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EX-32 - EXHIBIT 32 - Live Oak Bancshares, Inc.exhibit322017q2.htm
EX-31.2 - EXHIBIT 31.2 - Live Oak Bancshares, Inc.exhibit3122017q2.htm
EX-31.1 - EXHIBIT 31.1 - Live Oak Bancshares, Inc.exhibit3112017q2.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
ý
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2017
or
¨
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: 001-37497
liveoakbancshareslogo.jpg
LIVE OAK BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
North Carolina
26-4596286
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
1741 Tiburon Drive
Wilmington, North Carolina
28403
(Address of principal executive offices)
(Zip Code)
(910) 790-5867
(Registrant’s telephone number, including area code)
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.    YES  ý    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  ý    NO  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
¨
 
Accelerated filer
 
x
 
 
 
 
Non-accelerated filer
 
¨ (Do not check if smaller reporting company)
 
Smaller reporting company
 
¨
 
 
 
 
 
 
 
 
 
 
 
Emerging growth company
 
x
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     ¨
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  ý
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of August 4, 2017, there were 30,020,634 shares of the registrant’s voting common stock outstanding and 4,643,530 shares of the registrant’s non-voting common stock outstanding.




Live Oak Bancshares, Inc. and Subsidiaries
Form 10-Q
For the Quarterly Period Ended June 30, 2017
TABLE OF CONTENTS

 
 
Page
PART I. FINANCIAL INFORMATION
Item 1.
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
PART II. OTHER INFORMATION
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 




PART I. FINANCIAL INFORMATION
Item 1.        Financial Statements
Live Oak Bancshares, Inc.
Consolidated Balance Sheets
As of June 30, 2017 (unaudited) and December 31, 2016*
(Dollars in thousands)
 
June 30,
2017
 
December 31,
2016*
Assets
 
 
 
Cash and due from banks
$
207,373

 
$
238,008

Certificates of deposit with other banks
5,750

 
7,250

Investment securities available-for-sale
72,993

 
71,056

Loans held for sale
609,138

 
394,278

Loans and leases held for investment
1,084,503

 
907,566

Allowance for loan and lease losses
(19,560
)
 
(18,209
)
Net loans and leases
1,064,943

 
889,357

Premises and equipment, net
125,008

 
64,661

Foreclosed assets
2,140

 
1,648

Servicing assets
53,675

 
51,994

Other assets
57,087

 
37,009

Total assets
$
2,198,107

 
$
1,755,261

Liabilities and Shareholders’ Equity
 
 
 
Liabilities
 
 
 
Deposits:
 
 
 
Noninterest-bearing
$
40,966

 
$
27,990

Interest-bearing
1,830,755

 
1,457,086

Total deposits
1,871,721

 
1,485,076

Short term borrowings
10,000

 

Long term borrowings
52,173

 
27,843

Other liabilities
26,582

 
19,495

Total liabilities
1,960,476

 
1,532,414

Shareholders’ equity
 
 
 
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at June 30, 2017 and December 31, 2016

 

Class A common stock, no par value, 100,000,000 shares authorized, 29,996,318 and 29,530,072 shares issued and outstanding at June 30, 2017 and December 31, 2016, respectively
150,939

 
149,966

Class B common stock, no par value, 10,000,000 shares authorized, 4,643,530 and 4,723,530 shares issued and outstanding at June 30, 2017 and December 31, 2016, respectively
49,168

 
50,015

Retained earnings
38,041

 
23,518

Accumulated other comprehensive loss
(517
)
 
(652
)
Total equity
237,631

 
222,847

Total liabilities and shareholders’ equity
$
2,198,107

 
$
1,755,261

*    Derived from audited consolidated financial statements.
See Notes to Unaudited Consolidated Financial Statements

1


Live Oak Bancshares, Inc.
Consolidated Statements of Income
For the three and six months ended June 30, 2017 and 2016 (unaudited)
(Dollars in thousands, except per share data)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2017
 
2016
 
2017
 
2016
Interest income
 
 
 
 
 
 
 
Loans and fees on loans
$
23,559

 
$
12,902

 
$
43,313

 
$
23,907

Investment securities, taxable
316

 
252

 
639

 
503

Other interest earning assets
470

 
248

 
812

 
386

Total interest income
24,345

 
13,402

 
44,764

 
24,796

Interest expense
 
 
 
 
 
 
 
Deposits
5,592

 
3,243

 
10,135

 
5,687

Borrowings
361

 
242

 
596

 
483

Total interest expense
5,953

 
3,485

 
10,731

 
6,170

Net interest income
18,392

 
9,917

 
34,033

 
18,626

Provision for loan and lease losses
1,556

 
3,453

 
3,055

 
4,886

Net interest income after provision for loan and lease losses
16,836

 
6,464

 
30,978

 
13,740

Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
6,174

 
5,081

 
12,097

 
9,865

Loan servicing asset revaluation
(1,164
)
 
(1,604
)
 
(3,173
)
 
(1,630
)
Net gains on sales of loans
18,176

 
14,555

 
37,128

 
30,980

Construction supervision fee income
286

 
667

 
715

 
1,297

Title insurance income
2,397

 

 
3,835

 

Other noninterest income
798

 
649

 
1,818

 
1,268

Total noninterest income
26,667

 
19,348

 
52,420

 
41,780

Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
17,968

 
15,411

 
36,650

 
28,404

Travel expense
2,148

 
2,330

 
3,746

 
4,176

Professional services expense
1,424

 
910

 
3,160

 
1,438

Advertising and marketing expense
1,976

 
1,365

 
3,461

 
2,328

Occupancy expense
1,350

 
1,055

 
2,545

 
2,248

Data processing expense
1,858

 
1,404

 
3,554

 
2,612

Equipment expense
1,703

 
534

 
2,777

 
1,085

Other loan origination and maintenance expense
981

 
621

 
1,986

 
1,195

FDIC insurance
724

 
149

 
1,450

 
297

Title insurance closing services expense
785

 

 
1,190

 

Other expense
2,383

 
1,353

 
5,766

 
3,060

Total noninterest expense
33,300

 
25,132

 
66,285

 
46,843

Income before taxes
10,203

 
680

 
17,113

 
8,677

Income tax expense
408

 
557

 
1,206

 
3,871

Net income
9,795

 
123

 
15,907

 
4,806

Net loss attributable to noncontrolling interest

 

 

 
8

Net income attributable to Live Oak Bancshares, Inc.
$
9,795

 
$
123

 
$
15,907

 
$
4,814

Basic earnings per share
$
0.28

 
$
0.00

 
$
0.46

 
$
0.14

Diluted earnings per share
$
0.27

 
$
0.00

 
$
0.44

 
$
0.14

See Notes to Unaudited Consolidated Financial Statements

2


Live Oak Bancshares, Inc.
Consolidated Statements of Comprehensive Income
For the three and six months ended June 30, 2017 and 2016 (unaudited)
(Dollars in thousands)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2017
 
2016
 
2017
 
2016
Net income
$
9,795

 
$
123

 
$
15,907

 
$
4,806

Other comprehensive income before tax:
 
 
 
 
 
 
 
Net unrealized gain on investment securities arising during the period
293

 
251

 
220

 
640

Reclassification adjustment for (gain) loss on sale of securities available-for-sale included in net income

 

 

 

Other comprehensive income before tax
293

 
251

 
220

 
640

Income tax expense
(113
)
 
(97
)
 
(85
)
 
(247
)
Other comprehensive income, net of tax
180

 
154

 
135

 
393

Total comprehensive income
$
9,975

 
$
277

 
$
16,042

 
$
5,199

See Notes to Unaudited Consolidated Financial Statements

3


Live Oak Bancshares, Inc.
Consolidated Statements of Changes in Shareholders’ Equity
For the six months ended June 30, 2017 and 2016 (unaudited)
(Dollars in thousands)
 
Common stock
 
Retained
earnings
 
Accumulated
other
comprehensive
income (loss)
 
Non-
controlling
interest
 
Total
equity
Shares
 
 
 
Class A
 
Class B
 
Amount
 
Balance at December 31, 2015
29,449,369

 
4,723,530

 
$
187,507

 
$
12,140

 
$
(192
)
 
$
33

 
$
199,488

Net income (loss)

 

 

 
4,814

 

 
(8
)
 
4,806

Other comprehensive income

 

 

 

 
393

 

 
393

Issuance of restricted stock
2,776

 

 

 

 

 

 

Stock option exercises
16,707

 

 
107

 

 

 

 
107

Stock option based compensation expense

 

 
1,173

 

 

 

 
1,173

Restricted stock expense

 

 
2,409

 

 

 

 
2,409

Dividends (distributions to shareholders)

 

 

 
(1,026
)
 

 

 
(1,026
)
Balance at June 30, 2016
29,468,852

 
4,723,530

 
$
191,196

 
$
15,928

 
$
201

 
$
25

 
$
207,350

Balance at December 31, 2016
29,530,072

 
4,723,530

 
$
199,981

 
$
23,518

 
$
(652
)
 
$

 
$
222,847

Net income

 

 

 
15,907

 

 

 
15,907

Other comprehensive income

 

 

 

 
135

 

 
135

Issuance of restricted stock
287,190

 

 

 

 

 

 

Withholding cash issued in lieu of restricted stock issuance

 

 
(4,828
)
 

 

 

 
(4,828
)
Employee stock purchase program
12,411

 

 
241

 

 

 

 
241

Stock option exercises
58,921

 

 
456

 

 

 

 
456

Stock option based compensation expense

 

 
924

 

 

 

 
924

Restricted stock expense

 

 
2,768

 

 

 

 
2,768

Stock issued in acquisition of Reltco, Inc.
27,724

 

 
565

 

 

 

 
565

Non-voting common stock converted to voting common stock in private sale
80,000

 
(80,000
)
 

 

 

 

 

Dividends (distributions to shareholders)

 

 

 
(1,384
)
 

 

 
(1,384
)
Balance at June 30, 2017
29,996,318

 
4,643,530

 
$
200,107

 
$
38,041

 
$
(517
)
 
$

 
$
237,631

See Notes to Unaudited Consolidated Financial Statements

4


Live Oak Bancshares, Inc.
Consolidated Statements of Cash Flows
For the six months ended June 30, 2017 and 2016 (unaudited)
(Dollars in thousands)
 
Six Months Ended
June 30,
 
2017
 
2016
Cash flows from operating activities
 
 
 
Net income
$
15,907

 
$
4,806

Adjustments to reconcile net income to net cash used by operating activities:
 
 
 
Depreciation and amortization
4,062

 
2,109

Provision for loan losses
3,055

 
4,886

Amortization of premium on securities, net of accretion
219

 
79

Amortization (accretion) of discount on unguaranteed loans, net
1,255

 
156

Deferred tax expense (benefit)
1,427

 
(1,457
)
Originations of loans held for sale
(632,414
)
 
(471,295
)
Proceeds from sales of loans held for sale
466,309

 
322,748

Net gains on sale of loans held for sale
(37,128
)
 
(30,980
)
Net loss on sale of foreclosed assets
3

 
1

Net increase in servicing assets
(1,681
)
 
(4,224
)
Net loss on disposal of premises and equipment
213

 

Stock option based compensation expense
924

 
1,173

Restricted stock expense
2,768

 
2,409

Stock based compensation expense excess tax benefits
874

 

     Business combination contingent consideration fair value adjustment
350

 

Changes in assets and liabilities:
 
 
 
Other assets
(9,463
)
 
(1,301
)
Other liabilities
845

 
478

Net cash used by operating activities
(182,475
)
 
(170,412
)
Cash flows from investing activities
 
 
 
Purchases of securities available-for-sale
(6,403
)
 
(14,799
)
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale
4,467

 
2,318

Proceeds from sale/collection of foreclosed assets

 
91

Business combination, net of cash acquired
(7,684
)
 

Maturities of certificates of deposit with other banks
1,500

 
1,750

Loan and lease originations and principal collections, net
(192,018
)
 
(80,162
)
Purchases of premises and equipment, net
(63,482
)
 
(433
)
Net cash used in investing activities
(263,620
)
 
(91,235
)
See Notes to Unaudited Consolidated Financial Statements

5


Live Oak Bancshares, Inc.
Consolidated Statements of Cash Flows (Continued)
For the six months ended June 30, 2017 and 2016 (unaudited)
(Dollars in thousands)
 
Six Months Ended
June 30,
 
2017
 
2016
Cash flows from financing activities
 
 
 
Net increase in deposits
386,645

 
336,009

Proceeds from long term borrowings
16,900

 

Repayment of long term borrowings
(670
)
 
(202
)
Proceeds from short term borrowings
23,100

 

Repayment of short term borrowings
(5,000
)
 

Stock option exercises
456

 
107

Employee stock purchase program
241

 

Withholding cash issued in lieu of restricted stock
(4,828
)
 

Shareholder dividend distributions
(1,384
)
 
(1,368
)
Net cash provided by financing activities
415,460

 
334,546

Net (decrease) increase in cash and cash equivalents
(30,635
)
 
72,899

Cash and cash equivalents, beginning
238,008

 
102,607

Cash and cash equivalents, ending
$
207,373

 
$
175,506

 
 
 
 
Supplemental disclosure of cash flow information
 
 
 
Interest paid
$
10,858

 
$
6,180

Income tax
7,876

 
2,776

 
 
 
 
Supplemental disclosures of noncash operating, investing, and financing activities
 
 
 
Unrealized holding gains on available-for-sale securities, net of taxes
$
135

 
$
393

Transfers from loans to foreclosed real estate and other repossessions
495

 
406

Transfers from foreclosed real estate to SBA receivable

 
9

Transfer of loans held for sale to loans held for investment
4,149

 
336,263

Transfer of loans held for investment to loans held for sale
18,410

 
1,848

Transfers from short term borrowings to long term borrowings
8,100

 

Business combination:
 
 
 
Assets acquired (excluding goodwill)
5,766

 

Liabilities assumed
4,681

 

Purchase price
8,351

 

Goodwill recorded
7,266

 

See Notes to Unaudited Consolidated Financial Statements

6


Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements
Note 1. Basis of Presentation
Nature of Operations
Live Oak Bancshares, Inc. (the “Company” or “LOB”) is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was organized and incorporated under the laws of the State of North Carolina on February 25, 2008 and commenced operations on May 12, 2008. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within credit-worthy industries through expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 7(a) Loan Program and to a lesser extent by the U.S. Department of Agriculture ("USDA") Rural Energy for America Program ("REAP") and Business & Industry ("B&I") loan programs. On July 28, 2015 the Company completed its initial public offering. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank.
In addition to the Bank, the Company owns Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location, Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans, and 504 Fund Advisors, LLC (“504FA”), formed to serve as the investment adviser to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.
The Company acquired control over 504FA, previously carried as an equity method investment, on February 2, 2015 by increasing its ownership from 50.0% to 91.3%. The acquisition of an additional 41.3% of ownership occurred in exchange for contingent consideration estimated to total $170 thousand. Transactions in the third quarter of 2015 and first quarter of 2016 increased the Company’s ownership to 92.9%. On September 1, 2016, the Company acquired the remaining 7.1% ownership from a third party investor in exchange for contingent consideration estimated to total $24 thousand.
In August 2016, the Company formed Live Oak Ventures, Inc. for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology.
In November 2016, the Company formed Live Oak Clean Energy Financing LLC for the purpose of providing financing to entities for renewable energy applications.
On February 1, 2017, the Company completed its acquisition of Reltco Inc. and National Assurance Title, Inc. (collectively referred to as "Reltco"), two nationwide title agencies under common control based in Tampa, Florida. See Note 4. Business Combination for a further discussion of this transaction.
The Company earns revenue primarily from the sale of SBA and USDA-guaranteed loans and net interest income. Income from the sale of loans is comprised of net gains on the sale of loans, revenues on the servicing of sold loans and valuation of loan servicing rights. Offsetting these revenues are the cost of funding sources, provision for loan and lease losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.
General
In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all intercompany transactions have been eliminated in consolidation. Results of operations for the six months ended June 30, 2017 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2017. The consolidated balance sheet as of December 31, 2016 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed with the Securities Exchange Commission on March 9, 2017 (SEC File No. 001-37497) (the "2016 Annual Report"). A summary description of the significant accounting policies followed by the Company is set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2016 Annual Report. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes in the Company's 2016 Annual Report.
The preparation of financial statements in conformity with United States generally accepted accounting principles, or GAAP, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.

7



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Amounts in all tables in the Notes to Unaudited Consolidated Financial Statements have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
Business Segments
Management has determined that the Company has one significant operating segment, which is providing a lending platform for small businesses nationwide. In determining the appropriateness of segment definition, the Company considers the materiality of a potential segment, the components of the business about which financial information is available, and components for which management regularly evaluates relative to resource allocation and performance assessment.
Equipment Leasing
The Company purchases new equipment for the purpose of leasing such equipment to customers within its verticals. Equipment purchased to fulfill commitments to commercial renewable energy projects is rented out under operating leases while leases of equipment outside of the renewable energy vertical are generally direct financing leases. Accordingly, leased assets under operating leases are included in premises and equipment while leased assets under direct financing leases are included in loans and leases held for investment.
Direct Financing Leases
Interest income on direct financing leases is recognized when earned.  Unearned interest is recognized over the lease term on a basis which results in a constant rate of return on the unrecovered lease investment.  The term of each lease is generally 4-6 years which is consistent with the useful life of the equipment with no residual value.  As of June 30, 2017 the Company had net investments in direct financing lease receivables of $390 thousand.
Operating Leases
The term of each operating lease is generally 10 years. The Company retains ownership of the equipment and associated tax benefits such as investment tax credits and accelerated depreciation. At the end of the lease term, the lessee has the option to renew the lease for two additional terms or purchase the equipment at the then current fair market value.
Rental revenue from operating leases is recognized over a straight-line basis over the term of the lease. Rental equipment is recorded at cost and depreciated to an estimated residual value on a straight-line basis over the estimated useful life. The useful lives and residual values are generally 15 years and 30%, respectively; however, they are subject to periodic evaluation. Changes in useful lives or residual values will impact depreciation expense and any gain or loss from the sale of used equipment. The estimated useful lives and residual values of the Company's leasing equipment are based on industry disposal experience and the Company's expectations for future sale prices.
If the Company decides to sell or otherwise dispose of rental equipment, it is carried at the lower of cost or fair value less costs to sell or dispose.   Repair and maintenance costs that do not extend the lives of the rental equipment are charged to direct operating expenses at the time the costs are incurred.
As of June 30, 2017 the Company had a net investment of $42.5 million in assets included in premises and equipment that are subject to operating leases.
A maturity analysis of future minimum lease payments under non-cancelable operating leases is as follows:
As of June 30, 2017
 
Amount
2017
 
$
794

2018
 
2,966

2019
 
2,971

2020
 
2,975

2021
 
2,978

Thereafter
 
17,122

Total
 
$
29,806


8



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Impairment of Long-Lived Assets
The Company evaluates the carrying value of rental equipment and identifiable definite lived intangible assets for impairment whenever events or circumstances have occurred that would indicate the carrying amount may not be fully recoverable. A key element in determining the recoverability of long-lived assets is the Company’s outlook as to the future market conditions for its rental equipment. If the carrying amount is not fully recoverable, an impairment loss is recognized to reduce the carrying amount to fair value. The Company determines fair value based upon the condition of the rental equipment and the projected net cash flows from its rental and sale considering current market conditions. Goodwill and identifiable indefinite lived assets are evaluated for potential impairment annually or when circumstances indicate potential impairment may have occurred. Impairment losses, if any, are determined based upon the excess of carrying value over the estimated fair value of the asset. There have been no impairments of long-lived assets.
Change in Accounting Estimate
During 2017, the Company assessed its estimate of the useful lives of the Company’s aircraft transportation. The Company revised its original useful life estimate of 20 years and currently estimates that its aircraft transportation will have a useful life of 10 years. The effects of reflecting this change in accounting estimate on the 2017 consolidated financial statements are as follows:
 
 
Three months ended
June 30, 2017
 
Six months ended
June 30, 2017
Decrease in:
 
 
 
 
Net income
 
$
202

 
$
490

Basic EPS
 
$
0.01

 
$
0.01

Diluted EPS
 
$
0.01

 
$
0.01

Reclassifications
Certain reclassifications have been made to the prior period’s consolidated financial statements to place them on a comparable basis with the current year. Net income and shareholders’ equity previously reported were not affected by these reclassifications.
Note 2. Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”). This standard is intended to clarify the principles for recognizing revenue and to develop a common revenue standard for GAAP. ASU 2014-09 is effective for the Company on January 1, 2018. Adoption by the Company is not expected to have a material impact on the consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”). The FASB issued this ASU to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet by lessees for those leases classified as operating leases under current GAAP and disclosing key information about leasing arrangements. The amendments in this ASU are effective for the Company on January 1, 2019. The impact of this standard will depend on the Company's lease portfolio at the time of the adoption and the Company is currently assessing the effect that the adoption of this standard will have on the consolidated financial statements.
In March 2016, the FASB issued ASU No. 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). ASU 2016-09 simplifies the accounting for share-based payment transactions for items including income tax consequences, classification of awards as equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 was effective and adopted by the Company on January 1, 2017. Starting this quarter, stock-based compensation excess tax benefits or deficiencies are reflected in the Consolidated Statements of Income as a component of the income tax expense, where as they previously were recognized in equity. Additionally, the Consolidated Statements of Cash Flows now present excess tax benefits as an operating activity while any cash paid in lieu of shares for tax-withholding being classified as a financing activity. There were no excess tax benefits in the prior period presented for reclassification. Finally, the Company will continue to incorporate actual forfeitures as they occur in the accrual of compensation expense. As a result of the adoption of ASU 2016-09, the Consolidated Statement of Cash Flows for the six months ended June 30, 2017 was adjusted as follows: a $874

9



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

thousand increase to net cash provided by operating activities and a $4.8 million increase to net cash used in financing activities. The adoption of ASU 2016-09 further resulted in a $0.03 increase in basic EPS and $0.02 increase on diluted EPS for the six months ended June 30, 2017. See Note 9 for information regarding the additional impact on our consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). This new guidance replaces the incurred loss impairment methodology in current standards with an expected credit loss methodology and requires consideration of a broader range of information to determine credit loss estimates. ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 will be effective for the Company on January 1, 2020. The Company is currently evaluating required changes to loan loss estimation models and processes and assessing the effect the implementation of the new standard will have on its consolidated financial statements.
In January 2017, the FASB issued ASU No. 2017-01, “Business Combinations (Topic 805) - Clarifying the Definition of a Business” (“ASU 2017-01”).  ASU 2017-01 clarifies the definition and provides a more robust framework to use in determining when a set of assets and activities constitutes a business. ASU 2017-01 is intended to provide guidance when evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 will be effective for the Company on January 1, 2018. The Company does not expect this amendment to have a material effect on its consolidated financial statements.
In January 2017, the FASB issued ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). ASU 2017-04 removes Step 2 from the goodwill impairment test. A goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. ASU 2017-04 will be effective for the Company on January 1, 2020, with early adoption permitted for interim or annual impairment tests performed after January 1, 2017. ASU 2017-04 is not expected to have a material impact on its consolidated financial statements.
In February 2017, the FASB issued ASU No. 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20) - Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets” (“ASU 2017-05”). ASU 2017-05 clarifies the scope of Subtopic 610-20 and adds guidance on nonfinancial asset derecognition as well as the accounting for partial sales of nonfinancial assets. The amendments conform the derecognition guidance on nonfinancial assets with the model for transactions in the new revenue standard. ASU 2017-05 will be effective for the Company on January 1, 2018 and is not expected to have a significant impact on its consolidated financial statements.
In May 2017, the FASB issued ASU No. 2017-09, "Compensation - Stock Compensation (Topic 718) - Scope of Modification Accounting" ("ASU 2017-09"). ASU 2017-09 clarifies when changes to the terms or conditions of a share-based payment award should be accounted for as a modification. This guidance indicates modification accounting is required when the fair value, vesting conditions, or classification of the award changes. ASU 2017-09 will be effective for the Company on January 1, 2018 and is not expected to have a significant impact on its consolidated financial statements.
Note 3. Earnings Per Share
Basic and diluted earnings per share are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur, upon the exercise of stock options or upon the vesting of restricted stock grants, any of which would result in the issuance of common stock that would then be shared in the net income of the Company.

10



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2017
 
2016
 
2017
 
2016
Basic earnings per share:
 
 
 
 
 
 
 
Net income available to common shareholders
$
9,795

 
$
123

 
$
15,907

 
$
4,814

Weighted-average basic shares outstanding
34,618,721

 
34,189,217

 
34,543,229

 
34,183,004

Basic earnings per share
$
0.28

 
$
0.00

 
$
0.46

 
$
0.14

Diluted earnings per share:
 
 
 
 
 
 
 
Net income available to common shareholders, for diluted earnings per share
$
9,795

 
$
123

 
$
15,907

 
$
4,814

Total weighted-average basic shares outstanding
34,618,721

 
34,189,217

 
34,543,229

 
34,183,004

Add effect of dilutive stock options and restricted stock grants
1,323,320

 
1,016,908

 
1,228,953

 
896,656

Total weighted-average diluted shares outstanding
35,942,041

 
35,206,125

 
35,772,182

 
35,079,660

Diluted earnings per share
$
0.27

 
$
0.00

 
$
0.44

 
$
0.14

Anti-dilutive shares
245,583

 
1,807,823

 
983,174

 
1,807,823

 

11



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 4. Business Combination
On February 1, 2017, the Company completed its acquisition of Reltco Inc. and National Assurance Title, Inc. (collectively referred to as "Reltco"), two nationwide title agencies under common control based in Tampa, Florida. The acquisition continues the Company's growth strategy, including vertically integrating with complementary services to deliver a high-quality customer experience with speed.
On the acquisition date, the fair value of Reltco included $5.8 million in assets and $4.7 million in liabilities. The total acquisition gross consideration at the time of the transaction, including earn-out contingent consideration was approximately $15.8 million. The acquisition was valued at $12.7 million after consideration of the applicable fair value adjustments to the earn-out, resulting in the Company paying $7.8 million in cash and issuing 27,724 shares of its common stock at closing in addition to an earn-out of up to 184,012 shares of its stock and $3.8 million in cash, in exchange for all of the outstanding shares of Reltco. The earn-out was recorded as a $4.3 million contingent liability on the acquisition date and is earned proportionally based on the ratio of the new subsidiary's actual future aggregate net income after tax divided by a target net income after tax of approximately $6.0 million over the four year earn-out period. Fair value measurement of the earn-out was calculated using the Monte Carlo Simulation. The Monte Carlo Simulation simulates 100,000 trials to assess the expected market price as of the earn-out measurement date at the end of each of the next four years based on the Cox, Ross & Rubinstein option pricing methodology. The Monte Carlo Simulation utilized various assumptions that include a risk free rate of return through the end of each measurement period equivalent to that of a U.S. Treasury, expected volatility of 30.00% over four years and a dividend yield of 0.40%.
The merger was accounted for in accordance with the acquisition method of accounting, and the identifiable assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date separately from goodwill. The estimated fair values of assets acquired and liabilities assumed are based on the information available at the date of the acquisition. Management continues to evaluate these fair values, which are subject to revision as additional information becomes available. During the one year measurement period, contingent consideration is recorded at fair value based on the terms of the purchase agreement with subsequent quarterly changes in fair value recorded through earnings. For the three and six months ended June 30, 2017 the Company recorded expense of $150 thousand and $350 thousand, respectively, related to the increased fair value of contingent consideration using the Monte Carlo Simulation. The assumptions utilized include a risk free rate of return through the end of each measurement period equivalent to that of a U.S. Treasury, expected volatility of 30.00% over the remaining 3.5 years and a dividend yield of 0.33%.

12



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following table summarizes the allocation of the purchase price on the date of acquisition to assets acquired and the liabilities assumed based on their estimated fair values (dollars in thousands, except per share data):
Fair value of assets acquired
 
Cash
$
102

Accounts receivable
159

Intangible assets
5,505

Total assets acquired
5,766

Fair value of liabilities assumed
 
Contingent consideration
4,300

Accounts payable and other liabilities
381

Total liabilities assumed
4,681

Net assets acquired
$
1,085

Purchase price
 
Common shares issued
27,724

Purchase price per share of the Company’s common stock
$
20.38

Company common stock issued
565

Cash
7,786

Total purchase price
8,351

Goodwill
$
7,266

Goodwill recorded represents future revenues and efficiencies gained through the Reltco acquisition. Goodwill in this transaction is expected to be deductible for income tax purposes. Intangible assets consist of trade names of $1.2 million, customer relationships of $3.9 million, and non-compete agreements of $405 thousand. The trade names have indefinite lives and the customer relationships and non-compete agreements range from five to eight years.
The Company recorded merger expenses of $766 thousand during the six month period ended June 30, 2017. The company recorded $10 thousand in merger expenses during the three and six months period ended June 30, 2016.
The following pro forma financial information for the quarters ended June 30, 2017 and 2016 reflects the Company's estimated consolidated pro forma results of operations as if the Reltco acquisition occurred on January 1, 2016:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Revenue (net interest income and noninterest income)
$
51,012

 
$
36,086

 
$
97,952

 
$
72,503

Net income available to common stockholders
9,795

 
856

 
15,945

 
5,769

Basic earnings per share
0.28

 
0.03

 
0.46

 
0.17

Diluted earnings per share
0.27

 
0.02

 
0.45

 
0.16

Note 5. Investment Securities
The carrying amount of investment securities and their approximate fair values are reflected in the following table:

13



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
June 30, 2017
 
 
 
 
 
 
 
US government agencies
$
17,820

 
$
16

 
$
34

 
$
17,802

Residential mortgage-backed securities
53,963

 
1

 
785

 
53,179

Mutual fund
2,050

 

 
38

 
2,012

Total
$
73,833

 
$
17

 
$
857

 
$
72,993

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
US government agencies
$
17,803

 
$
52

 
$
32

 
$
17,823

Residential mortgage-backed securities
52,301

 
3

 
1,031

 
51,273

Mutual fund
2,012

 

 
52

 
1,960

Total
$
72,116

 
$
55

 
$
1,115

 
$
71,056

There were no sales of securities during the three and six months ended June 30, 2017 and June 30, 2016.
The following tables show gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
 
Less Than 12 Months
 
12 Months or More
 
Total
June 30, 2017
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
US government agencies
$
6,498

 
$
34

 
$

 
$

 
$
6,498

 
$
34

Residential mortgage-backed securities
32,480

 
516

 
13,881

 
269

 
46,361

 
785

Mutual fund
2,012

 
38

 

 

 
2,012

 
38

Total
$
40,990

 
$
588

 
$
13,881

 
$
269

 
$
54,871

 
$
857

 
Less Than 12 Months
 
12 Months or More
 
Total
December 31, 2016
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
US government agencies
$
6,508

 
$
32

 
$

 
$

 
$
6,508

 
$
32

Residential mortgage-backed securities
49,109

 
1,017

 
1,635

 
14

 
50,744

 
1,031

Mutual fund
1,960

 
52

 

 

 
1,960

 
52

Total
$
57,577

 
$
1,101

 
$
1,635

 
$
14

 
$
59,212

 
$
1,115

At June 30, 2017, there were seven residential mortgage-backed securities in unrealized loss positions for greater than 12 months and seventeen residential mortgage-backed securities, three US government agency securities and the 504 Fund mutual fund investment in an unrealized loss position for less than 12 months. Unrealized losses at December 31, 2016 were comprised of two residential mortgage-backed securities in unrealized loss positions for greater than 12 months and three US government agency securities, twenty-two residential mortgage-backed securities and the 504 Fund mutual fund investment in an unrealized loss position for less than 12 months.
These unrealized losses are primarily the result of volatility in the market and are related to market interest rates. Since none of the unrealized losses relate to marketability of the securities or the issuer’s ability to honor redemption obligations and the Company has the intent and ability to hold the securities for a sufficient period of time to recover unrealized losses, none of the securities are deemed to be other than temporarily impaired.
All residential mortgage-backed securities in the Company’s portfolio at June 30, 2017 and December 31, 2016 were backed by US government sponsored enterprises (“GSEs”).

14



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following is a summary of investment securities by maturity:
 
June 30, 2017
 
Available-for-Sale
 
Amortized
cost
 
Fair
value
US government agencies
 
 
 
Within one year
$
9,981

 
$
9,986

One to five years
7,839

 
7,816

Total
17,820

 
17,802

 
 
 
 
Residential mortgage-backed securities
 
 
 
Five to ten years
7,906

 
7,848

After 10 years
46,057

 
45,331

Total
53,963

 
53,179

 
 
 
 
Total
$
71,783

 
$
70,981

The table above reflects contractual maturities. Actual results will differ as the loans underlying the mortgage-backed securities may repay sooner than scheduled. This table excludes the 504 Fund mutual fund investment.
At December 31, 2016, an investment security with a fair market value of $1.5 million was pledged to secure a line of credit with the Company’s correspondent bank. At June 30, 2017, the security pledged to secure a line of credit with the Company's correspondent bank was released. At June 30, 2017 and December 31, 2016, an investment security with a fair market value of $100 thousand was pledged to the Ohio State Treasurer to allow the Company's trust department to conduct business in the state of Ohio and investment securities with a fair market value of $2.5 million and $1.2 million, respectively, were pledged to the Company's trust department for uninsured trust assets held by the trust department.
Note 6. Loans and Leases Held for Investment and Allowance for Loan and Lease Losses
Loan and Lease Portfolio Segments
The following describes the risk characteristics relevant to each of the portfolio segments. Each loan and lease category is assigned a risk grade during the origination and closing process based on criteria described later in this section.
Commercial and Industrial
Commercial and industrial loans (C&I) receive similar underwriting treatment as commercial real estate loans in that the repayment source is analyzed to determine its ability to meet cash flow coverage requirements as set forth by Bank policies. Repayment of the Bank’s C&I loans generally comes from the generation of cash flow as the result of the borrower’s business operations. This business cycle itself brings a certain level of risk to the portfolio. In some instances, these loans may carry a higher degree of risk due to a variety of reasons – illiquid collateral, specialized equipment, highly depreciable assets, uncollectable accounts receivable, revolving balances, or simply being unsecured. As a result of these characteristics, the SBA guarantee on these loans is an important factor in mitigating risk.
Construction and Development
Construction and development loans are for the purpose of acquisition and development of land to be improved through the construction of commercial buildings. Such loans are usually paid off through the conversion to permanent financing for the long-term benefit of the borrower’s ongoing operations. At the completion of the project, if the loan is converted to permanent financing or if scheduled loan amortization begins, it is then reclassified to the “Commercial Real Estate” segment. Underwriting of construction and development loans typically includes analysis of not only the borrower’s financial condition and ability to meet the required debt obligations, but also the general market conditions associated with the area and type of project being funded.
Commercial Real Estate

15



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Commercial real estate loans are extensions of credit secured by owner occupied and non-owner occupied collateral. Underwriting generally involves intensive analysis of the financial strength of the borrower and guarantor, liquidation value of the subject collateral, the associated unguaranteed exposure, and any available secondary sources of repayment, with the greatest emphasis given to a borrower’s capacity to meet cash flow coverage requirements as set forth by Bank policies. Such repayment of commercial real estate loans is commonly derived from the successful ongoing operations of the business occupying the property. These typically include small businesses and professional practices.
Commercial Land
Commercial land loans are extensions of credit secured by farmland. Such loans are often for land improvements related to agricultural endeavors that may include construction of new specialized facilities. These loans are usually repaid through the conversion to permanent financing, or if scheduled loans amortization begins, for the long-term benefit of the borrower’s ongoing operations. Underwriting generally involves intensive analysis of the financial strength of the borrower and guarantor, liquidation value of the subject collateral, the associated unguaranteed exposure, and any available secondary sources of repayment, with the greatest emphasis given to a borrower’s capacity to meet cash flow coverage requirements as set forth by Bank policies.
Each of the loan types referenced in the sections above is further segmented into verticals in which the Bank chooses to operate. The Bank chooses to finance businesses operating in specific industries because of certain similarities. The similarities range from historical default and loss characteristics to business operations. However, there are differences that create the necessity to underwrite these loans according to varying criteria and guidelines. When underwriting a loan, the Bank considers numerous factors such as cash flow coverage, the credit scores of the guarantors, revenue growth, practice ownership experience and debt service capacity. Minimum guidelines have been set with regard to these various factors and deviations from those guidelines require compensating strengths when considering a proposed loan.

16



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Loans and leases consist of the following:
 
June 30,
2017
 
December 31,
2016
Commercial & Industrial
 
 
 
Agriculture
$
2,673

 
$
1,714

Death Care Management
10,857

 
9,684

Healthcare
39,133

 
37,270

Independent Pharmacies
95,070

 
83,677

Registered Investment Advisors
80,868

 
68,335

Veterinary Industry
42,276

 
38,930

Other Industries
136,344

 
94,836

Total
407,221

 
334,446

Construction & Development
 
 
 
Agriculture
37,108

 
32,372

Death Care Management
4,385

 
3,956

Healthcare
40,252

 
30,467

Independent Pharmacies
1,319

 
2,013

Registered Investment Advisors
366

 
294

Veterinary Industry
14,325

 
11,514

Other Industries
39,163

 
31,715

Total
136,918

 
112,331

Commercial Real Estate
 
 
 
Agriculture
5,514

 
5,591

Death Care Management
58,130

 
52,510

Healthcare
114,343

 
114,281

Independent Pharmacies
18,116

 
15,151

Registered Investment Advisors
14,715

 
11,462

Veterinary Industry
104,879

 
102,906

Other Industries
84,911

 
46,245

Total
400,608

 
348,146

Commercial Land
 
 
 
Agriculture
141,110

 
113,569

Total
141,110

 
113,569

Total Loans and Leases1
1,085,857

 
908,492

Net Deferred Costs
8,475

 
7,648

Discount on SBA 7(a) and USDA Unguaranteed2
(9,829
)
 
(8,574
)
Loans and Leases, Net of Unearned
$
1,084,503

 
$
907,566

1
Total loans and leases include $39.0 million and $37.7 million of U.S. government guaranteed loans as of June 30, 2017 and December 31, 2016, respectively.
2
The Company measures the carrying value of the retained portion of loans sold at fair value under ASC Subtopic 825-10. The value of these retained loan balances is discounted based on the estimates derived from comparable unguaranteed loan sales.

17



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Credit Risk Profile
The Bank uses internal loan and lease reviews to assess the performance of individual loans and leases by industry segment. An independent review of the loan and lease portfolio is performed annually by an external firm. The goal of the Bank’s annual review of select borrowers' financial performance is to validate the adequacy of the risk grade assigned.
The Bank uses a grading system to rank the quality of each loan and lease. The grade is periodically evaluated and adjusted as performance dictates. Loan and lease grades 1 through 4 are passing grades and grade 5 is special mention. Collectively, grades 6 through 8 represent classified loans and leases in the Bank’s portfolio. The following guidelines govern the assignment of these risk grades:
Exceptional (1 Rated): These loans and leases are of the highest quality, with strong, well-documented sources of repayment. Debt service coverage (“DSC”) is over 1.75X based on historical results. Secondary source of repayment is strong, with a loan to value (“LTV”) of 65% or less if secured solely by commercial real estate (“CRE”). Discounted collateral coverage from all sources should exceed 125%. Guarantors have credit scores above 740.
Quality (2 Rated): These loans and leases are of good quality, with good, well-documented sources of repayment. DSC is over 1.25X based on historical or pro-forma results. Secondary source of repayment is good, with a LTV of 75% or less if secured solely by CRE. Discounted collateral coverage should exceed 100%. Guarantors have credit scores above 700.
Acceptable (3 rated): These loans and leases are of acceptable quality, with acceptable sources of repayment. DSC of over 1.00X based on historical or pro-forma results. Companies that do not meet these credit metrics must be evaluated to determine if they should be graded below this level.
Acceptable (4 rated): These loans and leases are considered very weak pass. These loans and leases are riskier than a 3-rated credit, but due to various mitigating factors are not considered a Special mention or worse. The mitigating factors must clearly be identified to offset further downgrade. Examples of loans and leases that may be put in this category include start-up loans and leases and loans and leases with less than 1:1 cash flow coverage with other sources of repayment.
Special mention (5 rated): These loans and leases are considered as emerging problems, with potentially unsatisfactory characteristics. These loans and leases require greater management attention. A loan or lease may be put into this category if the Bank is unable to obtain financial reporting from a company to fully evaluate its position.
Substandard (6 rated): Loans and leases graded Substandard are inadequately protected by current sound net worth, paying capacity of the borrower, or pledged collateral. They typically have unsatisfactory characteristics causing more than acceptable levels of risk, and have one or more well-defined weaknesses that could jeopardize the repayment of the debt.
Doubtful (7 rated): Loans and leases graded Doubtful have inherent weaknesses that make collection or liquidation in full questionable. Loans and leases graded Doubtful must be placed on non-accrual status.
Loss (8 rated): Loss rated loans and leases are considered uncollectible and of such little value that their continuance as an active Bank asset is not warranted. The asset should be charged off, even though partial recovery may be possible in the future.

18



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following tables summarize the risk grades of each category:
 
Risk Grades
1 - 4
 
Risk Grade
5
 
Risk Grades
6 - 8
 
Total
June 30, 2017
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
Agriculture
$
2,442

 
$
231

 
$

 
$
2,673

Death Care Management
10,628

 
119

 
110

 
10,857

Healthcare
30,078

 
2,440

 
6,615

 
39,133

Independent Pharmacies
84,555

 
5,642

 
4,873

 
95,070

Registered Investment Advisors
76,349

 
2,433

 
2,086

 
80,868

Veterinary Industry
38,342

 
1,811

 
2,123

 
42,276

Other Industries
136,174

 
170

 

 
136,344

Total
378,568

 
12,846

 
15,807

 
407,221

Construction & Development
 
 
 
 
 
 
 
Agriculture
37,108

 

 

 
37,108

Death Care Management
4,385

 

 

 
4,385

Healthcare
40,252

 

 

 
40,252

Independent Pharmacies
1,319

 

 

 
1,319

Registered Investment Advisors
366

 

 

 
366

Veterinary Industry
14,325

 

 

 
14,325

Other Industries
39,163

 

 

 
39,163

Total
136,918

 

 

 
136,918

Commercial Real Estate
 
 
 
 
 
 
 
Agriculture
5,514

 

 

 
5,514

Death Care Management
51,370

 
4,237

 
2,523

 
58,130

Healthcare
108,388

 
4,168

 
1,787

 
114,343

Independent Pharmacies
14,145

 
1,803

 
2,168

 
18,116

Registered Investment Advisors
14,567

 
148

 

 
14,715

Veterinary Industry
89,508

 
2,498

 
12,873

 
104,879

Other Industries
84,911

 

 

 
84,911

Total
368,403

 
12,854

 
19,351

 
400,608

Commercial Land
 
 
 
 
 
 
 
Agriculture
139,792

 
1,122

 
196

 
141,110

Total
139,792

 
1,122

 
196

 
141,110

Total1
$
1,023,681

 
$
26,822

 
$
35,354

 
$
1,085,857


19



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
Risk Grades
1 - 4
 
Risk Grade
5
 
Risk Grades
6 - 8
 
Total
December 31, 2016
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
Agriculture
$
1,656

 
$
58

 
$

 
$
1,714

Death Care Management
9,452

 
121

 
111

 
9,684

Healthcare
28,723

 
681

 
7,866

 
37,270

Independent Pharmacies
73,948

 
6,542

 
3,187

 
83,677

Registered Investment Advisors
65,297

 
2,246

 
792

 
68,335

Veterinary Industry
34,407

 
1,967

 
2,556

 
38,930

Other Industries
94,736

 
100

 

 
94,836

Total
308,219

 
11,715

 
14,512

 
334,446

Construction & Development
 
 
 
 
 
 
 
Agriculture
32,061

 

 
311

 
32,372

Death Care Management
3,956

 

 

 
3,956

Healthcare
30,467

 

 

 
30,467

Independent Pharmacies
2,013

 

 

 
2,013

Registered Investment Advisors
294

 

 

 
294

Veterinary Industry
9,725

 
1,789

 

 
11,514

Other Industries
31,715

 

 

 
31,715

Total
110,231

 
1,789

 
311

 
112,331

Commercial Real Estate
 
 
 
 
 
 
 
Agriculture
5,591

 

 

 
5,591

Death Care Management
46,427

 
4,314

 
1,769

 
52,510

Healthcare
103,097

 
7,142

 
4,042

 
114,281

Independent Pharmacies
12,654

 
1,968

 
529

 
15,151

Registered Investment Advisors
11,462

 

 

 
11,462

Veterinary Industry
88,168

 
3,995

 
10,743

 
102,906

Other Industries
46,245

 

 

 
46,245

Total
313,644

 
17,419

 
17,083

 
348,146

Commercial Land
 
 
 
 
 
 
 
Agriculture
112,333

 
1,138

 
98

 
113,569

Total
112,333

 
1,138

 
98

 
113,569

Total1
$
844,427

 
$
32,061

 
$
32,004

 
$
908,492

1
Total loans and leases include $39.0 million of U.S. government guaranteed loans as of June 30, 2017, segregated by risk grade as follows: Risk Grades 1 – 4 = $12.6 million, Risk Grade 5 = $3.2 million, Risk Grades 6 – 8 = $23.2 million. As of December 31, 2016, total loans and leases include $37.7 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $8.7 million, Risk Grade 5 = $7.7 million, Risk Grades 6 – 8 = $21.3 million.

20



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Past Due Loans and Leases
Loans and leases are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans and leases less than 30 days past due and accruing are included within current loans and leases shown below. The following tables show an age analysis of past due loans and leases as of the dates presented.
 
Less Than 30
Days Past
Due & Not
Accruing
 
30-89 Days
Past Due
& Accruing
 
30-89 Days
Past Due &
Not Accruing
 
Greater
Than 90
Days Past
Due
 
Total Not
Accruing
& Past Due
 
Current
 
Total Loans and Leases
 
90
Days or More
Past Due &
Still Accruing
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
$

 
$

 
$

 
$

 
$

 
$
2,673

 
$
2,673

 
$

Death Care Management

 

 

 

 

 
10,857

 
10,857

 

Healthcare
557

 
94

 
942

 
3,937

 
5,530

 
33,603

 
39,133

 

Independent Pharmacies

 

 
126

 
3,634

 
3,760

 
91,310

 
95,070

 

Registered Investment Advisors

 

 

 
707

 
707

 
80,161

 
80,868

 

Veterinary Industry
30

 
40

 
557

 
1,085

 
1,712

 
40,564

 
42,276

 

Other Industries

 

 

 

 

 
136,344

 
136,344

 

Total
587

 
134

 
1,625

 
9,363

 
11,709

 
395,512

 
407,221

 

Construction & Development
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
37,108

 
37,108

 

Death Care Management

 

 

 

 

 
4,385

 
4,385

 

Healthcare

 

 

 

 

 
40,252

 
40,252

 

Independent Pharmacies

 

 

 

 

 
1,319

 
1,319

 

Registered Investment Advisors

 

 

 

 

 
366

 
366

 

Veterinary Industry

 

 

 

 

 
14,325

 
14,325

 

Other Industries

 

 

 

 

 
39,163

 
39,163

 

Total

 

 

 

 

 
136,918

 
136,918

 

Commercial Real Estate
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
5,514

 
5,514

 

Death Care Management

 

 
179

 
1,423

 
1,602

 
56,528

 
58,130

 

Healthcare
40

 
466

 
118

 
832

 
1,456

 
112,887

 
114,343

 

Independent Pharmacies

 

 

 
2,168

 
2,168

 
15,948

 
18,116

 

Registered Investment Advisors

 

 

 

 

 
14,715

 
14,715

 

Veterinary Industry
1,978

 
4,455

 
135

 
3,212

 
9,780

 
95,099

 
104,879

 

Other Industries

 

 

 

 

 
84,911

 
84,911

 

Total
2,018

 
4,921

 
432

 
7,635

 
15,006

 
385,602

 
400,608

 

Commercial Land
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
196

 

 

 

 
196

 
140,914

 
141,110

 

Total
196

 

 

 

 
196

 
140,914

 
141,110

 

Total1
$
2,801

 
$
5,055

 
$
2,057

 
$
16,998

 
$
26,911

 
$
1,058,946

 
$
1,085,857

 
$


21



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
Less Than 30
Days Past
Due & Not
Accruing
 
30-89 Days
Past Due
& Accruing
 
30-89 Days
Past Due &
Not Accruing
 
Greater
Than 90
Days
Past Due
 
Total Not
Accruing
& Past Due
 
Current
 
Total Loans and Leases
 
90
Days or More
Past Due &
Still Accruing
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
$

 
$

 
$

 
$

 
$

 
$
1,714

 
$
1,714

 
$

Death Care Management

 

 

 

 

 
9,684

 
9,684

 

Healthcare

 
272

 
496

 
5,920

 
6,688

 
30,582

 
37,270

 

Independent Pharmacies
42

 
293

 
408

 
2,349

 
3,092

 
80,585

 
83,677

 

Registered Investment Advisors

 

 

 

 

 
68,335

 
68,335

 

Veterinary Industry
32

 
151

 
646

 
1,441

 
2,270

 
36,660

 
38,930

 

Other Industries

 

 

 

 

 
94,836

 
94,836

 

Total
74

 
716

 
1,550

 
9,710

 
12,050

 
322,396

 
334,446

 

Construction & Development
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
231

 
80

 

 

 
311

 
32,061

 
32,372

 

Death Care Management

 

 

 

 

 
3,956

 
3,956

 

Healthcare

 

 

 

 

 
30,467

 
30,467

 

Independent Pharmacies

 

 

 

 

 
2,013

 
2,013

 

Registered Investment Advisors

 

 

 

 

 
294

 
294

 

Veterinary Industry

 

 

 

 

 
11,514

 
11,514

 

Other Industries

 

 

 

 

 
31,715

 
31,715

 

Total
231

 
80

 

 

 
311

 
112,020

 
112,331

 

Commercial Real Estate
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
5,591

 
5,591

 

Death Care Management

 

 
188

 
1,423

 
1,611

 
50,899

 
52,510

 

Healthcare

 

 
3,180

 
45

 
3,225

 
111,056

 
114,281

 

Independent Pharmacies

 

 

 
529

 
529

 
14,622

 
15,151

 

Registered Investment Advisors

 

 

 

 

 
11,462

 
11,462

 

Veterinary Industry
898

 
3,981

 
737

 
5,158

 
10,774

 
92,132

 
102,906

 

Other Industries

 

 

 

 

 
46,245

 
46,245

 

Total
898

 
3,981

 
4,105

 
7,155

 
16,139

 
332,007

 
348,146

 

Commercial Land
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
58

 
40

 

 

 
98

 
113,471

 
113,569

 

Total
58

 
40

 

 

 
98

 
113,471

 
113,569

 

Total1
$
1,261

 
$
4,817

 
$
5,655

 
$
16,865

 
$
28,598

 
$
879,894

 
$
908,492

 
$

1
Total loans and leases include $39.0 million of U.S. government guaranteed loans as of June 30, 2017, of which $14.7 million is greater than 90 days past due, $3.8 million is 30-89 days past due and $20.5 million is included in current loans and leases as presented above. As of December 31, 2016, total loans and leases include $37.7 million of U.S. government guaranteed loans, of which $13.7 million is greater than 90 days past due, $6.8 million is 30-89 days past due and $17.2 million is included in current loans and leases as presented above.

22



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Nonaccrual Loans and Leases
Loans and leases that become 90 days delinquent, or in cases where there is evidence that the borrower’s ability to make the required payments is impaired, are placed in nonaccrual status and interest accrual is discontinued. If interest on nonaccrual loans and leases had been accrued in accordance with the original terms, interest income would have increased by approximately $306 thousand and $162 thousand for the three months ended June 30, 2017 and 2016, respectively, and for the six months ended June 30, 2017 and 2016 interest income would have increased approximately $582 thousand and $301 thousand, respectively. All nonaccrual loans and leases are included in the held for investment portfolio.
Nonaccrual loans and leases as of June 30, 2017 and December 31, 2016 are as follows:
June 30, 2017
Loan and Lease Balance
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Healthcare
$
5,436

 
$
4,542

 
$
894

Independent Pharmacies
3,760

 
3,304

 
456

Registered Investment Advisors
707

 
707

 

Veterinary Industry
1,672

 
1,547

 
125

Total
11,575

 
10,100

 
1,475

Commercial Real Estate

 
 
 
 
Death Care Management
1,602

 
1,264

 
338

Healthcare
990

 
776

 
214

Independent Pharmacies
2,168

 
1,626

 
542

Veterinary Industry
5,325

 
4,371

 
954

Total
10,085

 
8,037

 
2,048

Commercial Land


 
 
 
 
    Agriculture
196

 
173

 
23

     Total
196

 
173

 
23

Total
$
21,856

 
$
18,310

 
$
3,546

December 31, 2016
Loan and Lease Balance
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Healthcare
$
6,416

 
$
5,152

 
$
1,264

Independent Pharmacies
2,799

 
2,204

 
595

Veterinary Industry
2,119

 
2,079

 
40

Total
11,334

 
9,435

 
1,899

Construction & Development
 
 
 
 
 
Agriculture
231

 
173

 
58

Total
231

 
173

 
58

Commercial Real Estate
 
 
 
 
 
Death Care Management
1,611

 
1,263

 
348

Healthcare
3,225

 
2,731

 
494

Independent Pharmacies
529

 

 
529

Veterinary Industry
6,793

 
5,395

 
1,398

Total
12,158

 
9,389

 
2,769

Commercial Land
 
 
 
 
 
Agriculture
58

 

 
58

Total
58

 

 
58

Total
$
23,781

 
$
18,997

 
$
4,784


23



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Allowance for Loan and Lease Loss Methodology
The methodology and the estimation process for calculating the Allowance for Loan and Lease Losses (“ALLL”) is described below:
Estimated credit losses should meet the criteria for accrual of a loss contingency, i.e., a provision to the ALLL, set forth in GAAP. The Company’s methodology for determining the ALLL is based on the requirements of GAAP, the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other regulatory and accounting pronouncements. The ALLL is determined by the sum of three separate components: (i) the impaired loan and lease component, which addresses specific reserves for impaired loans and leases; (ii) the general reserve component, which addresses reserves for pools of homogeneous loans and leases; and (iii) an unallocated reserve component (if any) based on management’s judgment and experience. The loan and lease pools and impaired loans and leases are mutually exclusive; any loan or lease that is impaired is excluded from its homogenous pool for purposes of that pool’s reserve calculation, regardless of the level of impairment.
The ALLL policy for pooled loans and leases is governed in accordance with banking regulatory guidance for homogenous pools of non-impaired loans and leases that have similar risk characteristics. The Company follows a consistent and structured approach for assessing the need for reserves within each individual loan and lease pool.
Loans and leases are considered impaired when, based on current information and events, it is probable that the creditor will be unable to collect all interest and principal payments due according to the originally contracted, or reasonably modified, terms of the loan or lease agreement. The Company has determined that loans and leases that meet the criteria defined below must be reviewed quarterly to determine if they are impaired.
All commercial loans and leases classified substandard or worse.
Any other delinquent loan or lease that is in a nonaccrual status, or any loan or lease that is delinquent more than 89 days and still accruing interest.
Any loan or lease which has been modified such that it meets the definition of a Troubled Debt Restructuring (TDR).
Effective December 31, 2015, the Company’s policy for impaired loan and lease accounting subjects all loans and leases to impairment recognition; however, loan and lease relationships with unguaranteed credit exposure of less than $100,000 are generally not evaluated on an individual basis for impairment and instead are evaluated collectively using a methodology based on historical specific reserves on similar sized loans and leases. Any loan or lease not meeting the above criteria and determined to be impaired is subjected to an impairment analysis, which is a calculation of the probable loss on the loan or lease. This portion is the loan's or lease’s “impairment,” and is established as a specific reserve against the loan or lease, or charged against the ALLL.
Individual specific reserve amounts imply probability of loss and may not be carried in the reserve indefinitely. When the amount of the actual loss becomes reasonably quantifiable, the amount of the loss is charged off against the ALLL, whether or not all liquidation and recovery efforts have been completed. If the total amount of the individual specific reserve that will eventually be charged off cannot yet be sufficiently quantified but some portion of the impairment can be viewed as a confirmed loss, then the confirmed loss portion should be charged off against the ALLL and the individual specific reserve reduced by a corresponding amount.
For impaired loans or leases, the reserve amount is calculated on a loan or lease-specific basis. The Company utilizes two methods of analyzing impaired loans and leases not guaranteed by the SBA:
The Fair Market Value of Collateral method utilizes the value at which the collateral could be sold considering the appraised value, appraisal discount rate, prior liens and selling costs. The amount of the reserve is the deficit of the estimated collateral value compared to the loan or lease balance.
The Present Value of Future Cash Flows method takes into account the amount and timing of cash flows and the effective interest rate used to discount the cash flows.

24



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following table details activity in the allowance for loan and lease losses by portfolio segment allowance for the periods presented:
Three months ended
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
June 30, 2017
 
 
 
 
 
 
 
 
 
Beginning Balance
$
1,884

 
$
6,226

 
$
7,846

 
$
2,239

 
$
18,195

Charge offs

 
(19
)
 
(178
)
 

 
(197
)
Recoveries

 
4

 
2

 

 
6

Provision
(281
)
 
1,283

 
681

 
(127
)
 
1,556

Ending Balance
$
1,603

 
$
7,494

 
$
8,351

 
$
2,112

 
$
19,560

June 30, 2016
 
 
 
 
 
 
 
 
 
Beginning Balance
$
1,163

 
$
2,575

 
$
3,345

 
$
1,533

 
$
8,616

Charge offs

 

 
(100
)
 
(63
)
 
(163
)
Recoveries

 
3

 
400

 

 
403

Provision
45

 
1,501

 
1,956

 
(49
)
 
3,453

Ending Balance
$
1,208

 
$
4,079

 
$
5,601

 
$
1,421

 
$
12,309

Six months ended
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
June 30, 2017
 
 
 
 
 
 
 
 
 
Beginning Balance
$
1,693

 
$
5,897

 
$
8,413

 
$
2,206

 
$
18,209

Charge offs

 
(287
)
 
(1,411
)
 
(35
)
 
(1,733
)
Recoveries

 
13

 
16

 

 
29

Provision
(90
)
 
1,871

 
1,333

 
(59
)
 
3,055

Ending Balance
$
1,603

 
$
7,494

 
$
8,351

 
$
2,112

 
$
19,560

June 30, 2016
 
 
 
 
 
 
 
 
 
Beginning Balance
$
1,064

 
$
2,486

 
$
2,766

 
$
1,099

 
$
7,415

Charge offs

 
(7
)
 
(368
)
 
(63
)
 
(438
)
Recoveries

 
3

 
443

 

 
446

Provision
144

 
1,597

 
2,760

 
385

 
4,886

Ending Balance
$
1,208

 
$
4,079

 
$
5,601

 
$
1,421

 
$
12,309

The following tables detail the recorded allowance for loan and lease losses and the investment in loans and leases related to each portfolio segment, disaggregated on the basis of impairment evaluation methodology:
June 30, 2017
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
Allowance for Loan and Lease Losses:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$

 
$
1,923

 
$
1,143

 
$

 
$
3,066

Loans and leases collectively evaluated for impairment2
1,603

 
5,571

 
7,208

 
2,112

 
16,494

Total allowance for loan and lease losses
$
1,603

 
$
7,494

7,494

$
8,351

 
$
2,112

 
$
19,560

Loans and leases receivable1:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$

 
$
16,728

 
$
7,694

 
$

 
$
24,422

Loans and leases collectively evaluated for impairment2
136,918

 
383,880

 
399,527

 
141,110

 
1,061,435

Total loans and leases receivable
$
136,918

 
$
400,608

 
$
407,221

 
$
141,110

 
$
1,085,857


25



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

December 31, 2016
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
Allowance for Loan and Lease Losses:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$

 
$
1,496

 
$
1,458

 
$

 
$
2,954

Loans and leases collectively evaluated for impairment2
1,693

 
4,401

 
6,955

 
2,206

 
15,255

Total allowance for loan and lease losses
$
1,693

 
$
5,897

 
$
8,413

 
$
2,206

 
$
18,209

Loans and leases receivable1:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$

 
$
16,359

 
$
6,884

 
$

 
$
23,243

Loans and leases collectively evaluated for impairment2
112,331

 
331,787

 
327,562

 
113,569

 
885,249

Total loans and leases receivable
$
112,331

 
$
348,146

 
$
334,446

 
$
113,569

 
$
908,492

1
Loans and leases receivable includes $39.0 million of U.S. government guaranteed loans as of June 30, 2017, of which $23.3 million are impaired. As of December 31, 2016, loans and leases receivable includes $37.7 million of U.S. government guaranteed loans, of which $22.1 million are considered impaired.
2
Included in loans and leases collectively evaluated for impairment are impaired loans and leases with individual unguaranteed exposure of less than $100 thousand. As of June 30, 2017, these balances totaled $13.3 million, of which $11.6 million are guaranteed by the U.S. government and $1.7 million are unguaranteed. As of December 31, 2016, these balances totaled $12.3 million, of which $10.0 million are guaranteed by the U.S. government and $2.3 million are unguaranteed. The allowance for loan and lease losses associated with these loans and leases totaled $566 thousand and $438 thousand as of June 30, 2017 and December 31, 2016, respectively.

26



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Loans and leases classified as impaired as of the dates presented are summarized in the following tables.
June 30, 2017
Recorded
Investment
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Death Care Management
$
109

 
$

 
$
109

Healthcare
6,613

 
4,813

 
1,800

Independent Pharmacies
5,478

 
3,574

 
1,904

Registered Investment Advisors
2,101

 
707

 
1,394

Veterinary Industry
2,415

 
1,648

 
767

Total
16,716

 
10,742

 
5,974

Commercial Real Estate
 
 
 
 
 
Death Care Management
2,519

 
1,264

 
1,255

Healthcare
1,787

 
1,027

 
760

Independent Pharmacies
2,167

 
1,626

 
541

Veterinary Industry
14,289

 
8,437

 
5,852

Total
20,762

 
12,354

 
8,408

Commercial Land
 
 
 
 
 
Agriculture
190

 
173

 
17

Total
190

 
173

 
17

Total
$
37,668

 
$
23,269

 
$
14,399

December 31, 2016
Recorded
Investment
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Death Care Management
$
111

 
$

 
$
111

Healthcare
7,923

 
5,453

 
2,470

Independent Pharmacies
3,514

 
2,495

 
1,019

Registered Investment Advisors
796

 

 
796

Veterinary Industry
2,882

 
2,199

 
683

Total
15,226

 
10,147

 
5,079

Construction & Development
 
 
 
 
 
Agriculture
300

 
233

 
67

Total
300

 
233

 
67

Commercial Real Estate
 
 
 
 
 
Death Care Management
1,768

 
1,264

 
504

Healthcare
4,044

 
2,985

 
1,059

Independent Pharmacies
528

 

 
528

Veterinary Industry
13,561

 
7,518

 
6,043

Total
19,901

 
11,767

 
8,134

Commercial Land
 
 
 
 
 
Agriculture
91

 

 
91

Total
91

 

 
91

Total
$
35,518

 
$
22,147

 
$
13,371


27



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following table presents evaluated balances of loans and leases classified as impaired at the dates presented that carried an associated reserve as compared to those with no reserve. The recorded investment includes accrued interest and net deferred loan and lease fees or costs.
 
June 30, 2017
 
Recorded Investment
 
 
 
 
 
With a
Recorded
Allowance
 
With No
Recorded
Allowance
 
Total
 
Unpaid
Principal
Balance
 
Related
Allowance
Recorded
Commercial & Industrial
 
 
 
 
 
 
 
 
 
Death Care Management
$
7

 
$
102

 
$
109

 
$
110

 
$
1

Healthcare
5,981

 
632

 
6,613

 
7,155

 
434

Independent Pharmacies
3,994

 
1,484

 
5,478

 
5,967

 
152

Registered Investment Advisors
1,472

 
629

 
2,101

 
2,322

 
572

Veterinary Industry
2,288

 
127

 
2,415

 
2,736

 
191

Total
13,742

 
2,974

 
16,716

 
18,290

 
1,350

Commercial Real Estate
 
 
 
 
 
 
 
 
 
Death Care Management
2,047

 
472

 
2,519

 
2,658

 
218

Healthcare
1,277

 
510

 
1,787

 
1,801

 
47

Independent Pharmacies
2,167

 

 
2,167

 
2,168

 
437

Veterinary Industry
12,085

 
2,204

 
14,289

 
15,283

 
1,576

Total
17,576

 
3,186

 
20,762

 
21,910

 
2,278

Commercial Land
 
 
 
 
 
 
 
 
 
Agriculture
190

 

 
190

 
231

 
4

Total
190

 

 
190

 
231

 
4

Total Impaired Loans and Leases
$
31,508

 
$
6,160

 
$
37,668

 
$
40,431

 
$
3,632


28



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
December 31, 2016
 
Recorded Investment
 
 
 
 
 
With a
Recorded
Allowance
 
With No
Recorded
Allowance
 
Total
 
Unpaid
Principal
Balance
 
Related
Allowance
Recorded
Commercial & Industrial
 
 
 
 
 
 
 
 
 
Death Care Management
$
8

 
$
103

 
$
111

 
$
111

 
$
1

Healthcare
7,259

 
664

 
7,923

 
8,120

 
778

Independent Pharmacies
3,184

 
330

 
3,514

 
3,610

 
327

Registered Investment Advisors
796

 

 
796

 
792

 
514

Veterinary Industry
2,754

 
128

 
2,882

 
3,369

 
106

Total
14,001

 
1,225

 
15,226

 
16,002

 
1,726

Construction & Development
 
 
 
 
 
 
 
 
 
Agriculture
300

 

 
300

 
311

 
13

Total
300

 

 
300

 
311

 
13

Commercial Real Estate
 
 
 
 
 
 
 
 
 
Death Care Management
1,580

 
188

 
1,768

 
1,904

 
34

Healthcare
3,514

 
530

 
4,044

 
4,042

 
47

Independent Pharmacies
528

 

 
528

 
529

 
284

Veterinary Industry
11,193

 
2,368

 
13,561

 
14,283

 
1,273

Total
16,815

 
3,086

 
19,901

 
20,758

 
1,638

Commercial Land
 
 
 
 
 
 
 
 
 
Agriculture
91

 

 
91

 
161

 
15

Total
91

 

 
91

 
161

 
15

Total Impaired Loans and Leases
$
31,207

 
$
4,311

 
$
35,518

 
$
37,232

 
$
3,392


29



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

The following table presents the average recorded investment of impaired loans and leases for each period presented and interest income recognized during the period in which the loans and leases were considered impaired.
 
Three months ended
June 30, 2017
 
Three months ended
June 30, 2016
 
Average
Balance
 
Interest
Income
Recognized
 
Average
Balance
 
Interest
Income
Recognized
Commercial & Industrial
 
 
 
 
 
 
 
Death Care Management
$
111

 
$
2

 
$
9

 
$

Healthcare
6,708

 
19

 
4,440

 
21

Independent Pharmacies
5,647

 
23

 
1,935

 
17

Registered Investment Advisors
2,100

 
15

 
379

 
5

Veterinary Industry
2,448

 
10

 
2,640

 
9

Total
17,014

 
69

 
9,403

 
52

Commercial Real Estate
 
 
 
 
 
 
 
Death Care Management
2,536

 
14

 
1,582

 
2

Healthcare
1,808

 
12

 
1,038

 
7

Independent Pharmacies
2,169

 

 

 

Veterinary Industry
14,777

 
133

 
12,189

 
84

Total
21,290

 
159

 
14,809

 
93

Commercial Land
 
 
 
 
 
 
 
Agriculture
196

 

 
335

 

Total
196

 

 
335

 

Total
$
38,500

 
$
228

 
$
24,547

 
$
145

 
Six months ended
June 30, 2017
 
Six months ended
June 30, 2016
 
Average
Balance
 
Interest
Income
Recognized
 
Average
Balance
 
Interest
Income
Recognized
Commercial & Industrial
 
 
 
 
 
 
 
Death Care Management
$
1,776

 
$
3

 
$
9

 
$

Healthcare
5,054

 
41

 
4,721

 
32

Independent Pharmacies
5,050

 
37

 
1,907

 
33

Registered Investment Advisors
1,740

 
30

 
381

 
7

Veterinary Industry
8,663

 
21

 
2,675

 
16

Total
22,283

 
132

 
9,693

 
88

Commercial Real Estate
 
 
 
 
 
 
 
Death Care Management
6,637

 
19

 
1,588

 
3

Healthcare
1,642

 
24

 
1,055

 
9

Independent Pharmacies
1,176

 

 

 

Veterinary Industry
6,663

 
238

 
12,319

 
159

Total
16,118

 
281

 
14,962

 
171

Commercial Land
 
 
 
 
 
 
 
Agriculture
466

 

 
429

 

Total
466

 

 
429

 

Total
$
38,867

 
$
413

 
$
25,084

 
$
259


30



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

There was one TDR made for payment deferral and extension of amortization during the three and six months ended June 30, 2017 and none made during the three months ended June 30, 2016. The TDR had a pre-modification and post-modification recorded investment of $262 thousand. During the six months ended June 30, 2016, there was one commercial and industrial veterinary loan modified for payment deferral. This TDR had a pre-modification and post-modification recorded investment of $420 thousand.
Concessions made to improve a loan and lease’s performance have varying degrees of success. As of June 30, 2017, one TDR that was modified within the twelve months ended June 30, 2017 subsequently defaulted. This TDR was a commercial and industrial healthcare loan that was previously modified for payment deferral. The recorded investment for this TDR at June 30, 2017 was $107 thousand.
As of June 30, 2016, one TDR that was modified within the twelve months ended June 30, 2016 subsequently defaulted. This TDR was a commercial and industrial veterinary loan that was previously modified for payment deferral. The recorded investment for this TDR at June 30, 2016 was $313 thousand.
Note 7. Servicing Assets
Loans serviced for others are not included in the accompanying balance sheet. The unpaid principal balances of loans serviced for others requiring recognition of a servicing asset were $2.30 billion and $2.22 billion at June 30, 2017 and December 31, 2016, respectively.
The following summarizes the activity pertaining to servicing rights:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2017
 
2016
 
2017
 
2016
Balance at beginning of period
$
53,584

 
$
47,377

 
$
51,994

 
$
44,230

Additions, net
2,503

 
3,243

 
5,885

 
6,958

Fair value changes:
 
 
 
 
 
 
 
Due to changes in valuation inputs or assumptions
365

 
(262
)
 
861

 
559

Decay due to increases in principal paydowns or runoff
(2,777
)
 
(1,904
)
 
(5,065
)
 
(3,293
)
Balance at end of period
$
53,675

 
$
48,454

 
$
53,675

 
$
48,454

The fair value of servicing rights was determined using discount rates ranging from 9.0% to 13.2% on June 30, 2017 and 7.6% to 13.1% on June 30, 2016. The fair value of servicing rights was determined using prepayment speeds ranging from 3.1% to 10.2% on June 30, 2017 and 3.4% to 10.1% on June 30, 2016, depending on the stratification of the specific right. Changes to fair value are reported in loan servicing asset revaluation within the consolidated statements of income.
The fair value of servicing rights is highly sensitive to changes in underlying assumptions. Changes in prepayment speed assumptions have the most significant impact on the fair value of servicing rights. Generally, as interest rates rise on variable rate loans, loan prepayments increase due to an increase in refinance activity, which results in a decrease in the fair value of servicing assets. Measurement of fair value is limited to the conditions existing and the assumptions used as of a particular point in time, and those assumptions may not be appropriate if they are applied at a different time.


31



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 8. Borrowings
Total outstanding long term borrowings consisted of the following:
 
June 30,
2017
 
December 31,
2016
Short term borrowings
 
 
 
On June 30, 2017, the Company purchased $10 million in overnight federal funds from a correspondent bank. The line of credit is unsecured and accrues interest based on the daily federal funds rate plus a spread; the rate at June 30, 2017 was 2.25%. This line of credit requires full payment of principal and interest the following business day. The line of credit is fully disbursed and there was no remaining available credit on this line at June 30, 2017.
$
10,000

 
$

Total short term borrowings
$
10,000

 
$

 
June 30,
2017
 
December 31,
2016
Long term borrowings
 
 
 
On September 11, 2014, the Company financed the construction of an additional building located on the Company’s Tiburon Drive main campus with a $24 million construction line of credit with an unaffiliated commercial bank, secured by both properties at its Tiburon Drive main facility location. Payments were interest only through September 11, 2016 at a fixed rate of 3.95% for a term of 84 months. Monthly principal and interest payments of $146 thousand began in October 2016 with all principal and accrued interest due on September 11, 2021. The construction line is fully disbursed and there was no remaining available credit on this construction line at June 30, 2017.
$
23,396

 
$
23,864

On February 23, 2015, the Company transferred two related party loans to an unaffiliated commercial bank in exchange for $4.7 million. The exchange price equated to the unpaid principal balance plus accrued but uncollected interest at the time of transfer. The terms of the transfer agreement with the unaffiliated commercial bank identified the transaction as a secured borrowing for accounting purposes. Interest accrues at prime plus 1% with monthly principal and interest payments over a term of 60 months. The interest rate at June 30, 2017 is 5.00%. The maturity date is October 5, 2019. The pledged collateral is classified in other assets with a fair value of $3.8 million at June 30, 2017. Underlying loans carry a risk grade of 3 and are current with no delinquencies.
3,777

 
3,979

On September 18, 2014, the Company entered into a note payable revolving line of credit of $8.1 million with an unaffiliated commercial bank. On April 18, 2017, the Company renewed and increased the revolving line of credit to $25 million. The note is unsecured and accrues interest at Prime minus 0.50% for a term of 24 months. Payments are interest only with all principal and accrued interest due on April 30, 2019. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios. The line of credit is fully disbursed and there was no remaining available credit on this line at June 30, 2017.
25,000

 

Total long term borrowings
$
52,173

 
$
27,843

The Company may purchase federal funds though unsecured federal funds lines of credit with various correspondent banks, which totaled $32.5 million and $26.5 million as of June 30, 2017 and December 31, 2016, respectively. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and terms of advances. These lines of credit are payable on demand and bear interest based upon the daily federal funds rate. The Company had $10.0 million outstanding on the lines of credit as of June 30, 2017 and no outstanding balances on the lines of credit as of December 31, 2016.
The Company has entered into a repurchase agreement with a third party for $5 million as of June 30, 2017 and December 31, 2016. At the time the Company enters into a transaction with the third party, the Company must transfer securities or other assets against the funds received. The terms of the agreement are set at market conditions at the time the Company enters into such transaction. The Company had no outstanding balance on the repurchase agreement as of June 30, 2017 and December 31, 2016.
The Company may borrow funds through the Federal Reserve Bank’s discount window. These borrowings are secured by a blanket floating lien on qualifying loans with a balance of $326.3 million and $281.3 million as of June 30, 2017 and December 31, 2016, respectively. At June 30, 2017 and December 31, 2016, the Company had approximately $174.0 million and $142.7 million, respectively, in borrowing capacity available under these arrangements with no outstanding balance as of June 30, 2017 and December 31, 2016.

32



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 9. Income Taxes
The Company's effective tax rate is lower than the U.S. statutory rate primarily because of the anticipated effect of investment tax credits during 2017. The Company's effective tax rate in the future will depend on the actual investment tax credits earned as a part of its financing renewable energy applications.
In the first quarter of 2017, share based compensation expense excess tax benefits of $874 thousand were reflected in the consolidated statements of income as a component of the provision for income taxes as a result of the adoption of ASU 2016-09. Please refer to Note 2 for more details regarding the adoption of ASU 2016-09.
Note 10. Fair Value of Financial Instruments
Fair Value Hierarchy
There are three levels of inputs in the fair value hierarchy that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.
Financial Instruments Measured at Fair Value
The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the fair value hierarchy:
Investment securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, discounted cash flow or at net asset value per share. Level 2 securities would include US government agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed mutual fund and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.
Impaired loans: Impairment of a loan is based on the fair value of the collateral of the loan for collateral-dependent loans. Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. For non-collateral dependent loans, impairment is determined by the present value of expected future cash flows. Impaired loans classified as Level 3 are based on management’s judgment and estimation.
Servicing assets: Servicing rights do not trade in an active, open market with readily observable prices. While sales of servicing rights do occur, the precise terms and conditions typically are not readily available. Accordingly, the Company estimates the fair value of servicing rights using discounted cash flow models incorporating numerous assumptions from the perspective of a market participant including servicing income, servicing costs, market discount rates and prepayment speeds. Due to the nature of the valuation inputs, servicing rights are classified within Level 3 of the valuation hierarchy.
Foreclosed assets: Foreclosed real estate is adjusted to fair value less selling costs upon transfer of the loans to foreclosed real estate. Subsequently, foreclosed real estate is carried at the lower of carrying value or fair 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. Given the lack of observable market prices for identical properties and market discounts applied to appraised values, the Company generally classifies foreclosed assets as nonrecurring Level 3.
Contingent consideration liability: Contingent consideration associated with the acquisition of Reltco will be adjusted to fair value quarterly until settled. The assumptions used to measure fair value are based on internal metrics that are unobservable and therefore the contingent consideration liability is classified within Level 3 of the valuation hierarchy.

33



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Recurring Fair Value
The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.
June 30, 2017
Total
 
Level 1
 
Level 2
 
Level 3
Investment securities available-for-sale
 
 
 
 
 
 
 
US government agencies
$
17,802

 
$

 
$
17,802

 
$

Residential mortgage-backed securities
53,179

 

 
53,179

 

Mutual fund
2,012

 

 
2,012

 

Servicing assets1
53,675

 

 

 
53,675

Total assets at fair value
$
126,668

 
$

 
$
72,993

 
$
53,675

 
 
 
 
 
 
 
 
Contingent consideration liability2
$
4,650

 
$

 
$

 
$
4,650

Total liabilities at fair value
$
4,650

 
$

 
$

 
$
4,650

December 31, 2016
Total
 
Level 1
 
Level 2
 
Level 3
Investment securities available-for-sale
 
 
 
 
 
 
 
US government agencies
$
17,823

 
$

 
$
17,823

 
$

Residential mortgage-backed securities
51,273

 

 
51,273

 

Mutual fund
1,960

 

 
1,960

 

Servicing assets1
51,994

 

 

 
51,994

Total assets at fair value
$
123,050

 
$

 
$
71,056

 
$
51,994

1
See Note 7 for a rollforward of recurring Level 3 fair values for servicing assets and various assumptions used in the fair value measurement.
2
See Note 4 for activity related to the recurring Level 3 fair value for the contingent consideration liability and various assumptions used in the fair value measurement.
Non-recurring Fair Value
The tables below present the recorded amount of assets and liabilities measured at fair value on a non-recurring basis.
June 30, 2017
Total
 
Level 1
 
Level 2
 
Level 3
Impaired loans and leases
$
27,876

 
$

 
$

 
$
27,876

Foreclosed assets
2,140

 

 

 
2,140

Total assets at fair value
$
30,016

 
$

 
$

 
$
30,016

December 31, 2016
Total
 
Level 1
 
Level 2
 
Level 3
Impaired loans and leases
$
27,815

 
$

 
$

 
$
27,815

Foreclosed assets
1,648

 

 

 
1,648

Total assets at fair value
$
29,463

 
$

 
$

 
$
29,463


34



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Level 3 Analysis
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2017 and December 31, 2016 the significant unobservable inputs used in the fair value measurements were as follows:
June 30, 2017
Level 3 Assets with Significant
Unobservable Inputs
 
Fair Value
 
Valuation Technique
 
Significant
Unobservable
Inputs
 
Range
Impaired Loans and Leases
 
$
27,876

 
Discounted appraisals
Discounted expected cash flows
 
Appraisal adjustments (1)
Interest rate & repayment term
 
0% to 25% Weighted average discount rate 5.91%
Foreclosed Assets
 
$
2,140

 
Discounted appraisals
 
Appraisal adjustments (1)
 
10% to 35%
December 31, 2016
Level 3 Assets with Significant
Unobservable Inputs
 
Fair Value
 
Valuation Technique
 
Significant
Unobservable
Inputs
 
Range
Impaired Loans and Leases
 
$
27,815

 
Discounted appraisals
Discounted expected cash flows
 
Appraisal adjustments (1)
Interest rate & repayment term
 
0% to 25% Weighted average discount rate 5.28%
Foreclosed Assets
 
$
1,648

 
Discounted appraisals
 
Appraisal adjustments (1)
 
10% to 35%
(1)
Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments.
Estimated Fair Value of Other Financial Instruments
GAAP also requires disclosure of fair value information about financial instruments carried at book value on the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments not measured at fair value on the consolidated balance sheets:
Cash and due from banks: The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.
Certificates of deposit with other banks: The fair value of certificates of deposit with other banks is estimated based on discounting cash flows using the rates currently offered for instruments of similar remaining maturities.
Loans held for sale: The fair values of loans held for sale are based on quoted market prices, where available, and determined by discounting estimated cash flows using interest rates approximating the Company’s current origination rates for similar loans adjusted to reflect the inherent credit risk.
Loans and leases held for investment: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans and leases are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality. Loan and lease fair value estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.
Accrued interest: The carrying amounts of accrued interest approximate fair value.

35



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short and long term borrowings: The fair values of the Company’s short term borrowings approximate fair value while long term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental debt rates for similar types of debt arrangements.
The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:
June 30, 2017
Carrying
Amount
 
Quoted Price
In Active
Markets for
Identical Assets
/Liabilities
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
Fair
Value
Financial assets
 
 
 
 
 
 
 
 
 
Cash and due from banks
$
207,373

 
$
207,373

 
$

 
$

 
$
207,373

Certificates of deposit with other banks
5,750

 
5,751

 

 

 
5,751

Investment securities, available-for-sale
72,993

 

 
72,993

 

 
72,993

Loans held for sale
609,138

 

 

 
651,110

 
651,110

Loans and leases, net of allowance for loan and lease losses
1,064,943

 

 

 
1,040,246

 
1,040,246

Servicing assets
53,675

 

 

 
53,675

 
53,675

Accrued interest receivable
9,062

 
9,062

 

 

 
9,062

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
1,871,721

 

 
1,842,800

 

 
1,842,800

Accrued interest payable
192

 
192

 

 

 
192

Short term borrowings
10,000

 

 

 
10,002

 
10,002

Long term borrowings
52,173

 

 

 
53,323

 
53,323

December 31, 2016
Carrying
Amount
 
Quoted Price
In Active
Markets for
Identical Assets
/Liabilities
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
Fair
Value
Financial assets
 
 
 
 
 
 
 
 
 
Cash and due from banks
$
238,008

 
$
238,008

 
$

 
$

 
$
238,008

Certificates of deposit with other banks
7,250

 
7,236

 

 

 
7,236

Investment securities, available-for-sale
71,056

 

 
71,056

 

 
71,056

Loans held for sale
394,278

 

 

 
426,220

 
426,220

Loans and leases, net of allowance for loan and lease losses
889,357

 

 

 
873,158

 
873,158

Servicing assets
51,994

 

 

 
51,994

 
51,994

Accrued interest receivable
7,520

 
7,520

 

 

 
7,520

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
1,485,076

 

 
1,469,173

 

 
1,469,173

Accrued interest payable
319

 
319

 

 

 
319

Long term borrowings
27,843

 

 

 
29,559

 
29,559


36



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 11. Commitments and Contingencies
Litigation
In the normal course of business the Company is involved in various legal proceedings. Management believes that the outcome of such proceedings will not materially affect the financial position, results of operations or cash flows of the Company.
Financial Instruments with Off-balance-sheet Risk
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheet.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments is as follows:
 
June 30,
2017
 
December 31,
2016
Commitments to extend credit
$
1,424,861

 
$
1,342,271

Standby letters of credit
1,141

 
343

Solar purchase commitments
89,645

 

Finance lease commitments
289

 

Airplane purchase agreement commitments

 
21,500

Total unfunded off-balance-sheet credit risk
$
1,515,936

 
$
1,364,114

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties. In 2012, the Company began issuing commitment letters after approval of the loan by the Credit Department. Commitment letters generally expire ninety days after issuance.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Company deems necessary.
As of June 30, 2017 and December 31, 2016, the Company had commitments for on-balance sheet instruments in the amount of $4.6 million and $4.9 million, respectively.
Concentrations of Credit Risk
Although the Company is not subject to any geographic concentrations, a substantial amount of the Company’s loans and commitments to extend credit have been granted to customers in the agriculture, healthcare and veterinary verticals. The concentrations of credit by type of loan are set forth in Note 6. The distribution of commitments to extend credit approximates the distribution of loans outstanding. The Company does not have a significant number of credits to any single borrower or group of related borrowers whereby their retained unguaranteed exposure exceeds $5.0 million, except for ten relationships that have a retained unguaranteed exposure of $98.2 million of which $74.3 million of the unguaranteed exposure has been disbursed.
The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.

37



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 12. Stock Plans
On March 20, 2015, the Company adopted the 2015 Omnibus Stock Incentive Plan which replaced the previously existing Amended Incentive Stock Option Plan and Nonstatutory Stock Option Plan. Subsequently on May 24, 2016, the 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 7,000,000 common voting shares and has an expiration date of March 20, 2025. Options or restricted shares granted under the Amended and Restated 2015 Omnibus Stock Incentive Plan (the "Plan") expire no more than 10 years from the date of grant. Exercise prices under the Plan are set by the Board of Directors at the date of grant, but shall not be less than 100% of fair market value of the related stock at the date of the grant. Options or restricted shares vest over a minimum of three years from the date of the grant.
Stock Options
Compensation cost relating to share-based payment transactions are recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. For the three months ended June 30, 2017 and 2016, the Company recognized $468 thousand and $581 thousand in compensation expense for stock options, respectively. For the six months ended June 30, 2017 and 2016, the Company recognized $882 thousand and $1.2 million in compensation expense for stock options, respectively.
Stock option activity under the Plan during the six month periods ended June 30, 2017 and 2016 is summarized below.
 
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at December 31, 2016
3,478,208

 
$
11.51

 
 
 
 
Exercised
58,921

 
7.73

 
 
 
 
Forfeited
195,468

 
14.38

 
 
 
 
Granted

 

 
 
 
 
Outstanding at June 30, 2017
3,223,819

 
$
11.41

 
7.56 years
 
$
41,246,695

Exercisable at June 30, 2017
596,021

 
$
9.06

 
7.18 years
 
$
9,021,234

 
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at December 31, 2015
3,546,992

 
$
11.17

 
 
 
 
Exercised
16,707

 
6.39

 
 
 
 
Forfeited
107,594

 
8.12

 
 
 
 
Granted
169,987

 
14.02

 
 
 
 
Outstanding at June 30, 2016
3,592,678

 
$
11.41

 
8.55 years
 
$
13,895,411

Exercisable at June 30, 2016
333,066

 
$
5.79

 
7.69 years
 
$
2,772,308

The following is a summary of non-vested stock option activity for the Company for the six months ended June 30, 2017 and 2016.
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Non-vested at December 31, 2016
3,016,100

 
$
4.78

Granted

 

Vested
192,834

 
2.12

Forfeited
195,468

 
6.17

Non-vested at June 30, 2017
2,627,798

 
$
4.87


38



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

 
Shares
 
Weighted
Average
Grant Date
Fair Value
Non-vested at December 31, 2015
3,393,441

 
$
4.56

Granted
169,987

 
6.58

Vested
196,222

 
1.48

Forfeited
107,594

 
2.54

Non-vested at June 30, 2016
3,259,612

 
$
4.89

The total intrinsic value of options exercised at June 30, 2017 and 2016 was $867 thousand and $144 thousand, respectively.
At June 30, 2017, unrecognized compensation costs relating to stock options amounted to $10.4 million which will be recognized over a weighted average period of 3.03 years.
The weighted average fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The expected volatility is based on historical volatility. The risk-free interest rates for periods within the contractual life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life is based on historical exercise experience. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts. There were no stock options granted during the three and six months ended June 30, 2017.
Restricted Stock
Restricted stock awards are authorized in the form of restricted stock awards or units ("RSU"s) and restricted stock awards or units with a market price condition ("Market RSU"s).
RSUs have a restriction based on the passage of time and may also have a restriction based on a non-market-related performance criteria. The fair value of the RSUs is based on the closing price on the date of the grant.
Market RSUs also have a restriction based on the passage of time and non-market-related performance criteria, but also have a restriction based on market price criteria related to the Company’s share price closing at or above a specified price ranging from $34.00 to $38.00 per share for at least twenty (20) consecutive trading days at any time prior to expiration date. The amount of Market RSUs earned will not exceed 100% of the Market RSUs awarded. The fair value of the Market RSUs and the implied service period is calculated using the Monte Carlo Simulation method.
RSU stock activity under the Plan during the first six months of 2017 is summarized below.
 
Shares
 
Weighted
Average Grant
Date Fair Value
Non-vested at December 31, 2016
134,969

 
$
14.96

Granted
24,535

 
23.31

Vested
15,804

 
15.01

Forfeited
5,988

 
13.57

Non-vested at June 30, 2017
137,712

 
$
16.50

For the three months ended June 30, 2017 and 2016, the Company recognized $167 thousand and $2.1 million in compensation expense for RSUs, respectively. For the six months ended June 30, 2017 and 2016, the Company recognized $326 thousand and $2.2 million in compensation expense for RSUs, respectively.
At June 30, 2017, unrecognized compensation costs relating to RSUs amounted to $1.8 million which will be recognized over a weighted average period of 4.25 years.

39



Live Oak Bancshares, Inc.
Notes to Unaudited Consolidated Financial Statements

Market RSU stock activity under the Plan during the first six months of 2017 is summarized below.
 
Shares
 
Weighted
Average Grant
Date Fair Value
Non-vested at December 31, 2016
2,364,500

 
$
8.28

Granted
103,791

 
11.38

Vested

 

Forfeited
4,007

 
11.38

Non-vested at June 30, 2017
2,464,284

 
$
8.41

The compensation expense for Market RSUs is measured based on their grant date fair value as calculated using the Monte Carlo Simulation and is recognized on a straight-line basis over the average vesting period. The Monte Carlo Simulation used 100,000 simulation paths to assess the expected date of achieving the market price criteria.
Related to the 100,733 Market RSUs granted on January 31, 2017 and the 3,058 Market RSUs granted on May 8, 2017, the share price simulation was based on the Cox, Ross & Rubinstein option pricing methodology for a period of 7.0 years. The implied term of the restricted stock was 4.1 years. The Monte Carlo Simulation used various assumptions that included a risk free rate of return of 2.28%, expected volatility of 30.00% and a dividend yield of 0.39%.
For the three months ended June 30, 2017 and 2016, the Company recognized $1.2 million and $231 thousand in compensation expense for Market RSUs, respectively. For the six months ended June 30, 2017 and 2016, the Company recognized $2.4 million and $231 thousand in compensation expense for Market RSUs, respectively.
All of the Company's Market RSUs had an effective grant date of May 24, 2016, November 30, 2016, January 31, 2017 and May 8, 2017.
At June 30, 2017, unrecognized compensation costs relating to Market RSUs amounted to $17.1 million which will be recognized over a weighted average period of 3.46 years.
Employee Stock Purchase Plan
The Company adopted an Employee Stock Purchase Plan on October 8, 2014. On May 24, 2016, the plan was amended and the Amended and Restated Employee Stock Purchase Plan (the "ESPP") became effective within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended. Under the ESPP, eligible employees are able to purchase available shares with post-tax dollars as of the grant date. In order for employees to be eligible to participate in the ESPP they must be employed or on an authorized leave of absence from the Company or any subsidiary immediately prior to the grant date. ESPP stock purchases cannot exceed $25 thousand in fair market value per employee per calendar year. Options to purchase shares under the ESPP are granted at a 15% discount to fair market value. Expense recognized in relation to the ESPP for the six months ended June 30, 2017 was $43 thousand. There were no ESPP purchases for the six months ended June 30, 2016 and three months ended June 30, 2017 and 2016.


40


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following presents management’s discussion and analysis of the financial condition and results of operations of Live Oak Bancshares, Inc. (the “Company” or “LOB”). This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (the "2016 Annual Report"). Results of operations for the periods included in this quarterly report on Form 10-Q are not necessarily indicative of results to be obtained during any future period.
Important Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains statements that management believes are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. These statements generally relate to the Company’s financial condition, results of operations, plans, objectives, future performance or business. They usually can be identified by the use of forward-looking terminology, such as “believes,” “expects,” or “are expected to,” “plans,” “projects,” “goals,” “estimates,” “will,” “may,” “should,” “could,” “would,” “continues,” “intends to,” “outlook” or “anticipates,” or variations of these and similar words, or by discussions of strategies that involve risks and uncertainties. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to, those described in this quarterly report on Form 10-Q. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements management may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information actually known to the Company at the time. Management undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements contained in this quarterly report on Form 10-Q are based on current expectations, estimates and projections about the Company’s business, management’s beliefs and assumptions made by management. These statements are not guarantees of the Company’s future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements. These risks, uncertainties and assumptions include, without limitation:
deterioration in the financial condition of borrowers resulting in significant increases in the Company’s loan and lease losses and provisions for those losses and other adverse impacts to results of operations and financial condition;
changes in Small Business Administration ("SBA") rules, regulations and loan products, including specifically the Section 7(a) program, changes in SBA standard operating procedures or changes to the status of Live Oak Banking Company (the "Bank") as an SBA Preferred Lender;
changes in rules, regulations or procedures for other government loan programs, including those of the United States Department of Agriculture;
changes in interest rates that affect the level and composition of deposits, loan demand and the values of loan collateral, securities, and interest sensitive assets and liabilities;
the failure of assumptions underlying the establishment of reserves for possible loan and lease losses;
changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;
a reduction in or the termination of the Company’s ability to use the technology-based platform that is critical to the success of the Company’s business model, including a failure in or a breach of the Company’s operational or security systems or those of its third party service providers;
changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts operations, including reductions in rates of business formation and growth, demand for the Company’s products and services, commercial and residential real estate development and prices, premiums paid in the secondary market for the sale of loans, and valuation of servicing rights;
changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking;
fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;
the effects of competition from other commercial banks, non-bank lenders, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet;
the Company's ability to attract and retain key personnel;

41


changes in governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA lending programs and investment tax credits;
changes in political and economic conditions;
the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau;
the Company's ability to comply with any requirements imposed on it by regulators, and the potential negative consequences that may result;
operational, compliance and other factors, including conditions in local areas in which the Company conducts business such as inclement weather or a reduction in the availability of services or products for which loan proceeds will be used, that could prevent or delay closing and funding loans before they can be sold in the secondary market;
the effect of any mergers, acquisitions or other transactions, to which the Company or the Bank may from time to time be a party, including management’s ability to successfully integrate any businesses acquired;
other risk factors listed from time to time in reports that the Company files with the SEC, including in the Company’s 2016 Annual Report; and
the success at managing the risks involved in the foregoing.
Except as otherwise disclosed, forward-looking statements do not reflect: (i) the effect of any acquisitions, divestitures or similar transactions that have not been previously disclosed; (ii) any changes in laws, regulations or regulatory interpretations; or (iii) any change in current dividend or repurchase strategies, in each case after the date as of which such statements are made. All forward-looking statements speak only as of the date on which such statements are made, and the Company undertakes no obligation to update any statement, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
Amounts in all tables in Management’s Discussion and Analysis of Financial Condition and Results of Operations have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
Nature of Operations
LOB is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within selected industry sectors, or verticals, by leveraging expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the SBA under its 7(a) program. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank.
Effective July 29, 2016, the Company elected to become a “financial holding company” within the meaning of the Bank Holding Company Act. A financial holding company, and the nonbank companies under its control, are permitted to engage in activities considered financial in nature or incidental to financial activities. For the Company to become and remain eligible for financial holding company status, it and the Bank must meet certain criteria, including capital, management and Community Reinvestment Act (“CRA”) requirements. The failure to meet such criteria could, depending on which requirements were not met, result in the Company facing restrictions on new financial activities or acquisitions or being required to discontinue existing activities that are not otherwise permissible for bank holding companies.
In addition to the Bank, the Company owns Live Oak Clean Energy Financing LLC, formed in November 2016, for the purpose of providing financing to entities for renewable energy applications; Live Oak Ventures, Inc., formed in August 2016, for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology; Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location; Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and U.S. Department of Agriculture ("USDA")-guaranteed loans; and 504 Fund Advisors, LLC (“504FA”), which was formed to serve as the investment advisor to The 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.
On February 1, 2017, the Company completed its acquisition of Reltco Inc. and National Assurance Title, Inc. (collectively referred to as "Reltco" or "title insurance business"), two nationwide title agencies under common control based in Tampa, Florida.

42


The Company generates revenue primarily from the sale of SBA-guaranteed loans and USDA guaranteed Rural Energy for America Program ("REAP") and Business & Industry ("B&I") loans and interest income. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets and net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.
On July 23, 2015 the Company closed on its initial public offering.
Business Outlook
Below is a discussion of management’s current expectations regarding company performance over the near-term based on market conditions, the regulatory environment and business strategies as of the time the Company filed this Report. Actual outcomes and results may differ materially from what is expressed or forecasted in these forward-looking statements. See “Important Note Regarding Forward-Looking Statements” in this Report for more information on forward-looking statements.
The Company expects to originate approximately $1.80 to $1.90 billion in loans and leases and maintain an effective tax rate of less than 10% for the full year of 2017.
Results of Operations
Performance Summary
Three months ended June 30, 2017 compared with three months ended June 30, 2016
For the three months ended June 30, 2017, the Company reported net income of $9.8 million, or $0.27 per diluted share, as compared to $123 thousand, or $0.00 per diluted share, for the three months ended June 30, 2016. This increase in net income is primarily due to the following items:
Increased net interest income of $8.5 million, or 85.5%, predominately driven by significant growth in the loans and leases held for sale and held for investment portfolios combined with a much higher net interest margin;
Decreased provision for loan and lease losses of $1.9 million was driven largely by the effect of the one-time second quarter of 2016 transfer of $318.8 million in unguaranteed loans from held for sale to held for investment classification;
Increased loan servicing revenue of $1.1 million, or 21.5%, as a result of continued growth in the servicing portfolio due to ongoing in loan sales;
Increased net gains on sales of loans of $3.6 million, or 24.9%, due to higher loan sale volumes outpacing the lower average sale premium on guaranteed loans; and
Revenues of $2.4 million from the first full quarter of ownership in the title insurance company subsidiary acquired in the first quarter of 2017.
Partially offsetting the above factors that contributed to increased levels of net income was a $2.6 million increase in salaries and employee benefits, $1.2 million in equipment expense and $1.0 million in other expenses. The increase in salaries and employee benefits and other expenses were largely influenced by the addition of the title insurance subsidiary during the first quarter of 2017. Equipment expense increased principally due to higher levels of depreciation related to aircraft acquired in the first quarter of 2017 and solar panels purchased for the renewable energy leasing initiative.
Six months ended June 30, 2017 compared with six months ended June 30, 2016
For the six months ended June 30, 2017, the Company reported net income of $15.9 million, or $0.44 per diluted share, as compared to $4.8 million, or $0.14 per diluted share, for the six months ended June 30, 2016. This increase in net income is primarily attributable to the following items:
Increased net interest income of $15.4 million, or 82.7%, predominately driven by significant growth in the loans and leases held for sale and held for investment portfolios combined with a much higher net interest margin;
Decreased provision for loan and lease losses of $1.8 million driven largely by the one-time second quarter of 2016 transfer of $318.8 million in unguaranteed loans from held for sale to held for investment classification;
Increased loan servicing revenue of $2.2 million, or 22.6%, as a result of continued growth in the servicing portfolio due to ongoing loan sales;
Increased net gains on sales of loans of $6.1 million, or 19.8%, due to a higher year-to-date sale volume;

43


Revenues of $3.8 million from the title insurance company subsidiary acquired in the first quarter of 2017; and
Decreased income tax expense of $2.7 million, or 68.8%, due to the ongoing operation of the renewable energy leasing business yielding investment tax credits.
Partially offsetting the above factors that contributed to increased levels of net income was a $19.4 million increase in noninterest expense, largely comprised of the effects of continued investments to support growing levels of business.
Net Interest Income and Margin
Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” Without a branch network, the Bank generates deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates that the Bank offers are generally above the industry average.
Three months ended June 30, 2017 compared with three months ended June 30, 2016
For the three months ended June 30, 2017, net interest income increased $8.5 million, or 85.5%, to $18.4 million compared to the three months ended June 30, 2016. This increase was principally due to the significant growth in average interest earning assets and to a lesser extent higher yields on these assets which outpaced the growth and change in the cost of interest bearing liabilities. Average interest earning assets increased by $662.3 million, or 54.3%, to $1.88 billion for the three months ended June 30, 2017, compared to $1.22 billion for the three months ended June 30, 2016, while the yield on average interest earning assets rose sharply by seventy-eight basis points to 5.19%. The cost of funds on interest bearing liabilities for the three months ended June 30, 2017 increased slightly by eight basis points to 1.34%, and the average balance of interest bearing liabilities increased by $670.9 million, or 60.4%, over the same period. As indicated in the rate/volume table below, the increase in interest bearing liabilities and corresponding cost of funds was outpaced by the positive effects of the increased volume of interest earning assets along with much higher yields, resulting in increased interest income of $10.9 million and increased interest expense of $2.5 million for the three months ended June 30, 2017 compared to the first quarter of 2016. For the three months ended June 30, 2017 compared to the three months ended June 30, 2016, net interest margin increased sharply from 3.26% to 3.92% due to the aforementioned effects.
Six months ended June 30, 2017 compared with six months ended June 30, 2016
For the six months ended June 30, 2017, net interest income increased $15.4 million, or 82.7%, to $34.0 million compared to the six months ended June 30, 2016. This increase was also principally due to the significant growth in average interest earning assets and to a lesser extent higher yields on these assets outpacing the growth and change in the cost of interest bearing liabilities. Average interest earning assets increased by $678.6 million, or 61.3%, to $1.79 billion for the six months ended June 30, 2017 compared to $1.11 billion for the six months ended June 30, 2016, while the yield on average interest earning assets increased by fifty-seven basis points to 5.06%. The cost of funds on interest bearing liabilities for the six months ended June 30, 2017 increased slightly by five basis points to 1.29%, and the average balance of interest bearing liabilities increased by $672.6 million, or 67.3%, during the same period. As indicated in the rate/volume table below, the increase in interest bearing liabilities and corresponding cost of funds was outpaced by the positive effects of the increased volume of interest earning assets along with much higher yields, resulting in increased interest income of $20.0 million and increased interest expense of $4.6 million for the six months ended June 30, 2017. For the six months ended June 30, 2017 compared to the six months ended June 30, 2016, net interest margin increased sharply from 3.38% to 3.84% due to the aforementioned effects.

44


Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented and annualizing that result. Loan fees are included in interest income on loans.
 
 
Three months ended June 30,
 
 
2017
 
2016
 
 
Average Balance
 
 Interest
 
Average Yield/Rate
 
Average Balance
 
 Interest
 
Average Yield/Rate
Interest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
 
$
199,904

 
$
470

 
0.94
%
 
$
224,838

 
$
248

 
0.44
%
Investment securities
 
69,544

 
316

 
1.82

 
56,261

 
252

 
1.80

Loans held for sale
 
562,984

 
8,226

 
5.86

 
398,087

 
5,527

 
5.57

Loans and leases held for investment (1)
 
1,050,074

 
15,333

 
5.86

 
540,988

 
7,375

 
5.47

Total interest earning assets
 
1,882,506

 
24,345

 
5.19

 
1,220,174

 
13,402

 
4.41

Less: allowance for loan and lease losses
 
(18,198
)
 
 
 
 
 
(8,792
)
 
 
 
 
Non-interest earning assets
 
209,484

 
 
 
 
 
145,343

 
 
 
 
Total assets
 
$
2,073,792

 
 
 
 
 
$
1,356,725

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
 
$
40,541

 
$
57

 
0.56
%
 
$
18,303

 
$
25

 
0.55
%
Savings
 
3,809

 
12

 
1.26

 

 

 

Money market accounts
 
475,265

 
1,114

 
0.94

 
394,289

 
772

 
0.79

Certificates of deposit
 
1,219,542

 
4,409

 
1.45

 
670,144

 
2,446

 
1.46

Total deposits
 
1,739,157

 
5,592

 
1.29

 
1,082,736

 
3,243

 
1.20

Other borrowings
 
42,765

 
361

 
3.39

 
28,270

 
242

 
3.43

Total interest bearing liabilities
 
1,781,922

 
5,953

 
1.34

 
1,111,006

 
3,485

 
1.26

Non-interest bearing deposits
 
32,718

 
 
 
 
 
19,311

 
 
 
 
Non-interest bearing liabilities
 
22,165

 
 
 
 
 
18,518

 
 
 
 
Shareholders' equity
 
236,987

 
 
 
 
 
207,865

 
 
 
 
Noncontrolling interest
 

 
 
 
 
 
25

 
 
 
 
Total liabilities and shareholders' equity
 
$
2,073,792

 
 
 
 
 
$
1,356,725

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and interest rate spread
 
 
 
$
18,392

 
3.85
%
 

 
$
9,917

 
3.15
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
 
3.92

 
 
 
 
 
3.26

 
 
 
 
 
 
 
 
 
 
 
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
 
 
 
 
 
105.64
%
 
 
 
 
 
109.83
%
(1)
Average loan and lease balances include non-accruing loans.

45


 
 
Six months ended June 30,
 
 
2017
 
2016
 
 
Average Balance
 
Interest
 
Average Yield/Rate
 
Average Balance
 
Interest
 
Average Yield/Rate
Interest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
 
$
197,056

 
$
812

 
0.83
%
 
$
169,071

 
$
386

 
0.46
%
Investment securities
 
70,306

 
639

 
1.83

 
55,098

 
503

 
1.83

Loans held for sale
 
514,920

 
14,777

 
5.79

 
462,522

 
12,643

 
5.48

Loans and leases held for investment(1)
 
1,002,932

 
28,536

 
5.74

 
419,887

 
11,264

 
5.38

Total interest earning assets
 
1,785,214

 
44,764

 
5.06

 
1,106,578

 
24,796

 
4.49

Less: allowance for loan and lease losses
 
(18,199
)
 
 
 
 
 
(8,086
)
 
 
 
 
Non-interest earning assets
 
188,679

 
 
 
 
 
142,721

 
 
 
 
Total assets
 
$
1,955,694

 
 
 
 
 
$
1,241,213

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
 
$
42,436

 
$
121

 
0.57
%
 
$
14,950

 
$
41

 
0.55
%
Savings
 
1,915

 
12

 
1.26

 

 

 

Money market accounts
 
477,393

 
2,062

 
0.87

 
384,950

 
1,478

 
0.77

Certificates of deposit
 
1,115,307

 
7,940

 
1.44

 
571,543

 
4,168

 
1.46

Total deposits
 
1,637,051

 
10,135

 
1.25

 
971,443

 
5,687

 
1.17

Other borrowings
 
35,457

 
596

 
3.39

 
28,432

 
483

 
3.41

Total interest bearing liabilities
 
1,672,508

 
10,731

 
1.29

 
999,875

 
6,170

 
1.24

Non-interest bearing deposits
 
30,713

 
 
 
 
 
18,591

 
 
 
 
Non-interest bearing liabilities
 
22,104

 
 
 
 
 
18,756

 
 
 
 
Shareholders’ equity
 
230,369

 
 
 
 
 
203,962

 
 
 
 
Noncontrolling interest
 

 
 
 
 
 
29

 
 
 
 
Total liabilities and shareholders’ equity
 
$
1,955,694

 
 
 
 
 
$
1,241,213

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and interest rate spread
 
 
 
$
34,033

 
3.77
%
 
 
 
$
18,626

 
3.25
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
 
3.84

 
 
 
 
 
3.38

 
 
 
 
 
 
 
 
 
 
 
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
 
 
 
 
 
106.74
%
 
 
 
 
 
110.67
%
(1)
Average loan and lease balances include non-accruing loans.

46


Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, increases or decreases attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.
 
Three months ended June 30,
 
Six months ended June 30,
 
2017 vs. 2016
 
2017 vs. 2016
 
Increase (Decrease) Due to
 
Increase (Decrease) Due to
 
Rate
 
Volume
 
Total
 
Rate
 
Volume
 
Total
Interest income:
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
$
265

 
$
(43
)
 
$
222

 
$
336

 
$
90

 
$
426

Investment securities
4

 
60

 
64

 
(3
)
 
139

 
136

Loans held for sale
350

 
2,349

 
2,699

 
666

 
1,468

 
2,134

Loans and leases held for investment
771

 
7,187

 
7,958

 
1,157

 
16,115

 
17,272

Total interest income
1,390

 
9,553

 
10,943

 
2,156

 
17,812

 
19,968

Interest expense:
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
1

 
31

 
32

 
3

 
77

 
80

Savings

 
12

 
12

 

 
12

 
12

Money market accounts
168

 
174

 
342

 
207

 
377

 
584

Certificates of deposit
(33
)
 
1,996

 
1,963

 
(146
)
 
3,918

 
3,772

Other borrowings

 
119

 
119

 
3

 
110

 
113

Total interest expense
136

 
2,332

 
2,468

 
67

 
4,494

 
4,561

Net interest income
$
1,254

 
$
7,221

 
$
8,475

 
$
2,089

 
$
13,318

 
$
15,407

Provision for Loan and Lease Losses. The provision for loan and lease losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for loan and lease losses at a level that is appropriate in relation to the estimated losses inherent in the loan and lease portfolio. A number of factors are considered in determining the required level of loan and lease loss reserves and the provision required to achieve the appropriate reserve level, including loan and lease growth, credit risk rating trends, nonperforming loan and lease levels, delinquencies, loan and lease portfolio concentrations and economic and market trends.
The provision for loan and lease losses for the second quarter of 2017 was $1.6 million compared to $3.5 million for the same period in 2016, a decrease of $1.9 million, or 54.9%. For the six months ended June 30, 2017 the provision was $3.1 million compared to $4.9 million for the same period in 2016, a decrease of $1.8 million, or 37.5%. The decrease in the provision for loan and lease losses for both quarter over quarter and year to year periods was principally driven by the one-time transfer in the second quarter of 2016 of $318.8 million in unguaranteed loans and leases from being classified as held for sale to held for investment. This reclassification resulted in a $4.0 million increase in the provision for loan and lease losses during the second quarter of 2016. Partially offsetting the effects of the 2016 loan reclassification were additional reserves recorded to accommodate robust loan and lease growth in 2017.
Loans and leases held for investment of $1.08 billion as of June 30, 2017 increased by $394.0 million, or 57.1%, compared to June 30, 2016. This growth was fueled by strong loan origination volume of $1.06 billion in the first half of 2017.
Net charge-offs (recoveries) were $191 thousand, or 0.07% of average quarterly loans and leases held for investment on an annualized basis, for the three months ended June 30, 2017, compared to net recoveries of $(240) thousand, or (0.18)%, for the three months ended June 30, 2016. Net charge-offs (recoveries) for the first six months of 2017 and 2016 totaled $1.7 million and $(8) thousand, respectively. Year to date net charge-offs as a percentage of year to date average loans held for investment were 0.17% and 0.00% at June 30, 2017 and 2016, respectively. Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for loan and lease losses.
In addition, at June 30, 2017, nonperforming loans and leases not guaranteed by the SBA totaled $3.6 million, which was 0.33% of the held-for-investment loan and lease portfolio compared to $2.2 million, or 0.31%, of loans and leases held for investment at June 30, 2016.

47


Losses inherent in loan relationships are mitigated if a portion of the loan is guaranteed by the SBA or USDA. A typical SBA 7(a) loan carries a 75% guarantee while USDA guarantees range from 60% to 80% depending on loan size, which reduces the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from the SBA and USDA are key factors to managing this risk.
Noninterest Income
Noninterest income is principally comprised of net gains from the sale of SBA and USDA-guaranteed loans along with loan servicing revenue and revaluation. Revenue from the sale of loans depends upon the volume, maturity structure and rates of underlying loans as well as the pricing and availability of funds in the secondary markets prevailing in the period between completed loan funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates. Other less common elements of noninterest income include nonrecurring gains and losses on investments.
The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
 
Three Months Ended
June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
$
6,174

 
$
5,081

 
$
1,093

 
21.51
 %
Loan servicing asset revaluation
(1,164
)
 
(1,604
)
 
440

 
(27.43
)
Net gains on sales of loans
18,176

 
14,555

 
3,621

 
24.88

Construction supervision fee income
286

 
667

 
(381
)
 
(57.12
)
Title insurance income
2,397

 

 
2,397

 
100.00

Other noninterest income
798

 
649

 
149

 
22.96

Total noninterest income
$
26,667

 
$
19,348

 
$
7,319

 
37.83
 %
 
Six Months Ended
June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
$
12,097

 
$
9,865

 
$
2,232

 
22.63
 %
Loan servicing asset revaluation
(3,173
)
 
(1,630
)
 
(1,543
)
 
94.66

Net gains on sales of loans
37,128

 
30,980

 
6,148

 
19.85

Construction supervision fee income
715

 
1,297

 
(582
)
 
(44.87
)
Title insurance income
3,835

 

 
3,835

 
100.00

Other noninterest income
1,818

 
1,268

 
550

 
43.38

Total noninterest income
$
52,420

 
$
41,780

 
$
10,640

 
25.47
 %
For the three months ended June 30, 2017, noninterest income increased by $7.3 million, or 37.8%, compared to the three months ended June 30, 2016. Increases in the serviced loan portfolio and the volume of loans sold in the secondary market combined to generate $1.1 million of increased servicing revenue and $3.6 million of increased net gains on sale of loans. Also driving increased levels of noninterest income was $2.4 million in title insurance revenue from the acquisition of a nationwide title insurance business on February 1, 2017.
For the six months ended June 30, 2017, noninterest income increased by $10.6 million, or 25.5%, compared to the six months ended June 30, 2016. Increases in noninterest income were primarily the result of higher year to date levels in the serviced loan portfolio and the volume of loans sold in the secondary market which generated $2.2 million of increased servicing revenue and $6.1 million of increased net gains on sale of loans. Also driving increased levels of noninterest income was $3.8 million in title insurance revenue from the acquisition of a nationwide title insurance business in early 2017. Partly offsetting the overall increase in noninterest income was a higher negative loan servicing revaluation adjustment of $1.5 million.

48


The following table reflects loan and lease production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold. These components are key drivers of the Company's noninterest income.
 
Three months ended
June 30,
 
Three months ended
March 31,
 
2017
 
2016
 
2017
 
2016
Amount of loans and leases originated
$
586,471

 
$
356,865

 
$
468,663

 
$
284,530

Guaranteed portions of loans sold
203,714

 
135,555

 
208,715

 
155,643

Outstanding balance of guaranteed loans sold (1)
2,521,506

 
1,970,908

 
2,410,791

 
1,894,428

 
Six months ended June 30,
 
For years ended December 31,
 
2017
 
2016
 
2016
 
2015
 
2014
 
2013
Amount of loans and leases originated
$
1,055,134

 
$
641,395

 
$
1,537,010

 
$
1,158,640

 
$
848,090

 
$
498,752

Guaranteed portions of loans sold
412,429

 
291,198

 
761,933

 
640,886

 
433,912

 
339,342

Outstanding balance of guaranteed loans sold (1)
2,521,506

 
1,970,908

 
2,278,618

 
1,779,989

 
1,302,828

 
1,005,764

(1)
This represents the outstanding principal balance of guaranteed loans serviced, as of the last day of the applicable period, which have been sold into the secondary market.
Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Revenue: While portions of the loans that the Bank originates are sold and generate gain on sale revenue, servicing rights for all loans that the Bank originates, including loans sold, are retained by the Bank. In exchange for continuing to service loans that are sold, the Bank receives fee income represented in loan servicing revenue equivalent to one percent of the outstanding balance of SBA loans sold and 0.40% of the outstanding balance of USDA loans sold. In addition, the cost of servicing sold loans is approximately 0.40% of the balance of the loans sold, which is included in the loan servicing revaluation computations. Unrecognized servicing revenue is reflected in a servicing asset recorded on the balance sheet. Revenues associated with the servicing of loans are recognized over the expected life of the loan through the income statement, and the servicing asset is reduced as this revenue is recognized. For three and six months ended June 30, 2017, loan servicing revenue increased $1.1 million, or 21.5%, and $2.2 million, or 22.6%, respectively, compared to the three and six months ended June 30, 2016, as a result of an increase in the average outstanding balance of guaranteed loans sold. At June 30, 2017, the outstanding balance of SBA guaranteed loans sold in the secondary market was $2.30 billion, with a weighted average servicing rate of 1.04%. At June 30, 2016, the outstanding balance of SBA guaranteed loans sold was $1.97 billion, with a weighted average servicing rate of 1.06%. Prior to January 2010, the Company sold SBA guaranteed loans for servicing with rates in excess of 1.0%. As those loans sold with servicing fee rates in excess of 1.0% prior to fiscal year 2010 amortize, the Company expects that the weighted average servicing rate for SBA guaranteed loans will approach and stabilize at approximately 1.0%.
Loan Servicing Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The revaluation considers the amortization of the portfolio, current market conditions for loan sale premiums, and current prepayment speeds. For the three months ended June 30, 2017 and 2016, there was a net negative loan servicing revaluation adjustment of $1.2 million compared to a net negative revaluation adjustment of $1.6 million for the three months ended June 30, 2016. For the six months ended June 30, 2017, there was a net negative loan servicing revaluation adjustment of $3.2 million compared to a net negative revaluation adjustment of $1.6 million for the six months ended June 30, 2016. The lower negative loan servicing revaluation amount for the second quarter of 2017 as compared to the second quarter of 2016 was driven by improvements in the premium market outpacing the effects of increased prepayment rates during that period. The higher year to date negative loan servicing revaluation amount as compared to the same period in 2016 was principally driven by decreases in the secondary market for guaranteed portions of 7(a) loans.

49


Net Gains on Sale of Loans: For the three and six months ended June 30, 2017, net gains on sales of loans increased $3.6 million, or 24.9%, and $6.1 million, or 19.8%, respectively, compared to the three and six months ended June 30, 2016, driven largely by the higher volume of loans sold during 2017 partially offset by a reduction in the average net gain on sale of loans. For the three months ended June 30, 2017, the volume of guaranteed loans sold increased $68.2 million, or 50.3%, to $203.7 million from $135.6 million for the three months ended June 30, 2016. For the six months ended June 30, 2017, the volume of guaranteed loans sold increased $121.2 million, or 41.6%, to $412.4 million from $291.2 million for the six months ended June 30, 2016. The volume-driven increases in the net gain on loan sale comparisons were partially mitigated by lower average premiums paid in the secondary market. The lower average premiums paid in the second quarter of 2017 were also driven by increased USDA guaranteed loan sales which commonly receive lower premiums than SBA guaranteed loan sales. The average net gain on sale of loans for the three and six months ended June 30, 2017 was somewhat lower at $92 thousand and $91 thousand of revenue for each $1 million in loans sold, respectively, compared to $107 thousand and $106 thousand of revenue for each $1 million in loans sold for the three and six months ended June 30, 2016.
Noninterest Expense
Noninterest expense comprises all operating costs of the Company, such as employee related costs, travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.
The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.
 
Three Months Ended
June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
$
17,968

 
$
15,411

 
$
2,557

 
16.59
 %
Non-staff expenses:
 
 
 
 
 
 
 
Travel expense
2,148

 
2,330

 
(182
)
 
(7.81
)
Professional services expense
1,424

 
910

 
514

 
56.48

Advertising and marketing expense
1,976

 
1,365

 
611

 
44.76

Occupancy expense
1,350

 
1,055

 
295

 
27.96

Data processing expense
1,858

 
1,404

 
454

 
32.34

Equipment expense
1,703

 
534

 
1,169

 
218.91

Other loan origination and maintenance expense
981

 
621

 
360

 
57.97

FDIC insurance
724

 
149

 
575

 
385.91

Title insurance closing services expense
785

 

 
785

 
100.00

Other expense
2,383

 
1,353

 
1,030

 
76.13

Total non-staff expenses
15,332

 
9,721

 
5,611

 
57.72

Total noninterest expense
$
33,300

 
$
25,132

 
$
8,168

 
32.50
 %

50


 
Six Months Ended
June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
$
36,650

 
$
28,404

 
$
8,246

 
29.03
 %
Non-staff expenses:
 
 
 
 
 
 
 
Travel expense
3,746

 
4,176

 
(430
)
 
(10.30
)
Professional services expense
3,160

 
1,438

 
1,722

 
119.75

Advertising and marketing expense
3,461

 
2,328

 
1,133

 
48.67

Occupancy expense
2,545

 
2,248

 
297

 
13.21

Data processing expense
3,554

 
2,612

 
942

 
36.06

Equipment expense
2,777

 
1,085

 
1,692

 
155.94

Other loan origination and maintenance expense
1,986

 
1,195

 
791

 
66.19

FDIC insurance
1,450

 
297

 
1,153

 
388.22

Title insurance closing services expense
1,190

 

 
1,190

 
100.00

Other expense
5,766

 
3,060

 
2,706

 
88.43

Total non-staff expenses
29,635

 
18,439

 
11,196

 
60.72

Total noninterest expense
$
66,285

 
$
46,843

 
$
19,442

 
41.50
 %
Total noninterest expense for the three and six months ended June 30, 2017 increased $8.2 million, or 32.5%, and $19.4 million, or 41.5%, respectively, compared to the same periods in 2016. The increase in noninterest expense was predominately impacted by increased personnel, professional services, equipment expense and other expenses primarily driven by the significant growth of the Company's core business. Changes in various components of noninterest expense are discussed below.
Salaries and employee benefits: Total personnel expense for the three and six months ended June 30, 2017 increased by $2.6 million, or 16.6%, and $8.2 million, or 29.0%, respectively, compared to the same periods in 2016. A significant driver for this increase was the acquisition of a nationwide title insurance business on February 1, 2017 with 54 full-time and 5 part-time employees. Also contributing to the growth in personnel expense was continued investment in human capital to support the growing loan and lease production from new and existing verticals as well as development of a new small-loan and deposit platform. Total full-time equivalent employees increased from 383 at June 30, 2016 to 517 at June 30, 2017. Salaries and employee benefits expense included $1.9 million and $2.9 million of stock based compensation in the three months ended June 30, 2017 and 2016, respectively, and $3.9 million and $3.6 million for the six months ended June 30, 2017 and 2016, respectively. Expenses related to the employee stock purchase program, stock grants, stock options, stock option compensation and restricted stock expense are all considered stock based compensation.
Of the total stock based compensation, $378 thousand for the second quarter of 2017 and $724 thousand for the first half of 2017 included in salaries and employee benefits is related to restricted stock unit ("RSU") awards with a market price condition of $34 per share for key employee retention with an effective grant date of May 24, 2016. See Note 10 - Stock Plans in the Notes to the Unaudited Consolidated Financial Statements in our quarterly report on Form 10-Q for the period ended March 31, 2016, for more information.

Professional services expense: For the three and six months ended June 30, 2017, total professional services expense increased $514 thousand, or 56.5%, and $1.7 million, or 119.7%, respectively, compared to the same periods in 2016. The primary drivers of the year over year increase were advisory, consulting, and due diligence expenses related to the February 2017 acquisition of a title insurance business.
Advertising and marketing expense: For the three and six months ended June 30, 2017, total advertising and marketing expense increased $611 thousand, or 44.8%, and $1.1 million, or 48.7%, respectively, compared to the same periods in 2016. The primary driver of the increase in advertising and marketing expense was the cost of growing brand recognition in new and existing verticals.
Equipment expense: For the three and six months ended June 30, 2017, the total costs associated with equipment increased $1.2 million, or 218.9%, and $1.7 million, or 155.9%, respectively, compared to the same period in 2016. A major factor behind this increase was the higher level of depreciation related to the first quarter addition of two new aircraft combined with useful lives being shortened for existing aircraft as well as for solar panels acquired to meet leasing commitments.
FDIC insurance: For the three and six months ended June 30, 2017, total Federal Deposit Insurance Corporation (FDIC) insurance expense increased $575 thousand, or 385.9%, and $1.2 million, or 388.2%, respectively, compared to the same periods in 2016.

51


This increase was the result of revised premium requirements of all FDIC-insured financial institutions in the latter part of 2016 along with significantly higher deposit levels.
Title insurance closing services expense: With the first quarter 2017 acquisition of a nationwide title insurance company, this is a new expense category. This category reflects the cost of closing services such as notary and abstracting in the delivery of title insurance agency products. For the three and six months ended June 30, 2017, total title insurance closing services expense was $785 thousand and $1.2 million, respectively.
Other expense: For the three and six months ended June 30, 2017, the total costs associated with other expenses increased $1.0 million, or 76.1%, and $2.7 million, or 88.4%, respectively, compared to the same periods in 2016. The quarter over quarter increase in other expenses was predominately comprised of costs associated with the newly acquired title company of $292 thousand combined with support expenses driven by business growth. The year over year increase in other expense was comprised predominately of charitable initiatives of $636 thousand, costs associated with the newly acquired title company of $587 thousand and a first quarter 2017 loss incurred upon the trade-in of an existing aircraft of $206 thousand.
Income Tax Expense
The effective tax rates for the three and six months ended June 30, 2017 were 4.0% and 7.0%, respectively, compared to the effective rates of 81.9% and 44.6% for the three and six months ended June 30, 2016, respectively. The effective rates of 4.0% and 7.0% for the three and six-month periods ended June 30, 2017 principally reflected the generation of investment tax credits by the solar panel leasing activity under the Company’s strategic initiatives in the renewable energy sector. The year to date tax rate also benefited from the first quarter adoption of a new accounting pronouncement related to the treatment of share based compensation issued by the Financial Accounting Standards Board that was effective January 1, 2017; "Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," also referred to as ASU 2016-09. The effective tax rate of 81.9% for the second quarter of 2016 was principally due to higher levels of nondeductible expenses during that quarter in conjunction with a low level of pretax income.
Discussion and Analysis of Financial Condition
June 30, 2017 vs. December 31, 2016
Total assets at June 30, 2017 were $2.20 billion, an increase of $442.8 million, or 25.2%, compared to total assets of $1.76 billion at December 31, 2016. The growth in total assets was principally driven by the following:
Growth in loan and lease originations combined with longer retention times of loans held for sale, comprised largely of loans intentionally held for longer periods and those in newer verticals which require a period of loan advances to become fully funded prior to being sold;
Growth in premises and equipment related primarily to construction of a new aircraft hangar, the addition of two new aircraft in replacement of two older ones and the addition of solar panels to meet leasing commitments; and
Increased levels of deposits of $386.6 million, arising from successful deposit gathering campaigns.
Cash and cash equivalents were $207.4 million at June 30, 2017, a decrease of $30.6 million, or 12.9%, compared to $238.0 million at December 31, 2016. This decrease primarily reflected a deployment of excess liquidity as a result of loan and lease originations, investments in new initiatives and fixed asset infrastructure outpacing funding sources provided by loan sales and growth in deposit gathering.
Total investment securities increased $1.9 million during the first six months of 2017, from $71.1 million at December 31, 2016, to $73.0 million at June 30, 2017, an increase of 2.7%. The portfolio is comprised of US government agency securities, residential mortgage-backed securities and a mutual fund.
Loans held for sale increased $214.9 million, or 54.5%, during the first six months of 2017, from $394.3 million at December 31, 2016, to $609.1 million at June 30, 2017. The increase was primarily the result of strong growth in loan origination activities throughout 2017 along with growth in certain loans that take time to fully fund.
Loans and leases held for investment increased $176.9 million, or 19.5%, during the first six months of 2017, from $907.6 million at December 31, 2016, to $1.08 billion at June 30, 2017. The increase was primarily the result of robust loan and lease growth from origination activities during the first half of 2017 combined with greater retention of loans on the consolidated balance sheet.
Premises and equipment, net increased $60.3 million, or 93.3%, during the first half of 2017. This increase was primarily driven by construction of a new aircraft hangar and the replacement of two older aircraft with two new ones better suited to service the Company's growing nationwide customer base and the addition of solar panels to meet leasing commitments.

52


Servicing assets increased $1.7 million, or 3.2%, during the first six months of 2017, from $52.0 million at December 31, 2016, to $53.7 million at June 30, 2017. The increase in servicing assets is primarily the result of loan sales significantly outpacing the amortization of the existing serviced portfolio.
Other assets increased $20.1 million, or 54.3%, during the first six months of 2017, from $37.0 million at December 31, 2016 to $57.1 million at June 30, 2017. The increase in other assets was primarily driven by the recognition of $4.6 million in income taxes receivable during the second quarter arising from investment tax credits generated from the investment in solar panel leasing activities combined with the first quarter 2017 acquisition of the nationwide title insurance business. As a result of the title insurance acquisition, other assets includes goodwill and intangible assets of $7.3 million and $5.3 million, respectively.
Total deposits were $1.87 billion at June 30, 2017, an increase of $386.6 million, or 26.0%, from $1.49 billion at December 31, 2016. The increase in deposits was driven by success of deposit gathering campaigns to support the growth in loan and lease originations.
Short term borrowings were $10.0 million at June 30, 2017. At December 31, 2016, the Company did not carry a balance of short term borrowings. This increase was a result of the Company purchasing $10.0 million in overnight federal funds from a correspondent bank for liquidity purposes.
Long term borrowings increased $24.3 million, or 87.4%, during the first half of 2017, from $27.8 million at December 31, 2016 to $52.2 million at June 30, 2017. The increase in long term borrowings was primarily the result of new advances of $25 million to support the ongoing success of the Company's renewable energy leasing initiatives.
Other liabilities increased $7.1 million, or 36.4%, during the first half of 2017, from $19.5 million at December 31, 2016 to $26.6 million at June 30, 2017. The increase in other liabilities was principally driven by a $4.7 million earn-out contingent liability related to the acquisition of the title insurance business combined with a first quarter increase in deferred tax liabilities of $3.0 million related to reversal of deferred tax assets recorded for the significant RSU grants which vested early in 2017.
Shareholders’ equity at June 30, 2017 was $237.6 million as compared to $222.8 million at December 31, 2016. The book value per share was $6.86 at June 30, 2017 compared to a book value per share of $6.51 at December 31, 2016. Average equity to average assets was 11.8% for the six months ended June 30, 2017 compared to 14.6% for the year ended December 31, 2016. The increase in shareholders’ equity principally represents net income to common shareholders for the six months ended June 30, 2017 of $15.9 million combined with stock based compensation expense of $3.9 million and $565 thousand related to the issuance of stock in the title insurance company acquisition, partially offset by cash withheld in lieu of issuing restricted stock upon vesting of $4.8 million and $1.4 million in dividends.
Asset Quality
Management considers asset quality to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. This function reports directly to the Audit & Risk Committee of the Board of Directors.
Nonperforming Assets
The Bank places loans on nonaccrual status when they become 90 days past due as to principal or interest payments, or prior to that if management has determined based upon current information available to them that the timely collection of principal or interest is not probable. When a loan is placed on nonaccrual status, any interest previously accrued as income but not actually collected is reversed and recorded as a reduction of loan interest and fee income. Typically, collections of interest and principal received on a nonaccrual loan are applied to the outstanding principal as determined at the time of collection of the loan.
Troubled debt restructurings occur when, because of economic or legal reasons pertaining to the debtor’s financial difficulties, debtors are granted concessions that would not otherwise be considered. Such concessions would include, but are not limited to, the transfer of assets or the issuance of equity interests by the debtor to satisfy all or part of the debt, modification of the terms of debt or the substitution or addition of debtor(s).

53


The following table provides information with respect to nonperforming assets and troubled debt restructurings at the dates indicated.
 
June 30, 2017
 
December 31, 2016
Nonperforming assets:
 
 
 
Total nonperforming loans (all on nonaccrual)
$
21,856

 
$
23,781

Total accruing loans past due 90 days or more

 

Foreclosed assets
2,140

 
1,648

Total troubled debt restructurings
8,787

 
9,856

Less nonaccrual troubled debt restructurings
(6,422
)
 
(7,688
)
Total performing troubled debt restructurings
2,365

 
2,168

Total nonperforming assets and troubled debt restructurings
$
26,361

 
$
27,597

Total nonperforming loans to total loans and leases held for investment
2.02
%
 
2.62
%
Total nonperforming loans to total assets
0.99
%
 
1.36
%
Total nonperforming assets and troubled debt restructurings to total assets
1.20
%
 
1.57
%
 
June 30, 2017
 
December 31, 2016
Nonperforming assets guaranteed by U.S. government:
 
 
 
Total nonperforming loans guaranteed by the SBA (all on nonaccrual)
$
18,310

 
$
18,997

Total accruing loans past due 90 days or more guaranteed by the SBA

 

Foreclosed assets guaranteed by the SBA
1,795

 
1,402

Total troubled debt restructurings guaranteed by the SBA
5,644

 
6,723

Less nonaccrual troubled debt restructurings guaranteed by the SBA
(5,543
)
 
(6,602
)
Total performing troubled debt restructurings guaranteed by SBA
101

 
121

Total nonperforming assets and troubled debt restructurings guaranteed by the SBA
$
20,206

 
$
20,520

Total nonperforming loans not guaranteed by the SBA to total held for investment loans and leases
0.33
%
 
0.53
%
Total nonperforming loans not guaranteed by the SBA to total assets
0.16
%
 
0.27
%
Total nonperforming assets and troubled debt restructurings not guaranteed by the SBA to total assets
0.28
%
 
0.40
%
Total nonperforming assets and troubled debt restructurings at June 30, 2017 were $26.4 million, which represented a $1.2 million, or 4.5%, decrease from December 31, 2016. Total nonperforming assets at June 30, 2017 were comprised of $21.9 million in nonaccrual loans and $2.1 million in foreclosed assets. Of the $26.4 million of nonperforming assets and troubled debt restructurings ("TDRs"), $20.2 million carried an SBA guarantee, leaving an unguaranteed exposure of $6.2 million in total nonperforming assets and TDRs at June 30, 2017. The unguaranteed exposure in total nonperforming assets and TDRs at December 31, 2016 was $7.1 million. Unguaranteed exposure relating to nonperforming assets and TDRs at June 30, 2017 decreased by $922 thousand, or 13.0%, compared to December 31, 2016.
As a percentage of the Bank’s total capital, nonperforming loans represented 12.5% at June 30, 2017, compared to nonperforming loans of 15.3% of the Bank’s total capital at December 31, 2016. Adjusting the ratio to include only the unguaranteed portion of nonperforming loans to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratios at June 30, 2017 and December 31, 2016 were 2.0% and 3.1%, respectively.

54


As of June 30, 2017 and December 31, 2016, potential problem and impaired loans totaled $62.2 million and $64.1 million, respectively. Risk Grades 5 through 8 represent the spectrum of criticized and impaired loans. At June 30, 2017, the portion of criticized loans guaranteed by the SBA totaled $26.4 million resulting in unguaranteed exposure risk of $35.8 million, or 3.4% of total held for investment unguaranteed exposure. This compares to the December 31, 2016 portion of criticized loans guaranteed by the SBA which totaled $29.0 million resulting in unguaranteed exposure risk of $35.1 million, or 4.0% of total held for investment unguaranteed exposure. As of June 30, 2017 loans in Veterinary, Healthcare and Independent Pharmacies industry verticals comprise the largest portion of the total potential problem and impaired loans at 31.0%, 24.1% and 23.3%, respectively. As of December 31, 2016 loans in the Healthcare and Veterinary industries comprise the largest portion of the total potential problem and impaired loans at 30.8% and 32.9%, respectively. The Company believes that its underwriting and credit quality standards have improved as the business has matured.
The Bank does not classify loans that experience insignificant payment delays and payment shortfalls as impaired. The Bank considers an “insignificant period of time” from payment delays to be a period of 90 days or less. The Bank would consider a modification for a customer experiencing what is expected to be a short-term event that has temporarily impacted cash flow. This could be due, among other reasons, to illness, weather, impact from a one-time expense, slower than expected start-up, construction issues or other short-term issues. In all cases, credit will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan long term. To date, the only types of short term modifications the Bank has given are payment deferral and interest only extensions. The Bank does not typically alter the rate or lengthen the amortization of the note due to insignificant payment delays. Short term modifications are not classified as TDRs, because they do not meet the definition set by the applicable accounting standards and the Federal Deposit Insurance Corporation.
Management endeavors to be proactive in its approach to identify and resolve special mention (Risk Grade 5) loans and is focused on working with the borrowers and guarantors of these loans to provide loan modifications when warranted. At June 30, 2017 and December 31, 2016, Risk Grade 5 loans totaled $26.8 million and $32.1 million, respectively. The decrease in Risk Grade 5 loans from December 31, 2016 to June 30, 2017 was principally confined to three verticals; Veterinary ($3.4 million or 44.4% of decrease), Healthcare ($1.2 million or 15.5% of decrease), and Independent Pharmacy ($1.1 million or 12.5% of decrease). The decrease in Risk Grade 5 loans from December 31, 2016 to June 30, 2017 was the result of routine credit monitoring in the ongoing risk grade management process.  At June 30, 2017, approximately 97.9% of loans classified as Risk Grade 5 are performing with no current payments past due. While the level of nonperforming assets fluctuates in response to changing economic and market conditions, the relative size and composition of the loan portfolio, and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses (“ALLL”), a material estimate which could change significantly in the near-term in the event of rapidly deteriorating credit quality, is established through a provision for loan and lease losses charged to earnings to account for losses that are inherent in the loan and lease portfolio and estimated to occur, and is maintained at a level that management considers appropriate to absorb potential losses in the portfolio. Loan and lease losses are charged against the ALLL when management believes that the collectibility of the principal loan and lease balance is unlikely. Subsequent recoveries, if any, are credited to the ALLL when received.
Judgment in determining the adequacy of the ALLL is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available and as situations and information change.
The ALLL is evaluated on a quarterly basis by management and takes into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, review of specific problem loans and leases and current economic conditions and trends that may affect the borrower’s ability to repay.
Estimated credit losses should meet the criteria for accrual of a loss contingency, i.e., a provision to the ALLL, set forth in accounting principles generally accepted in the United States of America (“GAAP”). Methodology for determining the ALLL is generally based on GAAP, the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other regulatory and accounting pronouncements. The ALLL is determined by the sum of three separate components: (i) the impaired loan or lease component, which addresses specific reserves for impaired loans or leases; (ii) the general reserve component, which addresses reserves for pools of homogeneous loans and leases; and (iii) an unallocated reserve component (if any) based on management’s judgment and experience. The loan and lease pools and impaired loans and leases are mutually exclusive; any loan or lease that is impaired should be excluded from its homogeneous pool for purposes of that pool’s reserve calculation, regardless of the level of impairment.
During the second quarter of 2016, the Company implemented enhancements to the methodology for estimating the allowance for loan and lease losses, including refinements to the measurement of qualitative factors in the estimation process. Management believes these enhancements will improve the precision of the process for estimating the allowance.

55


The ALLL of $18.2 million at December 31, 2016 increased by $1.4 million, or 7.4%, to $19.6 million at June 30, 2017. The ALLL, as a percentage of loans and leases held for investment, amounted to 1.8% at June 30, 2017 and 2.0% at December 31, 2016. The declining level of the allowance for loan and lease losses in relation to total loans and leases held for investment was principally driven by improvements in industry-specific loss rates and lower levels of classified loans combined with the migration to Company-specific loss rates for maturing verticals which was partially offset by an increase in reserves due to loan and lease volume and the effect of higher net charge-offs, as addressed in the Provision for Loan and Lease Losses section of Results of Operations. General reserves as a percentage of non-impaired loans amounted to 1.52% at June 30, 2017 and 1.70% December 31, 2016. See the aforementioned Provision for Loan and Lease Losses section of this section for a discussion of the Company's charge-off experience.
Actual past due loans and leases and charge-offs have decreased since December 31, 2016 as management continues to work to improve asset quality. Management believes the ALLL of $19.6 million at June 30, 2017 is appropriate in light of the risk inherent in the loan and lease portfolio. Management’s judgments are based on numerous assumptions about current events that it believes to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan and lease losses in future periods will not exceed the current ALLL or that future increases in the ALLL will not be required. No assurance can be given that management’s ongoing evaluation of the loan and lease portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the ALLL, thus adversely affecting the Company’s operating results. Additional information on the ALLL is presented in Note 6 - Loans and Leases Held for Investment and Allowance for Loan and Lease Losses of the Notes to the Unaudited Consolidated Financial Statements in this report.
Liquidity Management
Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Liquidity is immediately available from four major sources: (a) cash on hand and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) the market value of unpledged investment securities; and (d) availability under lines of credit. At June 30, 2017, the total amount of these four items was $485.1 million, or 22.1% of total assets, a decrease of $10.7 million from $495.8 million, or 28.2% of total assets, at December 31, 2016.
Loans and other assets are funded primarily by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and an increased amount of long-term brokered deposits have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. Additionally, an investment securities portfolio is available for both immediate and secondary liquidity purposes.
At June 30, 2017, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, while $100 thousand was pledged for trust activities in the State of Ohio and $2.5 million was pledged for uninsured trust assets, leaving $70.4 million available as lendable collateral.
Contractual Obligations
The following table presents the Company’s significant fixed and determinable contractual obligations by payment date as of June 30, 2017. The payment amounts represent those amounts contractually due to the recipient. The table excludes liabilities recorded where management cannot reasonably estimate the timing of any payments that may be required in connection with these liabilities.
 
Payments Due by Period
 
Total
 
Less than
One
Year
 
One to
Three
Years
 
Three to
Five
Years
 
More
Than Five
Years
Contractual Obligations
 
Deposits without stated maturity
$
597,371

 
$
597,371

 
$

 
$

 
$

Time deposits
1,274,350

 
938,576

 
212,198

 
123,576

 

Short term borrowings
10,000

 
10,000

 

 

 

Long term borrowings
52,173

 
836

 
30,555

 
20,782

 

Operating lease obligations1
2,142

 
904

 
1,155

 
83

 

Total
$
1,936,036

 
$
1,547,687

 
$
243,908

 
$
144,441

 
$

1
The following obligations only include base rent and does not include any additional payments such as taxes, insurance, maintenance and repairs or common area maintenance.

56


As of June 30, 2017 and December 31, 2016, the Company had commitments for on-balance sheet instruments in the amount of $4.6 million and $4.9 million, respectively.
Asset/Liability Management and Interest Rate Sensitivity
One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps. This method, however, addresses only the magnitude of timing differences and does not address earnings or market value. Therefore, management uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios to more accurately measure interest rate risk.
The balance sheet is asset-sensitive with a total cumulative gap position of 2.69% at June 30, 2017. The sale of unguaranteed portions of fixed-rate loans along with increased short-term wholesale funding has changed the portfolio mix to asset-sensitive. An asset-sensitive position means that net interest income will generally move in the same direction as interest rates. For instance, if interest rates increase, net interest income can be expected to increase, and if interest rates decrease, net interest income can be expected to decrease. The Company attempts to mitigate interest rate risk with the majority of assets and liabilities being short-term, adjustable rate instruments. The quarterly revaluation adjustment to the servicing asset, however, adjusts in an opposite direction to interest rate changes. Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes and the longer duration of indeterminate term deposits.
Capital
The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis. The Company’s principal goals related to the maintenance of capital are to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; provide financial flexibility to support future growth and client needs; comply with relevant laws, regulations, and supervisory guidance; achieve optimal credit ratings for the Company and its subsidiaries; and provide a competitive return to shareholders. Management regularly monitors the capital position of the Company on both a consolidated and bank level basis. In this regard, management’s goal is to maintain capital at levels that are in excess of the regulatory “well capitalized” levels. Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.
The Basel III Capital Rules, a comprehensive capital framework for U.S. banking organizations, became effective for the Company and Bank on January 1, 2015 (subject to a phase-in period for certain provisions). Quantitative measures established by the Basel III Capital Rules to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of Common Equity Tier 1 capital, Tier 1 capital and Total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).
When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Company and Bank to maintain (i) a minimum ratio of Common Equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% Common Equity Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 capital to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average quarterly assets.
The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a three-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). Banking institutions with a ratio of Common Equity Tier 1 capital to risk-weighted assets below the effective minimum (4.5% plus the capital conservation buffer) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

57


Capital amounts and ratios as of June 30, 2017 and December 31, 2016, are presented in the table below.
 
Actual
 
Minimum
Capital
Requirement
 
Minimum
To Be Well
Capitalized Under
Prompt Corrective
Action Provisions (1)
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
Consolidated - June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
202,795

 
11.93
%
 
$
76,473

 
4.50
%
 
N/A

 
N/A

Total Capital (to Risk-Weighted Assets)
$
222,356

 
13.08
%
 
$
135,952

 
8.00
%
 
N/A

 
N/A

Tier 1 Capital (to Risk-Weighted Assets)
$
202,795

 
11.93
%
 
$
101,964

 
6.00
%
 
N/A

 
N/A

Tier 1 Capital (to Average Assets)
$
202,795

 
9.93
%
 
$
81,728

 
4.00
%
 
N/A

 
N/A

Bank - June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
155,053

 
9.54
%
 
$
73,140

 
4.50
%
 
$
105,647

 
6.50
%
Total Capital (to Risk-Weighted Assets)
$
174,889

 
10.76
%
 
$
130,027

 
8.00
%
 
$
162,534

 
10.00
%
Tier 1 Capital (to Risk-Weighted Assets)
$
155,053

 
9.54
%
 
$
97,520

 
6.00
%
 
$
130,027

 
8.00
%
Tier 1 Capital (to Average Assets)
$
155,053

 
7.85
%
 
$
79,057

 
4.00
%
 
$
98,821

 
5.00
%
Consolidated - December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
206,670

 
15.31
%
 
$
60,732

 
4.50
%
 
N/A

 
N/A

Total Capital (to Risk-Weighted Assets)
$
223,559

 
16.56
%
 
$
107,968

 
8.00
%
 
N/A

 
N/A

Tier 1 Capital (to Risk-Weighted Assets)
$
206,670

 
15.31
%
 
$
80,976

 
6.00
%
 
N/A

 
N/A

Tier 1 Capital (to Average Assets)
$
206,670

 
12.00
%
 
$
68,919

 
4.00
%
 
N/A

 
N/A

Bank - December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
139,078

 
10.68
%
 
$
58,579

 
4.50
%
 
$
84,615

 
6.50
%
Total Capital (to Risk-Weighted Assets)
$
155,423

 
11.94
%
 
$
104,141

 
8.00
%
 
$
130,177

 
10.00
%
Tier 1 Capital (to Risk-Weighted Assets)
$
139,078

 
10.68
%
 
$
78,106

 
6.00
%
 
$
104,141

 
8.00
%
Tier 1 Capital (to Average Assets)
$
139,078

 
8.41
%
 
$
66,142

 
4.00
%
 
$
82,678

 
5.00
%
(1)
Prompt corrective action provisions are not applicable at the bank holding company level.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Accounting policies, as described in detail in the Notes to the Company’s Unaudited Consolidated Financial Statements in this report, are an integral part of the Company’s consolidated financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. Management believes that the critical accounting policies and estimates listed below require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain.
Determination of the allowance for loan losses;
Valuation of servicing assets;
Valuation of foreclosed assets; and
Valuation of earn-out contingent liability.
Changes in these estimates, that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, would have a material impact on the Company’s financial position, results of operations or liquidity.

58


Item 3. Quantitative and Qualitative Disclosures About Market Risk
Management considers interest rate risk the most significant market risk. Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. Consistency of net interest income is largely dependent upon the effective management of interest rate risk.
The Company’s Asset/Liability Management Committee (“ALCO”), which includes senior management representatives and reports to the Board of Directors, monitors and manages interest rate risk. See “Asset/Liability Management and Interest Rate Sensitivity” in Item 2 of this Form 10-Q for further discussion.
The objective of asset/liability management is the maximization of net interest income within the Company’s risk guidelines. This objective is accomplished through management of the balance sheet composition, maturities, liquidity, and interest rate risk exposures arising from changing economic conditions, interest rates and customer preferences.
To identify and manage its interest rate risk, the Company employs an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on contractual cash flows and repricing characteristics and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes management projections for activity levels in each of the product lines offered by the Bank. Assumptions are inherently uncertain, and the measurement of net interest income or the impact of rate fluctuations on net interest income cannot be precisely predicted. Actual results may differ materially from simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), was carried out under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer as of June 30, 2017, the last day of the period covered by this Quarterly Report. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of June 30, 2017 in ensuring that the information required to be disclosed in the reports the Company files or submits under the Exchange Act is (i) accumulated and communicated to management (including the Company’s Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control Over Financial Reporting
There were no changes in the Company’s internal control over financial reporting during the three months ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.


59


PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In the ordinary course of operations, the Company is party to various legal proceedings. The Company is not involved in, nor has it terminated during the three and six months ended June 30, 2017, any pending legal proceedings other than nonmaterial proceedings occurring in the ordinary course of business.
Item 1A. Risk Factors
In addition to the risk factors set forth in “Risk Factors” in Part 1, Item 1A of our Annual Report on Form 10-K (the “10-K”) for the fiscal year ended December 31, 2016, investors should consider the following risk factor relating to our business. The risk factor below should be read in conjunction with the risk factors set forth in the 10-K and the other information contained in this report.
Our rental equipment is subject to residual value risk upon disposition, and may not sell at the prices or in the quantities we expect.
The market value of any given piece of rental equipment could be less than its depreciated value at the time it is sold. The market value of used rental equipment depends on several factors, including:
the market price for new equipment of a like kind;
the age of the equipment at the time it is sold, as well as wear and tear on the equipment relative to its age;
the supply of used equipment on the market;
technological advances relating to the equipment
demand for the used equipment; and
general economic conditions
We include in income from operations the difference between the sales price and the depreciated value of an item of equipment sold. Changes in our assumptions regarding depreciation could change our depreciation expense, as well as the gain or loss realized upon disposal of equipment. Sales of our used rental equipment at prices that fall significantly below our projections or in lesser quantities than we anticipate will have a negative impact on our results of operations and cash flows.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
None.
Item 6. Exhibits
Exhibits to this report are listed in the Index to Exhibits section of this report.

60


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
Live Oak Bancshares, Inc.
 
(Registrant)
 
 
 
Date: August 7, 2017
By:
/s/  S. Brett Caines
 
 
S. Brett Caines
 
 
Chief Financial Officer

61


INDEX TO EXHIBITS
Exhibit
No.
 
Description of Exhibit
 
 
 
2.1

 
Contribution Agreement dated as of May 9, 2017 (incorporated by reference to Exhibit 2.1 of the Current Report on Form 8-K, filed on May 15, 2017)
3.1

 
Amended and Restated Articles of Incorporation of Live Oak Bancshares, Inc. (incorporated by reference to Exhibit 3.1 of the registration statement on Form S-1, filed on June 19, 2015)
3.2

 
Amended Bylaws of Live Oak Bancshares, Inc. (incorporated by reference to Exhibit 3.2 of the registration statement on Form S-1, filed on June 19, 2015)
4.1

 
Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 of the registration statement on Form S-1, filed on June 19, 2015)
4.2

 
Registration and Other Rights Agreement between Live Oak Bancshares, Inc. and Wellington purchasers (incorporated by reference to Exhibit 4.2 of the registration statement on Form S-1, filed on June 19, 2015)
31.1

 
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2

 
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
32

 
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
101

 
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets as of June 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income for the Three and Six Months Ended June 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2017 and 2016; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the Six Months Ended June 30, 2017 and 2016; (v) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2017 and 2016; and (vi) Notes to Consolidated Financial Statements*
*    Indicates a document being filed with this Form 10-Q.
**
Furnished herewith. This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section. Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.


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