range of securities and merchant banking activities. MainStreet is not a financial holding company.

The Sarbanes-Oxley Act. The Sarbanes-Oxley Act (SOX) enacted sweeping reforms of the federal securities laws intended to protect investors by improving the accuracy and reliability of corporate disclosures. It impacts all companies with securities registered under the Securities Exchange Act of 1934, including MainStreet. SOX creates increased responsibilities for chief executive officers and chief financial officers with respect to the content of filings with the Securities and Exchange Commission. Section 404 of SOX and related Securities and Exchange Commission rules focused increased scrutiny by internal and external auditors on MainStreet’s systems of internal controls over financial reporting, which is designed to insure that those internal controls are effective in both design and operation. SOX sets out enhanced requirements for audit committees, including independence and expertise, and it includes stronger requirements for auditor independence and limits the types of non-audit services that auditors can provide. Finally, SOX contains additional and increased civil and criminal penalties for violations of securities laws.

Capital Requirements. The Federal Reserve has adopted risk-based capital guidelines that are applicable to MainStreet. The guidelines provide that the Company must maintain a minimum ratio of 8% of qualified total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit). At least half of total capital must be comprised of Tier 1 capital, for a minimum ratio of Tier 1 capital to risk-weighted assets of 4%. In addition, the Federal Reserve has established minimum leverage ratio guidelines of 4% for banks that meet certain specified criteria. The leverage ratio is the ratio of Tier 1 capital to total average assets, less intangibles. MainStreet is expected to be a source of capital strength for its subsidiary bank, and regulators can undertake a number of enforcement actions against MainStreet if its subsidiary bank becomes undercapitalized. MainStreet’s bank subsidiary is well capitalized and fully in compliance with capital guidelines. However, regulatory capital requirements relate to earnings and asset quality, among other factors. Bank regulators could choose to raise capital requirements for banking organizations beyond current levels. As discussed in Item 7, Management’s Discussion and Analysis, MainStreet’s subsidiary bank entered into a formal agreement with the Office of the Comptroller of the Currency which contains requirements relative to Franklin Bank’s capital levels. In addition, when the proposed “Basel III” framework is implemented in the United States, bank holding companies and their bank subsidiaries depending on their size will likely be required to increase their capital and compliance costs could be significant. Because of these matters, MainStreet is unable to predict if higher capital levels may be mandated in the future for it or its subsidiary bank. If so, such additional capital could be dilutive to MainStreet’s then existing shareholders in the future.

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Emergency Economic Stabilization Act of 2008. On October 14, 2008, the U. S. Treasury announced the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008. In the program, the Treasury was authorized to purchase up to $250 million of senior preferred shares in qualifying U. S. banks, savings and loan associations, and bank and savings and loan holding companies. The amount of TARP funds was later increased up to $350 million. The minimum subscription amount was 1% of risk-weighted assets and the maximum amount was the lesser of $25 billion or 3% of risk-weighted assets. MainStreet did not participate in TARP.

American Recovery and Reinvestment Act of 2009. The ARRA was enacted in 2009 and includes a wide range of programs to stimulate economic recovery. In addition, it also imposed new executive compensation and corporate governance obligations on TARP Capital Purchase Program recipients. Because MainStreet did not participate in TARP it is not affected by these requirements.

Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act was signed into law on July 21, 2010. Its wide ranging provisions affect all federal financial regulatory agencies and nearly every aspect of the American financial services industry. Among the provisions of the Dodd-Frank Act that directly impact the Company is the creation of an independent Consumer Financial Protection Bureau, (CFPB), which has the ability to write rules for consumer protections governing all financial institutions. All consumer protection responsibility formerly handled by other banking regulators is consolidated in the CFPB. It will also oversee the enforcement of all federal laws intended to ensure fair access to credit. The CFPB has begun implementing consumer mortgage lending and other rules which impact the availability and cost of providing certain consumer products. For smaller financial institutions such as MainStreet and Franklin Bank, the CFPB will coordinate its examination activities through their primary regulators.

Although the Dodd-Frank Act provisions themselves are extensive, the full impact on the Company of this massive legislation continues to be unknown. The Act provides that several federal agencies, including the Federal Reserve, the CFPB and the Securities and Exchange Commission, shall issue regulations implementing major portions of the legislation, and this process is ongoing.

Jumpstart Our Business Startups (JOBS ACT). On April 5, 2012, the President signed the Jumpstart our Business Startups (JOBS) Act into law. The objective of the legislation, as the name implies, is to stimulate the growth of small to midsized companies through facilitated access to capital and reduced regulatory reporting requirements. This, in turn, is expected to create jobs as businesses use this newly infused capital to expand operations.

Franklin Community Bank, N.A.

Franklin Bank is a national banking association incorporated under the laws of the United States, and the bank is subject to regulation and examination by the Office of the Comptroller of the Currency (OCC). Franklin Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to the limits of applicable law. The OCC, as the primary regulator, and the FDIC regulate and monitor all areas of Franklin Bank’s operation. These areas include adequacy of capitalization and loss reserves, loans, deposits, business practices related to the charging and payment of interest, investments, borrowings, payment of dividends, security devices and procedures, establishment of branches, corporate reorganizations and maintenance of books and records. Franklin Bank is required to maintain certain capital ratios. It must also prepare quarterly reports on its financial condition for the OCC and conduct an annual audit of its financial affairs. The OCC requires Franklin Bank to adopt internal control structures and procedures designed to safeguard assets and monitor and reduce risk exposure. While appropriate for the safety and soundness of banks, these requirements add to overhead expense for Franklin Bank and other banks. On April 16, 2009, Franklin Bank entered into a formal agreement (“Agreement”) with the OCC. Refer to Item 7, Management’s Discussion and Analysis for a detailed discussion.

The Community Reinvestment Act. Franklin Bank is subject to the provisions of the Community Reinvestment Act (CRA), which imposes an affirmative obligation on financial institutions to meet the credit needs of the communities they serve, including low and moderate income neighborhoods. The OCC monitors Franklin Bank’s compliance with the CRA and assigns public ratings based upon the bank’s performance in meeting stated assessment goals. Unsatisfactory CRA ratings can result in restrictions on bank operations or expansion. Franklin Bank received a “satisfactory” rating in its last CRA examination by the OCC.

3

The Gramm-Leach-Bliley Act. In addition to other consumer privacy provisions, the Gramm-Leach-Bliley Act (GLBA) restricts the use by financial institutions of customers’ nonpublic personal information. At the inception of the customer relationship and annually thereafter, Franklin Bank is required to provide its customers with information regarding its policies and procedures with respect to handling of customers’ nonpublic personal information. GLBA generally prohibits a financial institution from providing a customer’s nonpublic personal information to unaffiliated third parties without prior notice and approval by the customer.

The USA Patriot Act. The USA Patriot Act (Patriot Act) facilitates the sharing of information among government entities and financial institutions to combat terrorism and money laundering. The Patriot Act imposes an obligation on Franklin Bank to establish and maintain anti-money laundering policies and procedures, including a customer identification program. Franklin Bank is also required to screen all customers against government lists of known or suspected terrorists. There is additional regulatory oversight to insure compliance with the Patriot Act.

Consumer Laws and Regulations. There are a number of laws and regulations that regulate banks’ consumer loan and deposit transactions. Among these are the Truth in Lending Act, the Truth in Savings Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Fair Credit Reporting Act, and the Fair Debt Collections Practices Act. Franklin Bank is required to comply with these laws and regulations in its dealing with customers. In addition, the CFPB has begun adopting rules regulating consumer mortgage lending pursuant to the Dodd-Frank Act. There are numerous disclosure and other compliance requirements associated with the consumer laws and regulations.

Deposit Insurance. Franklin Bank has deposits that are insured by the Federal Deposit Insurance Corporation (FDIC). FDIC maintains a Bank Insurance Fund (BIF) that is funded by risk-based insurance premium assessments on insured depository institutions. Assessments are determined based upon several factors, including the level of regulatory capital and the results of regulatory examinations. FDIC may adjust assessments if the insured institution’s risk profile changes or if the size of the BIF declines in relation to the total amount of insured deposits. In 2012 and 2011, Franklin Bank paid $253,874 and $293,337, respectively, in FDIC assessments. It is anticipated that assessments may increase in the future to offset demands on the BIF from banks that fail in the troubled economy. Such increases could adversely affect the Bank’s profitability.

On October 3, 2008, the FDIC announced that deposits at FDIC-insured institutions would be insured up to at least $250,000. It was extended to December 31, 2013, and then permanently.

FDIC announced its Transaction Account Guarantee Program on October 14, 2008. The Transaction Account Guarantee Program, which is a part of the Temporary Liquidity Guarantee Program, provides full coverage for non-interest bearing deposit accounts of FDIC-insured institutions that elected to participate. Franklin Bank elected to participate in this program and opted to continue in the program. There were increased BIF assessments for program participants. This program has terminated.

After giving primary regulators an opportunity to first take action, FDIC may initiate an enforcement action against any depository institution it determines is engaging in unsafe or unsound actions or which is in an unsound condition, and the FDIC may terminate that institution’s deposit insurance.

Capital Requirements. The same capital requirements that are discussed above with relation to MainStreet are applied to Franklin Bank by the OCC. The OCC guidelines provide that banks experiencing internal growth or making acquisitions are expected to maintain strong capital positions well above minimum levels, without reliance on intangible assets. Also, capital requirements can be increased based on earnings and asset quality concerns as well as other issues. The Agreement between the Bank and the OCC required the Bank to develop a three year capital plan to provide for the Bank’s capital needs based on projected growth and other factors. The plan was implemented and is continually enhanced and updated. Additional capital requirements may cause dilution to then existing shareholders, if needed. In addition, implementation of the BASEL III requirements could increase required capital minimums as well as compliance costs due to their complexity.

Limits on Dividend Payments. As a national bank, Franklin Bank may not pay dividends from its capital, and it may not pay dividends if the bank would become undercapitalized, as defined by regulation, after paying the dividend. Without prior OCC approval, Franklin Bank’s dividend payments in any calendar year are restricted to the bank’s retained net income for that year, as that term is defined by the laws and regulations, combined with retained net income from the preceding two years, less any required transfer to surplus. Under the Agreement, Franklin Bank is restricted from paying dividends.

4

The OCC and FDIC have authority to limit dividends paid by Franklin Bank, if the payment were determined to be an unsafe and unsound banking practice. Any payment of dividends that depletes the Bank’s capital base could be deemed to be an unsafe and unsound banking practice. Currently under the MOU with the Federal Reserve, MainStreet cannot pay any dividends without approval.

Branching. As a national bank, Franklin Bank is required to comply with the state branch banking laws of Virginia, the state in which the Bank is located. Franklin Bank must also have the prior approval of OCC to establish a branch or acquire an existing banking operation. Under Virginia law, Franklin Bank may open branch offices or acquire existing banks or bank branches anywhere in the state. Virginia law also permits banks domiciled in the state to establish a branch or to acquire an existing bank or branch in another state.

Monetary Policy

The monetary and interest rate policies of the Federal Reserve, as well as general economic conditions, affect the business and earnings of MainStreet. Franklin Bank and other banks are particularly sensitive to interest rate fluctuations. The spread between the interest paid on deposits and that which is charged on loans is the most important component of Franklin Bank’s profits. In addition, interest earned on investments held by MainStreet and Franklin Bank has a significant effect on earnings. As conditions change in the national and international economy and in the money markets, the Federal Reserve’s actions, particularly with regard to interest rates, can impact loan demand, deposit levels and earnings at Franklin Bank. It is not possible to accurately predict the effects on MainStreet of economic and interest rate changes.

Other Legislative and Regulatory Concerns

Particularly because of current uncertain and volatile economic conditions as well as recent credit market turmoil and related financial institution concerns, federal and state laws and regulations are likely to be enacted that will affect the regulation of financial institutions. The Dodd-Frank Reform Act has been adopted and additional regulations affecting the financial sector have been enacted and additional regulations can be expected although many of these are not directly applicable to small community financial institutions like MainStreet. The net effect of these changes in this law as well as others will add to the regulatory burden on banks and increase the costs of compliance, or they could change the products that can be offered and the manner in which banks do business. We cannot foresee how the additional regulation of financial institutions may change in the future and how those changes might affect MainStreet.

Company Website

MainStreet maintains a website at www.msbsinc.com and for Franklin Bank at www.fcbva.com. The Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are made available on its website through a link to the Securities and Exchange Commission for filings. The Corporation’s proxy materials for the 2013 Annual Meeting of Shareholders are also posted on a separate website at www.cfpproxy.com/6043.

Employees

The total number of full-time equivalent persons employed by MainStreet and its wholly owned bank subsidiary as of December 31, 2012 was 53. MainStreet believes its relationship with its employees is good and no employees are represented by a labor union.

Item 1A. Risk Factors

Not required.

Item 1B. Unresolved Staff Comments

Not required.

5

Item 2. Properties

The Corporation leases its executive office and operations facility in Martinsville, Virginia. The lease commenced on November 19, 2010 for space located at 1075 Spruce Street in Martinsville, Virginia. The lease will expire November 30, 2015. The lease has an option to renew for one additional five year term.

Franklin Bank’s main office is located at 400 Old Franklin Turnpike, Suite 100, Rocky Mount, Virginia, in a section of town known as the Rocky Mount Marketplace. The bank leases a two-story facility with approximately 8,200 square feet of which the Bank provides permanent financing to the owners of which one is a director. The lease is for a 15-year period and the expiration date of the lease is June 30, 2018. The lease payment mirrors the loan payment plus an 8% return on investment to the owner. Subject to certain compliance issues, Franklin Bank has the option to extend the lease for one additional term of five years. If the right to extend this lease for the first renewal term is exercised, Franklin Bank has the right to extend this lease for five additional terms of five years each. One of the owners is a director of Franklin Bank and both owners are shareholders of BankShares. Franklin Bank owns a lot adjacent to their Rocky Mount Office which is utilized for employee parking. Franklin Bank leases its branch which opened on April 9, 2004 at 12930 Booker T. Washington Highway, Hardy, Virginia. Franklin Bank provides permanent financing to the owner of this facility. A director of Franklin Bank is a partner in the ownership of this facility. The lease commenced on April 7, 2004 and will expire April 6, 2019. The lease payment mirrors the loan payment plus an 8% return on investment to the owner. Subject to certain compliance issues, Franklin Bank has the option to extend the lease for one additional term of five years. If the right to extend this lease for the first renewal term is exercised, Franklin Bank has the right, or option, to extend or renew this lease for five additional terms of five years each. Franklin Bank leased its 220 North branch located at 35 Shepherd Drive, Rocky Mount, Virginia. A director of Franklin Bank was a partner in the ownership of the facility. The lease commenced June 1, 2007 and expired June 1, 2012. Franklin Bank closed this banking office effective November 13, 2010; however, the lease remained in effect until its maturity. Franklin Bank purchased the building at the maturity of the lease and assigned the purchase to another buyer which was a director of both the Corporation and Franklin Bank. The main office and all branches have a drive-up ATM.

MainStreet RealEstate, Inc. owns the Southlake branch located in the Union Hall area of Franklin County and leases it to Franklin Bank. The branch opened in August 2007. The total cost of the land and building were $425,286 and $881,123, respectively. MainStreet believes its banking facilities are well located to serve their intended banking markets and are attractively furnished and well equipped for banking purposes. All facilities are adequately insured in management’s opinion.

Item 3. Legal Proceedings

MainStreet currently is not involved in any legal proceedings outside the normal operations associated with problem credits.

Item 4. Mine Safety Disclosures

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

MainStreet has 10,000,000 authorized shares of common stock, no par value, and had 1,713,375 shares of its common stock outstanding at January 31, 2013. In addition, the initial organizers of MainStreet received 96,250 warrants in connection with the initial public offering. Each warrant provided the holder with the right to buy one share of common stock at a price of $9.09 per share of which 27,500 were exercised and the remainder were either forfeited or expired unexercised in 2010.

Options in the amount of 33,000 (included in the total 161,272 outstanding at year-end), of which all are vested and exercisable, were granted at the then fair market value of $9.55 to a former employee.

In addition, the shareholders of MainStreet BankShares, Inc. approved the 2004 Key Employee Stock Option Plan (the “Plan”) at its Annual Meeting on April 15, 2004. The Plan permitted the grant of Non-qualified Stock Options and Incentive Stock Options to persons designated as “Key Employees” of BankShares and its subsidiaries. The Plan terminated on January 21, 2009. Awards made under the Plan prior to and outstanding on that date remain outstanding in accordance with their terms. Option awards were generally granted with an exercise price equal to the market value of MainStreet’s stock at the date of grant. The options issued in 2007 and 2006 had a vesting period of 3 years and have a ten year exercise term. The options issued in 2005 vested immediately upon grant and have a ten year exercise term. All option awards provide for accelerated vesting if there is a change in control (as defined in the Plan). As of December 31, 2012, there were 136,527 options granted under this plan of which 822 options have been exercised and 7,433 stock options have been forfeited. The rest remain unexercised.

6

As of December 31, 2012, 161,272 stock options are outstanding, of which all are vested and exercisable, including those issued to a former employee.

MainStreet enrolled its stock with the OTC Bulletin Board (“OTCBB”) quotation service effective February 12, 2007. In order to continue on the OTCBB, MainStreet must maintain at least one market maker and continue to submit its periodic reports to the Securities and Exchange Commission (“SEC”) in a timely manner. MainStreet has been current on all periodic filings with the SEC and currently has three market makers. MainStreet is quoted under the symbol MREE. According to information obtained by Corporation management and believed to be reliable, the quarterly range of closing prices per share for the common stock during the last two fiscal years was as follows:

	2012				2011
	High		Low		High		Low
Quarter Ended	Close		Close		Close		Close
March 31	$	4.25	$	3.75	$	5.00	$	3.75
June 30	$	6.39	$	4.25	$	9.50	$	4.15
September 30	$	4.90	$	4.50	$	5.50	$	4.50
December 31	$	6.00	$	4.55	$	4.75	$	4.25

There are approximately 1,581 shareholders of common stock as of December 31, 2012.

MainStreet declared its first cash dividend in the amount of $.05 per share in September 2007. Given the injection of $1.3 million into the loan loss reserve by Franklin Bank during the fourth quarter of 2008, MainStreet’s Board of Directors deemed it prudent to suspend the cash dividend at that time. The only source of funds for dividends is dividends paid to MainStreet by Franklin Bank. Franklin Bank is limited in the amount of dividend payments by the Office of the Comptroller of the Currency, (“OCC”), its primary regulator. Under normal circumstances the OCC limits annual dividends to a maximum of retained profits of the current year plus the two prior years, without prior OCC approval. However, on April 16, 2009, Franklin Bank entered into the Agreement with the OCC. Among other things, the Agreement required the Bank to adopt a three year capital program and prohibits the payment of a dividend until the Bank is in compliance with the program and satisfies certain other conditions. Thus, the payment of future dividends by MainStreet will depend in part on a return by Franklin Bank to more historical levels of profitability, compliance with its capital program and the formal agreement. On June 17, 2009, MainStreet entered into a Memorandum of Understanding (“MOU”) with the Federal Reserve Bank of Richmond, which was amended January 26, 2011. Under the MOU, MainStreet is prohibited from paying any dividends. Refer to Item 7, Management’s Discussion and Analysis for a detailed discussion. We cannot predict when these regulatory restrictions on dividends may be lifted, and even if that were to occur, when MainStreet would resume the payment of dividends.

Information in the format relating to MainStreet securities authorized for issuance under the Company’s Equity Compensation plans is as follows:

					Number of Securities
					Remaining Available
	Number of Securities				For Future Issuance
	To be Issued Upon		Weighted-Average		Under Equity
	Exercise of		Exercise Price of		Compensation Plans
	Outstanding Options,		Outstanding Options,		(Excluding Securities
Plan Category	Warrants and Rights		Warrants and Rights		Reflected in Column (a))
	(a)		(b)		(c)
Equity compensation plans approved by security holders		128,272	$	12.85	—
Equity compensation plans not approved by security holders		33,000		9.55	—
Total		161,272	$	12.17	—

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The Plan terminated January 21, 2009, except with respect to awards granted prior to that date.

Refer to Part II, Item 8, Note 14 for a detailed discussion of the stock options and warrants that are outstanding.

Item 6. Selected Financial Data

Not required

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist in understanding and evaluating the financial condition and results of operations of MainStreet BankShares, Inc. (“MainStreet”, “BankShares”, or “Corporation”) on a consolidated basis. This discussion and analysis should be read in conjunction with BankShares’ consolidated financial statements and related notes included in Item 8 of this report on Form 10-K.

Forward-Looking Statements

This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. MainStreet takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic conditions, either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; and (4) legislative or regulatory changes including changes in accounting standards, may adversely affect the business.

General

MainStreet was incorporated on January 14, 1999 in the Commonwealth of Virginia. MainStreet was primarily formed to serve as a bank holding company. Its first wholly-owned subsidiary was located in Martinsville, Virginia, and was sold on March 23, 2005. In 2002, MainStreet organized a second bank subsidiary, Franklin Community Bank, National Association (“Franklin Bank’) to serve the Franklin County area of Virginia. MainStreet provides a wide variety of banking services through Franklin Bank. Franklin Bank operates as a locally-owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. It relies on local advertising and the personal contacts of its directors, employees, and shareholders to attract customers and business to the Bank. Franklin Bank has three banking offices in Rocky Mount and Franklin County. On February 8, 2007, MainStreet formed a wholly-owned real estate company, MainStreet RealEstate, Inc. for the sole purpose of owning the real estate of the Corporation. MainStreet RealEstate, Inc. owns the Union Hall (Southlake) branch of Franklin Bank.

On April 16, 2009, Franklin Bank entered into a formal agreement (“Agreement”) with The Comptroller of the Currency (“OCC”). The Agreement required Franklin Bank to perform certain actions within designated time frames. The Bank must comply with the Agreement while it is outstanding. The Bank submitted the responses required in the respective time frames described below.

Within 30 days, Franklin Bank was required to adopt sublimits for concentrations in acquisition and development loans, speculative lot loans, and speculative single-family housing construction loans and determine if any action is necessary to reduce these concentrations. Franklin Bank reviewed and amended these limits and certain concentrations were lowered.

Within 60 days, Franklin Bank was required to do the following:

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§ Franklin Bank was required to establish an effective program for early identification of emerging and potential problem credits to include accurate ratings, accrual status, continued financial analyses, and formal work out plans. Franklin Bank developed an attestation process monthly for loan officers to include risk rating and the accrual status of their loan portfolios. Franklin Bank has a Problem Loan Committee made up of senior management and one Board Loan Committee director that meets monthly. Criticized loan worksheets were enhanced and expanded to include a summary of the most recent financial analysis; most recent collateral valuation factoring possible liquidation and timing discount; and enhanced action plans with target dates. Primary and secondary repayment sources are detailed on the worksheets. Our internal loan review function now reports to the loan committee of the board of directors rather than to management. This committee of the board meets quarterly and reporting was enhanced to include the overall quality of the loan portfolio; the identification, type, rating, and amount of problem loans; the identification and amount of delinquent loans; credit and collateral documentation exceptions; the identification and status of credit-related violations of law; the identification of the loan officer who originated each loan reported; concentrations of credit; and loans to executive officers and directors.

§ Franklin Bank was required to develop a written underwriting program to include reasonable amortization of speculative lot and single family housing construction loans and ensure updated appraisals are documented. Our credit policy was amended to address the amortization periods. Personnel were designated to ensure the reporting system has updated appraisals and evaluations. All files were reviewed to ensure correct appraisal information. A credit analyst position was added in December 2008 that performs required financial analysis on all loans $100,000 and over at origination or renewal and at the receipt of new financial statements. In addition, new software was purchased to assist with this process and to assist the credit analyst and lenders in the risk rating of each loan.

§ The Bank also had to eliminate the basis of criticism of assets criticized by the OCC. Franklin Bank has dedicated an experienced employee to work through problem assets. The other actions described above also assist in achieving compliance with this requirement. The Bank continually strives to lower its problem assets.

§ Franklin Bank was required to enhance its asset liability management policy to ensure monitoring of the Bank’s liquidity position which included more detailed reporting to the Board. The Agreement also required Franklin Bank to increase its liquidity immediately and to take action to ensure adequate sources of liquidity. Franklin Bank increased its sources by adding correspondent bank lines; becoming a member of QwickRate (an internet certificate of deposit program); becoming a member of the Certificate of Deposit Account Registry Service (“CDARS”); and partnering with certain institutions to acquire brokered deposits. According to the Agreement, brokered deposits cannot exceed 15% of total deposits. At December 31, 2012 and 2011, brokered deposits were $5.3 million and $6.9 million, respectively, and were less than 5% of total deposits in both years. Franklin Bank also participated loans during the first half of 2009 which improved our liquidity. Franklin Bank revised its Contingency Liquidity Plan to include crises relevant to current balance sheet composition. New reports created to assist with monitoring asset liability and liquidity include a maturity schedule of certificates of deposit; the volatility of demand deposits; loan commitments and letters of credit; borrowing lines and continued availability; an analysis of the impact of decreased cash flow from the loss of income from nonperforming loans and loans sold or participated; rolling sources and uses report; rollover risk analysis; and prioritization of funding sources and uses. Franklin Bank was required to review and enhance the analysis of the allowance for loan losses. The Bank has continued to review and enhance the process.

Within 90 days, Franklin Bank was required to develop and implement a three-year detailed capital plan. The Plan was put in place and is continually updated. The plan includes detailed projections for growth and capital requirements; projections for primary sources and secondary sources of capital; and a revised dividend policy. The Agreement prohibits the Bank from paying dividends until compliance with the program and certain other conditions are met.

Under the Agreement, a Compliance Committee of three members of the Franklin Bank’s Board of Directors was formed to monitor the progress and make regular reports to the OCC. Failure to comply with the provisions of the Agreement could subject Franklin Bank and its directors to additional enforcement actions. The Compliance Committee of Franklin Bank continues to meet monthly to ensure adherence and compliance with the Agreement. The Compliance Committee reviews the Agreement by article in detail at each meeting along with the corresponding actions of Franklin Bank within each article. The Compliance Committee reports monthly to the full board of directors. While Franklin Bank intends to continue to take such actions as may be necessary to enable it to comply with the requirements of the Agreement, there can be no assurance that it will be able to comply fully with the provisions of the Agreement. Such compliance is costly and affects the operations of Franklin Bank and the Corporation. Franklin Bank met all of the required time lines for submission of information to the OCC along with regular reporting. Franklin Bank must demonstrate sustained performance under the Agreement.

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On June 17, 2009, MainStreet BankShares, Inc. entered into a Memorandum of Understanding (“MOU”) with the Federal Reserve Bank of Richmond (“Federal Reserve”). The MOU required the bank holding company to utilize its financial and managerial resources to assist Franklin Bank in functioning in a safe and sound manner. The MOU restricted MainStreet from declaring or paying any dividends without the prior written approval of the Federal Reserve. Under the MOU, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve. Since then, MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. On January 26, 2011, the MOU with the Federal Reserve was amended to include additional requirements. The bank holding company must comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act (12 U.S.C. 1828(k)) and Part 359 of the Federal Deposit Insurance Corporation’s regulations (12 C.F.R. Part 359). Also, the Corporation shall not appoint any individual to the board or employ or change the responsibilities of any individual as senior executive officer if the Federal Reserve notifies the Corporation of disapproval within the required time limits. MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. Management believes the holding company is appropriately using its financial and managerial resources to assist Franklin Bank to function in a safe and sound manner.

MainStreet and Franklin Bank’s President and CEO, Larry A. Heaton, was tragically killed in a car accident on Sunday, December 9, 2012. On Monday, December 10, 2012, the Board of Directors named Brenda H. Smith, Acting President and Chief Executive Officer. Mrs. Smith has been with the Corporation since its inception and is also the Executive Vice President and Chief Financial Officer. A search committee has been formed and is actively pursuing a permanent President and Chief Executive Officer.

Critical Accounting Policies

MainStreet’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors, peer comparisons, regulatory factors, concentrations of credit, past dues, and the trend in the economy as factors in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk.

The allowance for loan losses reflects our best estimate of the losses inherent in our loan portfolio. The allowance is based on two basic principles of accounting: (i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, reflects management’s best estimate of probable credit losses inherent in the loan portfolio and is, therefore, believed to be appropriate.

The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions and other risks inherent in the portfolio. Management reviews the past due reports and risk-rated loans and discusses individually the loans on these reports with the responsible loan officers. Management uses these tools and provides a quarterly analysis of the allowance based on our historical loan loss experience, risk-rated loans, past dues, concentrations of credit, unsecured loans, loan exceptions, and the economic trend. These are generally grouped by homogeneous loan pools. Impaired loans are reviewed individually to determine possible impairment based on one of three recognized methods which are fair value of collateral, present value of expected cash flows, or observable market price. A specific reserve is then allocated for the amount of the impairment. Although management uses available information to recognize losses on loans, the substantial uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, make it possible that a material change in the allowance for loan losses in the near term may be appropriate. However, the amount of the change cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms.

Overview

Total assets at December 31, 2012 and 2011 were $183,110,988 and $203,855,311, respectively, a decline of $20,744,323, or 10.18%. The composition of the balance sheet has also changed. The largest components of change were in cash and cash equivalents and loans, net of unearned deferred fees and costs. Total cash and cash equivalents declined $6.4 million from year-end 2011 while loans, net of unearned deferred fees and costs declined $8.7 million. Loan demand has remained soft during 2012 and we have aggressively continued to work through our problem loans, which has resulted in additional payouts and foreclosures. Please refer to Footnote #4 for a discussion of our criticized assets. We continue to monitor our asset quality closely and we have had great improvement in the level of our criticized assets. Securities available for sale declined to $18.8 million at year-end 2012 from $21.2 million at year-end 2011 primarily from pay downs on mortgage backed securities and called agency securities. Our total deposits declined $16.5 million from year-end 2011 to year-end 2012. With the continued focus on lowering our overall deposit costs and soft loan demand, this was an anticipated and appropriate result. Our loan to deposit ratio was 89.32% and 85.72% at December 31, 2012 and 2011, respectively. Overall costs of our interest bearing deposits declined 30 basis points in 2012 compared to 2011. We maintained our relationships as can be evidenced by the increase in demand deposits which are our non-interest bearing funds. We also had $7.5 million in repurchase agreements mature in September 2012 for which certain securities available for sale were utilized as collateral. At maturity, we paid off the $7.5 million and now have additional securities that can be utilized and pledged for other purposes, as needed.

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Total shareholders’ equity at December 31, 2012 and 2011 was $24,250,373 and $22,240,789, respectively. MainStreet and Franklin Bank were considered well capitalized at December 31, 2012 and 2011 under the standards of regulatory capital classification. The book value of shareholders’ equity at December 31, 2012 and 2011 was $14.15 and $12.98 per share, respectively.

MainStreet had net income of $1,970,776 for the twelve months ending December 31, 2012 compared to a net loss of $(146,445) for the twelve month period ending December 31, 2011. Net income for 2012 was impacted substantially by reduced provision expense and income from bank owned life insurance as discussed below. Basic and diluted net income (loss) per share was $1.15 and $(.09) for 2012 and 2011, respectively. Return on average assets in 2012 and 2011 was 1.02% and (.07%), respectively while return on average shareholders’ equity was 8.69% and (.66%) for 2012 and 2011, respectively. The return on average assets and average equity for 2010 was .36% and 3.57%, respectively. Year 2012 continued to be impacted by our level of criticized assets. As we worked through these assets and they moved through the cycle, we experienced losses on the sales of other real estate, write downs associated with lower appraisals and selling prices, and had expenses associated with holding these assets. Our overall losses and expenses associated with our other real estate properties were $1.4 million and $1.2 million for the years ending December 31, 2012 and 2011, respectively. Provision expense in 2012 was lower than 2011 as we worked through our problem loans. Provision expense for the periods ending December 31, 2012 and 2011 was $486,257 and $1,660,783, respectively.

Franklin Bank has bank owned life insurance on the lives of its executive officers. Upon the tragic death of CEO, Larry A. Heaton, Franklin Bank collected a death benefit of which approximately $2.4 million was attributed to income on bank owned life insurance. Also, Franklin Bank has a supplemental executive retirement plan in place for its executives. Upon Mr. Heaton’s death, the present value of the payout of this benefit was accrued and expensed totaling approximately $1 million.

Results of Operations

Net Interest Income

The low interest rate environment continued during 2012 with the Federal Reserve leaving the short-term interest rates within a range of 0% - .25% which has been effective since 2008. At the most recent meeting of the Federal Reserve, the Board of Governors indicated a continued willingness to keep rates at low levels thru mid-2015. By employing the QE 3 strategy the Federal Reserve plans to continue purchasing assets to affect what is called a “twist”. The decision to “twist” will drive the yield curve up for short term rates and lower long term rates. The net effect is to keep mortgage rates low for an extended period of time to help spur the housing industry and economic growth. It is also designed to maintain inflation at low levels.

As interest rates have remained low, our borrowers have extended pressure to move to more fixed rate interest products; however, interest rates on variable rate loans make up approximately 24% of Franklin Bank’s loan portfolio. In a rising interest rate environment, this initially would have a positive impact on the net interest margin because deposit rates are slower to reprice at the higher rates. In a declining interest rate environment such as we have been in, asset sensitivity initially has had a negative impact on the net interest margin until deposit rates have an opportunity to reprice. Throughout our history, our overall deposit maturity has been short which has benefited us by allowing us to reprice our deposits downward as they have matured in the lower interest rate environment. On the other hand, in an environment of increasing interest rates, short deposit maturity would reduce the benefit of rising interest rates on loans. Furthermore, even though lower interest rates have been beneficial for our cost of deposits, with prime at 3.25% which is the interest rate basis for many of our loans, MainStreet’s net interest margin has been adversely affected by the prolonged, recessionary low interest rate environment. In addition, competition for deposits remains fierce in our market; however, our goal is to continue to lower our cost of deposits during 2013. The maturity of our repurchase agreement in September 2012 had a positive impact on our net interest margin for the last quarter of 2012 and will continue in 2013. In addition, the remaining $6 million in repurchase agreements will mature in January 2013 which will also have a positive impact on our net interest margin going forward.

Net interest income is the difference between total interest income and total interest expense. The amount of net interest income is determined by the volume of interest-earning assets, the level of interest rates earned on those assets and the cost of supporting funds. The difference between rates earned on interest-earning assets and the cost of supporting funds is measured as the net interest margin. MainStreet’s principal source of income is from the net interest margin. The distribution of assets, liabilities, and equity along with the related interest income and interest expense is presented in the following table. The statistical information in the table is based on daily average balances.

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Distribution of Assets, Liabilities, and Shareholders’ Equity: Interest Rates and Interest Differentials

				2012								2011								2010
	Average					Yield/			Average					Yield/			Average					Yield/
	Balance			Interest		Rate			Balance			Interest		Rate			Balance			Interest		Rate
Loans, net of unearned (1)	$	138,184,714		$	7,782,200		5.63	%	$	153,201,363		$	8,608,985		5.62	%	$	162,931,745		$	9,588,767		5.89	%
Loans held for sale		244,544			7,613		3.11			8,016			270		3.37			—			—		—
Securities available-for-sale-taxable		18,863,608			468,374		2.48			24,103,456			753,407		3.13			25,650,372			963,875		3.76
Securities available-for-sale-non taxable		3,717,392			56,838		2.25			96,835			2,029		3.08			—			—		—
Restricted equity securities		778,190			32,098		4.12			927,000			30,280		3.27			1,042,853			28,215		2.71
Interest-bearing deposits in banks		13,450,334			29,526		.22			11,857,846			25,757		.22			15,387,260			34,501		.22
Federal funds sold		7,074,748			12,634		.18			6,820,273			11,497		.17			5,597,638			11,650		.21
Total Interest Earning Assets		182,313,530			8,389,283		4.62	%		197,014,789			9,432,225		4.79	%		210,609,868			10,627,008		5.05	%
Cash and due from banks		2,877,211								2,746,269								2,596,935
Other assets		10,182,472								12,119,036								12,324,767
Allowance for loan losses		(2,755,936	)							(3,280,304	)							(3,328,725	)
Total Assets	$	192,617,277							$	208,599,790							$	222,202,845
Interest checking deposits	$	7,475,890		$	3,687		.05	%	$	6,928,098		$	6,720		.10	%	$	8,023,116		$	16,356		.20	%
Money market deposits		23,419,522			49,132		.21			24,678,500			105,840		.43			21,916,385			217,881		.99
Savings deposits		13,324,572			7,318		.05			12,231,895			26,004		.21			11,072,683			37,411		.34
Time deposits $100,000 and over		38,988,324			627,801		1.61			46,314,130			853,058		1.84			53,618,002			1,230,463		2.29
Other time deposits		51,597,511			684,629		1.33			61,126,990			1,000,582		1.64			72,304,687			1,584,464		2.19
Federal funds purchased		164			2		1.22			603			2		.33			5,781			41		.71
Corporate cash management		—			—		—			—			—		—			—			—		—
Repurchase agreements		11,348,361			447,233		3.94			13,500,000			538,071		3.99			13,500,000			538,071		3.99
Short-term borrowings		55			—		—			712			3		.42			5,479			27		.49
Total interest-bearing liabilities		146,154,399			1,819,802		1.25	%		164,780,928			2,530,280		1.54	%		180,446,133			3,624,714		2.01	%
Demand deposits		22,899,719								20,680,934								18,904,678
Other liabilities		878,634								870,010								655,347
Total Liabilities		169,932,752								186,331,872								200,006,158
Shareholders’ Equity		22,684,525								22,267,918								22,196,687
Total Liabilities and Shareholders’ Equity	$	192,617,277							$	208,599,790							$	222,202,845
Net Interest Earnings				$	6,569,481		3.37	%				$	6,901,945		3.25	%				$	7,002,294		3.04	%
Net Yield on Interest Earning Assets							3.62	%							3.50	%							3.20	%

(1) Loan fees, net of costs, are included in total interest income. Gross loan fee income totaled $279,789, $269,618 and $257,369 as of December 31, 2012, 2011, and 2010, respectively. The average balance of nonaccrual assets is included in the calculation of asset yields. The yield is calculated based on the tax equivalent yield for tax exempt interest on municipal securities using a 34% marginal tax rate.

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MainStreet’s net interest margin for the years ending December 31, 2012 and 2011 was 3.62% and 3.50%, respectively, an increase of 12 basis points. Both interest income and interest expense declined in comparison to last year, primarily due to the interest rate environment. The yield on earning assets dropped 17 basis points to 4.62%. The funding side dropped 29 basis points. In addition to the low interest rate environment and lower average balances, the effect of lost interest on nonaccrual loans impacted the net interest margin. Lost interest for 2012 was $221,579 compared to $521,729 in 2011. Loan competition for good loans is great and declining rates reduced loan profitability as loans repriced and new loans were made at lower rates. The ability of nonfinancial entities to provide financial services also increases competition, particularly during periods of reduced loan demand, like the present one. These factors also negatively impact the margin. Finally, Franklin Bank’s growth has been quite dependent on consumer and real estate based lending and in the current economic environment sound growth opportunities in these areas are dramatically reduced.

The following table sets forth, for the period indicated, a summary of the change in interest income and interest expense resulting from changes in volume and rates. The change in interest attributable to both rate and volume changes has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.

	2012 Compared to 2011 Increase									2011 Compared to 2010 Increase
	(Decrease) Due to Change In									(Decrease) Due to Change In
							Total									Total
	Average			Average			Increase			Average			Average			Increase
	Volume			Rate			(Decrease)			Volume			Rate			(Decrease)
Interest Income:
Loans, net of unearned	$	(845,658	)	$	18,873		$	(826,785	)	$	(557,922	)	$	(421,860	)	$	(979,782	)
Loans held for sale		7,365			(22	)		7,343			270			—			270
Securities available-for- sale-taxable		(146,475	)		(138,558	)		(285,033	)		(55,549	)		(154,919	)		(210,468	)
Securities available for sale-nontaxable		55,505			(696	)		54,809			2,029			—			2,029
Restricted equity securities		(5,345	)		7,163			1,818			(3,361	)		5,426			2,065
Interest-bearing deposits in banks		3,493			276			3,769			(7,696	)		(1,048	)		(8,744	)
Federal funds sold		782			355			1,137			2,286			(2,439	)		(153	)
Total Interest Income	$	(930,333	)	$	(112,609	)	$	(1,042,942	)	$	(619,943	)	$	(574,840	)	$	(1,194,783	)
Interest Expense:
Interest checking deposits	$	495		$	(3,528	)	$	(3,033	)	$	(1,991	)	$	(7,645	)	$	(9,636	)
Money market deposits		(5,149	)		(51,559	)		(56,708	)		24,627			(136,668	)		(112,041	)
Savings deposits		2,138			(20,824	)		(18,686	)		3,597			(15,004	)		(11,407	)
Certificates of deposit $100,000 and over		(125,480	)		(99,777	)		(225,257	)		(154,105	)		(223,300	)		(377,405	)
Other time deposits		(142,648	)		(173,305	)		(315,953	)		(221,439	)		(362,443	)		(583,882	)
Federal funds purchased		(2	)		2			—			(24	)		(15	)		(39	)
Repurchase agreements		(84,858	)		(5,980	)		(90,838	)		—			—			—
Short-term borrowings		(1	)		(2	)		(3	)		(21	)		(3	)		(24	)
Total Interest Expense	$	(355,505	)	$	(354,973	)	$	(710,478	)	$	(349,356	)	$	(745,078	)	$	(1,094,434	)
Net Interest Income	$	(574,828	)	$	242,364		$	(332,464	)	$	(270,587	)	$	170,238		$	(100,349	)

For 2012 and 2011, net interest income totaled $6,569,481 and $6,901,945, respectively, a decline of $332,464, or 4.82%. The total average interest-earning assets were $182,313,530 and $197,014,789 for the years ending December 31, 2012 and 2011, respectively, a decrease of $14,701,259, or 7.46%. The largest category of decline was in loans, net of unearned deferred fees and costs which decreased by $15.0 million. Higher yielding loan volume declines far exceeded other lower yielding earning assets, hence decreasing total interest income. Interest income was also affected by lost interest on nonaccrual loans as discussed above. The total average interest-bearing liabilities were $146,154,399and $164,780,928 for the years ending December 31, 2012 and 2011, respectively, a decrease of $18.6 million. This decline can be seen primarily in time deposits including certificates of deposit $100,000 and over. Deposits declined due to our strategy to lower our overall deposit costs. While implementing this strategy, loan demand remained soft, which complemented our strategy. Repurchase agreements also declined due to the maturity in September 2012.

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Provision for Loan Losses

A provision for loan losses is charged to earnings for the purpose of establishing an allowance for loan losses that is maintained at a level which reflects management’s best estimate of probable credit losses inherent in the loan portfolio and is, therefore, believed to be appropriate. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. As part of this process, management reviews the past due reports and risk ratings and discusses individually the loans on these reports with the responsible loan officers. Management provides a detailed quarterly analysis of the allowance based on homogenous loan pools, identifying impairment, historical losses, credit concentrations, economic conditions, and other risks. As the allowance is maintained losses are, in turn, charged to this allowance rather than being reported as a direct expense.

Our methodology for determining the allowance is based on two basic principles of accounting: (i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Our analysis is based on an individual review of all credits rated Pass/Watch and lower in our risk rating system by account officers in addition to a review of management information system reports on numerous portfolio segments. The analysis of the allowance is solely based on historical and qualitative factors with historical losses adjusted to higher factors for our criticized and classified loans compared to similar banks with comparable real estate concentrations nationally. Our process allows loan groups to be identified and properly categorized. Our impaired loans are individually reviewed to determine possible impairment based on one of three recognized methods which are fair value of collateral, present value of expected cash flows, or observable market price. A specific reserve is then allocated for the amount of the impairment. Impairment is defined as a loan in which we feel it is probable (meaning likely, not virtually certain) that we will be unable to collect all amounts due under the contractual terms of the loan agreement. Possible loss for loans risk rated special mention or lower are then allocated based on a historical loss migration and adjusted for qualitative factors. Remaining loans are pooled based on homogenous loan groups and allocated based on Franklin Bank’s historical net loss experience. These pools are as follows: 1) commercial and industrial loans not secured by real estate; 2) construction and land development loans; 3) residential 1-4 family loans; 4) residential 1-4 family junior liens; 5) home equity lines; 6) commercial real estate; and 7) consumer or loans to individuals. Historical loss is calculated based on a three-year average history. Historical net loss data is adjusted and applied to pooled loans based on qualitative factors. We utilize the following qualitative factors: 1) changes in the value of underlying collateral such as loans not conforming to supervisory loan to value limits; 2) national and local economic conditions; 3) changes in portfolio volume and nature such as borrower’s living outside our primary trade area; 4) changes in past dues, nonaccruals; and 5) quality and impact and effects of defined credit concentrations. The methodology has continued to evolve as our company has grown and our loan portfolio has grown and become more diverse.

The provision for loan losses was $486,257 and $1,660,783 for the years ending December 31, 2012 and 2011, respectively, a decline of $1,174,526, or 70.72%. The allowance for loan losses was $2,602,098 at December 31, 2012 which equated to 1.93% of loans, net of unearned deferred fees and costs. At December 31, 2011, the allowance was $3,272,945, or 2.29% of loans, net of unearned deferred fees and costs. Net charge-offs of $1,157,104 and $1,972,018 for the years ending December 31, 2012 and 2011, respectively equated to .84% and 1.29%, respectively, of average loans outstanding net of unearned income and deferred fees. The amount of charge-offs can fluctuate substantially based on the financial condition of the borrowers, business conditions in the borrower’s market, collateral values and other factors which are not capable of precise projection at any point in time. Nonaccrual loans were $1.5 million and $7.1 million at December 31, 2012 and 2011, respectively, a positive impact of $5.6 million. These loans were 1.13% and 4.93% of loans, net of unearned deferred fees and costs at December 31, 2012 and 2011, respectively. In addition, troubled debt restructurings, not included in nonaccrual loans, were $1,305,180 and $1,685,658 at December 31, 2012 and 2011, respectively. Specific reserves allocated to the nonaccrual loans and troubled debt restructurings at year end 2012 and 2011 were $292,003 and $818,572, respectively, a decline of $526,569. Our criticized and classified loans, not included in the individually evaluated, decreased in the year-to-year comparison approximately $1.2 million which caused a decline in the year-to-year comparison of the allowance by approximately $195,000. The remainder of the loans, collectively evaluated, declined in volume $1.6 million; however, once the qualitative factors were adjusted, the allowance allocated to this group increased approximately $6,000. The change in the unallocated amount increased about $45,000 in the year to year comparison.

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Following is a breakdown of our nonperforming loans by balance sheet type which includes nonaccrual loans, loans past due 90 days and still accruing, and troubled debt restructurings.

	December 31, 2012		December 31, 2011		December 31, 2010		December 31, 2009		December 31, 2008
Commercial	$	212,738	$	136,680	$	354,125	$	167,267	$	—
Real Estate:
Construction and land development		1,100,585		1,624,238		3,835,729		1,863,772		4,205,875
Residential 1-4 families:
First liens		938,555		4,852,061		4,055,568		1,615,027		457,247
Junior Liens		225,669		424,795		196,970		302,781		—
Home equity lines		—		131,439		147,978		—		—
Commercial real estate		346,807		1,533,473		530,432		494,249		—
Consumer		—		50,694		18,312		—		19,277
Total Nonperforming Loans	$	2,824,354	$	8,753,380	$	9,139,114	$	4,443,096	$	4,682,399

As can be seen by the chart above, the construction and land development segment had the largest nonperforming loans at December 31, 2012 followed by the residential 1-4 family first lien loan segment. These two loan segments have the largest categories of nonperforming loans in the five years shown above. The remainder of the loans in these loan segments were performing credits at December 31, 2012 and December 31, 2011. Loans 90 days and more and still accruing at December 31, 2012 were $3,485. There were no loans 90 days or more past due and still accruing included in the nonperforming loans at December 31, 2011. Troubled debt restructurings included in nonperforming loans that were not on nonaccrual at December 31, 2012 and 2011 were $1,305,180 and $1,685,658, respectively. Many of the asset quality issues are the result of our borrowers having to sell various real estate properties to repay the loan. In order to sell the properties and repay the loan, there must be buyers in the marketplace to acquire the properties. Our market, mainly real estate, continues to produce few buyers. In addition, borrowers’ incomes have been reduced which increases the debt to income ratio. Please refer to Item 8, Financial Statements, Note 4, for further disclosures of past due loans, nonaccrual loans, troubled debt restructurings, impaired loans, and the allowance.

The overall economy in Franklin County has shown little improvement over the last year. We continue to struggle with high unemployment, a continued slowing of building activity, and a slowing of transportation and warehousing. Unemployment was at 5.6% at December 31, 2012. Absorption analysis in our market place shows increased turnover rates for various inventories. With the sale of our other real estate properties, we have seen the decline in real estate values. Smith Mountain Lake is a core area for development in Franklin County and is largely real estate based. It is a resort area and largely follows the national trend rather than the local trend. Until unemployment declines and consumer confidence increases, these trends may continue. There is continued economic pressure on consumers and business enterprises. No assurance can be given that continuing adverse economic conditions or other circumstances will not result in increased provisions in the future. Our level of nonperforming loans improved greatly since last year-end; however, we remain cautious and prudent with our allowance. Economists believe that small businesses will continue to be challenged during 2013. As a community bank, small businesses are core for our loan portfolio.

The following table shows MainStreet’s average loan balance for each period, changes in the allowance for loan losses by loan category, and additions to the allowance which have been charged to operating expense.

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	December 31, 2012			December 31, 2011			December 31, 2010			December 31, 2009			December 31, 2008
Average amount of loans, net of unearned, outstanding during the year	$	138,184,714		$	153,201,363		$	162,931,745		$	182,502,689		$	185,844,676
Balance of allowance for loan losses at beginning of year		3,272,945			3,584,180			3,277,559			3,502,029			2,086,592
Loans charged off:
Commercial		(186	)		(482,651	)		(142,335	)		(488,436	)		(140,003	)
Construction and land development		(257,796	)		(922,440	)		(597,206	)		(585,219	)		(102,637	)
Residential 1-4 families		(1,055,384	)		(476,172	)		(377,957	)		(704,347	)		(190,662	)
Home equity lines		—			(34,745	)		(21,766	)		—			(81,097	)
Commercial real estate		—			(205,824	)		—			(325,646	)		(3,397	)
Consumer		(16,785	)		(21,670	)		(15,971	)		(30,318	)		(36,688	)
Total loans charged off:		(1,330,151	)		(2,143,502	)		(1,155,235	)		(2,133,966	)		(554,484	)
Recoveries of loans previously charged off:
Commercial		1,842			32,312			1,740			128,901			1,740
Construction and land development		8,377			62,883			117,595			11,571			3,731
Residential 1-4 families		145,830			63,987			46,247			41			150
Home equity lines		3,374			—			—			—			—
Commercial real estate		—			—			—			—			—
Consumer		13,624			12,302			4,174			2,683			—
Total recoveries:		173,047			171,484			169,756			143,196			5,621
Net loans charged off:		(1,157,104	)		(1,972,018	)		(985,479	)		(1,990,770	)		(548,863	)
Additions to the allowance for loan losses		486,257			1,660,783			1,292,100			1,766,300			1,964,300
Balance of allowance for loan losses at end of year	$	2,602,098		$	3,272,945		$	3,584,180		$	3,277,559		$	3,502,029
Ratio of net charge offs during the period to average loans outstanding during period		.84	%		1.29	%		.60	%		1.09	%		.30	%

The amount of the loan loss reserve by category and the percentage of each category to total loans is as follows:

	December 2012				December 2011				December 2010				December 2009				December 2008
Commercial	$	108,336	7.77	%	$	154,991	7.73	%	$	138,449	6.85	%	$	236,610	7.11	%	$	274,588	9.43	%
Real Estate:
Construction & land development		767,018	15.82			902,644	18.24			1,086,183	19.78			1,053,136	20.78			1,606,333	26.47
Residential real 1-4 families
1st liens		701,668	26.40			1,100,139	26.36			1,065,683	24.89			817,387	22.77			594,858	17.65
Jr liens		134,847	5.68			174,809	5.93			243,526	6.01			184,617	5.39			149,817	4.95
Home equity lines		88,411	4.54			98,582	5.34			217,063	6.71			349,041	8.96			223,972	8.28
Commercial real estate		740,073	38.58			824,759	35.12			793,308	34.30			613,786	33.21			634,581	31.62
Consumer		11,745	1.21			11,911	1.28			39,968	1.46			22,982	1.78			17,880	1.60
Unallocated		50,000	—			5,110	—			—	—			—	—			—	—
Total	$	2,602,098	100.00	%	$	3,272,945	100.00	%	$	3,584,180	100.00	%	$	3,277,559	100.00	%	$	3,502,029	100.00	%

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Noninterest Income

Noninterest income for the years ending December 31, 2012 and December 31, 2011 was $3,480,767 and $1,090,357, respectively, an increase of $2,390,410 or 219.23%. The following chart demonstrates the categories of change:

Noninterest Income	YTD 12/31/12		YTD 12/31/11		Dollar Change			Percentage Change
Service charges on deposit accounts	$	261,487	$	288,724	$	(27,237	)		(9.43	)%
Mortgage commission		239,565		171,727		67,838			39.50
Electronic card fees		179,443		160,429		19,014			11.85
Investment fee income		185,780		140,758		45,022			31.99
Income on bank owned life insurance		2,494,285		110,106		2,384,179			2,165.35
Gain on sale of securities available for sale		1,848		116,734		(114,886	)		(98.42	)
Other fee income & miscellaneous		118,359		101,879		16,480			16.18

As can be seen by the above chart, the largest increase in noninterest income was in our income received from our bank owned life insurance. Franklin Bank has bank owned life insurance on the lives of its two executives. As reported, CEO Larry Heaton was tragically killed in a car accident in December 2012. Franklin Bank recorded approximately $2.4 million in income from the death benefit of the bank owned life insurance. Mortgage commission increased $67,838, or 39.50% in 2012 over the 2011 income. Franklin Bank partners with several organizations in which we originate residential mortgage loans that are sold to other companies. Franklin Bank receives the mortgage commission income on the sales. Our partners provide the underwriting of the loans. Franklin Bank has an investment advisor which partners with Infinex Financial Group to advise and manage investment portfolios for our clients. Franklin Bank receives fee income from this partnership based upon volume. Fee income received on investment income in 2012 was $185,780 as compared to $140,758 in 2011, an increase of $45,022 or 31.99%. Electronic card fees also experienced an increase in the year to year comparison at $19,014. Other fee income and miscellaneous income increased $16,480. Securities gains in 2012 were $1,848 compared to $116,734 in 2011. Service charges on deposit accounts decreased $27,237, or 9.43%, primarily due to a decline in overall NSF fee income. Customers are more aware of these charges in this difficult economic time and monitor their accounts more closely to protect against these fees.

Noninterest Expense

Total noninterest expense for the years ending December 31, 2012 and December 31, 2011 was $7,898,161 and $6,618,319, respectively, an increase of $1,279,842, or 19.34%. Nonrecurring other real estate and repossession expenses were $1,429,254 and $1,224,894 for the twelve months ending December 31, 2012 and 2011, respectively. Excluding these expenses, total noninterest expense would have been $6,468,907 and $5,393,425, respectively, for 2012 and 2011, an increase of $1,075,482. This increase is primarily due to the increase in the Supplemental Executive Retirement Plan (“SERP”) expense which increased $975,580. Our President and CEO, Larry Heaton, was tragically killed in a car accident in December 2012. This caused the expediting of the present value of the death benefit and expense required to be recorded. The following chart shows the noninterest expense by category for the years ending December 31, 2012 and 2011, the dollar change and the percentage change.

Expense	12-31-12		12-31-11		Dollar Change			Percentage Change
Salaries and employee benefits	$	2,727,946	$	2,686,338	$	41,608			1.55	%
Supplemental executive retirement plan		1,097,227		121,647		975,580			801.98
Occupancy and equipment		791,736		850,647		(58,911	)		(6.93	)
Professional fees		262,633		245,677		16,956			6.90
Outside processing		494,235		433,004		61,231			14.14
FDIC Assessment		253,874		293,337		(39,463	)		(13.45	)
Franchise tax		199,587		167,500		32,087			19.16
Regulatory examination fees		109,559		111,332		(1,773	)		(1.59	)
Other real estate and repossessions		1,429,254		1,224,894		204,360			16.68
Other expenses		532,110		483,943		48,167			9.95

17

As can be seen by the table, the largest component of noninterest expense is salaries and employee benefits, followed by other real estate and repossessions, supplemental executive retirement plan, and then by occupancy and equipment costs. Salaries and benefit expense comprised 48.43% and 42.43% of total noninterest expense for the years ending December 31, 2012 and December 31, 2011, respectively. MainStreet’s employees continue to be its most valuable resource and asset. Salaries and employee benefits, as a whole, increased in 2012 compared to 2011 by $41,608, or 1.55%. During 2012 and 2011, salaries were frozen for all employees with the exception of certain budgeted promotions. Commissions were only paid to mortgage and investment personnel. Referral fees were also paid to employees for mortgage and investment referrals. Under FAS ASC 310 certain costs associated with originating loans are amortized over the life of the loan. These costs begin as credits to salary expense and are amortized into the net interest margin over the life of the loan as a reduction. These credits to salary expense were $10,800 less in 2012 than 2011 causing an overall increase in salary expense. This was due to decreased loan volumes. Employee insurance costs and 401-K expense decreased $9,718 and $974, respectively in the year to year comparison. This expense declined primarily due to the utilization of part-time employees as attrition occurred in certain areas.

The supplemental executive retirement plan expense was $1,097,227 and $121,647 for the years ending 2012 and 2011, an increase of $975,580. As discussed above, this was due to the acceleration of the recording of the retirement funds due to the tragic death of our President and CEO, Larry A. Heaton.

Other real estate and repossessions experienced an increase in expense of $204,360 in 2012 over 2011 levels which equates to an increase of 16.68%. This increase was due to our continued efforts to reduce our criticized assets and aggressively sell our other real estate properties. This expense includes loss on sales, write-downs due to updated appraisals reflecting depressed values, write-downs due to length of time in other real estate, and expenses associated with these properties. Expenses on these properties are influenced by the volume of these properties and the duration of time properties remain on our balance sheet.

Occupancy and equipment costs include rent, utilities, janitorial service, repairs and maintenance, real estate taxes, equipment rent, service maintenance contracts and depreciation expense. This expense decreased $58,911 or 6.93% for the year 2012 as compared to 2011 primarily due to a decline in depreciation expense and service maintenance costs.

Professional fees include fees for audit, legal, and other and experienced an increase of $16,956 or 6.90%. Of this amount, legal fees increased $10,673 primarily due to fees associated with work outs of our criticized assets. Audit expense increased $9,015 due to increased fees from our external and internal auditors. These fees were offset due to a modest decline in other professional fees. Our outside processing expenses increased $61,231, or 14.14%, with the major increase in data processing fees which increased $37,116. In this category, bank insurance increased $23,045 due to an increase in our bond and directors and officers insurance and the addition of other real estate properties to our insurance. Our FDIC premium expense decreased $39,463, or 13.45% for the year over year expense comparison due to a change in the calculation of the premium. However, the overall premium is still burdensome. The turmoil in the financial services industry has resulted in the need to increase FDIC insurance premiums to sustain the insurance fund depending on the length and depth of the effects of the recent recession. These assessments may increase again in the future, which could place a great burden on our financial institution. Franchise tax expense increased $32,087 due to a decreased deduction associated with our other real estate properties at year end 2012 over 2011, and an increase in our net income for 2012. Regulatory fees from examinations had a modest decline of $1,773 in the year-to-year comparison; however, these expenses remain elevated due to additional monitoring of Franklin Bank because of the formal agreement with the OCC. The other expenses category includes supplies, advertising and promotion, shareholder communications, telephone, postage, director fees, travel expense, meals and entertainment, subscriptions and dues, seminars and education, and contributions. This category increased $48,167, or 9.95%, in the year over year comparison.

Income Taxes

MainStreet is subject to both federal and state income taxes. Franklin Bank is not subject to state income taxes. A bank in Virginia is required to pay a franchise tax that is based on the capital of the entity. The liability (or balance sheet) approach is used in financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed quarterly for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. No valuation allowances were deemed necessary at December 31, 2012 and December 31, 2011. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. MainStreet recorded income tax benefit in the amounts of $304,946 and $140,355 for the years ending December 31, 2012 and 2011, respectively.

18

BALANCE SHEET

Investment Portfolio

MainStreet’s investment portfolio is used for the following purposes: 

1) To maintain sufficient liquidity to cover deposit fluctuations and loan demand.

2) To fulfill pledging collateral requirements.

3) To help balance the overall interest rate risk position of the balance sheet.

4) To make a reasonable return on investments.

Funds not utilized for capital expenditures or lending are invested in overnight federal funds, securities of the U.S. Government and its agencies, mortgage-backed securities, municipal bonds, and certain other debt and equity securities. Currently, the Corporation has invested in U.S. agencies, mortgage backed securities, municipal bonds, Federal Reserve Bank stock and Federal Home Loan Bank stock. MainStreet’s policy is not to invest in derivatives or other high-risk instruments at this time. The entire securities portfolio was categorized as available-for-sale at December 31, 2012 and December 31, 2011 and is carried at estimated fair value. Unrealized market valuation gains and losses, net of deferred taxes, on securities classified as available-for-sale are recorded as a separate component of shareholders’ equity. The amortized cost and approximate market values and gross unrealized gains and losses of securities available for sale for years ending December 31, 2012 and 2011 appear in Part II, Item 8, Note 2 of this report. The amortized cost and approximate market values and gross unrealized gains and losses of securities available for sale for the year ending December 31, 2010 is shown in the table below:

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	2010
	Amortized		Gross Unrealized		Gross Unrealized			Approximate
	Cost		Gains		Losses			Market Value
U.S. government sponsored agencies	$	3,375,529	$	33,938	$	(43,260	)	$	3,366,207
Mortgage backed securities		23,592,541		287,034		(191,255	)		23,688,320
Total securities available-for-sale	$	26,968,070	$	320,972	$	(234,515	)	$	27,054,527

Proceeds from the sale of these securities are included in the cash flow statement. Gross gains and losses along with pledged information appear in Part II, Item 8, Note 2 of this report. The following table shows the maturities of securities available-for-sale as of December 31, 2012 and the weighted average yields of such securities. The weighted average yields are calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. The maturities of the mortgage backed securities are based on stated final maturity. Cash flows from prepayments can cause actual maturities to differ significantly.

	Due in One					Due After					Due After					Due After
	Year or Less					1 – 5 Years					5 – 10 Years					10 Years
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Total
U. S. government sponsored agencies	$	—		—	%	$	—		—	%	$	1,471,773		1.54	%	$	—		—	%	$	1,471,773
Mortgage backed securities		—		—			—		—			905,245		2.88			11,732,292		3.01			12,637,537
States and political subdivisions		—		—			—		—			4,727,251		2.15			—		—			4,727,251
Total	$	—				$	—				$	7,104,269				$	11,732,292				$	18,836,561

Loan Portfolio

MainStreet has established a credit policy detailing the credit process and collateral in loan originations. Loans to purchase real estate and personal property are generally collateralized by the related property with loan amounts established based on certain percentage limitations of the property’s total stated or appraised value. Credit approval is primarily a function of the credit worthiness of the individual borrower or project based on pertinent financial information, the amount to be financed, and collateral. At December 31, 2012, 2011, 2010, 2009 and 2008 the breakdown of gross loans in the loan portfolio was as follows:

20

	2012					2011					2010					2009					2008
Commercial	$	10,439,173		7.77	%	$	11,061,471		7.73	%	$	10,874,581		6.85	%	$	11,882,830		7.11	%	$	18,251,922		9.43	%
Real Estate:
Construction & land development		21,268,316		15.82			26,102,914		18.24			31,397,922		19.78			34,744,468		20.78			51,200,170		26.47
Residential 1-4 families
1st liens		35,490,285		26.41			37,735,618		26.36			39,509,829		24.89			38,082,662		22.77			34,128,944		17.65
Junior liens		7,633,851		5.68			8,486,594		5.93			9,537,112		6.01			9,011,349		5.39			9,579,042		4.95
Home equity lines		6,093,783		4.53			7,639,785		5.34			10,650,365		6.71			14,974,066		8.96			16,012,671		8.28
Commercial real estate		51,861,252		38.58			50,272,002		35.12			54,455,674		34.30			55,537,593		33.21			61,174,895		31.62
Loans to individuals		1,627,706		1.21			1,836,110		1.28			2,320,162		1.46			2,978,950		1.78			3,087,053		1.60
Gross Loans		134,414,366		100.00	%		143,134,494		100.00	%		158,745,645		100.00	%		167,211,918		100.00	%		193,434,697		100.00	%
Unearned income & deferred fees		78,300					89,510					79,176					105,524					72,853
Loans, net of unearned income & deferred fees		134,492,666					143,224,004					158,824,821					167,317,442					193,507,550
Less: Allowance for loan losses		(2,602,098	)				(3,272,945	)				(3,584,180	)				(3,277,559	)				(3,502,029	)
Loans, net	$	131,890,568				$	139,951,059				$	155,240,641				$	164,039,883				$	190,005,521

As can be seen by the loan portfolio volume, our loan volume has been on a decline over the last five years. Loans, net of unearned income and deferred fees, decreased $8.7 million, or 6.1%, at December 31, 2012 compared to December 31, 2011. The real estate market continues to be soft and the credit markets have tightened substantially. In addition, we have been aggressively working through our troubled assets which has resulted in charge-offs and foreclosures, thus lowering outstanding loans. These and other factors have resulted in diminished economic activity and lower loan demand particularly in real estate related loans. Moreover, Franklin Bank’s current concentration in real estate related loans reduces the Bank’s participation in these loan markets. Our loan to deposit ratio for 2012 and 2011 was 89.32% and 85.72%, respectively. In prior years, we maintained a larger loan to deposit ratio and leverage of the balance sheet. We deemed it prudent to decrease the ratio by reducing the loan portfolio thereby increasing liquidity and preserving the institution’s history of safety and soundness during these difficult economic times. As can be seen by the chart above, loans secured by real estate represent 91.02% and 90.99% of gross loans at December 31, 2012 and December 31, 2011, respectively. Franklin Bank’s loan portfolio has a large composition of real estate related loans primarily due to the markets we serve. Accordingly, the Bank took steps to reduce certain concentrations including participating loans. The loan committee of the board of directors reviews all new loans and renewals of loans within our target concentrations for approval.

MainStreet’s loan portfolio is its primary source of profitability; therefore, our underwriting approach is critical and is designed throughout our policies to have an acceptable level of risk. Cash flow adequacy has always been a necessary condition of creditworthiness. If the debt cannot be serviced by the borrower’s cash flow, there must be an additional secondary source of repayment. As we have discussed, many of our loans are real estate based so they are also secured by the underlying collateral. We strive to build relationships with our borrowers, so it is very important to continually understand and assess our borrowers’ financial strength and condition.

The credit policy requires that new loans originated must have a maximum loan-to-value of 80% while certain loans have lower limits as follows: raw land (65%); improved land (75%); non-obsolete inventory (60% of value); used automobiles (75% of purchase price; and stock (75%). We do not require mortgage insurance; however, loans exceeding supervisory loan to value limits are one of our qualitative factors in the analysis of the allowance for loan loss methodology.

Our credit policy requires updated appraisals to be obtained on existing loans where collateral value is critical to the repayment of the loan and market value may have declined by 15% or more. In regard to development projects our policy requires a new appraisal when the project sale out rate is less than 25% of the original assumptions documented by the existing appraisal in the file. Development loans must be reviewed at least annually or sooner in a declining real estate cycle. Once an appraisal exceeds 18 months, it must be updated and reviewed before additional funding may occur. An appraisal in file may not be used for additional funding under any circumstances after 36 months. Loan account officers prepare criticized loan workout sheets for the Problem Loan Committee on all loans risk rated special mention or lower and any loan delinquent 60 days or more. Account officers who indicate a loan is impaired are required to determine collateral value by one of three recognized methods which are 1) fair value of collateral; 2) present value of expected cash flows; or 3) observable market value. The difference in the collateral value, less estimated selling expense, compared to the recorded loan balance is allocated as a specific reserve in the loan loss analysis. Any collateral declines dropping loans below supervisory loan to value limits are included in the qualitative factors based on loan pools in the loan loss analysis.

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We continue to review and enhance our credit policies. We monitor our concentration limits and have targets that reflect the current environment. Our concentrations levels are within the established limits. All new credits that are deemed to be in concentration buckets are reviewed by loan committee. We have floors in our home equity lines and certain commercial loan products. Our maximum debt to income ratio is 40% for all retail loans. Construction loans and bridge loans can be underwritten within retail products with the use of interest only payments. Also, we have the interest only feature available to unsecured retail lines with a one-year term which are underwritten on strict guidelines on retail products. New loans originated must have a maximum loan-to-value of 80%; certain loans have lower limits as follows: raw land (65%); improved land (75%); non-obsolete inventory (60% of value); used automobiles (75% of purchase price); and stock (75%). We have an outside service to perform environmental risk assessments prior to funding. Our home equity line products previously had a maturity of 20 years with a three or five year review feature. The loan policy was modified for these loans to mature in five years and be renewed only upon proper underwriting.

In addition, we have an experienced in-house credit analyst and purchased software to assist lenders with cash flow and certain ratio analysis. We also have software to assist with the credit ratings of loans upon origination, renewal, and the receipt of new financials.

Please refer to Item 8, Financial Statements, Notes #3 and #4 for further discussion of underwriting and risk ratings of loans.

MainStreet’s variable rate loans comprise approximately 24% of our loan portfolio. Variable commercial loans are underwritten to the current fully indexed rate at origination with cash flow analysis in underwriting at fully drawn lines. In most cases account officers stress borrowers at 2% over the fully indexed rate. Home equity lines are underwritten and qualified at 1.5% of the full equity line commitment.

For the most part, MainStreet’s business activity is with customers located in its primary market area. Accordingly, operating results are closely correlated with the economic trends within the region and influenced by the significant industries in the region including pre-built housing, real estate development, agriculture, and resort and leisure services.

Please refer to Item 8, Note 18, Concentrations of Credit Risk, for a detailed discussion of our concentrations of credit.

The following table shows the amount of commercial loans outstanding at December 31, 2012 and their maturity distribution.

			After One
	Within		But Within		After
	One Year		Five Years		Five Years		Total
Commercial	$	4,114,412	$	4,821,066	$	1,503,695	$	10,439,173
Interest rates are floating or adjustable		2,124,976		1,584,471		—		3,709,447
Interest rates are fixed or predetermined		1,989,436		3,236,595		1,503,695		6,729,726

The following table shows the amount of real estate construction loans outstanding at December 31, 2012 and their maturity distribution.

			After One
	Within		But Within		After
	One Year		Five Years		Five Years		Total
Real estate construction	$	8,211,244	$	9,441,651	$	3,615,421	$	21,268,316
Interest rates are floating or adjustable		945,467		2,069,956		—		3,015,423
Interest rates are fixed or predetermined		7,265,777		7,371,695		3,615,421		18,252,893

Nonaccrual loans, loans past due 90 days or more, and troubled debt restructurings are considered by MainStreet to be nonperforming loans. MainStreet’s policy is to discontinue the accrual of interest on loans once they become 90 days past due and are not well-collateralized, or earlier when it becomes doubtful that the full principal and interest will be collected. Once a loan is placed on nonaccrual status, any interest that is collected will generally be recorded on a cash basis until the loan is satisfied in full or circumstances have changed to such an extent that the collection of both principal and interest is probable.

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To ensure timely identification of nonaccrual loans, loan account officers review monthly their individual portfolios along with past due reports to determine the proper accrual status. Account officers also prepare quarterly criticized loan workout sheets for all loans risk rated special mention or lower and all loans 60-days or more delinquent to the Franklin Bank’s Problem Loan Committee made up of senior management. The accrual status of these loans is reviewed and approved by the Problem Loan Committee. Account officers must attest to the accrual status and risk rating of all loans in their portfolio on a monthly basis. Attestations are presented to and reviewed by the Problem Loan Committee. The Committee meets monthly to review updates on these loans along with the attestation sheets completed by the account officers. The criticized loan worksheets have been expanded to include a summary of the most recent financial analysis; most recent collateral valuation factoring possible liquidation and timing discount; and enhanced action plans with target dates. Primary and secondary repayment sources are detailed. An officer has been assigned to manage our problem assets as a full-time position. A credit analyst performs required financial analysis on all loans $100,000 and over at origination or renewal and at the receipt of new financial statements. In addition, new software was purchased to assist with this process. Software has been purchased to assist the credit analyst and lender in the risk rating of each loan. We have an internal loan review function that has an annual loan review plan approved by the loan committee and the President. Enhanced reporting includes the overall quality of the loan portfolio; the identification, type, rating, and amount of problem loans; the identification and amount of delinquent loans; credit and collateral documentation exceptions; the identification and status of credit-related violations of law; the loan officer who originated each loan reported; concentrations of credit; and loans to executive officers and directors.

In summary, we have enhanced our processes, personnel and software to address nonaccrual and criticized loans. Also, more detailed and frequent reporting regarding asset quality helps insure more timely and greater oversight of asset quality. We believe these enhancements are assisting us in working through the asset quality issues resulting from the severe recession.

Net charge offs of $1,157,104 and $1,972,018 for 2012 and 2011, respectively, equated to .84% and 1.29%, respectively, of average loans outstanding, net of unearned deferred fees and costs. Gross charge offs were $1,330,151 for 2012 which was $843,894 more than the provision expense for 2012. This was due to a specific reserve of $818,572 at year end 2011. The loan loss reserve at December 31, 2012 and 2011 represented 1.93% and 2.29%, respectively, of loans, net of unearned deferred fees and costs. Refer to the provision for loan losses section of this discussion and analysis for a breakdown by loan type of nonperforming loans at December 31, 2012 and 2011, respectively. Following is a breakdown of our nonperforming assets.

	For the Periods Ended
	December 31, 2012		December 31, 2011
Nonaccrual loans and leases	$	1,515,689	$	7,067,722
Loans 90 days or more past due and still accruing		3,485		—
Troubled debt restructurings (not on nonaccrual)		1,305,180		1,685,658
Total nonperforming loans		2,824,354		8,753,380
Foreclosed real estate		1,441,722		3,572,518
Other foreclosed property		111,149		103,649
Total foreclosed property		1,552,871		3,676,167
Total nonperforming assets	$	4,377,225	$	12,429,547

At December 31, 2010, 2009, and 2008, nonaccrual loans were $7,702,343, $3,890,152, and $4,217,698, respectively. Lost interest related to impaired loans as of December 31, 2012, 2011, 2010, 2009, and 2008 was $221,579, $521,729, $282,181, $334,620, and $113,626, respectively. Interest income reflected in the 2012, 2011, 2010, 2009, and 2008 income statements related to impaired loans was $73,697, $272,445, $240,882, $203,755, and $207,346, respectively. Loans that were past due more than 90 days and still accruing at December 31, 2010, 2009, and 2008 were $1,062,174, $552,944, and $464,701, respectively. Nonaccrual loans, troubled debt restructurings and loans 90 days or more past due are considered to be our impaired loans. A specific reserve allowance was maintained against these loans at December 31, 2012 and 2011 in the amount of $292,003 and $818,572, respectively. Overall, Franklin Bank continues to work with troubled borrowers when appropriate and to move quickly to identify and resolve any problem loans. Please refer to Item 8, Financial Statements, Note #4 for further discussions and break downs of our past due loans, nonaccrual loans, and troubled debt restructurings.

At December 31, 2012, 2011, and 2010, MainStreet had $1,441,722, $3,572,518, and $4,152,667, respectively, in other real estate, which is property acquired through foreclosure. Other real estate is carried at the lower of cost or fair market value, less selling costs, based on appraised value. Because of the regulatory environment, we worked aggressively in 2012 to sell our other real estate properties. We also have $1.2 million of our other real estate at year-end under contract. Other foreclosed assets were $111,149 and $103,649 at December 31, 2012 and 2011, respectively. There were no other foreclosed assets at December 31, 2010.

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Deposits

Deposits are the largest source of funds used to support the liquidity of MainStreet and to fund our loan portfolio. The ratio of loans, net of unearned deferred costs and fees, to deposits was 89.32% and 85.72% as of December 31, 2012 and 2011, respectively. The ratio of total time deposits, including $100,000 and over, to total deposits declined to 55.97% at year end 2012, from 59.78% at December 31, 2011. Total deposits at December 31, 2012 and 2011 were $150,579,368 and $167,082,842, respectively, a decrease of $16,503,474, or 9.88%. The deposit mix was as follows:

	2012				2011
Demand deposits	$	22,819,544	15.15	%	$	20,975,660	12.56	%
Interest checking deposits		8,882,374	5.90			7,472,911	4.47
Money market deposits		19,929,905	13.24			24,651,034	14.75
Savings deposits		14,672,674	9.74			14,093,416	8.44
Time deposits $100,000 and over		36,757,507	24.41			42,776,337	25.60
Other time deposits		47,517,364	31.56			57,113,484	34.18
Total	$	150,579,368	100.00	%	$	167,082,842	100.00	%

The chart reflects that the largest component of deposits continues to be in time deposits including $100,000 and over; however these categories have declined as a whole. As a percentage of total deposits, the mix has changed somewhat over the past year. Demand deposits rose $1.8 million, or 8.79%, in 2012 compared to the prior year volume. Demand deposits are essentially considered low cost funds. As a percentage of total deposits, demand deposits also increased. This certainly had a positive impact on our overall cost of funds. Interest checking and savings deposits have all increased in dollars in comparison to the prior year and as a percentage of total deposits. As discussed above, total deposits declined $16.5 million in comparison to the prior year of which time deposits including $100,000 and over experienced a $15.6 million decline. Our strategy for deposits in 2012 continued to be to lower our deposit costs while maintaining ample liquidity to fill our needs and for contingency planning. The levels and mix of deposits are influenced by such factors as customer service, interest rates paid, service charges, and the convenience of banking locations. Competition for deposits is great in our market. This affects the availability and ultimately the pricing of deposits. Management attempts to identify and implement the pricing and marketing strategies that will help control the overall cost of deposits and to maintain a stable deposit mix. Our goal has been to strive to gather the whole relationship and not just certificates of deposit. We have been successful in lowering our deposit costs and maintaining liquidity. Loan demand has been soft, therefore, paralleling our strategy. The overall rate on interest bearing deposits was 1.02% and 1.32% for 2012 and 2011, respectively, a decline of 30 basis points. Our strategic plan in 2013 also includes continued lowering of our deposit costs to benefit net income. Franklin Bank attracted brokered deposits for the first time during 2009. These deposits were $5.3 million and $6.9 million, respectively, at December 31, 2012 and 2011 and included deposits through the CDARS program. The average amount and rate of deposits can be found in the Net Interest Income section of this Management’s Discussion and Analysis in the Distribution of Assets, Liabilities, and Shareholders’ Equity: Interest Rate and Interest Differentials table. The maturities of time deposits $100,000 and over and other time deposits are shown in Part II, Item 8, Footnote #7. Demand deposits were 15.15% and 12.56% of total deposits at year end 2012 and 2011, respectively. A further increase in demand deposits would improve the net interest margin and the total rate paid on interest bearing deposits. Increasing demand deposits is a continued focus in 2013.

Borrowings

MainStreet has several sources for borrowings generally to assist with liquidity. At December 31, 2012, MainStreet had no balances outstanding with Federal Home Loan Bank of Atlanta (“FHLB”), overnight federal funds purchased, or corporate cash management accounts. The FHLB holds a blanket lien on loans secured by commercial real estate and loans secured by 1-4 family first liens, second liens, and equity lines, which provide a source of liquidity to the Corporation. Loans included in these portfolios at December 31, 2012 and 2011 were $100,810,587 and $103,468,835, respectively.

The Corporation has an internal Corporate Cash Management account for customers into which excess demand deposit accounts are swept on an overnight basis in order to earn interest. This account is not FDIC insured but the Corporation is required to pledge agency funds at 100% towards these balances. There were no balances in these sweep accounts at December 31, 2012 and December 31, 2011.

The Corporation entered into a repurchase agreement with Citigroup Global Markets, Inc. (“CGMI”) in the amount of $7,500,000 on September 18, 2007. The repurchase date was September 18, 2012. The interest rate was fixed at 4.22% until maturity or until it was called. Beginning September 18, 2008, the repurchase agreement became callable by CBMI and could have been called quarterly with two business days prior notice. Interest was payable quarterly. The repurchase agreement was collateralized by federal agency and agency mortgage backed securities.

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The Corporation entered into a repurchase agreement with Barclays Capital on January 2, 2008 in the amount of $6,000,000. The repurchase date is January 2, 2013. The interest rate was fixed at 3.57% until maturity or until it is called. Beginning January 2, 2009 the repurchase agreement became callable and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by federal agency and agency mortgage backed securities. The interest rate remained at 3.57% at December 31, 2012.

The following table presents information on each category of MainStreet’s borrowings.

	December 31, 2012			December 31, 2011			December 31, 2010
Short-term Federal Home Loan Bank advances
Amount outstanding at period end	$	—		$	—		$	—
Weighted average interest rate at period end		—	%		—	%		—	%
Maximum amount outstanding at any month-end during the period	$	—		$	—		$	—
Average amount outstanding during the period	$	55		$	712		$	5,479
Weighted average interest rate during period		.00	%		.42	%		.49	%
Federal funds purchased
Amount outstanding at period end	$	—		$	—		$	—
Weighted average interest rate at period end		—	%		—	%		—	%
Maximum amount outstanding at any month-end during the period	$	—		$	—		$	—
Average amount outstanding during the period	$	164		$	603		$	5,781
Weighted average interest rate during period		1.22	%		.33	%		.71	%
Repurchase agreements
Amount outstanding at period end	$	6,000,000		$	13,500,000		$	13,500,000
Weighted average interest rate at period end		3.57	%		3.93	%		3.93	%
Maximum amount outstanding at any month-end during the period	$	13,500,000		$	13,500,000		$	13,500,000
Average amount outstanding during the period	$	11,348,361		$	13,500,000		$	13,500,000
Weighted average interest rate during the period		3.94	%		3.99	%		3.99	%
Corporate Cash Management
Amount outstanding at period end	$	—		$	—		$	—
Weighted average interest rate at period end		—	%		—	%		—	%
Maximum amount outstanding at any month-end during the period	$	—		$	—		$	—
Average amount outstanding during the period	$	—		$	—		$	—
Weighted average interest rate during the period		—	%		—	%		—	%

Shareholders’ Equity

Total shareholders’ equity was $24,250,373, $22,240,789, and $22,089,467 at December 31, 2012, 2011 and 2010, respectively. Average shareholders’ equity to average assets was 11.78%, 10.67%, and 9.99% for 2012, 2011, and 2010, respectively. Book value per share was $14.15, $12.98, and $12.89 at December 31, 2012, 2011, and 2010, respectively.

In September 2007, the Board of Directors approved a plan to repurchase up to 100,000 shares of the Company’s common stock. By year end 2008, a total of 78,800 shares had been repurchased with total costs of $1,176,170. Of this 26,000 shares were repurchased in 2008 for a total cost of $383,330. The plan has been terminated. In addition, the Corporation is prohibited from repurchasing any of its own stock by the terms of the MOU with the Federal Reserve Bank of Richmond.

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Also, in September 2007, MainStreet’s Board of Directors approved a cash dividend of $.05 per share which was MainStreet’s first cash dividend paid. Since that date, MainStreet paid a quarterly dividend until the fourth quarter of 2008. The dividend payout ratio for 2008 was 43.99%. Under the MOU with the Federal Reserve Bank of Richmond, MainStreet is restricted from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank of Richmond. Also, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve Bank of Richmond.

The maintenance of appropriate levels of capital is a priority and is continually monitored. MainStreet and Franklin Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Quantitative measures established by regulations to ensure capital adequacy require MainStreet and Franklin Bank to maintain certain capital ratios. Failure to meet capital ratios can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. Also, declining capital can impact the ability of the bank to grow other assets. The required level of capital can also be affected by earnings, asset quality and other issues. Franklin Bank was required under the Agreement with the OCC to implement a three-year capital program which, among other things, requires Franklin Bank to plan for adequate capital to meet its current and future needs. While MainStreet and Franklin Bank were considered well-capitalized under established regulatory classifications at December 31, 2012 and 2011 in the current economic circumstances, capital resources continue to be a focus for the Corporation. Tier I capital to average assets, Tier I risk based and Tier II risk based for the Corporation were 13.02%, 18.15%, and 19.41%, respectively. See Note 15 to the financial statements for capital ratios. Should it be necessary or appropriate to obtain additional capital, then current shareholders could suffer dilution.

Liquidity and Asset Liability Management

Asset liability management functions to maximize profitability within established guidelines for liquidity, capital adequacy, and interest rate risk. It also helps to ensure that there is adequate liquidity to meet loan demand or deposit outflows and interest rate fluctuations. Liquidity is the ability to meet maturing obligations and commitments, withstand deposit fluctuations, fund operations, and provide for loan requests. MainStreet’s material off-balance sheet obligations are loan commitments that were $15,726,309 and $18,556,714, respectively at December 31, 2012 and 2011. MainStreet has a liquidity contingency plan that gives guidance on the maintenance of appropriate liquidity and what action is required under various liquidity scenarios. MainStreet’s liquidity is provided by cash and due from banks, interest-bearing deposits, overnight federal funds sold, securities available-for-sale, and loan repayments. MainStreet also has overnight borrowing lines available with their correspondent banks, the ability to borrow from the Federal Reserve Bank’s discount window, and the ability to borrow long-term and short-term from the Federal Home Loan Bank (“FHLB”). At December 31, 2012 and December 31, 2011, we had available credit from borrowings in the amount of $47,521,700 and $45,091,542, respectively. MainStreet’s ratio of liquid assets to total liabilities at December 31, 2012, December 31, 2011 and December 31, 2010 was 22.28%, 19.17%, and 14.93%, respectively. As can be seen from the ratios, liquidity has continued to be strong and has increased over the last three years due to strategies implemented. Deposits provide the basic core for our liquidity. As discussed previously, our deposits declined $16.5 million at December 31, 2012 compared to December 31, 2011. Pricing in our market continues to be competitive. As a company, one of our strategies for 2012 was to lower deposit costs. In doing this, we have lost some deposits. Loan demand in 2012 was soft which worked well with our strategy to lower deposits. We have accomplished this and have increased our liquidity percentages at the same time. We have managed these levels and continue to do so as we work towards lowering our deposits costs in 2013.

In addition to the borrowing facilities, MainStreet has continuing relationships with several entities allowing for the gathering of brokered deposits. We are also a member of the Certificate of Deposit Account Registry Service (“CDARS”). This allows us to provide our depositors with up to $50 million dollars in FDIC insurance. We receive the deposits and forward them to CDARS and we receive deposits back if wanted. The send and receive transaction is called a reciprocal transaction. We can also bid on deposits in a one-way buy transaction which would allow for new depositors. Based upon our IDC rating, we are not eligible to conduct one-way buy transactions. CDARS deposits are also considered brokered deposits. Franklin Bank has accepted brokered deposits in the amount of $5.3 million as of December 31, 2012 which was 3.5% of total deposits. We are restricted by our Agreement with the OCC to not have more than 15% brokered deposits as a percentage of total deposits. We are well within this margin. At December 31, 2012, this would allow us to gather an additional $17.4 million in brokered deposits. Franklin Bank continues to be a member of QwickRate in order to bid for internet certificates of deposit as another source of liquidity. At December 31, 2012, Franklin Bank had $5.5 million in internet certificates of deposit. We have set policy limits on the amount of internet certificates of deposit that we can gather. According to our policy, we would be able to accept an additional $21.9 million at December 31, 2012.

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Interest rate sensitivity is measured by the difference, or gap, between interest sensitive earning assets and interest sensitive interest bearing liabilities and the resultant change in net interest income due to market rate fluctuations, and the effect of interest rate movements on the market. MainStreet utilizes these techniques for management of interest rate risk in order to minimize change in net interest income with interest rate changes. MainStreet BankShares, Inc. has partnered with Compass Bank using the Sendero model to help measure interest rate risk. The asset liability management process requires a number of key assumptions. Management determines the most likely outlook for the economy and interest rates measuring the effect on net interest income in a rising and declining 100, 200, 300 and 400 basis point interest rate environment, as applicable. With the change from level shock, net interest income is modeled assuming that interest rates move the full rate change in the first month. With the change from level ramp, net interest income is modeled assuming rates move one quarter of the full rate change in each quarter. With this approach, management also reviews the economic value of equity that is the net present value of the balance sheet’s cash flows or the residual value of future cash flows ultimately due to shareholders. The following table demonstrates the percentage change in net interest income from the then current level prime rate of 3.25% at December 31, 2012 in a rising and declining 100, 200, 300 and 400, basis point interest rate environment; as applicable:

Net Interest Income Percentage Change From Level Rates
Rate Shift	Prime Rate			Change From Level Ramp			Change from Level Shock
+400 bp		7.25	%		10.00	%		17.00	%
+300 bp		6.25			7.00			13.00
+200 bp		5.25			5.00			8.00
+100 bp		4.25			2.00			4.00
-100 bp		2.25			0.00			0.00
-200 bp		1.25			-1.00			-3.00
-300 bp		0.25			-2.00			-5.00

MainStreet is sensitive to change in the interest rate environment particularly due to variable rate loans in our loan portfolio. In a rising rate environment, it is anticipated that the impact would be positive on the net interest margin. In a declining rate environment, MainStreet has exposure to the net interest margin. Management seeks to lower the impact on the net interest margin.

Contractual Obligations, Commitments, Contingent Liabilities, Off-Balance Sheet Arrangements, and Related Party Transactions

MainStreet provides certain services for its subsidiary bank and real estate company. These services include accounting, investments, treasury management, compliance, audit, deposit and loan operations, and data processing. In exchange for these services, the Bank and the real estate company pay an affiliate fee to the holding company.

The affiliate fee paid to MainStreet helps support MainStreet’s cash requirements since most of the expenses are directly related to the companies it owns. Dividends from Franklin Bank are also a source of cash for MainStreet. Under the applicable federal laws, the Comptroller of the Currency restricts the total dividend payments of any calendar year, without prior approval, to the net profits of that year as defined, combined with retained net profits for the two preceding years. In addition, as previously noted, the Agreement between Franklin Bank and the OCC prohibits the payment of dividends by Franklin Bank.

MainStreet RealEstate owns the facility in which the Southlake branch of Franklin Bank operates. The land cost was $425,286 and the cost of the building was $881,123. The construction of the facility was completed and operations began in August 2007. The corporation has only a modest amount of fixed assets.

A summary of MainStreet’s significant contractual obligations and commitments is presented in the following table, with a reference to the footnote disclosure in Item 8 detailing the dollar amount by maturity.

	Footnote Disclosure in Item 8
	Notes to Consolidated Financial Statements
Contractual Cash Obligations
Operating Leases	Footnote #13
Other Commitments
Commitments to extend credit	Footnote #17
Related Person Loans	Footnote #5
Borrowings	Footnote #8

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Impact of Inflation

Most of MainStreet’s assets are monetary in nature and therefore are sensitive to interest rate fluctuations. MainStreet does not have significant fixed assets or inventories. Fluctuations in interest rates and actions of the Board of Governors of the Federal Reserve System (“FRB”) have a great effect on MainStreet’s profitability. Management continually strives to manage the relationship between interest-sensitive assets and liabilities. As discussed above, MainStreet and Franklin Bank must comply with numerous federal and state laws and regulations. In light of the increasing government involvement in the financial services industry and to address the underlying causes of the recent credit crunch, it is likely that financial institutions like MainStreet and Franklin Bank will have to meet additional legal requirements, all of which add to the Corporation’s cost of doing business. In addition, regulatory concerns over real estate related assets on the balance sheets of financial institutions and liquidity due to deposit fluctuations and other factors are likely to translate into higher regulatory scrutiny of financial institutions. This could impact MainStreet.

Stock Compensation Plans

BankShares approved the 2004 Key Employee Stock Option Plan at its Annual Meeting of Shareholders on April 15, 2004. This Plan permitted the granting of Non-qualified Stock Options and Incentive Stock Options to persons designated as “Key Employees” of BankShares and its subsidiaries. The Plan terminated on January 21, 2009. Awards made under the Plan prior to and outstanding on that date remain valid in accordance with their terms.

Recent Accounting Developments

In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU are effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should have been applied prospectively to transactions or modifications of existing transactions that occurred on or after the effective date. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Corporation’s consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards (IFRS). The amendments were effective for interim and annual periods beginning after December 15, 2011 with prospective application. The adoption of the new guidance did not have a material impact on the Corporation’s consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The new guidance amends disclosure requirements for the presentation of comprehensive income. The amended guidance eliminates the option to present components of other comprehensive income (“OCI”) as part of the statement of changes in shareholders’ equity. All changes in OCI must be presented either in a single continuous statement of comprehensive income or in two separate but consecutive financial statements. The guidance did not change the items that must be reported in OCI. The Corporation adopted this guidance effective 2012, and has elected to present two separate but consecutive financial statements.

In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Corporation does not expect the adoption of ASU 2011-11 to have a material impact on its consolidated financial statements.

28

In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU clarify the scope for derivatives accounted for in accordance with Topic 815, “Derivatives and Hedging”, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either offset or subject to netting arrangements. An entity is required to apply the amendments for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. The Corporation does not expect the adoption of ASU 2013-01 to have a material impact on its consolidated financial statements.

In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Public companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Corporation is currently assessing the impact that ASU 2011-03 will have on its consolidated financial statements.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Not required.

29

Item 8. Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

MainStreet BankShares, Inc.

Martinsville, Virginia

We have audited the accompanying consolidated balance sheets of MainStreet BankShares, Inc. and Subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Corporation is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MainStreet BankShares, Inc. and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

Winchester, Virginia

March 15, 2013

30

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

	December 31, 2012			December 31, 2011
ASSETS
Cash and due from banks	$	3,076,535		$	2,767,395
Interest-bearing deposits in banks		11,546,938			17,091,438
Federal funds sold		9,414,880			10,612,680
Total Cash and Cash Equivalents		24,038,353			30,471,513
Securities available-for-sale, at fair value		18,836,561			21,199,884
Restricted equity securities		741,000			830,000
Loans held for sale		432,000			—
Loans:
Total Gross Loans		134,414,366			143,134,494
Unearned deferred fees and costs, net		78,300			89,510
Loans, net of unearned deferred fees and costs		134,492,666			143,224,004
Less: Allowance for loan losses		(2,602,098	)		(3,272,945	)
Net Loans		131,890,568			139,951,059
Bank premises and equipment, net		1,566,987			1,654,496
Accrued interest receivable		552,402			547,905
Bank owned life insurance		1,061,440			3,049,696
Other real estate, net of valuation allowance		1,441,722			3,572,518
Other assets		2,549,955			2,578,240
Total Assets	$	183,110,988		$	203,855,311
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Non-interest bearing demand deposits	$	22,819,544		$	20,975,660
Interest bearing deposits		127,759,824			146,107,182
Total Deposits		150,579,368			167,082,842
Repurchase agreements		6,000,000			13,500,000
Accrued interest payable and other liabilities		2,281,247			1,031,680
Total Liabilities		158,860,615			181,614,522
Commitments and contingencies		—			—
Shareholders’ Equity:
Preferred stock, no par value, authorized 10,000,000 shares; none issued		—			—
Common stock, no par value, authorized 10,000,000 shares; issued and outstanding 1,713,375 shares in 2012 and 2011, respectively		17,866,890			17,866,890
Retained earnings		5,956,926			3,986,150
Accumulated other comprehensive income		426,557			387,749
Total Shareholders’ Equity		24,250,373			22,240,789
Total Liabilities and Shareholders’ Equity	$	183,110,988		$	203,855,311

See accompanying notes to consolidated financial statements.

31

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

	Year Ended			Year Ended
	December 31, 2012			December 31, 2011
Interest and Dividend Income:
Interest and fees on loans	$	7,789,813		$	8,609,255
Interest on interest-bearing deposits		29,526			25,757
Interest on federal funds sold		12,634			11,497
Interest on securities available-for-sale:
Taxable		468,374			753,407
Nontaxable		56,838			2,029
Dividends on restricted equity securities		32,098			30,280
Total Interest and Dividend Income		8,389,283			9,432,225
Interest Expense:
Interest on deposits		1,372,567			1,992,204
Interest on short-term borrowings		2			5
Interest on repurchase agreements		447,233			538,071
Total Interest Expense		1,819,802			2,530,280
Net Interest Income		6,569,481			6,901,945
Provision for loan losses		486,257			1,660,783
Net Interest Income After Provision for Loan Losses		6,083,224			5,241,162
Noninterest Income:
Service charges on deposit accounts		261,487			288,724
Mortgage commission		239,565			171,727
Electronic card fees		179,443			160,429
Investment fee income		185,780			140,758
Income on bank owned life insurance		2,494,285			110,106
Gain on sale of securities available-for-sale		1,848			116,734
Other fee income and miscellaneous income		118,359			101,879
Total Noninterest Income		3,480,767			1,090,357
Noninterest Expense:
Salaries and employee benefits		2,727,946			2,686,338
Supplemental executive retirement plan		1,097,227			121,647
Occupancy and equipment expense		791,736			850,647
Professional fees		262,633			245,677
Outside processing		494,235			433,004
FDIC assessment		253,874			293,337
Franchise tax		199,587			167,500
Regulatory examination fees		109,559			111,332
Other real estate and repossessions		1,429,254			1,224,894
Other expenses		532,110			483,943
Total Noninterest Expense		7,898,161			6,618,319
Net Income (Loss) Before Tax	$	1,665,830		$	(286,800	)
Income Tax Benefit		(304,946	)		(140,355	)
Net Income (Loss)	$	1,970,776		$	(146,445	)
Basic Net Income (Loss) Per Common Share	$	1.15		$	(.09	)
Diluted Net Income (Loss) Per Common Share	$	1.15		$	(.09	)

See accompanying notes to consolidated financial statements.

32

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

	Year Ended			Year Ended
	December 31, 2012			December 31, 2011
Net Income (Loss)	$	1,970,776		$	(146,445	)
Other Comprehensive Income:
Net unrealized holding gains on securities available for
sale during the period		37,218			555,422
Deferred income tax expense on unrealized holding gains on securities available for sale		(12,653	)		(188,844	)
Less reclassification adjustments for gains included in net income		(1,848	)		(116,734	)
Tax related to realized gain on securities sold		628			39,690
Change in actuarial gain on benefit plan		23,429			12,474
Deferred income tax expense on actuarial gain		(7,966	)		(4,241	)
Other Comprehensive Income		38,808			297,767
Total Comprehensive Income	$	2,009,584		$	151,322

See accompanying notes to consolidated financial statements.

33

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity

	Number Of Common Shares		Common Stock		Retained Earnings			Accumulated Other Comprehensive Income		Total Shareholders’ Equity
Balance at December 31, 2010		1,713,375	$	17,866,890	$	4,132,595		$	89,982	$	22,089,467
Comprehensive Income:
Net loss		—		—		(146,445	)		—		(146,445	)
Other comprehensive income, net of taxes		—		—		—			297,767		297,767
Balance at December 31, 2011		1,713,375	$	17,866,890	$	3,986,150		$	387,749	$	22,240,789
Comprehensive Income:
Net income		—		—		1,970,776			—		1,970,776
Other comprehensive income, net of taxes		—		—		—			38,808		38,808
Balance at December 31, 2012		1,713,375	$	17,866,890	$	5,956,926		$	426,557	$	24,250,373

See accompanying notes to consolidated financial statements.

34

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

	Year Ended			Year Ended
	December 31, 2012			December 31, 2011
Cash Flows From Operating Activities:
Net income (loss) from operations	$	1,970,776		$	(146,445	)
Adjustments to reconcile net income (loss) from operations to net cash provided by operating activities:
Provision for loan losses		486,257			1,660,783
Depreciation and amortization		179,512			209,718
Amortization of discounts and premiums, net		201,223			159,390
Gain on sale of securities		(1,848	)		(116,734	)
Loss and impairment on other real estate owned and repossessions		1,314,015			1,139,172
Loss on disposal of fixed assets		5,767			—
Deferred tax expense (benefit)		(438,135	)		53,182
Change in loans held for sale		(432,000	)
(Increase) decrease in accrued interest receivable		(4,497	)		177,356
Decrease in other assets		453,929			163,131
Increase in value of BOLI		(2,494,285	)		(110,106	)
Change in reserve for unfunded lending commitments		22,725			—
Increase in executive retirement plan accrual		1,089,065			109,173
Increase (decrease) in accrued interest payable and other liabilities		161,206			(136,993	)
Net cash provided by operating activities		2,513,710			3,161,627
Cash Flows From Investing Activities:
Purchases of furniture, fixtures, and equipment		(97,770	)		(52,541	)
Purchases of securities available-for-sale		(9,862,042	)		(3,361,486	)
Purchases of restricted equity securities		(500	)		—
Redemption of restricted equity securities		89,500			166,600
Calls/maturities/repayments of securities available-for-sale		12,061,360			8,020,623
Proceeds from sale of securities		—			1,591,538
Capital improvements to other real estate owned		—			(277,372	)
Proceeds from sale of other real estate owned and repossessions		4,165,523			4,933,631
Proceeds from life insurance		4,482,541			—
Loan originations and principal collections, net		4,217,992			8,314,668
Net cash provided by investing activities		15,056,604			19,335,661
Cash Flows From Financing Activities:
Increase in non-interest bearing deposits		1,843,884			1,618,282
Decrease in interest bearing deposits		(18,347,358	)		(12,409,404	)
Repayment of repurchase agreement		(7,500,000	)		—
Net cash used in financing activities		(24,003,474	)		(10,791,122	)
Net increase (decrease) in cash and cash equivalents		(6,433,160	)		11,706,166
Cash and cash equivalents at beginning of year	$	30,471,513		$	18,765,347
Cash and cash equivalents at end of year	$	24,038,353		$	30,471,513
Supplemental disclosure of cash flow information:
Cash paid during the year for interest	$	1,869,277		$	2,644,065
Cash paid during the period for taxes	$	45,000		$	—
Unrealized gain on securities available for sale	$	35,370		$	438,688
Charge in actuarial gain on benefit plan	$	23,429		$	12,474
Transfer of loans to other real estate and other assets	$	3,356,242		$	5,314,131

See accompanying notes to consolidated financial statements.

35

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Note 1 – Summary of Accounting Policies

(a) General

MainStreet BankShares, Inc. (the “Corporation”, “MainStreet”, or “BankShares”), was incorporated in Virginia on January 14, 1999. The Corporation was primarily organized to serve as a bank holding company. Its first wholly-owned subsidiary was located in Martinsville, Virginia and was sold on March 23, 2005. In 2002, MainStreet organized a second bank subsidiary, Franklin Community Bank, National Association (“Franklin Bank”). On February 8, 2007, MainStreet formed a wholly-owned real estate company, MainStreet RealEstate, Inc., for the sole purpose of owning the real estate of the Corporation. When MainStreet sold its first banking subsidiary, the capital was redeployed to Franklin Bank.

Franklin Bank was organized as a nationally chartered commercial bank and member of the Federal Reserve Bank of Richmond. Franklin Bank opened for business on September 16, 2002. Franklin Bank operates as a locally owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. Franklin Bank’s primary service area is Franklin County, Town of Rocky Mount and surrounding areas. It currently has three banking offices including its main office.

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

(b) Principles of Consolidation

The consolidated financial statements include the accounts of MainStreet and its wholly-owned subsidiaries, Franklin Bank and MainStreet RealEstate, Inc. All significant intercompany accounts and transactions associated with MainStreet’s subsidiaries have been eliminated.

(c) Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash, due from banks, interest-bearing deposits in banks, and federal funds sold.

(d) Securities

Certain debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Trading securities are recorded at fair value with changes in fair value included in earnings. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security, whether it is more likely than not that the Corporation will be required to sell the security before recovery of its amortized cost basis, and whether the Corporation expects to recover the security’s entire amortized cost basis.

36

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

(e) Loans

The recorded investment in loans represents the customers unpaid principal balances, net of partial charge-offs and unearned deferred fees and costs. Interest on loans is computed by methods which generally result in level rates of return on principal amounts outstanding. Past due status on all loans is recognized and determined based on contractual terms. It is the Corporation’s policy to discontinue the accrual of interest on all loans once they become 90 days past due and are not well-collateralized or earlier when it becomes doubtful that the full principal and interest will be collected. Generally, all payments for all loans on nonaccrual status are applied as a principal reduction until the principal is satisfied. As a general rule, a nonaccrual loan may be restored to accrual status when none of its principal and interest is due and unpaid, and the Company expects repayment of the remaining contractual principal and interest. If any interest payments received while the loan was in nonaccrual status were applied to reduce the recorded investment in the loan, the application of these payments to the loan’s recorded investment is not reversed (and interest income is not credited) when the loan is returned to accrual status. The Company must have received repayment of the past due principal and interest unless the asset has been formally restructured and qualifies for accrual status or the borrower has resumed paying the full amount of the scheduled contractual interest and principal payments on a loan that is past due and in nonaccrual status, even though the loan has not been brought fully current, and the following two criteria are met: 1) all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within a reasonable period and, 2) there is a sustained period of repayment performance (generally a minimum of six months) by the borrower in accordance with the contractual terms involving payments of cash or cash equivalents. A loan that meets these two criteria may be restored to accrual status but must continue to be disclosed as past due if all arrearages have not been paid.

BankShares collectively reviews for impairment all consumer loans and smaller homogeneous loans. BankShares considers a loan to be impaired when, based upon current information and events, it is probable that BankShares will be unable to collect all amounts due according to the contractual terms of the loan agreement. Included in our analysis of impaired loans are loans 90 days or more past due and still accruing, nonaccrual loans and troubled debt restructurings. BankShares evaluates its impaired loans and troubled debt restructurings on an individual basis. For collateral dependent loans, BankShares bases the measurement of these impaired loans on the fair value of the loan’s collateral properties. For all other loans, BankShares uses the measurement of these impaired loans on the more readily determinable of the present value of expected future cash flows discounted at the loan’s effective interest rate or the observable market price. Impairment losses are recognized through an increase in the allowance for loan losses and a corresponding charge to the provision for loan losses. Adjustments to impairment losses due to changes in the fair value of impaired loans are included in the provision for loan losses.

(f) Troubled Debt Restructurings

In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a troubled debt restructuring (“TDR”). Management strives to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans. Total troubled debt restructurings at December 31, 2012 and 2011were $2.2 million and $3.7 million, respectively.

(g) Loan Fees and Costs

Using a method that approximates the interest method, loan origination and commitment fees and certain costs are deferred over the contractual life of the related loan as an adjustment to the net interest margin.

37

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

(h) Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. As part of this process management reviews the past due reports and risk-rated loans and discusses individually the loans on these reports with the responsible loan officers. Management provides a detailed quarterly analysis of the allowance based on our historical loan loss experience, risk-rated loans, past dues, concentrations of credit, unsecured loans, loan exceptions and the economic trend. These are generally grouped by loan segments. Our impaired loans are individually reviewed to determine possible impairment based on one of three recognized methods which are described above. A specific reserve is then allocated for the amount of the impairment. Possible loss for loans risk rated special mention or lower are then allocated based on a historical loss migration and adjusted for qualitative factors. Remaining loans are pooled based on homogenous loan groups and allocated based on Franklin Bank’s historical net loss experience. These pools are as follows: 1) commercial and industrial loans not secured by real estate; 2) construction and land development loans; 3) residential 1-4 family first liens; 4) residential 1-4 family junior liens; 5) home equity lines; 6) commercial real estate; and 7) consumer or loans to individuals. Historical loss is calculated based on a three-year average history. Historical net loss data is adjusted and applied to pooled loans based on qualitative factors. We utilize the following qualitative factors: 1) changes in the value of underlying collateral such as loans not conforming to supervisory loan to value limits; 2) national and local economic conditions; 3) changes in portfolio volume and nature such as borrowers living outside our primary trade area; 4) changes in past dues, nonaccruals; and 5) quality, impact and effects of defined credit concentrations.

Our allowance methodology has continued to evolve as our Company has grown and our loan portfolio has grown and become more diverse. Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term; however, this amount cannot be reasonably estimated.

The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Charge-offs on commercial loans are recorded when available information confirms the loan is not fully collectible and the loss is reasonably quantifiable. Consumer loans are generally charged off for closed end loans after 120 days past due and open end loans after 180 days past due, or earlier if there is information related to a loss. Loans secured by real estate are generally written down to appraised value less liquidation expenses with the remainder charged-off when a loss is apparent. Refer to Note 4 of the consolidated financial statements for detailed information related to the allowance for loan losses.

(i) Other Real Estate

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value less costs to sell at the date of foreclosure. Any losses at this point in time are charged against the allowance for loan losses. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of like properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Corporation may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further other-than-temporary deterioration in market conditions. These write-downs are recorded in the consolidated statement of operations.

(j) Bank Premises and Equipment

Land is carried at cost. Buildings, furniture, fixtures and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are charged to expense on a straight-line basis over the estimated useful lives ranging from three years to forty years. Maintenance, repairs and minor improvements are charged to expense as incurred. Significant improvements are capitalized.

38

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

(k) Stock Options and Warrants

MainStreet recognizes compensation cost relating to share-based payment transactions in accordance with generally accepted accounting principles. That cost is measured based on the fair value of the equity or liability instruments issued. The expense measures the cost of employee services received in exchange for the award based on the grant-date fair value of the award and recognizes the cost over the period the employee is required to provide services for the award. MainStreet recorded no compensation cost for the years ended December 31, 2012 and December 31, 2011. Additional disclosures required are included in Note 14 to the consolidated financial statements herein.

(l) Income Taxes

The Corporation is subject to federal and state income taxes. The liability (or balance sheet) approach is used in financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed quarterly for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statements of operations.

(m) Net Income (Loss) Per Common Share

ASC 260, “Earnings Per Share”, requires dual presentation of basic and diluted earnings per share on the face of the consolidated statements of operations and requires a reconciliation of the numerators and denominators of the basic and diluted earnings per common share calculation. Basic income (loss) per common share is calculated based on the weighted average number of shares of common stock outstanding during each period. Diluted income (loss) per common share is computed using the weighted average number of shares of common stock outstanding during each period adjusted to reflect the dilutive effect of all potential common shares that were outstanding during the period. Please refer to Note 11 for detailed information on net income (loss) per common share for the years ending December 31, 2012 and 2011, respectively. Please refer to Note 14 for detailed information on stock options for the years ending December 31, 2012 and 2011, respectively.

(n) Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities and pension liability adjustments, are reported as a separate component of the equity section of the consolidated balance sheet, such items, along with net income are components of comprehensive income.

39

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

(o) Fair Value Measurements

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 19. Fair value estimates involve uncertainties and matters of significant judgment. Changes in assumptions or in market conditions could significantly affect the estimates.

(p) Advertising Costs

The Corporation follows the policy of charging the costs of advertising to expense as incurred. Advertising expense was $62,301 and $48,906 for 2012 and 2011, respectively.

(q) Transfers of Financial Assets

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation – put presumptively beyond reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

(r) Loans Held for Sale

The Corporation accounts for new originations of prime residential mortgage loans held for sale at fair value. The Corporation accounts for the derivatives used to economically hedge the loans held for sale at fair value. Income from the sale of these mortgage loans is included in mortgage commissions.

(s) Reclassifications

Certain reclassifications have been made to prior period balances to conform to current year provisions.

(t) Use of Estimates

The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, other-than-temporary impairments of securities, valuation of other real estate owned, and the fair value of financial instruments.

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management periodically obtains independent appraisals for significant collateral.

The Corporation’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Corporation to recognize additional losses based on their judgments about information available to them at the time of their examination.

40

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

Note 2 – Securities

The carrying values, unrealized gains and losses and approximate market values of investment securities at December 31, 2012 and 2011 are shown in the following tables. The entire investment portfolio is classified as available-for-sale to preserve maximum liquidity for funding needs.

	2012
	Amortized		Gross Unrealized		Gross Unrealized			Approximate
	Cost		Gains		Losses			Market Value
U. S. government sponsored agencies	$	1,464,102	$	7,671	$	—		$	1,471,773
Mortgage backed securities		12,130,273		507,264		—			12,637,537
States and political subdivisions		4,681,671		53,683		(8,103	)		4,727,251
Total securities available-for-sale	$	18,276,046	$	568,618	$	(8,103	)	$	18,836,561

	2011
	Amortized		Gross Unrealized		Gross Unrealized			Approximate
	Cost		Gains		Losses			Market Value
U.S. government sponsored agencies	$	2,804,763	$	7,497	$	(1,478	)	$	2,810,782
Mortgage backed securities		16,758,613		496,577		—			17,255,190
States and political subdivisions		1,111,363		22,549		—			1,133,912
Total securities available-for-sale	$	20,674,739	$	526,623	$	(1,478	)	$	21,199,884

All of our mortgage backed securities are either guaranteed by U. S. government agencies or issued by U. S. government sponsored agencies.

The amortized costs and market values of securities available-for-sale at December 31, 2012, by contractual maturity, are shown in the following table. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Approximate Market Value
Due in one year or less	$	—	$	—
Due after one year but within five years		—		—
Due after five years but within ten years		7,011,852		7,104,269
Due after ten years		11,264,194		11,732,292
	$	18,276,046	$	18,836,561

There were gross gains of $1,848 and $116,734 and no losses recorded on sales and calls of securities available for sale during the years ended December 31, 2012 and 2011, respectively.

Securities available-for-sale with carrying values approximating $6,865,968 and $15,802,309 at December 31, 2012 and December 31, 2011, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

41

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Following demonstrates the unrealized loss position of securities available for sale at December 31, 2012 and 2011.

						December 31, 2012
	Less Than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses
States and political subdivisions	$	1,182,824	$	(8,103	)	$	—	$	—	$	1,182,824	$	(8,103	)
Total temporarily impaired securities	$	1,182,824	$	(8,103	)	$	—	$	—	$	1,182,824	$	(8,103	)

						December 31, 2011
	Less Than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses
U. S. government sponsored agencies	$	2,248,523	$	(1,478	)	$	—	$	—	$	2,248,523	$	(1,478	)
Total temporarily impaired securities	$	2,248,523	$	(1,478	)	$	—	$	—	$	2,248,523	$	(1,478	)

An impairment is considered “other than temporary” if any of the following conditions are met: the Corporation intends to sell the security, it is more likely than not that the Corporation will be required to sell the security before the recovery of its amortized cost basis, or the Corporation does not expect to recover the security’s entire amortized cost basis (even if the Bank does not intend to sell). At December 31, 2012, $1.2 million of securities had unrealized losses and at December 31, 2011, $2.2 million of securities had unrealized losses based on market prices at the respective dates. Declines in fair value are due to interest rate fluctuations and not due to credit deterioration of the issuers. The Corporation does not have any securities that are considered “other than temporarily impaired” at December 31, 2012 and December 31, 2011.

Federal Reserve Bank stock is included in restricted equity securities and totaled $435,100 at December 31, 2012 and December 31, 2011. Federal Home Loan Bank (“FHLB”) stock makes up the remainder of the balance in restricted equity securities and totaled $305,900 and $394,900 at December 31, 2012 and 2011, respectively. FHLB stock is generally viewed as a long term investment and as a restricted investment security which is carried at cost, because there is no market for the stock other than the FHLB or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing temporary declines in value.

42

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Note 3 – Loans Receivable

The major components of gross loans in the consolidated balance sheets at December 31, 2012 and 2011 are as follows:

	2012		2011
Commercial	$	10,439,173	$	11,061,471
Real Estate:
Construction and land development		21,268,316		26,102,914
Residential 1-4 families
First liens		35,490,285		37,735,618
Junior liens		7,633,851		8,486,594
Home Equity lines		6,093,783		7,639,785
Commercial real estate		51,861,252		50,272,002
Consumer		1,627,706		1,836,110
Total Gross Loans		134,414,366		143,134,494
Unearned fees and costs, net		78,300		89,510
Recorded Investment	$	134,492,666	$	143,224,004

Overdrafts reclassified to loans at December 31, 2012 and 2011 were $5,287 and $4,916, respectively.

Loan Origination/Risk Management: Franklin Bank’s Board of Directors annually approves and reviews policies and procedures to be utilized as tools by account officers for the purpose of making sound and prudent credit decisions. Every loan transaction is closely evaluated from the perspective of profitability realizing that there is no profit in a loan that becomes a loss. Each credit decision is based on merit and no other factors. Account officers carry a heavy burden of accountability in being assigned the responsibility for the development of the Corporation’s loan portfolio by meeting the legitimate credit needs of our customers while also exercising prudence and seasoned judgment. A comprehensive reporting system has been developed to provide senior management timely information related to portfolio performance including growth, delinquency, adversely risk rated, and credit concentrations. The portfolio is constantly reviewed based on segments of concern, past due status, extension of credits along with stress testing the portfolio’s collateral values and debt service coverage for a significant portion of loans within defined loan concentrations. Annually, a loan review plan is developed to identify and mitigate potential weakness in the loan portfolio. Scope is determined based upon a risk assessment of various concentrations and loan product types in which higher risk may exist. The developed plan is presented to the Loan Committee of Franklin Bank’s Board of Directors each year for approval. Review segments vary from year to year to ensure a complete cycle of all significant loan product types. Results of each review segment are communicated to the Loan Committee of the Board of Directors with a response from the Bank’s Senior Lender or Head of Retail lending depending on the product type reviewed.

In general all loans exceeding $100,000 are documented by three years of financial reports in conjunction with review and analysis by a credit analyst independent of the lending approval process. Generally all real estate loans are underwritten based on verified income, or cash flow, and margined at 80% or less depending upon the regulatory supervisory limit. All loans are underwritten based upon analysis of all identified primary and secondary repayment sources.

Construction & Land Development: Emphasis is placed on the estimated absorption period of the project based on the intimate knowledge of local demand and geographic concentrations by appraisers and account officers. Projects are monitored by Franklin Bank’s in-house construction inspector to ensure adherence to project specifications and timely completion. Loan to values are manually tracked to ensure conforming collateral coverage is maintained throughout the development phase. Interest carry abilities are determined by analyzing global cash flow and available liquidity. Due to the complex nature of loans for speculative housing and speculative lots, requests are underwritten by Franklin Bank’s business lending group. Terms at origination for speculative lot loans are based on collateral margins and on qualifying the borrower to policy requirements based on a ten year amortization period. Speculative housing terms generally are held to eighteen months with allowance made for substantial curtailments.

43

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Commercial Real Estate: Loans are generally underwritten based on verified income or cash flow to ensure a global debt service coverage ratio of at least 1.25. In general, collateral margin is determined based on appraisal or evaluation market value not to exceed 80 percent of appraised market value or cost, whichever is less. All properties receive proper environmental due diligence prior to funding of the credit. Account officers perform and document a market analysis which may include data on competing businesses and projects. When applicable, market analysis data may be obtained from independent sources. Cash flows and collateral margins are appropriately stress tested. Terms generally range from five to fifteen years, however, may be longer based on approval from Franklin Bank’s President and Chief Credit Officer.

Commercial Loans: Loans are generally underwritten based on verified income or cash flow to ensure global debt service coverage ratio of at least 1.25. Terms can range up to seven years based on loan purpose and collateral offered. Based on policy, credit lines have maturities of one year. Generally inventory loans are margined at 50% while equipment loans, depending on age of collateral, range from 90%, if new, to 80%, if used. Receivables are margined at 80% based on the aging of receivables outstanding sixty days or less.

Consumer /Residential 1-4 Families and Equity Lines: Loans are generally underwritten based on a maximum debt to income ratio of 40 percent gross. Incomes are verified for all secured loans exceeding $35,000 and unsecured loans totaling $10,000 or more. Policy requires income verification to be documented for all real estate loans. Collateral margins and terms for non-real estate collateral are determined and made available to retail lenders by Franklin Bank’s Chief Credit Officer. Cash flows for all self employed borrowers are determined by Franklin Bank’s independent credit analyst. Policy defines unsecured loan terms at a maximum of thirty six months while individual unsecured lines are underwritten to maturities of less than one year with the line amount being based on a percentage of available liquidity and net worth. Construction loans for individuals are underwritten to policy based on cost overruns of at least fifteen percent. Debt to income ratios for equity lines are underwritten based on the borrower paying 1.5% of the total available line monthly. All equity lines are reviewed annually and filtered based on updated credit scores, average percentage drawn and delinquency. “Watch” accounts are identified based on filters and then individually reviewed by the responsible account officer.

44

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Note 4 – Allowance for Loan Losses

Changes in the allowance for loan losses for the years ended December 31, 2012 and 2011 are as follows:

	2012			2011
Balance at beginning of year	$	3,272,945		$	3,584,180
Provision for loan losses		486,257			1,660,783
Losses charged to allowance		(1,330,151	)		(2,143,502	)
Recoveries credited to allowance		173,047			171,484
Balance at end of year	$	2,602,098		$	3,272,945

A breakdown of the allowance for loan losses by loan segment for the year ended December 31, 2012 is as follows:

				Real Estate
				Construction			Residential 1-4 Families						Home			Commercial
				and Land			First			Junior			Equity			Real
	Commercial			Development			Liens			Liens			Lines			Estate			Consumer			Unallocated		Total
Beginning Balance	$	154,991		$	902,644		$	1,100,139		$	174,809		$	98,582		$	824,759		$	11,911		$	5,110	$	3,272,945
Charge-offs		(186	)		(257,796	)		(911,535	)		(143,849	)		—			—			(16,785	)		—		(1,330,151	)
Recoveries		1,842			8,377			134,305			11,525			3,374			—			13,624			—		173,047
Provision		(48,311	)		113,793			378,759			92,362			(13,545	)		(84,686	)		2,995			44,890		486,257
Ending Balance	$	108,336		$	767,018		$	701,668		$	134,847		$	88,411		$	740,073		$	11,745		$	50,000	$	2,602,098

A breakdown of the allowance for loan losses by loan segment for the year ended December 31, 2011 is as follows: 

				Construction			Residential 1-4 Families						Home			Commercial
				and Land			First			Junior			Equity			Real
	Commercial			Development			Liens			Liens			Lines			Estate			Consumer			Unallocated		Total
Beginning Balance	$	138,449		$	1,086,183		$	1,065,683		$	243,526		$	217,063		$	793,308		$	39,968		$	—	$	3,584,180
Charge-offs		(482,651	)		(922,440	)		(311,265	)		(164,907	)		(34,745	)		(205,824	)		(21,670	)		—		(2,143,502	)
Recoveries		32,312			62,883			62,755			1,232			—			—			12,302			—		171,484
Provision		466,881			676,018			282,966			94,958			(83,736	)		237,275			(18,689	)		5,110		1,660,783
Ending Balance	$	154,991		$	902,644		$	1,100,139		$	174,809		$	98,582		$	824,759		$	11,911		$	5,110	$	3,272,945

45

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

A breakdown of the allowance for loan losses and the recorded investment in loans by individually and collectively evaluated for impairment at December 31, 2012 is shown below.

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial
			and Land		First		Junior		Equity		Real
	Commercial		Development		Liens		Liens		Lines		Estate		Consumer		Unallocated		Total
Allowance for loan losses:
Ending Balance:
Individually
evaluated for
impairment	$	—	$	268,850	$	23,122	$	31	$	—	$	—	$	—	$	—	$	292,003
Ending Balance:
Collectively
evaluated for
impairment		108,336		498,168		678,546		134,816		88,411		740,073		11,745		50,000		2,310,095
	$	108,336	$	767,018	$	701,668	$	134,847	$	88,411	$	740,073	$	11,745	$	50,000	$	2,602,098

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial
			and Land		First		Junior		Equity		Real				Gross
	Commercial		Development		Liens		Liens		Lines		Estate		Consumer		Loans
Recorded investment in loans:
Ending Balance:
Individually
evaluated for
impairment	$	212,738	$	1,100,584	$	938,556	$	225,669	$	—	$	346,807	$	—	$	2,824,354
Ending Balance:
Collectively
evaluated for
impairment		10,226,435		20,167,732		34,551,729		7,408,182		6,093,783		51,514,445		1,627,706		131,590,012
	$	10,439,173	$	21,268,316	$	35,490,285	$	7,633,851	$	6,093,783	$	51,861,252	$	1,627,706	$	134,414,366

46

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

A breakdown of the allowance for loan losses and the recorded investment in loans by individually and collectively evaluated for impairment at December 31, 2011 is shown below.

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial
			and Land		First		Junior		Equity		Real
	Commercial		Development		Liens		Liens		Lines		Estate		Consumer		Unallocated		Total
Allowance for loan losses:
Ending Balance:
Individually
evaluated for
impairment	$	2,075	$	292,323	$	413,354	$	—	$	—	$	110,820	$	—	$	—	$	818,572
Ending Balance:
Collectively
evaluated for
impairment		152,916		610,321		686,785		174,809		98,582		713,939		11,911		5,110		2,454,373
	$	154,991	$	902,644	$	1,100,139	$	174,809	$	98,582	$	824,759	$	11,911	$	5,110	$	3,272,945

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial
			and Land		First		Junior		Equity		Real				Gross
	Commercial		Development		Liens		Liens		Lines		Estate		Consumer		Loans
Recorded investment in loans:
Ending Balance:
Individually
evaluated for
impairment	$	136,680	$	1,624,238	$	4,852,061	$	424,795	$	131,439	$	1,533,473	$	50,694	$	8,753,380
Ending Balance:
Collectively
evaluated for
impairment		10,924,791		24,478,676		32,883,557		8,061,799		7,508,346		48,738,529		1,785,416		134,381,114
	$	11,061,471	$	26,102,914	$	37,735,618	$	8,486,594	$	7,639,785	$	50,272,002	$	1,836,110	$	143,134,494

47

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

An age analysis of past due loans as of December 31, 2012 is as follows:

													Accruing Loans
	Loans		Loans		Loans 90								90 or More Days		Nonaccrual Loans
	30-59 Days Past Due		60-89 Days Past Due		Or More Days Past Due		Total Past Due Loans		Current Loans		Gross Loans		Past Due (Included in Past Dues)		(Included in Past Dues & Current)
Commercial	$	1,612	$	—	$	—	$	1,612	$	10,437,561	$	10,439,173	$	—	$	—
Real Estate:
Construction and land development		338,195		88,022		364,099		790,316		20,478,000		21,268,316		3,485		447,542
Residential 1-4 Families
First Liens		751,946		—		291,682		1,043,628		34,446,657		35,490,285		—		938,556
Junior Liens		19,000		—		128,905		147,905		7,485,946		7,633,851		—		129,591
Home Equity lines		—		—		—		—		6,093,783		6,093,783		—		—
Commercial Real Estate		329,921		—		—		329,921		51,531,331		51,861,252		—		—
Consumer		4,262		—		—		4,262		1,623,444		1,627,706		—		—
	$	1,444,936	$	88,022	$	784,686	$	2,317,644	$	132,096,722	$	134,414,366	$	3,485	$	1,515,689

An age analysis of past due loans as of December 31, 2011 is as follows:

													Accruing Loans
	Loans		Loans		Loans 90								90 or More Days		Nonaccrual Loans
	30-59 Days Past Due		60-89 Days Past Due		Or More Days Past Due		Total Past Due Loans		Current Loans		Gross Loans		Past Due (Included in Past Dues)		(Included in Past Dues & Current)
Commercial	$	150,390	$	4,287	$	88,350	$	243,027	$	10,818,444	$	11,061,471	$	—	$	104,579
Real Estate:
Construction and land development		52,406		43,274		1,526,501		1,622,181		24,480,733		26,102,914		—		1,624,238
Residential 1-4 Families
First Liens		836,919		1,674,264		2,689,459		5,200,642		32,534,976		37,735,618		—		4,852,061
Junior Liens		208,807		—		—		208,807		8,277,787		8,486,594		—		156,490
Home Equity lines		26,773		—		—		26,773		7,613,012		7,639,785		—		131,439
Commercial Real Estate		—		—		148,221		148,221		50,123,781		50,272,002		—		148,221
Consumer		2,103		—		—		2,103		1,834,007		1,836,110		—		50,694
	$	1,277,398	$	1,721,825	$	4,452,531	$	7,451,754	$	135,682,740	$	143,134,494	$	—	$	7,067,722

48

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Impaired loans at December 31, 2012 are as follows:

	Unpaid		Recorded		Recorded
	Contractual		Investment		Investment				Average		Interest
	Principal		with Related		with No Related		Related		Recorded		Income
	Balance		Allowance		Allowance		Allowance		Investment		Recognized
Commercial	$	212,738	$	—	$	212,738	$	—	$	170,618	$	14,359
Real Estate:
Construction and land development		1,345,286		268,850		831,735		268,850		1,044,368		17,765
Residential 1-4 Families
First Liens		943,996		238,722		699,833		23,122		2,700,973		17,067
Junior Liens		229,886		52,031		173,638		31		390,654		10,898
Home Equity lines		—		—		—		—		77,775		—
Commercial Real Estate		346,807		—		346,807		—		1,259,284		13,608
Consumer		—		—		—		—		20,098		—
	$	3,078,713	$	559,603	$	2,264,751	$	292,003	$	5,663,770	$	73,697

Impaired loans at December 31, 2011 are as follows:

	Unpaid		Recorded		Recorded
	Contractual		Investment		Investment				Average		Interest
	Principal		with Related		with No Related		Related		Recorded		Income
	Balance		Allowance		Allowance		Allowance		Investment		Recognized
Commercial	$	170,080	$	36,388	$	100,292	$	2,075	$	327,051	$	593
Real Estate:
Construction and land development		1,664,551		1,263,551		360,687		292,323		2,163,855		24,174
Residential 1-4 Families
First Liens		4,901,815		2,474,255		2,377,806		413,354		3,618,240		122,856
Junior Liens		424,795		—		424,795		—		570,365		15,383
Home Equity lines		163,703		—		131,439		—		177,972		3,520
Commercial Real Estate		1,533,473		1,385,252		148,221		110,820		809,181		105,266
Consumer		142,188		—		50,694		—		56,639		653
	$	9,000,605	$	5,159,446	$	3,593,934	$	818,572	$	7,723,303	$	272,445

49

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Impaired loans on nonaccrual were $1,515,689 and $7,067,722 at December 31, 2012 and December 31, 2011, respectively. The average balance for impaired loans was approximately $5,663,770 and $7,723,303 for the years ending December 31, 2012 and December 31, 2011, respectively. Of the impaired loans at December 31, 2012, $559,603 had specific reserves of $292,003 included in the allowance for loan losses and $188,220 had portions of the loan charged off. Of the impaired loans at December 31, 2011, $5,159,446 had specific reserves of $818,572 included in the allowance for loan losses and an additional $526,948 had portions of the loan charged off. Following is a breakdown of the interest for impaired loans for the years ending December 31, 2012 and 2011, respectively.

	December 2012		December 2011
Interest that would have been earned	$	295,276	$	794,174
Interest reflected in income		73,697		272,445
Lost interest	$	221,579	$	521,729

All interest in income on impaired loans had been received in 2012 and 2011. No additional interest was reflected in income for 2012 and 2011 on impaired loans.

At December 31, 2012 and December 31, 2011, the balance in loans under the terms of troubled debt restructurings not included in nonaccrual loans was $1,305,180 and $1,685,658, respectively. These loans did not have any additional commitments at December 31, 2012 and December 31, 2011, respectively. Loan restructurings generally occur when a borrower is experiencing, or is expected to experience, financial difficulties in the near-term. Consequently, a modification that would otherwise not be considered is granted to the borrower. These loans may continue to accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance with the modified terms. The borrowers were complying with the modified terms of their contracts at December 31, 2012 and December 31, 2011, respectively. Troubled debt restructurings are included in the impaired loan disclosures.

Of the December 31, 2012 balance of $1,418,929 in troubled debt restructurings modified during the year ended December 31, 2012, $238,722 are on nonaccrual and are also included in the nonaccrual loan disclosures. For the period ended December 31, 2012, below describes the troubled debt restructurings at the time of modification:

	Pre-Modification				Post-Modification
	Number				Number
	of Loans		Balance		of Loans		Balance
Commercial		2	$	183,842		2	$	183,842
Real Estate:
Construction and land development		3		683,410		3		689,954
Residential 1-4 families:
First liens		1		239,036		1		239,036
Junior liens		—		—		—		—
Home Equity Lines		—		—		—		—
Commercial Real Estate		1		354,156		1		354,156
Consumer		—		—		—		—
		7	$	1,460,444		7	$	1,466,988

One of the commercial loans restructured was a renewal of an existing loan for a short period of time to allow the borrower to come up with an action plan. The borrower’s debt service ratio had declined moving the credit to a criticized asset. The second commercial loan was restructured to interest only to lower the payment to allow the borrower time to receive their inheritance. The first construction and land development loan was the renewal of a criticized credit for a short term to allow the borrower to sell assets. The second construction and land development loan was restructured to obtain additional collateral and reduce impairment. The third construction and land development loan was restructured to give the borrower additional time to have an auction in the spring to sell properties. The loan was modified to interest only. The residential 1-4 family loan was modified to gain additional collateral and allow the borrower to improve cash flow. The commercial real estate loan was the restructure of a stale line of credit into an amortizing loan of a criticized asset.

50

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Of the credits modified during 2012, none have defaulted during the past twelve months. For this purpose, if a note defaults it means at some point it has been greater than 60 days past due or we have received some information that leads us to believe the full collection of the principal and interest is doubtful.

Of the December 31, 2011 balance of $1,965,318 in troubled debt restructurings modified during the year ended December 31, 2011, $279,660 are on nonaccrual and are also included in the nonaccrual loan disclosures. For the period ended December 31, 2011, below describes the troubled debt restructurings at the time of modification:

	Pre-Modification				Post-Modification
	Number				Number
	of Loans		Balance		of Loans		Balance
Commercial		1	$	34,940		1	$	34,940
Real Estate:
Construction and land development		—		—		—		—
Residential 1-4 families:
First liens		—		—		—		—
Junior liens		3		616,249		3		272,921
Home Equity Lines		1		165,744		1		133,480
Commercial Real Estate		3		1,535,647		3		1,535,647
Consumer		—		—		—		—
		8	$	2,352,580		8	$	1,976,988

The commercial loan restructured represents the deficiency balance remaining after foreclosure. There were three junior lien troubled debt restructurings during 2011. One of the credits was a lot loan where the borrower suffered financial difficulty and the lot lost value. The lot was taken into other real estate and the deficit was put into a new note secured by a second lien on the borrower’s home. The new note is interest only for two years to allow for time to sell the property. On another junior lien the borrower had lost his job and taken another job with significantly less income. The rate was reduced to assist the borrower. The third credit was renewed for a borrower that had consolidated debt and the loan to value was greater than 100%. The home equity line was renewed for six months to allow the borrower additional time to sell property. The loan to value was greater than 100%. Commercial real estate loans consisted of three loans and two relationships. One relationship consisted of two loans modified with a lower interest rate and a longer amortization period where the borrower was experiencing financial difficulty due to increased vacancies and reduced cash flow. The second relationship was a credit reworked after part of the collateral was sold. This borrower is continuing to have difficulty with making payments.

The table below details the troubled debt restructurings that originated in 2011 and subsequently defaulted.

	2011
	Number
	of Loans		Balance
Commercial		—	$	—
Real Estate:
Construction and land development		—		—
Residential 1-4 families:
First liens		—		—
Junior liens		—		—
Home Equity Lines		—		—
Commercial Real Estate		1		148,221
Consumer		—		—
		1	$	148,221

Of the credits modified during 2011, one commercial real estate loan totaling $148,221 has defaulted during the past twelve months. The loan was individually evaluated for impairment at year end. For this purpose, if a note defaults it means at some point it has been greater than 60 days past due or we have received some information that leads us to believe the full collection of the principal and interest is doubtful.

51

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The Corporation’s internally assigned grades for credit quality are as follows:

Prime (1.00)

Exceptional credits are of the highest quality. These loans are supported by large, well-established borrowers with excellent financial stability and strength, and may be secured by cash or cash equivalents. Where applicable, guarantors have substantial net worth and personal cash flow, and could easily fulfill their obligation should the need arise.

Good (2.00)

Superior credits are supported by well-established borrowers with excellent financial stability and strength. The borrower’s cash flow, liquidity, and equity are more than ample. These credits may be secured by cash or cash equivalents. For loans with personal guarantees, the guarantors are high net worth individuals, and have the resources available to satisfy their obligation if necessary.

Acceptable (3.00)

Loans in this category are supported by borrowers and guarantors that are financially sound. Cash flow, liquidity and equity are sufficient to provide a comfortable margin in the event of short-term economic disturbances. Assets pledged as collateral would provide a dependable secondary source of repayment.

Pass/Watch (4.00)

Credits in this category present the maximum acceptable risk for new facilities. Borrowers generate enough cash for debt service needs, but may not have sufficient resources to weather short-term market fluctuations. Management may lack depth or experience, and industry volatility may be an issue. Where applicable, guarantors have sufficient resources to provide an additional margin of protection.

Special Mention (5.00)

Assets in this category demonstrate signs of potential weakness, which, if uncorrected, could result in default. The borrower’s liquidity or equity may be marginal, trends in cash flow and profitability may point to a weakening financial condition, or the borrower’s industry may be slightly unstable or showing early indications of decline. Collateral may be illiquid or provide only a relatively small margin. Migration analysis data is performed and updated quarterly on these loans. It is based on loans downgraded originally into this category. Our loss factor is determined based on charge-offs during the quarter divided by the balance of special mention loans at the beginning of the quarter, which is then increased by qualitative factors resulting in an applied loss factor of 3%.

Substandard (6.00)

Loans in this category present an unacceptable credit risk. Borrowers and guarantors may be financially weak, and may lack the sufficient resources to adequately service debt. The abilities of management and industry stability may also be of concern. Collateral may be lacking in quality or liquidity, and offers little additional protection. Migration analysis data is performed and updated quarterly on these loans. It is based on loans downgraded originally into this category. For nonimpaired substandard loans, our loss factor is determined based on charge-offs during the quarter divided by the balance of substandard loans at the beginning of the quarter. This is then increased by the substandard loans’ qualitative factors resulting in an applied loss factor of 8%.

Doubtful (7.00)

These loans have an extremely high probability of loss, though the timing and magnitude of the loss may remain unclear. Borrowers and guarantors exhibit major financial shortcomings, and clearly lack the sufficient resources to adequately service debt or honor their commitments. Collateral is lacking in quality or liquidity, and offers little, if any, additional protection.

Loss (8.00)

The probability of collection on these credits is so low that they may be properly classified as uncollectible.

Generally, consumer loans, home equity lines, and residential 1-4 family loans are not risk rated and considered a pass credit unless they are related to a risk rated commercial loan relationship or exhibit criticized asset characteristics.

52

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The tables below represent the balances in the risk rating categories at December 31, 2012 and 2011.

December 31, 2012 

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial				Totals by
Internal Risk Rating Grades	Commercial		And Land Development		First Liens		Junior Liens		Equity Lines		Real Estate		Consumer		Internal Risk Rating Grade
Grade:
Pass	$	10,077,178	$	18,038,151	$	32,046,560	$	6,719,907	$	5,984,847	$	45,339,487	$	1,624,080	$	119,830,210
Special Mention		169,616		658,199		943,993		228,364		—		4,014,141		—		6,014,313
Substandard		192,379		2,571,966		2,261,010		685,580		108,936		2,507,624		3,626		8,331,121
Doubtful		—		—		238,722		—		—		—		—		238,722
Loss		—		—		—		—		—		—		—		—
	$	10,439,173	$	21,268,316	$	35,490,285	$	7,633,851	$	6,093,783	$	51,861,252	$	1,627,706	$	134,414,366

December 31, 2011

			Real Estate
			Construction		Residential 1-4 Families				Home		Commercial				Totals by
Internal Risk Rating Grades	Commercial		And Land Development		First Liens		Junior Liens		Equity Lines		Real Estate		Consumer		Internal Risk Rating Grade
Grade:
Pass	$	9,869,976	$	21,364,943	$	30,016,743	$	7,251,555	$	7,486,498	$	43,885,034	$	1,782,754	$	121,657,503
Special Mention		878,058		1,067,783		492,941		—		—		1,611,592		—		4,050,374
Substandard		312,325		3,377,865		6,812,580		1,235,039		153,287		4,775,376		53,356		16,719,828
Doubtful		1,112		292,323		413,354		—		—		—		—		706,789
Loss		—		—		—		—		—		—		—		—
	$	11,061,471	$	26,102,914	$	37,735,618	$	8,486,594	$	7,639,785	$	50,272,002	$	1,836,110	$	143,134,494

Note 5 – Related Party Loans

Directors, executive officers and related interests provide the Corporation with business and many are among its significant depositors and borrowers. Total amounts outstanding at December 31, 2012 and 2011 for all such loans are summarized below:

	2012			2011
Balance at beginning of year	$	11,164,683		$	11,714,823
Additions		9,419,490			10,140,995
Payments		(9,707,315	)		(10,691,135	)
Balance at end of year	$	10,876,858		$	11,164,683

53

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

These loans, in the opinion of management, were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable loans with persons not related to the lender and did not involve more than the normal risk of collectability or present other unfavorable features. Total unfunded commitments to related persons were $2,281,956 and $3,378,002 at December 31, 2012 and 2011, respectively.

Note 6 – Bank premises and Equipment

Bank premises and equipment at December 31, 2012 and 2011 are as follows:

	2012			2011
Buildings and land	$	1,306,410		$	1,306,410
Furniture and equipment		1,408,707			1,317,906
Computer software		256,741			249,773
Leasehold improvements		402,638			425,865
Automobiles		20,284			20,284
		3,394,780			3,320,238
Accumulated depreciation and amortization		(1,827,793	)		(1,665,742	)
Bank premises and equipment, net	$	1,566,987		$	1,654,496

Depreciation expense was $179,512 and $209,718 for 2012 and 2011, respectively.

Note 7 – Deposits

The maturities of time deposits $100,000 and over and other time deposits at December 31, 2012 are as follows:

	2012
	Time Deposits
	$100,000 and Over		Other Time Deposits
2013	$	21,243,138	$	30,160,216
2014		7,485,064		6,993,797
2015		3,900,000		5,955,368
2016		2,929,676		2,387,172
2017		1,199,629		2,020,031
2018		—		780
Total	$	36,757,507	$	47,517,364

Total deposit dollars from executive officers, directors, and their related interests at December 31, 2012 and 2011 were $7,053,010 and $7,129,598, respectively. Brokered deposits totaled $5.3 million and $6.9 million at December 31, 2012 and 2011, respectively.

Note 8 – Borrowings

The Corporation has the ability to borrow from Federal Home Loan Bank of Atlanta (“FHLB”). Borrowing capacity is secured by a blanket lien on loans secured by commercial real estate and loans secured by 1-4 family first liens, second liens, and equity lines. There were no FHLB advances outstanding at December 31, 2012 and December 31, 2011.

There were no overnight federal funds purchased at December 31, 2012 and December 31, 2011.

The Corporation has an internal Corporate Cash Management account for customers to sweep their excess demand deposit accounts on an overnight basis in order to earn interest. This account is not FDIC insured but the Corporation is required to pledge agency funds at 100% towards these balances. There were no Corporate Cash Management sweep accounts at December 31, 2012 and December 31, 2011.

54

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Note 9 – Repurchase Agreements

The Corporation entered into a repurchase agreement with Citigroup Global Markets, Inc. (“CGMI”) in the amount of $7,500,000 on September 18, 2007. The repurchase date was September 18, 2012. The interest rate was fixed at 4.22% until maturity or until it was called. Beginning September 18, 2008, the repurchase agreement became callable by CGMI and could have been called quarterly with two business days prior notice. Interest was payable quarterly. The repurchase agreement was collateralized by agency mortgage backed securities.

The Corporation entered into a repurchase agreement with Barclays Capital on January 2, 2008 in the amount of $6,000,000. The repurchase date is January 2, 2013. The interest rate was fixed at 3.57% until maturity or until it is called. Beginning January 2, 2009 the repurchase agreement became callable and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by agency mortgage backed securities. The interest rate remained at 3.57% at December 31, 2012.

Note 10 – Income Taxes

The Corporation files income tax returns in the U.S. federal jurisdiction and the state of Virginia. With few exceptions, the Corporation is no longer subject to U. S. federal, state and local income tax examinations by tax authorities for years prior to 2009.

Allocation of federal and state income taxes between current and deferred portions is as follows:

	2012			2011
Current expense (benefit)	$	133,189		$	(193,537	)
Deferred tax expense (benefit)		(438,135	)		53,182
Income tax benefit	$	(304,946	)	$	(140,355	)

The reasons for the differences between the statutory federal income tax rate and the effective tax rate are summarized as follows:

	2012			2011
Computed at the expected federal statutory rate	$	566,382		$	(97,512	)
Nondeductible meals & entertainment		1,020			959
Bank owned life insurance		(848,057	)		(37,436	)
Tax exempt loan interest		(7,396	)		(5,797	)
Tax exempt securities income		(16,895	)		(569	)
Income tax benefit	$	(304,946	)	$	(140,355	)

55

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The components of deferred tax assets and liabilities are as follows:

	2012		2011
Allowance for loan losses	$	565,904	$	836,020
SERP accrual		571,567		193,319
Alternative minimum tax carry forward		295,543		—
Interest on nonaccrual loans		82,557		140,694
Charitable Contributions		17,856		12,160
Other		16,499		5,558
Unrealized losses on other real estate		140,065		80,179
Deferred tax assets		1,689,991		1,267,930
Prepaid service contracts and insurance		31,691		34,541
Depreciation and amortization		62,999		76,841
Unrealized gain on securities available-for-sale		190,575		178,549
Other		38,222		29,638
Deferred tax liabilities		323,487		319,569
Net deferred tax assets	$	1,366,504	$	948,361

Note 11 – Net Income (Loss) Per Common Share

The following table shows the weighted average number of shares used in computing earnings per common share and the effect on weighted average number of shares of diluted potential common stock. Potential dilutive common stock had no effect on income available to common stockholders.

	2012				2011
			Per Share				Per Share
	Shares		Amount		Shares		Amount
Earnings (loss) per common share, basic		1,713,375	$	1.15		1,713,375	$	(.09	)
Effect of dilutive securities:
Stock options and warrants		—				—
Earnings (loss) per common share, diluted		1,713,375	$	1.15		1,713,375	$	(.09	)

In 2012 and 2011, stock options representing 161,272 shares were not included in the calculation of earnings per share because they would have been antidilutive.

Note 12 - Employee Benefit Plans

MainStreet funds certain costs for medical benefits in amounts determined at the discretion of management. BankShares has a 401-K plan which provides for contributions by employees and a matching contribution by the Company. Total 401-K match expense was $71,197 and $72,171 for the years ended December 31, 2012 and 2011, respectively.

In addition, MainStreet has supplemental retirement benefits provided to its executive officers under a supplemental executive retirement plan (“SERP”) executed in 2007. Although technically unfunded, a Rabbi Trust and insurance policies on the lives of the covered executives are available to finance future benefits. The Bank is the owner and beneficiary of these policies. The expense for 2012 and 2011 was $1,097,227 and $121,647, respectively. Total expected expense for 2013 is $120,720. The following were significant actuarial assumptions used to determine benefit obligations:

56

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

	December 31, 2012			December 31, 2011
Actuarial Assumptions
Weighted average assumed discount rate		6.25	%		6.25	%
Assumed rate of annual compensation increases		3.50			4.50

	December 31, 2012			December 31, 2011
Changes in Projected Benefit Obligation
Projected benefit obligation January 1,	$	506,232		$	397,059
Service cost		1,023,743			101,804
Interest cost		78,842			23,790
Prior gain amortized		(5,358	)		(3,947	)
Actuarial gain		(8,162	)		(12,474	)
Benefits paid		—			—
Projected benefit obligation, December 31	$	1,595,297		$	506,232

The SERP liability, equal to the projected benefit obligation above, is included in other liabilities on the Corporation’s consolidated balance sheet.

Amounts Recognized in Accumulated Other Comprehensive Income
Actuarial gains	$	70,517		$	62,354
Deferred income tax liability		(23,976	)		(21,200	)
	$	46,541		$	41,154
Components of Net Periodic Benefit Cost
Service cost	$	1,023,743		$	101,804
Interest cost		78,842			23,790
Actuarial gains		(5,358	)		(3,947	)
Net Periodic Benefit Cost	$	1,097,227		$	121,647
Other Pre-tax Changes in Benefit Obligations Recognized in Other Comprehensive Income
Actuarial gains	$	(8,162	)	$	(12,474	)
Total Pre-tax Amounts Recognized in Net Periodic
Cost and Other Comprehensive Income	$	1,089,065		$	109,173

The SERP is designed to provide 65% of final average five years base salary less the social security contribution. The SERP has certain provisions for early retirement, death benefits and disability. Upon the death of Larry A. Heaton in December 2012, his beneficiary began receiving payments in 2013. These payments will be made over 15 years continuing through January 2027. Brenda H. Smith is scheduled to begin receiving benefit payments in 2025.

Note 13 – Leases and Commitments

The Corporation has a lease agreement for its facility in Martinsville, Virginia. MainStreet’s executive office and operations area lease, which commenced on November 19, 2010, is for 7,900 square feet of space located at 1075 Spruce Street in Martinsville, Virginia. The lease will expire November 30, 2015.

57

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Franklin Bank’s main office is located at 400 Old Franklin Turnpike, Suite 100, Rocky Mount, Virginia, in a section of town known as the Rocky Mount Marketplace. The bank leases a two-story facility with approximately 8,200 square feet of which the Bank provides permanent financing to the owners. The lease is for a 15-year period and the expiration date of the lease is June 30, 2018. The lease payment mirrors the loan payment plus an 8% return on investment to the owner. One of the owners is also a director of Franklin Bank and both owners are shareholders of BankShares. A banking office, Westlake Branch, of Franklin Bank opened on April 9, 2004 at 12930 Booker T. Washington Highway, Hardy, Virginia. The bank also provides permanent financing to the owner of this facility, of which a director of the bank is a partner. The lease commenced on April 7, 2004 and will expire April 6, 2019. The lease payment mirrors the loan payment plus an 8% return on investment to the owner. Franklin Bank’s 220 North banking office was located at 35 Shepherd Drive, Rocky Mount, Virginia. A director of Franklin Bank was a partner in the ownership of the facility. The lease commenced June 1, 2007 and expired June 1, 2012. This banking office was closed effective November 13, 2010; however, the lease remained in effect until its maturity and had a sublease until then. Franklin Bank purchased the building at the maturity of the lease and assigned the purchase to another buyer who was a director of both the Corporation and Franklin Bank.

In addition to the leases for office space, the Corporation also leases various pieces of office equipment under short and long-term leases.

Total rent expense approximated $356,000 and $364,000 for the years ended December 31, 2012 and 2011, respectively. Future rental payments under non-cancelable operating leases approximate $354,000, $360,000, $357,000, $320,000 and $320,000 for the years ended December 31, 2013, 2014, 2015, 2016 and 2017, respectively. The total aggregate of lease payments after 2017 total approximately $245,000.

The Corporation and Franklin Bank had an employment agreement with Larry A. Heaton, former President and Chief Executive Officer. This agreement is no longer in effect as a result of Mr. Heaton’s death. The Corporation also has an employment agreement with its Acting President and Chief Executive Officer, Brenda H. Smith. This agreement has a three-year term and is automatically extended by one year if not terminated at least 90 days prior to each anniversary.

MainStreet and Franklin Bank entered into change in control agreements with its Vice Presidents effective November 14, 2007. The agreements shall remain in effect until the termination of the officers’ employment, other than a termination of employment which results in a payment obligation, at which time it will become null and void. The Franklin Community Bank agreements provide for a non competition obligation within a 50 mile radius of the office where the officer was principally located during the twelve months preceding the officer’s termination.

Note 14 - Stock Options and Warrants

The shareholders of MainStreet approved the 2004 Key Employee Stock Option Plan, (the “Plan”), at its Annual Meeting on April 15, 2004. The Plan permitted the grant of Non-Qualified Stock Options and Incentive Stock Options to persons designated as “Key Employees” of BankShares or its subsidiaries. The Plan was approved by the Board of Directors on January 21, 2004 and terminated on January 21, 2009, except with respect to awards made prior to and outstanding on that date which remain valid in accordance with their terms. Option awards were granted with an exercise price equal to the market value of MainStreet’s stock at the date of grant. The options issued in 2007 and 2006 had a vesting period of 3 years and have a ten year contractual term. The options issued in 2005 vested immediately upon grant and have a ten year contractual term. All share awards provide for accelerated vesting if there is a change in control (as defined in the Plan). The maximum number of shares that could have been issued under the Plan could not exceed 150,700. As of December 31, 2012, there were 136,527 options granted under this Plan of which 822 options have been exercised and 7,433 stock options forfeited.

Options in the amount of 33,000, of which all are vested and exercisable, have been granted at the then fair market value of $9.55 to a former employee and expire in June 2013.

The Corporation has reserved 161,272 shares of authorized but unissued shares of common stock related to these option agreements as of December 31, 2012.

58

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

There were no stock option grants during 2012 and 2011. The Black-Scholes option-pricing model was utilized for grants using the assumptions of risk-free interest rate; expected life of options; expected volatility of the stock price and expected dividend yield.

Expected volatilities are based on the historical volatility of MainStreet’s stock. The risk-free rate for the period within the contractual life of the stock option was based upon the applicable Treasury rate at the date of the grant. Expected life was calculated using the simplified method based on the average of the vesting period and contractual life of the options.

MainStreet recorded no stock-based compensation during the years ended December 31, 2012 and 2011.

MainStreet did not have anyone exercise warrants or stock options during the years ended December 31, 2012 and 2011.

Following is a status and summary of changes of stock options and warrants during the year ended December 31, 2012:

					Weighted
			Weighted		Average
			Average		Remaining		Aggregate
			Exercise		Contractual		Intrinsic
	2012		Price		Term		Value
Outstanding at beginning of year		161,272	$	12.17
Granted		—		—
Exercised		—		—
Forfeited		—		—
Expired		—		—
Outstanding at year-end		161,272	$	12.17		1.83	$	—
Exercisable at year-end		161,272	$	12.17		1.83	$	—

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2012. This amount changes based on changes in the market value of the Corporation’s stock.

As of December 31, 2012 and 2011, there was no unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan.

As of December 31, 2012, stock options outstanding and exercisable are summarized as follows:

	Stock Options
Range of	and Warrants		Remaining
Exercise	Outstanding		Contractual
Prices	And Exercisable		Life
9.55		33,000		.50
12.09		49,403		1.00
12.09		43,977		2.90
12.09		9,066		3.00
15.00		5,796		1.00
15.00		7,464		4.95
16.75		6,050		1.00
16.75		6,516		4.00
$9.55 - $16.75		161,272

59

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Note 15 – Regulatory Requirements and Restrictions

Under the applicable federal laws, the Comptroller of the Currency restricts the total dividend payments of any calendar year, without prior approval, to the net profits of that year as defined, combined with retained net profits for the two preceding years. As of December 31, 2012, the aggregate amount of unrestricted funds according to the regulation that could be transferred from the Corporation’s bank subsidiary to the Parent Corporation for payment of dividends to shareholders without prior regulatory approval, totaled $2,493,579 or 1.36% of the total consolidated assets; however, on April 16, 2009, Franklin Bank entered into a formal agreement with the Office of the Comptroller of the Currency that restricts dividend payments to the holding company.

Franklin Bank is a member of the Federal Reserve System; however, Franklin Bank processes daily through a correspondent bank, Community Bankers’ Bank. As of December 31, 2012, Franklin Bank was required to maintain a reserve balance of $250,000 with Community Bankers’ Bank.

BankShares on a consolidated basis and Franklin Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital ratios can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, MainStreet and Franklin Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulations to ensure capital adequacy require BankShares and Franklin Bank to maintain minimum capital ratios. MainStreet and Franklin Bank were well-capitalized at December 31, 2012 and 2011. On June 17, 2009, MainStreet entered into an agreement with the Federal Reserve Bank of Richmond, which among other things restricted dividend payments.

As of December 31, 2012, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category. Actual capital amounts and ratios for MainStreet at December 31, 2012 and 2011 are presented in the following table:

						Minimum Capital
	Actual					Requirement
As of December 31, 2012	Amount		Ratio			Amount		Ratio
Total capital (to risk weighted assets)	$	25,477,053		19.41	%	$	10,503,000		8.00	%
Tier I capital (to risk weighted assets)		23,823,816		18.15			5,251,000		4.00
Tier I capital (to average assets)		23,823,816		13.02			7,322,000		4.00

60

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

						Minimum Capital
	Actual					Requirement
	Amount		Ratio			Amount		Ratio
Total capital (to risk weighted assets)	$	23,680,761		16.36	%	$	11,582,000		8.00	%
Tier I capital (to risk weighted assets)		21,853,040		15.09			5,791,000		4.00
Tier I capital (to average assets)		21,853,040		10.68			8,183,000		4.00

Actual capital amounts and ratios for Franklin Bank at December 31, 2012 and 2011 are presented in the following table:

											Minimum to be Well
											Capitalized Under
						Minimum Capital					Prompt Corrective
	Actual					Requirement					Action Provisions
As of December 31, 2012	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total capital (to risk weighted assets)	$	24,400,282		18.68	%	$	10,452,000		8.00	%	$	13,065,000		10.00	%
Tier I capital (to risk weighted assets)		22,754,882		17.42			5,226,000		4.00			7,839,000		6.00
Tier I capital (to average assets)		22,754,882		12.47			7,298,000		4.00			9,122,000		5.00

											Minimum to be Well
											Capitalized Under
						Minimum Capital					Prompt Corrective
	Actual					Requirement					Action Provisions
As of December 31, 2011	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total capital (to risk weighted assets)	$	22,654,644		15.71	%	$	11,554,000		8.00	%	$	14,442,000		10.00	%
Tier I capital (to risk weighted assets)		20,833,548		14.44			5,769,000		4.00			8,654,000		6.00
Tier I capital (to average assets)		20,833,548		10.21			8,162,000		4.00			10,202,000		5.00

Note 16 – Parent Company Financial Information

CONDENSED BALANCE SHEETS

	December 31, 2012		December 31, 2011
Assets
Cash and due from banks	$	176,652	$	158,105
Interest-bearing deposits in other banks		422,381		428,503
Furniture, fixtures and equipment, net		80,608		95,441
Other assets		94,296		41,527
Investment in subsidiaries		23,600,121		21,590,119
Total Assets	$	24,374,058	$	22,313,695
Liabilities and Shareholders’ Equity
Accrued interest payable and other liabilities	$	123,685	$	72,906
Shareholders’ Equity
Common shareholders’ equity		24,250,373		22,240,789
Total Liabilities and Shareholders’ Equity	$	24,374,058	$	22,313,695

61

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

CONDENSED STATEMENTS OF OPERATIONS

	Year Ended			Year Ended
	December 31, 2012			December 31, 2011
Income
Equity (loss) in undistributed income of subsidiaries	$	1,971,194		$	(146,450	)
Interest income		913			2,018
Other income		561			158
Affiliate fee income		1,563,393			1,543,560
Total Income		3,536,061			1,399,286
Expenses
Salaries and employee benefits		1,008,864			1,016,713
Occupancy and equipment expense		132,422			143,394
Professional fees		201,621			179,613
Outside processing		104,379			83,145
Other expenses		118,002			122,683
Total Expenses		1,565,288			1,545,548
Net Income (Loss) Before Tax		1,970,773			(146,262	)
Income Tax Expense (Benefit)		(3	)		183
Net Income (Loss)	$	1,970,776		$	(146,445	)

CONDENSED STATEMENTS OF CASH FLOWS

	Year Ended			Year Ended
	December 31, 2012			December 31, 2011
Cash Flows From Operating Activities:
Net income (loss)	$	1,970,776		$	(146,445	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		32,301			42,294
Equity in undistributed (income) loss of subsidiaries		(1,971,194	)		146,450
Increase in other assets		(52,769	)		(3,344	)
Increase (decrease) in other liabilities		50,779			(19,910	)
Net Cash Provided by Operating Activities		29,893			19,045
Cash Flows From Investing Activities:
Decrease in interest-bearing deposits		6,122			51,843
Purchases of furniture and equipment		(17,468	)		(38,721	)
Net Cash Provided By (Used) in Investing Activities		(11,346	)		13,122
Net Increase in Cash		18,547			32,167
Cash at Beginning of Year		158,105			125,938
Cash at End of Year	$	176,652		$	158,105

Note 17 – Financial Instruments With Off-Balance-Sheet Risk

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

62

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk. At December 31, 2012 and 2011, outstanding commitments to extend credit including letters of credit were $15,726,309 and $18,556,714 respectively.

	2012		2011
Commercial	$	3,507,973	$	4,053,217
Real Estate:
Construction and land development		1,496,661		2,355,055
Residential 1-4 families
First liens		1,046,761		1,606,089
Junior liens		209,253		224,181
Home Equity lines		7,979,295		8,263,110
Commercial real estate		1,062,715		1,507,845
Consumer		423,651		547,217
Total Outstanding Commitments	$	15,726,309	$	18,556,714

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

Note 18 – Concentrations of Credit Risk

MainStreet monitors its loan portfolio by the segments found in Note 3 of these financial statements. In addition, we look at the trends of significant industries within the segments. Loan segments are categorized primarily based upon regulatory guidelines which follows the underlying collateral. For the most part, MainStreet’s business activity is with customers located in our primary market area. Accordingly, operating results are closely correlated with the economic trends within the region and influenced by the significant regional industries within the region including pre-built housing, real estate development, agricultural, and resort and leisure services. In addition, the ultimate collectability of the loan portfolio is susceptible to changes in the market condition of the region. The real estate market in our area is also affected by the national economy because a portion of our real estate lending is dependent on buyers who move into our region. There are three industry concentrations that are broken out in the table below by our loan segments.

	December 31, 2012
			Loans for
			Construction of		Loans for
	Loans for		Heavy & Civil		Real Estate
	Construction		Engineering		Including
	of Buildings		Buildings		Construction		Total
Commercial	$	383,219	$	580,462	$	758,289	$	1,721,970
Real Estate
Construction and land development		2,776,618		4,364,771		2,669,695		9,811,084
Residential, 1-4 families
First Liens		4,292,479		1,324,124		6,739,075		12,355,678
Junior Liens		900,379		—		616,553		1,516,932
Home Equity Lines		19,881		—		—		19,881
Commercial real estate		3,971,666		—		22,907,145		26,878,811
Consumer		6,457		—		3,000		9,457
Total	$	12,350,699	$	6,269,357	$	33,693,757	$	52,313,813

63

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

	December 31, 2011
			Loans for
			Construction of		Loans for
	Loans for		Heavy & Civil		Real Estate
	Construction		Engineering		Including
	of Buildings		Buildings		Construction		Total
Commercial	$	1,253,591	$	483,320	$	1,498,370	$	3,235,281
Real Estate
Construction and land development		2,492,124		5,301,322		3,623,938		11,417,384
Residential, 1-4 families
First Liens		5,496,770		1,301,934		6,179,892		12,978,596
Junior Liens		577,046		124,413		763,513		1,464,972
Home Equity Lines		9,845		—		—		9,845
Commercial real estate		3,995,367		315,979		23,396,327		27,707,673
Consumer		10,602		—		—		10,602
Total	$	13,835,345	$	7,526,968	$	35,462,040	$	56,824,353

Disclosed below are concentrations in acquisition and development loans, speculative lot loans, and speculative single-family housing construction. Some of these amounts are also included in the above concentrations.

	December 31, 2012
	Total		Concentrations		Net Addition to
	Concentration		Included Above		Concentrations
Acquisition & development	$	124,964	$	124,964	$	—
Speculative lot loans		4,912,535		3,086,490		1,826,045
Speculative single-family housing construction		4,275,965		1,802,221		2,473,744

	December 31, 2011
	Total		Concentrations		Net Addition to
	Concentration		Included Above		Concentrations
Acquisition & development	$	498,228	$	223,228	$	275,000
Speculative lot loans		7,267,049		3,223,647		4,043,402
Speculative single-family housing construction		6,200,835		4,194,489		2,006,346

MainStreet has established policies related to the credit process and collateral in loan originations. Loans to purchase real and personal property are generally collateralized by the related property with loan amounts established based on certain percentage limitations of the property’s total stated or appraised value. Credit approval is primarily a function of cash flow, collateral and the evaluation of the creditworthiness of the individual borrower or project based on pertinent financial information and the amount to be financed.

MainStreet has established policies for correspondent bank risk to include cash and due from accounts and overnight federal funds sold. Correspondents are monitored on a quarterly basis, and more frequently if warranted, on several financial and credit ratios. Total exposure is evaluated.

Note 19 – Fair Value Measurements

Generally accepted accounting principles specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect MainStreet’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

64

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Level 1 –	Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –	Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –	Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by MainStreet to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the consolidated financial statements:

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). We only utilize third party vendors to provide fair value data for the purposes of recording amounts related to our fair value measurements of our securities available for sale portfolio. We obtain SSAE16 reports from our third party vendor on an annual basis. Our third party vendor also utilizes a reputable pricing company for security market data that utilizes a matrix pricing model. For government sponsored agencies, the model gathers information from market sources and integrates relative credit information, observed market movements and sector news. For agency mortgage backed securities, the model incorporates the current weighted average maturity and takes into account additional pool level information supplied directly by the agency or government sponsored enterprise. The third party vendor system has controls and edits in place for month-to-month market checks and zero pricing. We make no adjustments to the pricing service data received for our securities available for sale.

Loans held for sale: Loans held for sale are recorded at fair value on a recurring basis which is the carrying value. Loans held for sale, generally are closed and sold within two weeks.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012:

			Fair Value Measurements at December 31, 2012 Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
	Balance as of		Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
Description	2012		(Level 1)		(Level 2)		(Level 3)
Available-for-sale securities:
U. S. government sponsored agencies	$	1,471,773	$	—	$	1,471,773	$	—
Mortgage backed securities		12,637,537		—		12,637,537		—
States and political subdivisions		4,727,251		—		4,727,251		—
Total available-for-sale Securities	$	18,836,561	$	—	$	18,836,561	$	—
Loans held for sale		432,000		—		432,000		—
Total assets at fair value	$	19,268,561	$	—	$	19,268,561	$	—

65

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2011:

			Fair Value Measurements at December 31, 2011 Using
			Quoted Prices
			in Active		Significant
			Markets for		Other		Significant
	Balance as of		Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
Description	2011		(Level 1)		(Level 2)		(Level 3)
Available-for-sale securities:
U. S. government sponsored agencies	$	2,810,782	$	—	$	2,810,782	$	—
Mortgage backed securities		17,255,190		—		17,255,190		—
States and political subdivisions		1,133,912		—		1,133,912		—
Total available-for-sale securities	$	21,199,884	$	—	$	21,199,884	$	—
Total assets at fair value	$	21,199,884	$	—	$	21,199,884	$	—

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by MainStreet to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans or the present value of future cash flows. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing recent appraisals conducted by an independent, licensed appraiser using observable market data (Level 2). However, if the appraisal of the real estate property is not current, or has been discounted, then the fair value is considered Level 3. It is also considered Level 3 if an evaluation is conducted by Franklin Bank, rather than by a third party. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Operations.

Other Real Estate Owned (OREO): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on a recent appraisal conducted by an independent licensed appraiser using observable market data, the Corporation records the OREO as nonrecurring Level 2. When the appraisal of the real estate property is not current, or has been discounted, the Corporation records the OREO as nonrecurring Level 3. It is also considered Level 3 if an evaluation is conducted by Franklin Bank, rather than by a third party.

The following table summarizes MainStreet’s assets that were measured at fair value on a nonrecurring basis during the period.

66

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

			Carrying value at December 31, 2012
			Quoted Prices
			in Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
	Balance as of		Assets		Inputs		Inputs
Description	December 31, 2012		(Level 1)		(Level 2)		(Level 3)
Impaired loans, net	$	455,820	$	—	$	—	$	455,820
Other real estate owned, net		1,441,722		—		—		1,441,722
Total assets at fair value	$	1,897,542	$	—	$	—	$	1,897,542

The following table summarizes MainStreet’s financial assets that were measured at fair value on a nonrecurring basis during the period.

			Carrying value at December 31, 2011
			Quoted Prices
			in Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
	Balance as of		Assets		Inputs		Inputs
Description	December 31, 2011		(Level 1)		(Level 2)		(Level 3)
Impaired loans, net	$	4,867,822	$	—	$	4,218,384	$	649,438
Other real estate owned, net		3,572,518		—		1,596,190		1,976,328
Total assets at fair value	$	8,440,340	$	—	$	5,814,574	$	2,625,766

The changes in Level 3 assets measured at estimated fair value on a nonrecurring basis during the period ended December 31, 2012 were as follows:

	Fair Value Measurements at December 31, 2012
	Impaired			Other Real Estate
	Loans			Owned
Balance – January 1, 2012	$	649,438		$	1,976,328
Total gains (losses) realized/unrealized
Included in earnings (write downs)		—			(464,558	)
Newly Impaired /New OREO		1,177,993			2,564,074
Sales		(88,350	)		(3,566,871	)
Settlements/Foreclosures/Pay downs/charge offs		(771,981	)		—
Transfers into Level 3		1,781,403			932,749
Transfers out of Level 3		(2,292,683	)		—
Balance – December 31, 2012	$	455,820		$	1,441,722

The following table displays quantitative information about Level 3 Fair Value Measurements for December 31, 2012:

	Quantitative information about Level 3 Fair Value Measurements for December 31, 2012
	Fair		Valuation	Unobservable				(Weighted
	Value		Technique(s)	Input	Range			Average)
Assets
Impaired loans	$	455,820	Internal evaluations	Internal evaluations / market discount		6%-100	%		(47	)%
Other real estate owned	$	1,077,399	Discounted appraised value	Selling cost / market discount		33%- 41	%		(38	)%
	$	364,323	Internal evaluations	Internal evaluations		38%- 74	%		(44	)%

67

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

(a) Short-Term Financial Instruments

The carrying values of short-term financial instruments including cash and cash equivalents, federal funds sold and interest-bearing deposits in domestic banks approximate the fair value of these instruments. These financial instruments generally expose the Corporation to limited credit risk and have no stated maturity or have an average maturity of 30-45 days and carry interest rates which approximate market value.

(b) Securities Available-for-Sale

The fair value of investments is estimated based on quoted market prices or dealer quotes.

(c) Restricted Equity Securities

The carrying value of restricted equity securities approximates fair value based on the redemption provisions of the appreciable entities.

(d) Loans Held for Sale

The carrying value of these loans approximates the fair value. These loans close in our name but are generally sold within a two-week period.

(e) Loans

Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, real estate – commercial, real estate – construction, real estate – mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan as well as estimates for operating expenses and prepayments. The estimate of maturity is based on management’s assumptions with repayment for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.

(f) Accrued Interest

The carrying amounts of accrued interest approximate fair value.

(g) Bank Owned Life Insurance

The carrying amount is a reasonable estimate of fair value.

(h) Deposits

The fair value of demand, interest checking, savings and money market deposits is the amount payable on demand. The fair value of fixed maturity time deposits and certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities and repayment characteristics.

(i) Repurchase Agreements

The fair value of repurchase agreements is estimated using a discounted cash flow calculation that applies contracted interest rates being paid on the debt to the current market interest rate of similar debt.

(j) Short-term Borrowings

The carrying amount is a reasonable estimate of fair value.

68

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

(k) Commitments to Extend Credit and Standby Letters of Credit

The only amounts recorded for commitments to extend credit and standby letters of credit are the fees arising from these unrecognized financial instruments. The fair value of these commitments has been determined to be immaterial.

The carrying values and estimated fair values of financial instruments at December 31, 2012 and 2011 are as follows:

			Fair Value measurements at December 31, 2012 using
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	Carrying Value		Level 1		Level 2		Level 3		Fair Value
FINANCIAL ASSETS:
Cash and due from banks	$	3,076,535	$	3,076,535	$	—	$	—	$	3,076,535
Interest-bearing deposits in banks		11,546,938		11,546,938		—		—		11,546,938
Federal funds sold		9,414,880		9,414,880		—		—		9,414,880
Securities available-for-sale		18,836,561		—		18,836,561		—		18,836,561
Restricted equity securities		741,000		—		741,000		—		741,000
Loans held for sale		432,000		—		432,000		—		432,000
Loans, net		131,890,568		—		—		132,468,434		132,468,434
Accrued interest receivable		552,402		—		552,402		—		552,402
Bank owned life insurance		1,061,440		—		1,061,440		—		1,061,440
FINANCIAL LIABILITIES:
Deposits:
Non-interest bearing demand deposits	$	22,819,544	$	—	$	22,819,544	$	—	$	22,819,544
Interest bearing deposits		127,759,824		—		128,335,646		—		128,335,646
Repurchase agreements		6,000,000		—		6,001,070		—		6,001,070
Accrued interest payable		176,136		—		176,136		—		176,136

The carrying values and estimated fair values of financial instruments at December 31, 2011 are as follows:

	Carrying Value		Fair Value
FINANCIAL ASSETS:
Cash and due from banks	$	2,767,395	$	2,767,395
Interest-bearing deposits in other banks		17,091,438		17,091,438
Federal funds sold		10,612,680		10,612,680
Securities available-for-sale		21,199,884		21,199,884
Restricted equity securities		830,000		830,000
Loans, net		139,951,059		138,716,777
Accrued interest receivable		547,905		547,905
Bank owned life insurance		3,049,696		3,049,696
FINANCIAL LIABILITIES:
Deposits:
Non-interest bearing demand deposits	$	20,975,660	$	20,975,660
Interest bearing deposits		146,107,182		146,767,245
Repurchase agreements		13,500,000		13,874,422
Accrued interest payable		225,611		225,611

69

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and-off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.

The Corporation assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Corporation’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Corporation. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Corporation’s overall interest rate risk.

Note 20 – Contingencies and Other Matters

The Corporation currently is not involved in any litigation matters outside the normal operations associated with problem credits.

Note 21 - Subsequent Events

In preparing these consolidated financial statements, the Corporation has evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.

Note 22 – Regulatory

On April 16, 2009, Franklin Bank entered into a formal agreement (“Agreement”) with The Comptroller of the Currency (“OCC”). The Agreement required Franklin Bank to perform certain actions within designated time frames. The Agreement is intended to demonstrate Franklin Bank’s commitment to review/enhance certain aspects of various policies. The Agreement describes Franklin Bank’s commitment to enhance practices related to credit administration and liquidity. While Franklin Bank expects to achieve full compliance and submitted the responses required in the respective time frames, we are required to show sustained performance with various requirements under the Agreement and compliance with certain obligations are dependent, in part, on factors that we may not control. Therefore, we cannot assume that we will be able to achieve full compliance.

On June 17, 2009, MainStreet BankShares, Inc. entered into a Memorandum of Understanding (“MOU”) with the Federal Reserve Bank of Richmond (“Federal Reserve”). The MOU required the bank holding company to utilize its financial and managerial resources to assist Franklin Bank in functioning in a safe and sound manner. The MOU restricted MainStreet from declaring or paying any dividends without the prior written approval of the Federal Reserve. Under the MOU, MainStreet cannot incur or guarantee any debt or redeem or repurchase any shares of its common stock without the prior written consent of the Federal Reserve. On January 26, 2011, we entered into a new MOU with the Federal Reserve which contained the same terms of the previous MOU (which was terminated) but added provisions respecting compliance with certain laws and regulations as follows. The bank holding company is required to comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act (12 U.S.C. 1828(k)) and Part 359 of the Federal Deposit Insurance Corporation’s regulations (12 C.F.R. Part 359). Also, the Corporation may not appoint any individual to the board or employ or change the responsibilities of any individual as senior executive officer if the Federal Reserve notifies the Corporation of disapproval within the required time limits. MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. Management believes the holding company is appropriately using its financial and managerial resources to assist Franklin Bank to function in a safe and sound manner.

70

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2012 and 2011 

Note 23 – Other Comprehensive Income

Changes in each component of accumulated other comprehensive income were as follows:

	Net Unrealized
	Gains on Securities available for			Adjustments Related to Post Retirement			Accumulated Other Comprehensive
	sale (1)			Benefits (2)			Income
Balance at December 31, 2010	$	57,061		$	32,921		$	89,982
Net unrealized holding gains on securities available for sale during the period		555,422			—			555,422
Deferred income tax expense on unrealized holding gains on securities available for sale		(188,844	)		—			(188,844	)
Less reclassification adjustments for gains included in net income		(116,734	)		—			(116,734	)
Tax related to gains on securities sold		39,690			—			39,690
Change in actuarial gain on SERP		—			12,474			12,474
Deferred income tax expense		—			(4,241	)		(4,241	)
Balance at December 31, 2011	$	346,595		$	41,154		$	387,749
Net unrealized holding gains on securities available for sale during the period		37,218			—			37,218
Deferred income tax expense on unrealized holding gains on securities available for sale		(12,653	)		—			(12,653	)
Less reclassification adjustments for gains included in net income		(1,848	)		—			(1,848	)
Tax related to gains on securities sold		628			—			628
Change in actuarial gain on SERP		—			23,429			23,429
Deferred income tax expense		—			(7,966	)		(7,966	)
Balance at December 31, 2012	$	369,940		$	56,617		$	426,557

(1) Represents the difference between the fair value and amortized cost of securities available for sale.

(2) Represents changes in the SERP liability due to prior service costs, gains and losses, and amortizations.

71

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

December 31, 2012 and 2011

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None.

PART III

Item 9A. Controls and Procedures

MainStreet’s principal executive officer and principal financial officer have reviewed MainStreet’s disclosure controls and procedures (as defined in 204.13a-15(e) and 204.15d-15(e)) as of the end of the period covered by this annual report and based on their evaluation believe that MainStreet’s disclosure controls and procedures are effective. There have not been any changes in our internal control over financial reporting that occurred during the period that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

To the Stockholders:

Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.

Management is also responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control over financial reporting includes those policies and procedures that pertain to the Corporation’s ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.

In order to ensure that the Company’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2012. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management has concluded that the internal control over financial reporting was effective as of December 31, 2012.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to the Securities and Exchange Commission final rule effective September 21, 2010 providing this requirement shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934.

Item 9B. Other Information

None.

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

December 31, 2012 and 2011

Item 10. Directors, Executive Officers and Corporate Governance

Directors of the Registrant

MainStreet’s Board of Directors are divided into three classes that serve staggered three-year terms. The members of one class are elected at each annual meeting of shareholders and hold office until the third annual meeting following their election or until successors are elected and qualified. The term of the Class C Directors expires in 2013, the term of the Class A Directors expires in 2014, and the term of the Class B Directors expires in 2015. The following tables set forth material information about MainStreet’s current executive officers and directors.

Name (Age)		Offices and Positions Held
	Class A Directors – Term Expires 2014
Michael A. Turner (59)		Director since December 2002
	Class B Directors – Term Expires 2015
Charles L. Dalton (49)		Director since July 2001
Joel R. Shepherd (49)		Director since December 2002
	Class C Directors – Terms Expires 2013
William L. Cooper, III (59)		Director since February 2007
John M. Deekens (65)		Director since July 2001
Danny M. Perdue (67)		Director since December 2002

William L. Cooper, III is partial owner and President of Cooper Classics, Inc. He is CEO and partial owner of CWP, Inc. He is a managing partner of Grassy Hill Investment and Grassy Hill Properties. He is also a director of Franklin Community Bank, N.A. Mr. Cooper is Vice President of the Rocky Mount Historic Foundation and Treasurer of Rocky Mount Methodist Church. Mr. Cooper brings financial, managerial, business building, and corporate governance skills and experience to BankShares. He has extensive “bank board” experience. He was on the board of MainStreet Financial Corporation from 1994 – 1999, a public bank holding company. He was on the Corporate Virginia State BB&T board from 1999 – 2007. Mr. Cooper is active in the community in which he lives and which Franklin Bank serves. He has been on many committees and boards including the Heart Fund and the YMCA. He was chairman of the deacon board of his church for 20 years.

Charles L. Dalton is Vice President, General Manager and partial owner of Dalton Insurance Agency, Inc. in Stuart, Virginia. He is a Member/Partial owner Stuart Laurel Court, LLC. He has been a past president of the Stuart Rotary Club. He is a member of the Patrick County Chamber of Commerce where he has been a past President. He is a member of the Professional Agents of Virginia and is active in the Patrick County American Legion Baseball. Mr. Dalton brings financial services/insurance industry and management experience to BankShares demonstrated by the success of his insurance agency. He has been active in his community and through these services he contributes experience to BankShares’ board.

John M. Deekens is a retired General Manager for Stuart Forest Products in Stuart, Virginia. In addition he held the position of Plant Manager for Stuart Forest Products. Prior to that, he was the Quality Control Manager for Hooker Furniture Corporation in Martinsville, Virginia. He is a past member of the Stuart Rotary Club where he held various offices. He served as Mayor of Stuart for eight years and was a member of the Town council for an additional four years. He currently serves as chairman of the finance committee of the church he attends and is a member. Mr. Deekens brings managerial and financial skills to the Board of Directors. He also served on a Bi-County Economic Commission for four years and held various offices in the Stuart Rotary Club. Through his community services, he also contributes this experience to BankShares’ Board.

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

December 31, 2012 and 2011

Danny M. Perdue is currently the owner of the Franklin Shopping Center. He is a partial owner and President of Redwood Minute Markets, Inc. He is a partial owner of First Minute Markets, LLC, FFH Operations, Inc. and FFH Investors, LLC. He is also an owner of Redwood Petroleum Products, Ferrum Petroleum Products, Franklin Petroleum Products, 604 Petroleum Products and Penhook Petroleum Products. He is Vice President of Perdue Properties, Inc. Mr. Perdue is also a director of Franklin Community Bank, N.A. He is currently active in the Rocky Mount Rotary Club and is on the Board of Trustees of Ferrum College. He is a past member and President of the Rocky Mount Chamber of Commerce and the United Way in Franklin County. He was a founding member of the Burnt Chimney Volunteer Fire Department. Mr. Perdue brings entrepreneurial, business management and financial skills to BankShares as demonstrated through the successful businesses that he owns and manages. He also served as a board director for The Bank of Ferrum, a community bank in Franklin County from 1994 – 1999 and an advisory board member for BB&T in Franklin County from 1999 – 2001 which brings financial institution governance to BankShares’ Board. Mr. Perdue is very active in the community that Franklin Bank serves and brings that experience to the board.

Joel R. Shepherd is a partial owner and President of Virginia Home Furnishings, Inc., and 220 Self Storage, Inc. He is also a partial owner of Shepherd Properties, LLC, Wirtz Properties, LLC, Wirtz Services, LLC, Kyle Avenue, LLC, FFH Operations, Inc., FFH Investors, LLC, the Franklin LLC, Wirtz Lot 2, LLC and King Street Properties, LLC. Prior to developing his current businesses, Mr. Shepherd served from 1986 to 1993 as a Vice President and Portfolio Manager in the Funds Management Division of Dominion Bankshares, Inc. (acquired by First Union). Mr. Shepherd is also a director of Franklin Community Bank, N.A. He is also on the Business Advisory Council for Ferrum College. He is a member of the board of Trustees of Faith Christian School in Roanoke, Virginia and a member of the finance committee for the school. Mr. Shepherd brings entrepreneurial, business building, finance and management skills to BankShares through the operations of his various companies which are diversified in their business. He also brings financial institution management and investment skills to BankShares. Mr. Shepherd is active in the community that Franklin Bank serves and brings that experience to the Board.

Michael A. Turner has served as the partial owner and President of Turner’s Building, Inc. from 1976 to present. He also serves as a partner in T & J Property Associates, LC and Pigg Riverville, LLC. In addition, Mr. Turner was a partner in Deep River Investments (developer of real estate) from 1989 to 2003. He is also a director of Franklin Community Bank, N.A. He is also a member of the Cool Branch Volunteer Rescue Squad, and the Smith Mountain Lake Chamber of Commerce. Mr. Turner is an entrepreneur that brings financial and management experience to BankShares demonstrated by the building and successfulness of his own construction and real estate development companies. He also served as a board director for The Bank of Ferrum, a community bank in Franklin County from 1994 – 1999 and an advisory board member for BB&T in Franklin County from 1999 – 2001 which brings governance to BankShares as a board member. Mr. Turner has been active in the community where he lives and Franklin Bank operates.

There are no family relationships that need to be reported, nor are any directors serving as directors on boards of other reporting companies.

Prior to his tragic death, Larry A. Heaton served as President, CEO and Director of MainStreet BankShares, Inc. Mr. Heaton was appointed this responsibility upon the retirement of Cecil R. McCullar in May 2006. Mr. Heaton also served as the President, CEO and Chairman of Franklin Community Bank, N.A. along with President, Treasurer and Director of MainStreet RealEstate, Inc. Through his 34 years of banking experience Mr. Heaton had great knowledge and perspective of the banking and financial services industry which Franklin Bank operates.

Joseph F. Clark, President of Clark Brothers Company, Inc. in Stuart, Virginia delivered his resignation as a Director of MainStreet BankShares, Inc. effective August 10, 2012. Mr. Clark served as a Director of MainStreet BankShares, Inc. for eleven years.

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

December 31, 2012 and 2011

	Executive Officers Not a Director
		First Elected
Name (Age)	Offices and Positions Held	As an Officer
Brenda H. Smith (53)	Acting President and CEO	8/99
	and Executive Vice President
	Chief Financial Officer
	Corporate Secretary

Brenda H. Smith joined the Corporation in August 1999. In December 2012, upon the tragic death of Larry A. Heaton, Mrs. Smith was named Acting President and CEO of MainStreet BankShares, Inc. and Franklin Community Bank, N.A. In her dual capacity role, Mrs. Smith also continues to serve as the Executive Vice President, Chief Financial Officer, and Corporate Secretary for MainStreet BankShares, Inc. and board secretary of Franklin Community Bank, N.A. She is also Acting President and Executive Vice President, Secretary and a Director of MainStreet RealEstate, Inc. From 1995 to 1999, Ms. Smith was Vice President, Corporate Controller and Assistant Secretary of MainStreet Financial Corporation, a $2 billion multi-bank holding company headquartered in Martinsville, Virginia. From 1988 to 1995, she was an Accounting Officer for Piedmont Trust Bank, a subsidiary of MainStreet Financial Corporation. Ms. Smith is a member of Pleasant Grove Christian Church and serves on the Safetynet Board of Trustees.

MainStreet has a standing Audit Committee. The Audit Committee is responsible for the oversight of the Company’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent auditor and approves decisions regarding the appointment or removal of the Company’s Internal Auditor. It meets periodically with management, the independent auditors and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company in addition to reviewing the Company’s financial reports. The independent auditors and the internal auditor have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee. The members of the Audit Committee are C. Laine Dalton, J. Mac Deekens, Joel R. Shepherd (Chairman), Michael A. Turner, and Danny M. Perdue.

MainStreet’s Board of Directors has determined that MainStreet does not have a financial expert serving on its Audit Committee. MainStreet is a small and relatively young corporation located outside a major metropolitan area. Because of our size and location, we have not pursued a financial expert and there is no certainty that one could be found. The Board of Directors as a whole has adequate financial expertise.

MainStreet has adopted a Code of Ethics for all of its employees including its Chief Executive and Chief Accounting Officers. A copy of the Code of Ethics may be obtained without charge upon request by writing to Brenda H. Smith, Executive Vice President, 1075 Spruce Street, Martinsville, Virginia, 24112.

Other information required by Item 10 of Form 10-K appears on pages 10 through 12 of the Corporation’s 2013 Proxy Statement and is incorporated herein by reference.

Item 11. Executive Compensation

The information required by Item 11 of Form 10-K appears on pages 12 through 15 of the Corporation’s 2013 Proxy Statement and is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 of Form 10-K appears on pages 8 through 10 of the Corporation’s 2013 Proxy Statement and is incorporated herein by reference.

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

December 31, 2012 and 2011

Item 13. Certain Relationships and Related Transactions, and Director Independence

MainStreet’s executive officers and directors, and other corporations, business organizations, and persons with which some of MainStreet’s executive officers and directors are associated have banking relationships with Franklin Bank. All such transactions were made in the ordinary course of business on substantially the same terms, including interest rates and security for loans, as those prevailing at the time in comparable transactions with others and did not involve more than the normal risk of collectability or present other unfavorable features. None of such loans are classified as nonaccrual, past due, restructured or potential problem. Information related to loans to MainStreet’s executive officers and directors and their related interests can be found in Part II, Item 8, Note 5 of this document. Deposit information related to MainStreet’s executive officers and directors and their related interests can be found in Part II, Item 8, Note 7 of this document.

Franklin Community Bank, N.A., a subsidiary of MainStreet BankShares, Inc., leases its main office in Rocky Mount, Virginia, and its Westlake office. The owners of the buildings are directors of Franklin Bank.

The information required by Item 13 of Form 10-K concerning director independence appears on page 16 of the Corporations’ 2013 Proxy Statement and is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services

The information required by Item 14 of Form 10-K appears in the Corporation’s 2013 Proxy Statement under the Audit Committee Report and is incorporated herein by reference.

PART IV

Item 15. Exhibits and Financial Statement Schedules

    a) The following documents are filed as part of this report:

1. Financial Statements:

Report of Independent Registered Public Accounting Firm.

Consolidated Balance Sheets as of December 31, 2012 and 2011.

Consolidated Statements of Operations for the Years Ended December 31, 2012 and 2011.

Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2012 and 2011.

Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2012 and 2011.

Consolidated Statements of Cash Flows for the Years Ended December 31, 2012 and 2011.

Notes to Financial Statements.

2. Financial Statement Schedules:

All schedules are omitted as the required information is not applicable or the information is presented in the Financial Statements or related notes.

3. Exhibits and Reports on Form 8-K:

See Index to Exhibits.

76

SIGNATURES

In accordance with section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

MAINSTREET BANKSHARES, INC.

By:	/s/Brenda H. Smith
	Brenda H. Smith, Acting President and Chief Executive Officer

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

NAME	TITLE	DATE
/s/Brenda H. Smith	Acting President/CEO	03/15/13
Brenda H. Smith	Executive Vice President	Date
	Chief Financial Officer
	Corporate Secretary
/s/ William L. Cooper, III	Director	03/15/13
William L. Cooper, III		Date
/s/Charles L. Dalton	Director	03/15/13
Charles L. Dalton		Date
/s/John M. Deekens	Director	03/15/13
John M. Deekens		Date
/s/Danny M. Perdue	Director	03/15/13
Danny M. Perdue		Date
/s/Joel R. Shepherd	Chairman of the Board	03/15/13
Joel R. Shepherd		Date
/s/Michael A. Turner	Director	03/15/13
Michael A. Turner		Date

77

Index to Exhibits

Number	Description of Exhibit
3(i)**	Restated Articles of Incorporation of the Corporation, dated March 6, 2001.
3(ii)	By-laws of the Corporation, dated August 5, 1999 amended February 20, 2001; amended October 16, 2002; amended September 17, 2003; amended July 13, 2005; amended April 20, 2006; and amended October 21, 2009; filed on Form 8-K on October 22, 2009 and herein incorporated by reference.
4.1	Warrant Plan and Certificates as adopted July 27, 1999 and amended August 26, 1999 and amended December 19, 2000 incorporated by reference to the Corporation’s Quarterly Form 10-QSB for quarter ended September 30, 1999, filed December 20, 1999, and herein incorporated by reference.
4.2	Provision in Registrant’s Articles of Incorporation and Bylaws defining the Rights of Holders of the Registrant’s common stock (included in Exhibits 3.1 and 3.2, respectively).
4.3*	Form of Shares Subscription Agreement.
4.3.1***	Form of Shares Subscription Agreement.
4.4*	Form of Units Subscription Agreement.
4.5	2004 Key Employee Stock option Plan filed March 16, 2005 on Form S-8 and herein incorporated by reference.
10.1#	Employment Agreement by and between MainStreet, Franklin Bank, and Larry A. Heaton (President and CEO of Franklin Bank) dated December 30, 2005 incorporated by reference to the Corporation’s Form 8-K filed January 4, 2006.
10.2#	Employment agreement with Executive Vice President, Brenda H. Smith, dated October 1, 2002, filed with the Corporation’s Quarterly Form 10-QSB on November 7, 2002 and herein incorporated by reference. Amendment to employment agreement filed on Form 8-K on April 24, 2006 and herein
	incorporated by reference.
10.3#	Supplemental Executive Retirement Agreement by and between Franklin Community Bank, N.A. and Larry A. Heaton incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.4#	Supplemental Executive Retirement Agreement by and between Franklin Community Bank, N.A. and Brenda H. Smith incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.5#	Change in Control Agreement between MainStreet BankShares, Inc. and Lisa J. Correll incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.6#	Change in Control Agreement between MainStreet BankShares, Inc., Franklin Community Bank, N.A. and Robert W. Shorter incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.7#	Change in Control Agreement between MainStreet BankShares, Inc., Franklin Community Bank, N.A. and Debra B. Scott incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.8#	Change in Control Agreement between MainStreet BankShares, Inc., Franklin Community Bank, N.A. and Linda P. Adams incorporated by reference to the Corporation’s Form 10-KSB filed March 6, 2008.
10.9	Formal agreement by and between The Comptroller of the Currency and Franklin Community Bank, National Association dated April 16, 2009 incorporated by reference to the Corporation’s Form 8-K filed April 20, 2009.
14	Code of Ethics filed March 13, 2006 on Form 10-K and herein incorporated by reference.
21	Subsidiaries of the Registrant.
31.1	Certification of Acting President and Chief Executive Officer, Executive Vice President, Chief Financial Officer and Corporate Secretary Pursuant to Rule 13a-14(a) or 15(d)-14(a) under the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 USC 1350).

*	(Incorporated by reference to Registration statement #333-86993 on Form SB-2 filed September 13, 1999.)
**	(Incorporated by reference to the Corporation’s Annual Report on Form 10-K filed March 15, 2001.)
***	(Incorporated by reference to Registration Statement # 333-63424 on Form SB-2 filed June 20, 2001.)
#	Management contract or compensatory plan or agreement required to be filed as an Exhibit to this Form 10-K pursuant to Item 14(c).

78