NOTE 3: ACQUISITION of NUVO BANK & TRUST COMPANY

On December 4, 2015, the Company completed the merger of NUVO Bank & Trust Company (NUVO), located in Springfield, Massachusetts. NUVO's banking business operates as a division of Merchants Bank, a wholly owned subsidiary of Merchants. Total consideration paid by Merchants for NUVO's outstanding stock is comprised of 517,109 shares of common stock and $5.109 million in cash. Merchants also paid an aggregate of $878,718 to cash out NUVO stock options and a portion of its common stock warrants and issued replacement warrants to purchase an aggregate of 90,756 shares of Merchants common stock on adjusted terms, consisting of warrants expiring in 2017 to purchase 56,386 shares at an exercise price of $20.69 and warrants expiring in 2018 to purchase 34,370 shares at an exercise price of $41.39 per share. The results of NUVO’s operations for the period beginning December 4, 2015, the date of the acquisition, through December 31, 2015, were immaterial to the consolidated entity, and are included in the Company’s consolidated statement of income for the year ended December 31, 2015.

The acquisition of NUVO expands the Company’s New England footprint beyond Vermont and into the Springfield and greater Western Massachusetts commercial banking market. The Company now has 33 banking locations, including the new office in Springfield, Massachusetts.

The acquisition of NUVO was accounted for using the purchase method of accounting and, accordingly, assets acquired, liabilities assumed and consideration paid were recorded at their estimated fair values as of the acquisition date. The excess of consideration paid of $6.967 million over the fair value of net assets acquired has been reported as goodwill in the Company’s consolidated statements of financial condition as of December 31, 2015. Goodwill created in the acquisition is not deductible for income tax purposes. This goodwill consists largely of the synergies and cost savings arising from the combining of the operations of the two companies.

The assets acquired and liabilities assumed in the acquisition of NUVO were recorded at their preliminary estimated fair

values based on management’s best estimates using information available at the date of the acquisition and are subject

to adjustment. While they are not expected to be materially different from those shown, any material adjustments to the estimates will be reflected retroactively as of the date of the acquisition.

In connection with the acquisition, the consideration paid and the fair value of identifiable assets acquired and liabilities assumed as of the date of acquisition are summarized in the following table:


(in thousands)
Consideration paid:
Common stock issued in exchange for NUVO shares	$	16,889
Cash paid for NUVO shares		5,988
Stock warrants issued		544
Total consideration paid	$	23,421

Assets acquired:
Cash and cash equivalents	$	7,070
Interest bearing time deposits with banks		110
Investments		4,344
Restricted investment in bank stock		376
Loans		149,360
Premises and equipment , net		580
Accrued interest receivable		369
Core deposit intangible		1,377
Deferred tax asset		1,926
Other assets		347
Total assets acquired		165,859
Liabilities assumed:
Deposits		144,482
Federal Home Loan Bank advances		4,001
Accrued interest payable		42
Tax effect of acquisition fair value adjustments		705
Other liabilities		183
Total liabilities assumed		149,413
Net assets acquired	$	16,446

Goodwill	$	6,967

Acquired loans purchased credit impaired

The Company has purchased loans, for which there was at acquisition, evidence of credit deterioration since origination and it was probable that all contractually required principal and interest would not be collected. The excess of expected cash flows from acquired loans over the estimated fair value of acquired loans at acquisition is called the accretable discount and is recognized in interest income over the remaining life of the acquired loans using the interest method. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount. The non-accretable discount represents estimated future credit losses expected to be incurred over the life of the acquired loans. Subsequent decreases to the expected cash flows require us to evaluate the need for an addition to the allowance for loan losses. Subsequent improvements in expected cash flows result in the reversal of a corresponding amount of the non-accretable discount which we can then reclassify as accretable discount that is recognized in interest income over the remaining life of the loan using the interest method. The Company’s evaluation of the amount of future cash flows are expected to be collected takes into account actual credit performance of the acquired loans to date and best estimates for the expected lifetime credit performance of the loans using currently available information. Charge offs of the principal amount on acquired loans would be first applied to the non-accretable discount portion of the fair value adjustment. To the extent that the Company experiences a deterioration in credit quality in the expected cash flows subsequent to acquisition of the loans, an allowance for loan losses would be established based on an estimate of future credit losses over the remaining life of the loans.

In accordance with ASC 310-30, recognition of income is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected. The Company performs such an evaluation on a quarterly basis on the acquired loans individually accounted for under ASC 310-30. To the extent that cash flows cannot be reasonably estimated, interest income recognition is discontinued. The carrying amount of loans purchased with evidence of credit deterioration accounted for under ASC 310-30 acquired in the acquisition totaled $3.3 million.

Fair value of acquired assets and liabilities

The fair values of assets acquired and liabilities assumed in the NUVO acquisition were determined, for many categories, by estimating the cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. The most significant category of assets for which this procedure was used was acquired loans. The excess of expected cash flows above the fair value of the majority of acquired loans will be accreted to interest income over the remaining lives of the loans in accordance with FASB ASC 310-20, Nonrefundable Fees and Other Costs. Receivables acquired that were not subject to the requirements of ASC 310-30 include non-impaired loans with a fair value and gross contractual receivables of $146,086 and $145,855 on the date of acquisition.

In accordance with U.S. GAAP, there was no carryover of the allowance for loan losses that had previously been recorded by NUVO.

In connection with the acquisition of NUVO, the Company recorded a net deferred income tax asset of $1.2 million related to NUVO’s net operating loss carryforward, as well as other tax attributes of the acquired company, along with the effects of fair value adjustments resulting from applying the purchase method of accounting.

The fair value of savings and transaction deposit accounts acquired from NUVO provide value to the Company as a source of core funding. The fair value of the core deposit intangible (“CDI”) was determined based on a discounted cash flow analysis using a discount rate based on the estimated cost of capital for a market participant. To calculate cash flows, deposit account servicing costs (net of deposit fee income) and interest expense on deposits were compared to the cost of alternative funding sources available to the Company. The life of the deposit base and projected deposit attrition rates were determined using the Company’s historical deposit data as NUVO, being a de novo bank in 2008, has relatively little history related to account attrition. The CDI was valued at $1.38 million or 2.08% of savings and demand deposits. The intangible asset is being amortized on an accelerated basis over ten years Amortization since the December 4, 2015 acquisition date through December 31, 2015 was $17 thousand.

The fair value of time deposit and brokered time deposit accounts was determined by discounting the future cash flows by the market interest rates. This valuation adjustment was determined to be $650 thousand and is being amortized in line with the expected cash flows driven by the maturities of these deposits primarily over the next two years. Amortization since the December 4, 2015 acquisition date through December 31, 2015 was $27 thousand. Direct costs related to the merger were expensed as incurred. For the year ended December 31, 2015, the Company incurred $1.88 million, in merger-related expenses, including a fee paid to our financial advisor, merger proxy expenses, integration and conversion fees legal fees and other merger-related expenses.

The following table presents pro forma information as if the acquisition had occurred at the beginning of 2014. The pro forma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits acquired, and the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transactions been effected on the assumed dates.


(In thousands except per share data)	2015		2014
Net interest income	$	53,275	$	51,732
Net income		14,073		11,512
Basic earnings per share		2.05		1.68
Diluted earnings per share	$	2.05	$	1.68