UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended June 30, 2006

OR

o  TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from                  to                  

Commission File Number 0-21021

Enterprise Bancorp, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (978) 459-9000

Indicate by check mark whether the registrant (1) has 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.

x Yes   o No

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

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

o Yes   x No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: July 31, 2006, Common Stock - Par Value $0.01: 7,686,106 shares outstanding

ENTERPRISE BANCORP, INC.

INDEX

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ENTERPRISE BANCORP, INC.

Consolidated Balance Sheets

June 30, 2006 and December 31, 2005

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statements of Income

Three and six months ended June 30, 2006 and 2005

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statement of Changes in Stockholders’ Equity

Six months ended June 30, 2006

 (unaudited)

(1)Stock-based compensation represents vesting of restricted stock awards and stock option grants.

See the accompanying notes to the unaudited consolidated financial statements

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ENTERPRISE BANCORP, INC.

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2006 and 2005

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Notes to Unaudited Consolidated Financial Statements

(1)           Organization of Holding Company

Enterprise Bancorp, Inc. (the “company”) is a Massachusetts corporation organized at the direction of Enterprise Bank and Trust Company, (the “bank”), for the purpose of becoming the holding company for the bank. The bank, a Massachusetts trust company, has three wholly owned subsidiaries, Enterprise Insurance Services, LLC, Enterprise Investment Services, LLC, and Enterprise Security Corporation, organized for the purposes of engaging in insurance sales activities, offering non-deposit investment products and services and investing in equity securities on its own behalf and not as a broker, respectively.

(2)           Basis of Presentation

The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the company’s December 31, 2005 audited consolidated financial statements and notes thereto contained in the company’s 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2006. Interim results are not necessarily indicative of results to be expected for the entire year. The company has not changed its significant accounting and reporting policies from those disclosed in its 2005 annual report.

In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation. All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.

Certain fiscal 2005 information has been reclassified to conform to the 2006 presentation.

On May 3, 2006, the company announced a two-for-one stock split in the form of a stock dividend payable to shareholders of record as of June 15, 2006. On June 30, 2006 the company issued 3,842,015 shares related to this dividend. All share and per share amounts have been retroactively adjusted to reflect the stock dividend for all periods presented.

(3)                     Stock-Based Compensation

The company currently has three individual stock incentive plans (the 1988 plan, the 1998 plan as amended in 2001, and the 2003 plan).  No additional options or other rights of any kind may be granted under the 1988 plan.  The remaining plans permit the Board of Directors under various terms to grant both incentive and non-qualified stock options, stock appreciation rights and other rights for the purchase of newly issued shares of common stock to officers and other employees, directors and consultants. These plans also allow for the issuance of new shares of common stock with or without restrictions, to officers and other employees, directors and consultants.  The plans allow for the issuance of a cumulative total of 2,024,746 new shares of common stock.  As of June 30, 2006, 1,590,578 shares, net of forfeited and expired shares, have been granted and 434,168 shares remain available for future grants under these plans.

To date the company has utilized the plans to issue stock option awards and restricted stock awards to officers and other employees, and director stock compensation. No options or other awards of any kind have been granted to consultants. Total stock-based compensation expense related to these plans was $134 thousand and $252 thousand for the three and six months ended June 30, 2006, respectively. The total recognized tax benefit related to stock based compensation expense was $39 thousand and $72 thousand, for the three and six months ended June 30, 2006, respectively.

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Stock Option Awards

Prior to January 1, 2006, the company accounted for stock-based compensation plans using the intrinsic value method under which no compensation cost was recorded if, at the grant date, the exercise price of the options was equal to or greater than the fair market value of the company’s common stock. However, the company supplementally disclosed pro forma net income and earnings per share amounts as if the fair value based method of accounting had been applied to its stock-based compensation.

On January 1, 2006, the company adopted Financial Accounting Standards No. 123(R) “Share-Based Payment” (“SFAS 123(R)”), using the modified version of the prospective application method. Pursuant to this transition method, beginning in 2006 the company’s financial statements include (1) stock-based compensation expense for the portion of stock option awards outstanding on January 1, 2006, net of estimated forfeitures, for which the requisite service has been rendered during the period, based on the grant-date fair value estimate of the awards as calculated under the original provisions of SFAS 123 for the pro forma disclosures, and (2) compensation expense for the portion of stock awards issued subsequent to January 1, 2006, net of estimated forfeitures, for which the requisite service has been rendered during the period, based on the grant-date fair value estimate of the awards as calculated under the provisions of SFAS 123(R). The company will recognize the remaining compensation expense for the portion of outstanding awards and compensation expense for any future awards, net of estimated forfeitures, as the requisite service is rendered (i.e., on a straight-line basis over the remaining vesting period of each grant).

As a result of adopting SFAS 123(R), the company recognized stock-based compensation expense related to stock option awards of $70 thousand and $139 thousand for the three and six months ended June 30, 2006, respectively. Accordingly, income before taxes and net income for the three months ended June 30, 2006 were $70 thousand and $57 thousand lower, respectively, and for the six months ended June 30, 2006 were $139 thousand and $114 thousand lower, respectively, than if the company had continued to account for stock-based compensation using the intrinsic value method. The impact on both basic and diluted earnings per share for both the three and six months ended June 30, 2006 was a reduction of $0.01. In addition, prior to the adoption of SFAS 123(R), the company presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options in the consolidated statement of income are classified as financing cash flows.

As of June 30, 2006, there was $536 thousand of unrecognized stock-based compensation expense, net of estimated forfeitures, related to non-vested stock options. That cost is expected to be recognized over a weighted average period of 2.8 years.

In accordance with the modified prospective transition method, the company’s Consolidated Financial Statements for prior periods have not been restated to reflect the impact of SFAS 123(R) or SFAS 123. The pro forma table below reflects net income, basic and diluted earnings per share for the three and six months ended June 30, 2005 had the company determined stock-based compensation expense based on the fair value at the grant date for its options under SFAS 123:

All options that have been granted under the plans generally become exercisable at the rate of 25% a year, in addition options granted since June 2002 provide for full vesting upon attainment of age 62 while remaining employed with the bank. All options granted prior to 1998 expire 10 years from the grant date. Options granted from 1998 through 2004 expire 7 years from the grant date, and options granted in 2005 and 2006 expire 8 years from the grant date.

Under the terms of the plans, incentive stock options may not be granted at less than 100% of the fair market value of the shares on the date of grant and may not have a term of more than ten years. Any shares of common stock reserved for issuance pursuant to options granted under the 1998 and 2003 plans that are returned to the company unexercised shall remain available

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for issuance under such plans. For participants owning 10% or more of the company’s outstanding common stock (of which there are currently none), incentive stock options may not be granted at less than 110% of the fair market value of the shares on the date of grant.

During 2005, management replaced the Binomial option valuation model (a lattice style model) with the Black-Scholes option valuation model. The company has determined that option values calculated prior to 2005 under the Binomial model are not materially different from those that would have been calculated using the Black-Scholes model.

The per share weighted average fair value of stock options granted in 2006 was determined to be $3.79. The weighted average fair value of the options was determined to be 22% of the market value of the stock at the date of grant. The average assumptions used in the model for the 2006 grant for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.91%, 16%, 1.66% and 6, respectively. There were no options granted during the six months ended June 30, 2005. Refer to notes 1 and 9 to the consolidated financial statements contained in the company’s Annual Report on Form 10-K for the year ended December 31, 2005 for assumptions used to estimate the fair value of options granted prior to 2006.

The expected volatility is the anticipated variability in the company’s share price over the expected life of the option. The company’s shares began trading on a public exchange in February 2005 and limited trading has occurred. Management determined its expected volatility by reviewing the historical volatility of peer financial institutions and a banking index, in addition to reviewing its own limited history.

The expected life represents the period of time that the option is expected to be outstanding. The company utilized the simplified method and under this method, the expected term equals the vesting term plus the contractual term divided by 2.

The dividend yield is the company’s annualized dividend rate divided by its share price.

The risk-free rate is based on the U.S. Treasury rate in effect at the time of grant for a period equivalent to the expected life of the option.

In addition, as SFAS 123(R) requires that the stock-based compensation expense recognized in earnings be based on the amount of awards ultimately expected to vest, a forfeiture assumption should be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to the adoption of SFAS 123(R), the Company was not estimating forfeitures, but was rather adjusting pro forma compensation cost as actual forfeitures occurred, as permitted by SFAS 123. There is no cumulative effect of a change in accounting principle recognized in income at the time of adoption of SFAS 123(R) as the stock-based compensation expense recognized in income prior to adoption was immaterial and therefore the adjustment to reflect estimated forfeitures related to this expense was immaterial. Forfeitures are estimated based on historical experience.

Stock option transactions during the six months ended June 30, 2006 are summarized as follows:

The aggregate intrinsic value in the table above represents the difference between the closing price of the company’s common stock on June 30, 2006 and the exercise price, multiplied by the number of options. The intrinsic value of options vested and exercisable represents the total pretax intrinsic value that would have been received by the option holders had all in-the-money vested option holders exercised their options on June 30, 2006. The intrinsic value changes based on the fair market value of the company’s stock.

Total intrinsic value of options exercised for the three and six months ended June 30, 2006 was $712 thousand and $792 thousand, respectively. Cash received from option exercises was $188 thousand and $227 thousand for the three and six

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months ended June 30, 2006, respectively. Cash received from option exercises for the three and six months ended June 30, 2005 was $318 thousand and $334 thousand, respectively. The actual tax benefit arising during the period for the tax deduction from the disqualifying disposition of shares acquired upon exercise was $3 thousand and $14 thousand for the three and six months ended June 30, 2006, respectively.

Restricted Stock Awards

At June 30, 2006, the company had restrictive stock awards outstanding comprised of 17,500 non-vested shares issued in September 2005. There were no restricted stock awards granted or forfeited during the six months ended June 30, 2006. The shares granted vest twenty percent per year starting on the first anniversary date of the award. The restricted stock award allows for the receipt of dividends, and the voting of all shares, whether or not vested, throughout the vesting period. For the three and six months ended June 30, 2006, compensation expense recognized in association with this restricted stock award amounted to $13 and $25 thousand, respectively. At June 30, 2006 the weighted-average grant date fair value of non-vested restricted stock awards was $14.25 per share. As of June 30, 2006, there was $208 thousand of unrecognized compensation expense related to restricted stock awards. That cost is expected to be recognized over a weighted average period of 4.2 years.

Director Stock Compensation

The members of the company’s Board of Directors are offered the choice to receive shares of the company’s common stock in lieu of cash compensation for attendance at Board and Board Committee meetings. The issuance of the new shares related to director compensation occurs in December of each year. For the year 2006, Directors will be granted shares of common stock in lieu of cash fees at the per share price of $15.79, which reflects the value of the common stock on January 3, 2006, based on the average of the high and low trade prices of the common stock on the NASDAQ Global Market on that date (split adjusted).

Director compensation expense amounted to $77 thousand for the three months ended June 30, 2006, compared to $80 thousand for the three months ended June 30, 2005. Included in the expense for the three months ended June 30, 2006 were cash fees of $51 thousand, which represented approximately 3,249 shares to be issued at the end of the fiscal year. Included in the expense for the three months ended June 30, 2005 were cash fees of $56 thousand, which represented approximately 3,814 shares that were issued in December 2005.

Director compensation expense amounted to $126 thousand for the six months ended June 30, 2006, compared to $129 thousand for the six months ended June 30, 2005. Included in the expense for the six months ended June 30, 2006 were cash fees of $88 thousand, which represented approximately 5,579 shares to be issued at the end of the fiscal year. Included in the expense for the six months ended June 30, 2005 were cash fees of $92 thousand which represented approximately 6,198 shares that were issued in December 2005.

(4)         Supplemental Retirement Plan

The following table illustrates the net periodic benefit cost for the supplemental executive retirement plan as of June 30, 2006:

The plan was established on July 15, 2005. The company anticipates accruing an additional $313 thousand to the plan during the remainder of 2006.

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(5)                     Critical Accounting Estimates

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ from those estimates. Certain of the critical accounting estimates are more dependent on management’s judgment and in some cases may contribute to volatility in the company’s reported financial performance should the assumptions and estimates used change over time due to changes in circumstances.

As discussed in the company’s 2005 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill. Refer to note 1 to the consolidated financial statements contained in the company’s 2005 Annual Report on Form 10-K for significant accounting policies.

(6)                     Earnings Per Share

Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.

The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation for the three and six months ended June 30th and the effect of those shares on earnings:

At June 30, 2006, there were 5,000 outstanding stock options, which were excluded from the calculation of diluted earnings per share due to the exercise price exceeding the average market price. These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.

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(7)                     Guarantees and Commitments

Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. If the letter of credit is drawn upon, the company creates a loan for the customer with the same criteria associated with similar loans. The fair value of these commitments was estimated to be the fees charged to enter into similar agreements. The estimated fair value of these commitments carried on the balance sheet was $72 thousand and $88 thousand at June 30, 2006 and 2005, respectively. These amounts are amortized to income over the life of the letters of credit, typically one year.

The company generally originates fixed rate residential mortgage loans with the anticipation of selling such loans. The company generally does not pool mortgage loans for sale but instead sells the loans on an individual basis and generally does not retain the servicing of these loans. Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments. The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment is quoted on the origination of the loan. The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates. At June 30, 2006, the estimated fair value of the company’s derivative instruments was considered to be immaterial.

Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis should be read in conjunction with the company’s consolidated financial statements and notes thereto contained in this report and the company’s 2005 Annual Report on Form 10-K.

Special Note Regarding Forward-Looking Statements

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact. Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as “anticipates”, “believes”, “expects”, “intends”, “may”, “plans”, “pursue”, “views” and similar terms or expressions. Various statements contained in Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 3 – “Quantitative and Qualitative Disclosures About Market Risk,” including, but not limited to, statements related to management’s views on the banking environment and the economy, market expansion and opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements. The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the company’s future results. The following important factors, among others, could cause the company’s results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income; (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the company’s reserve for loan losses; (iii) changes in consumer spending could negatively impact the company’s credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the company’s competitive position within its market area and reduce demand for the company’s products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the company’s assets and the availability of funding sources necessary to meet the company’s liquidity needs; (vi) changes in technology could adversely impact the company’s operations and increase technology-related expenditures; (vii) increases in employee compensation and benefit expenses could adversely affect the company’s financial results; (viii) changes in laws and regulations that apply to the company’s business and operations could increase the company’s regulatory compliance costs and adversely affect the company’s business environment, operations and financial results; and (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board could negatively impact the company’s financial results. Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.

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Accounting Policies/Critical Accounting Estimates

The company has not changed its significant accounting and reporting policies from those disclosed in its 2005 Annual Report on Form 10-K. In applying these accounting policies, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. As discussed in the company’s 2005 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill. Management’s estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ from those estimates.

Overview

Composition of Earnings

The company reported second quarter 2006 net income of $2.182 million compared to $1.981 million during the second quarter of 2005, an increase of 10%. Diluted earnings per share were $0.28 for the quarter compared to $0.26 for second quarter 2005, an increase of 8%. All prior period per share amounts have been adjusted to reflect the two-for-one stock split paid on June 30, 2006 in the form of a stock dividend.

Net income for the six months ended June 30, 2006 amounted to $4.238 million compared to $3.832 million for the same period in 2005, an increase of 11%. Diluted earnings per share were $0.54 for the six months ended June 30, 2006 compared to $0.50 for the same period in 2005, an increase of 8%.

The company’s earnings are largely dependent on its net interest income, which is the difference between interest income on loans and investments and interest expense on deposits and borrowings. The re-pricing frequency of these assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as “interest rate risk” and is reviewed in more detail in Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”

The company’s net income growth continues to result primarily from strong net interest income performance, offset by increases in non-interest expense. Net interest income for the six months ended June 30, 2006 amounted to $20.5 million compared to $18.0 million for the same period in 2005, an increase of 14%. The primary driver of net interest income growth over the period was loan growth, which increased 17% since June 30, 2005. Net interest margin, the spread earned between interest-earning assets and the company’s funding sources, primarily deposits, was 4.83% and 4.81% for the three and six months ended June 30, 2006 compared to 4.77% and 4.74% for the same periods in 2005. The slight increase in margin primarily resulted from increases in the market rates on assets, which were mostly offset by increases in funding costs. Although net interest margin was higher than the June 30, 2005 comparable periods, the flat yield curve and a very competitive marketplace continue to pressure margin.

Non-interest expense amounted to $16.5 million for the six months ended June 30, 2006 compared to $14.6 million for the same period in 2005, an increase of 13%, and reflected the strategic and operational costs necessary to support the company’s continued growth.

The year-to-date results also included an increase in non-interest income consisting primarily of strong growth in investment advisory fees and other income, and were offset by a reduction in the net gains on the sales of investment securities. Included in other income are $62 thousand of tax credit income and $82 thousand of bank-owned life insurance income that were not present in the prior year period.

The provision for loan losses is also a significant factor in the company’s operating results. It directly increases the company’s allowance for loan losses, which reflects management’s estimate of the reserves necessary to support the credit risk inherent in the loan portfolio. The company’s management of credit risk is reviewed in more detail in this Item 2, under the heading “Asset Quality and the Allowance for Loan Losses.”

Financial Position

Total assets amounted to $982.8 million at June 30, 2006, and grew 7% over December 31, 2005 and 9% over June 30, 2005.

The company’s core asset strategy is to grow loans, primarily commercial loans. Total loans at June 30, 2006 amounted to $732.8 million, or 75% of total assets and commercial loans amounted to $626.1 million. The loan portfolio increased 5% since December 31, 2005 and 17% since June 30, 2005.

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The investment portfolio is the other key component of the company’s earning assets and is primarily used to invest excess funds, provide liquidity and to manage the company’s asset-liability position. Total investments amounted to $145.5 million at June 30, 2006, or 15% of total assets. The portfolio declined 7% and 19% since December 31, 2005 and June 30, 2005, respectively. The decline in investments since June 30, 2005 reflects a reduction in excess liquidity due to the funding gap discussed below.

From a funding perspective, management’s strategy is to maximize low cost deposit growth, primarily through relationship-based checking and savings accounts. When asset growth exceeds low cost deposit growth, a funding gap occurs. Management’s principal options are then to grow higher cost deposits (certificates of deposit and higher cost money market products), raise funds externally through brokered deposits (“brokered CDs”) or Federal Home Loan Bank of Boston borrowings (“FHLB borrowings”), sell investment securities, and/or to utilize the ongoing cash flow from the investment portfolio.

Over the past nine months, a funding gap has occurred as loan growth has exceeded low cost deposit growth. Consequently, management has utilized brokered CDs, FHLB borrowings and investment portfolio cash flows. In the fourth quarter of 2005, the company began using brokered CDs as an alternative to FHLB borrowings. At June 30, 2006, FHLB borrowings and brokered CDs outstanding amounted to $3.3 million and $78.5 million, respectively, compared to $6.9 million and $0 million, respectively, at June 30, 2005.

At June 30, 2006, total deposits, which included brokered CDs, amounted to $890.5 million, representing 15% and 11% growth over December 31, 2005 and June 30, 2005, respectively. Total deposits, excluding brokered CDs, amounted to $812.0 million at June 30, 2006 and grew 6% and 1% over the December 31 and June 30, 2005 comparable periods, respectively.

At June 30, 2006, the company has the capacity to borrow approximately $450 million in additional funds. Management believes the company has adequate capacity to fund its business.

Opportunities and Risks

Management believes that the company has established a market presence in the Merrimack Valley and North Central regions of Massachusetts and in South Central New Hampshire. Management also believes the company’s business model, strong service culture, skilled management team and brand name create opportunities for the company to be the leading provider of banking and investment management services in its growing market area. Management continually strives to differentiate the company from competitors by providing innovative commercial banking, investment, and insurance products delivered through prompt and personal service based on management’s familiarity and understanding of the banking and other financial service needs of its customers, which include businesses, professionals, and consumers.

Management recognizes that substantial competition exists in the marketplace and views this as a key business risk. Market competition includes the expanded commercial lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks, as well as the products offered by non-bank financial service competitors.

Despite these challenges, the company has continued to maintain strong commercial loan growth. Management believes this achievement is the result of ongoing business development efforts and continued market expansion within existing and into new markets. The company has fourteen branch locations and continues to look for market and branch opportunities that will increase long-term franchise value and shareholder returns. Such expansion typically increases the company’s operating expenses, primarily in salary and benefits, marketing, and occupancy, before the growth benefits are fully realized in those markets.

In addition to growth and competition, the company’s significant challenges continue to be the effective management of credit, interest rate and operational risk.

Credit risk management is reviewed below in this Item 2 under the heading “Asset Quality and the Allowance for Loan Losses.”

Interest rate risk management is reviewed under Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”

Operational risk management is also a key component of the company’s risk management process, particularly as it relates to technology administration, information security, and business continuity.

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Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to continually monitor and safeguard information on its operating systems and that of third party service providers. The company contracts with outside parties to perform a broad scope of both internal and external security assessments on a regular basis. These third parties test the company’s security controls and network configuration, and assess internal practices and other key items. The company also utilizes firewall technology and an intrusion detection system to protect against unauthorized access and commercial software that continuously scans for computer viruses on the company’s information systems. The company maintains an Information Security and Technology Practices policy applicable to all employees. The policy outlines the employee’s responsibilities and key components of the company’s Information Security and Technology Practices Program, which include the following: identification and assessment of risk; institution of policies and procedures to manage and control the risk; risk assessment of outsourced service providers; development of strategic security contingency plans; training of all officers and employees; and reporting to the Board of Directors. Significant technology issues, related changes in risk and results of third party security assessments are reported to the Board’s Banking Technology and Audit Committees. The Board, through these committees, reviews the status of the Information Security and Technology Practices Program and makes adjustments to the policy as deemed necessary.

The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence which would disable the company for an extended period. The plan establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which critical services will be restored.

Financial Condition

Total assets increased $64.3 million, or 7%, over December 31, 2005, to $982.8 million at June 30, 2006. The increase was primarily attributable to increases in total loans and short-term investments.

Short-term investments

As of June 30, 2006, short-term investments amounted to $32.6 million, or 3% of total assets compared to $5.4 million, or 1% of total assets, at December 31, 2005. The increase in short-term investments resulted from temporary deposit inflows at the end of June. Short-term investments carried as cash equivalents consist of overnight and term federal funds sold and money market mutual funds.

Investments

At June 30, 2006, the investment portfolio’s fair market value was $145.5 million, representing a decline of $11.0 million since December 31, 2005, and a decline of $33.8 million since June 30, 2005. The fair market value of the investment portfolio represented 15%, 17%, and 20% of the total assets at June 30, 2006, December 31, 2005, and June 30, 2005, respectively.

The following table summarizes the fair market value of investments at the dates indicated:

(1)          Federal agency obligations include securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the FHLB. These securities do not represent obligation of the US government and are not backed by the full faith and credit of the United States Treasury.

(2)          The bank is required to purchase FHLB stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.

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Since June 30, 2005, the investment portfolio had $32.5 million of principal paydowns, calls and maturities. Of these proceeds, $7.2 million was reinvested in the portfolio, with the remainder utilized to fund loan growth.

The net unrealized loss on the portfolio at June 30, 2006 was $2.9 million compared to net unrealized losses of $1.1 million at December 31, 2005 and $1.5 million at June 30, 2005. The decrease in fair market value was primarily due to higher market interest rates in the current period over the prior periods. The net unrealized gains/losses in the company’s fixed income portfolio fluctuate as interest rates rise and fall. Due to the fixed rate nature of the portfolio, as rates rise, or the securities approach maturity, the market value of the portfolio declines, and as rates fall the value of the portfolio rises. The net unrealized gains/losses in the company’s equities portfolio fluctuate based on the performance of the individual equities that comprise the portfolio.

Unrealized gains or losses will only be recognized in the statements of income if the securities are sold. However, if an unrealized loss on a fixed income or equity security is deemed to be other-than-temporary, the company marks the investment down to its carrying value through a charge to earnings.

Loans

Total loans were $732.8 million, or 75% of total assets, at June 30, 2006, an increase of $33.0 million, or 5% compared to December 31, 2005 and an increase of $108.2 million, or 17%, compared to June 30, 2005. Year-to-date loan growth has been at a slower rate in 2006 than in the twelve months of 2005 when total loans grew 23%.

The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans.