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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, 2018
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 every Interactive Data File required to be submitted 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 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 6, 2018, there were 35,473,289 shares of the registrant’s voting common stock outstanding and 4,643,530 shares of the registrant’s non-voting common stock outstanding.




Table of Contents

Live Oak Bancshares, Inc. and Subsidiaries
Form 10-Q
For the Quarterly Period Ended June 30, 2018
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.
 
 




Table of Contents

PART I. FINANCIAL INFORMATION
Item 1.        Financial Statements
Live Oak Bancshares, Inc.
Consolidated Balance Sheets
As of June 30, 2018 (unaudited) and December 31, 2017*
(Dollars in thousands)
 
June 30,
2018
 
December 31,
2017*
Assets
 
 
 
Cash and due from banks
$
392,941

 
$
295,271

Certificates of deposit with other banks
2,250

 
3,000

Investment securities available-for-sale
384,943

 
93,355

Loans held for sale
757,494

 
680,454

Loans and leases held for investment
1,534,368

 
1,343,973

Allowance for loan and lease losses
(29,350
)
 
(24,190
)
Net loans and leases
1,505,018

 
1,319,783

Premises and equipment, net
234,817

 
178,790

Foreclosed assets
1,725

 
1,281

Servicing assets
52,689

 
52,298

Other assets
141,092

 
134,242

Total assets
$
3,472,969

 
$
2,758,474

Liabilities and Shareholders’ Equity
 
 
 
Liabilities
 
 
 
Deposits:
 
 
 
Noninterest-bearing
$
46,192

 
$
57,868

Interest-bearing
2,923,044

 
2,202,395

Total deposits
2,969,236

 
2,260,263

Long term borrowings
3,385

 
26,564

Other liabilities
37,362

 
34,714

Total liabilities
3,009,983

 
2,321,541

Shareholders’ equity
 
 
 
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at June 30, 2018 and December 31, 2017

 

Class A common stock, no par value, 100,000,000 shares authorized, 35,442,879 and 35,252,053 shares issued and outstanding at June 30, 2018 and December 31, 2017, respectively
274,043

 
268,557

Class B common stock, no par value, 10,000,000 shares authorized, 4,643,530 shares issued and outstanding at June 30, 2018 and December 31, 2017
49,168

 
49,168

Retained earnings
144,791

 
120,241

Accumulated other comprehensive loss
(5,016
)
 
(1,033
)
Total equity
462,986

 
436,933

Total liabilities and shareholders’ equity
$
3,472,969

 
$
2,758,474

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

1


Table of Contents

Live Oak Bancshares, Inc.
Consolidated Statements of Income
For the three and six months ended June 30, 2018 and 2017 (unaudited)
(Dollars in thousands, except per share data)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2018
 
2017
 
2018
 
2017
Interest income
 
 
 
 
 
 
 
Loans and fees on loans
$
36,267

 
$
23,559

 
$
68,958

 
$
43,313

Investment securities, taxable
2,530

 
316

 
3,647

 
639

Other interest earning assets
2,179

 
470

 
3,394

 
812

Total interest income
40,976

 
24,345

 
75,999

 
44,764

Interest expense
 
 
 
 
 
 
 
Deposits
13,927

 
5,592

 
24,345

 
10,135

Borrowings
1

 
361

 
130

 
596

Total interest expense
13,928

 
5,953

 
24,475

 
10,731

Net interest income
27,048

 
18,392

 
51,524

 
34,033

Provision for loan and lease losses
2,087

 
1,556

 
6,479

 
3,055

Net interest income after provision for loan and lease losses
24,961

 
16,836

 
45,045

 
30,978

Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
6,965

 
6,174

 
13,863

 
12,097

Loan servicing asset revaluation
(3,670
)
 
(1,164
)
 
(8,758
)
 
(3,173
)
Net gains on sales of loans
23,061

 
18,176

 
47,479

 
37,128

Lease income
1,920

 
9

 
3,528

 
9

Construction supervision fee income
597

 
286

 
1,376

 
715

Title insurance income
996

 
2,397

 
2,296

 
3,835

Other noninterest income
744

 
789

 
1,585

 
1,809

Total noninterest income
30,613

 
26,667

 
61,369

 
52,420

Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
22,146

 
17,968

 
42,355

 
36,650

Travel expense
2,041

 
2,148

 
3,884

 
3,746

Professional services expense
1,119

 
1,424

 
2,417

 
3,160

Advertising and marketing expense
1,868

 
1,976

 
3,530

 
3,461

Occupancy expense
1,882

 
1,350

 
3,739

 
2,545

Data processing expense
2,906

 
1,858

 
5,743

 
3,554

Equipment expense
3,368

 
1,703

 
6,445

 
2,777

Other loan origination and maintenance expense
1,414

 
981

 
2,743

 
1,986

FDIC insurance
1,010

 
724

 
1,582

 
1,450

Title insurance closing services expense
372

 
785

 
798

 
1,190

Other expense
2,704

 
2,383

 
5,666

 
5,766

Total noninterest expense
40,830

 
33,300

 
78,902

 
66,285

Income before taxes
14,744

 
10,203

 
27,512

 
17,113

Income tax expense
491

 
408

 
806

 
1,206

Net income
$
14,253

 
$
9,795

 
$
26,706

 
$
15,907

Basic earnings per share
$
0.36

 
$
0.28

 
$
0.67

 
$
0.46

Diluted earnings per share
$
0.34

 
$
0.27

 
$
0.64

 
$
0.44

See Notes to Unaudited Consolidated Financial Statements

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Table of Contents

Live Oak Bancshares, Inc.
Consolidated Statements of Comprehensive Income
For the three and six months ended June 30, 2018 and 2017 (unaudited)
(Dollars in thousands)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
14,253

 
$
9,795

 
$
26,706

 
$
15,907

Other comprehensive (loss) income before tax:
 
 
 
 
 
 
 
Net unrealized (loss) gain on investment securities arising during the period
(1,965
)
 
293

 
(4,920
)
 
220

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

 

 

 

Other comprehensive (loss) income before tax
(1,965
)
 
293

 
(4,920
)
 
220

Income tax benefit (expense)
471

 
(113
)
 
1,181

 
(85
)
Other comprehensive (loss) income, net of tax
(1,494
)
 
180

 
(3,739
)
 
135

Total comprehensive income
$
12,759

 
$
9,975

 
$
22,967

 
$
16,042

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.
Consolidated Statements of Changes in Shareholders’ Equity
For the six months ended June 30, 2018 and 2017 (unaudited)
(Dollars in thousands)
 
Common stock
 
Retained
earnings
 
Accumulated
other
comprehensive
loss
 
Total
equity
Shares
 
 
 
Class A
 
Class B
 
Amount
 
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-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

Balance at December 31, 2017
35,252,053

 
4,643,530

 
$
317,725

 
$
120,241

 
$
(1,033
)
 
$
436,933

Net income

 

 

 
26,706

 

 
26,706

Other comprehensive loss

 

 

 

 
(3,739
)
 
(3,739
)
Issuance of restricted stock
39,133

 

 

 

 

 

Withholding cash issued in lieu of restricted stock issuance

 

 
(495
)
 

 

 
(495
)
Employee stock purchase program
7,022

 

 
165

 

 

 
165

Stock option exercises
144,671

 

 
1,252

 

 

 
1,252

Stock option based compensation expense

 

 
809

 

 

 
809

Restricted stock expense

 

 
3,755

 

 

 
3,755

Reclassification of accumulated other comprehensive income due to tax rate change

 

 

 
244

 
(244
)
 

Dividends (distributions to shareholders)

 

 

 
(2,400
)
 

 
(2,400
)
Balance at June 30, 2018
35,442,879

 
4,643,530

 
$
323,211

 
$
144,791

 
$
(5,016
)
 
$
462,986

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.
Consolidated Statements of Cash Flows
For the six months ended June 30, 2018 and 2017 (unaudited)
(Dollars in thousands)
 
Six Months Ended
June 30,
 
2018
 
2017
Cash flows from operating activities
 
 
 
Net income
$
26,706

 
$
15,907

Adjustments to reconcile net income to net cash used by operating activities:
 
 
 
Depreciation and amortization
7,823

 
4,062

Provision for loan and lease losses
6,479

 
3,055

Amortization of premium on securities, net of accretion
353

 
219

Amortization of discount on unguaranteed loans, net
3,501

 
1,255

Deferred tax expense
807

 
1,427

Originations of loans held for sale
(621,290
)
 
(632,414
)
Proceeds from sales of loans held for sale
613,911

 
466,309

Net gains on sale of loans held for sale
(47,479
)
 
(37,128
)
Net loss on sale of foreclosed assets
1

 
3

Net increase in servicing assets
(391
)
 
(1,681
)
Net loss on disposal of premises and equipment

 
213

Stock option based compensation expense
809

 
924

Restricted stock expense
3,755

 
2,768

Stock based compensation expense excess tax benefits
24

 
874

     Business combination contingent consideration fair value adjustment
(260
)
 
350

Changes in assets and liabilities:
 
 
 
Other assets
(7,445
)
 
(9,463
)
Other liabilities
909

 
845

Net cash used by operating activities
(11,787
)
 
(182,475
)
Cash flows from investing activities
 
 
 
Purchases of securities available-for-sale
(316,588
)
 
(6,403
)
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale
19,727

 
4,467

Proceeds from sale/collection of foreclosed assets
212

 

Business combination, net of cash acquired

 
(7,684
)
Maturities of certificates of deposit with other banks
750

 
1,500

Loan and lease originations and principal collections, net
(217,743
)
 
(192,018
)
Purchases of premises and equipment, net
(61,217
)
 
(63,482
)
Net cash used by investing activities
(574,859
)
 
(263,620
)
See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.
Consolidated Statements of Cash Flows (Continued)
For the six months ended June 30, 2018 and 2017 (unaudited)
(Dollars in thousands)
 
Six Months Ended
June 30,
 
2018
 
2017
Cash flows from financing activities
 
 
 
Net increase in deposits
708,973

 
386,645

Proceeds from long term borrowings
18

 
16,900

Repayment of long term borrowings
(23,197
)
 
(670
)
Proceeds from short term borrowings

 
23,100

Repayment of short term borrowings

 
(5,000
)
Stock option exercises
1,252

 
456

Employee stock purchase program
165

 
241

Withholding cash issued in lieu of restricted stock
(495
)
 
(4,828
)
Shareholder dividend distributions
(2,400
)
 
(1,384
)
Net cash provided by financing activities
684,316

 
415,460

Net increase (decrease) in cash and cash equivalents
97,670

 
(30,635
)
Cash and cash equivalents, beginning
295,271

 
238,008

Cash and cash equivalents, ending
$
392,941

 
$
207,373

 
 
 
 
Supplemental disclosure of cash flow information
 
 
 
Interest paid
$
24,308

 
$
10,858

Income tax (refunds) payments, net
(542
)
 
7,876

 
 
 
 
Supplemental disclosures of noncash operating, investing, and financing activities
 
 
 
Unrealized holding (losses) gains on available-for-sale securities, net of taxes
$
(3,739
)
 
$
135

Transfers from loans and leases to foreclosed real estate and other repossessions
346

 
495

Net transfers from SBA receivable to foreclosed real estate
311

 

Transfer of loans held for sale to loans and leases held for investment
19,774

 
4,149

Transfer of loans and leases held for investment to loans held for sale
51,614

 
18,410

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

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Table of Contents

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. The Bank identifies and grows lending to credit-worthy borrowers both within specific industries, also called verticals, through expertise within those industries, and more broadly to select borrowers outside of 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 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 with a secondary offering completed in August of 2017.
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.
In August 2016, the Company formed Canapi, Inc. for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology. Canapi was formerly known as Live Oak Ventures, Inc.
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 13. Subsequent Event for disposition of Reltco on August 1, 2018.
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, occupancy, 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, 2018 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2018. The consolidated balance sheet as of December 31, 2017 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, 2017, filed with the Securities Exchange Commission on March 8, 2018 (SEC File No. 001-37497) (the "2017 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 2017 Annual Report. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes in the Company's 2017 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.
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.

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Table of Contents

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

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.
Unconsolidated Joint Venture
On October 1, 2017, the Company started the digital banking joint venture between Live Oak Banking Company and First Data Corporation ("First Data"). The new company, named Apiture, combines First Data's and the Bank's digital banking platforms, products, services, and certain human resources used in the creation and delivery of technology solutions for financial institutions. The contributed assets of both the Company and First Data are considered businesses in accordance with relevant accounting standards. At closing both the Bank and First Data received equal voting interests in Apiture in exchange for their respective contributions. As a term of the closing agreements, First Data is entitled to a preference in Apiture's cash earnings from the date of closing through December 31, 2017 and all of 2018, not to exceed $18.0 million and $18.9 million, respectively.
As a result of the above cash earnings preference, income (loss) is allocated utilizing the hypothetical liquidation at book value ("HLBV") method. Under the HLBV method, we allocate income or loss based on the change in each unitholders’ claim on the net assets of Apiture at period end, after adjusting for any distributions or contributions made during such period. As a result of the HLBV method there was no net income or loss attributed to the Company related its ownership interest in Apiture during the three and six months ended June 30, 2018.
As of June 30, 2018 and December 31, 2017 the Company had a $68.0 million equity method investment included in other assets on the consolidated balance sheet for this investment.
Derivative Financial Instruments
Interest Rate Futures Contracts
During the fourth quarter of 2016, the Company began using exchange-traded interest rate futures contracts to manage interest rate risk that may impact expected gains arising from future secondary market loan sales. Upon entering into a futures contract, the Company is required to pledge to the counterparty an amount of cash equal to a certain percentage of the contract amount, also known as an initial margin deposit. Subsequent payments, known as variation margin, are made or received by the Company each day to settle the daily fluctuations in the fair value of the underlying contract. Investments in these derivative contracts are subject to risks that can result in a loss of all or part of an investment. Credit risk is considered low because the counterparties are futures exchanges. The Company has not designated any derivative as a hedging instrument under applicable accounting guidance. Changes in fair value of the derivative contracts is recorded as a component of "net gains on sales of loans" on the consolidated statement of income. The fair value of the derivative contracts on the balance sheet date is zero due to the daily cash settlement of contracts.
Equity Warrant Assets
In connection with negotiated credit facilities and certain other services, the Company may obtain equity warrant assets giving the Company the right to acquire stock in private companies in certain verticals. These assets are held for prospective investment gains and are not used to hedge any economic risks. Further, the Company does not use other derivative instruments to hedge economic risks stemming from equity warrant assets.
Equity warrant assets in certain private client companies are recorded as derivatives when they contain net settlement terms and other qualifying criteria under Accounting Standards Codification 815. Equity warrant assets entitle the Company to purchase a specific number of shares of stock at a specific price within a specific time period, generally 10 years. Certain equity warrant assets contain contingent provisions, which adjust the underlying number of shares or purchase price upon the occurrence of certain future events to prevent dilution of the Company’s implied ownership represented by the warrants. Certain warrant agreements contain net share settlement provisions, which permit the receipt of, upon exercise, a share count equal to the intrinsic value of the warrant divided by the share price (otherwise known as a “cashless” exercise). These equity warrant assets are recorded at fair value and are classified as derivative assets, a component of other assets, on the consolidated balance sheet at the time they are obtained.
The grant date fair values of equity warrant assets classified as derivatives received in connection with the issuance of a credit facility are deemed to be loan fees and recognized as an adjustment of loan yield through loan interest income. Similar to other loan fees, the yield adjustment related to grant date fair value of warrants is recognized over the life of that credit facility.

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

Any changes in fair value from the grant date fair value of equity warrant assets classified as derivatives will be recognized as increases or decreases to other assets on the consolidated balance sheet and as net gains or losses on derivative instruments, in other noninterest income, a component of consolidated net income. When a portfolio company is acquired, the Company may exercise these equity warrant assets for shares or cash.
The fair value of equity warrant assets classified as derivatives is reviewed quarterly using a Black-Scholes option pricing model.
For those equity warrant assets that do not contain net share settlement provisions, the Company considers these to be equity investments without readily determinable market values and records the asset at cost.
Revenue Recognition
On January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) No. 2014-09 “Revenue from Contracts with Customers” (Topic 606) and all subsequent ASUs that modified Topic 606. The implementation of the new standard did not have a material impact on the measurement or recognition of revenue and a cumulative effect adjustment to opening retained earnings was not necessary. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts were not adjusted and continue to be reported in accordance with the Company's historic accounting under Topic 605.
Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and lease financings or investment securities. In addition, certain noninterest income streams such as fees associated with servicing rights, financial guarantees, derivatives, title insurance, and equity and cost method investments are also not in scope of the new guidance. Therefore, the recognition of these revenue streams did not change upon adoption of Topic 606. Substantially all of the Company’s revenue is generated from contracts with customers. Noninterest revenue streams in-scope of Topic 606 are discussed below.
Other noninterest income
Other noninterest income consists of other recurring revenue streams from administration of trust assets held by the Company's trust department and from services provided by GLS to its clients for settlement, accounting, and valuation for government guaranteed loan sales and holdings. Trust account administration performance obligations are generally satisfied over time and fees are recognized monthly, based on the month-end market value of assets in fiduciary accounts and the applicable fee rate. Payment is generally received after month end through a direct charge to customers' accounts. The Company does not earn performance-based incentives from trust account administration services. GLS provides services when requested by clients. Each requested service represents a specific performance obligation with a transaction price outlined by GLS' fee schedule. Revenue is recognized as the requested services are completed and payment is generally received the following month.
Contract Balances
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as trust administration fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into long-term revenue contracts with customers, and therefore, does not experience significant contract balances. As of June 30, 2018 and December 31, 2017, the Company did not have any significant contract balances.
Contract Acquisition Costs
In connection with the adoption of Topic 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. Upon adoption of Topic 606, the Company did not capitalize any contract acquisition cost.
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.

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Table of Contents

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

Note 2. Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued 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. The Company's revenue is comprised of loan servicing revenue, net gains on sales of loans and net interest income on financial assets and financial liabilities, all of which are explicitly excluded from the scope of ASU 2014-09, and non-interest income. The Company's revenue streams included in non-interest income that are within the scope of the guidance are primarily related to sales of foreclosed assets, construction supervision fees, title insurance income and trust fiduciary fees. The Company adopted the standard in the first quarter of 2018 with no material impact on the consolidated financial statements. Refer to Note 1. Basis of Presentation for additional information.
In January 2016, the FASB issued ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”). ASU 2016-01, among other things, (i) requires equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet, (iv) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments, (vi) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (viii) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale. The Company adopted the standard in the first quarter of 2018 with no material impact on the consolidated financial statements. In accordance with (iv) above, the Company measured the fair value of the loan and lease portfolio using an exit price notion. See Note 10. Fair Value of Financial Instruments for additional information.
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 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 the potential impact of ASU 2016-13 on the consolidated financial statements. In that regard, a cross-functional working group has been formed, under the direction of the Company's Chief Financial Officer and Chief Credit Officer. The working group is comprised of individuals from various functional areas including credit, risk management, finance and information technology, among others. The Company is currently developing an implementation plan to include assessment of processes, portfolio segmentation, model development, system requirements and the identification of data and resource needs, among other things. The Company has also selected a third-party vendor solution to assist in the application of the ASU 2016-13. While the Company is currently unable to reasonably estimate the impact of adopting ASU 2016-13, the impact of adoption is expected to be significantly influenced by the composition, characteristics and quality of loan and securities portfolios as well as the prevailing economic conditions and forecasts as of the adoption date.

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Table of Contents

Live Oak Bancshares, Inc.
Notes to Unaudited 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. The Company adopted the standard in the first quarter of 2018 with no effect on the 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. The Company adopted the standard in the first quarter of 2018 with no effect on the 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. The Company adopted the standard in the first quarter of 2018 with no effect on the consolidated financial statements.
In February 2018, the FASB issued ASU No. 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” (“ASU 2018-02”). ASU 2018-02 addresses the income tax accounting treatment of the stranded tax effects within other comprehensive income. The ASU allows for an entity to reclassify the stranded tax effects resulting from the Tax Cuts and Jobs Act from accumulated other comprehensive income to retained earnings. ASU 2018-02 will be effective for the Company on January 1, 2019, with early adoption permitted. The Company early adopted ASU 2018-02 in the first quarter of 2018 and reclassified its stranded tax credit of $244 thousand within accumulated other comprehensive income to retained earnings at March 31, 2018.
In February 2018, the FASB issued ASU No. 2018-03, “Technical Corrections and Improvements to Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2018-03”). ASU 2018-03 amendments clarify certain aspects of the guidance issued in ASU 2016-01. The amendments are effective for the Company for fiscal year 2018 with adoption as of July 1, 2018. The Company does not expect these amendments to have a material effect on its consolidated financial statements.
In March 2018, the FASB issued ASU No. 2018-05, “Income Taxes (Topic 740) - Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 118” (“ASU 2018-05”). ASU 2018-05 amends Accounting Standard Codification 740 to include recent SEC guidance pursuant to the issuance of SAB 118. These amendments address situations when a registrant does not have the necessary information available, prepared, or analyzed in reasonable detail to complete the accounting for certain income tax effects of the Tax Cuts and Jobs Act. The amendments were effective upon issuance and do not have a material effect on the Company's consolidated financial statements.
In June 2018, the FASB issued ASU No. 2018-07 “Compensation - Stock Compensation (Topic 718) Improvements to Nonemployee Share-Based Payment Accounting” (“ASU 2018-07”). ASU 2018-07 amends Accounting Standard Codification 718 to largely align accounting for share-based payment awards issued to employees and nonemployees. Under the new guidance existing employee guidance will generally apply to nonemployee share-based transactions, except for specific guidance on inputs into option pricing models and the attribution of cost. The amendments are effective for the Company on January 1, 2019 with early adoption permitted. The Company does not expect these amendments to have a material effect on its consolidated financial statements.


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Table of Contents

Live Oak Bancshares, Inc.
Notes to Unaudited 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.
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2018
 
2017
 
2018
 
2017
Basic earnings per share:
 
 
 
 
 
 
 
Net income available to common shareholders
$
14,253

 
$
9,795

 
$
26,706

 
$
15,907

Weighted-average basic shares outstanding
40,027,336

 
34,618,721

 
39,977,336

 
34,543,229

Basic earnings per share
$
0.36

 
$
0.28

 
$
0.67

 
$
0.46

Diluted earnings per share:
 
 
 
 
 
 
 
Net income available to common shareholders, for diluted earnings per share
$
14,253

 
$
9,795

 
$
26,706

 
$
15,907

Total weighted-average basic shares outstanding
40,027,336

 
34,618,721

 
39,977,336

 
34,543,229

Add effect of dilutive stock options and restricted stock grants
1,592,311

 
1,323,320

 
1,538,997

 
1,228,953

Total weighted-average diluted shares outstanding
41,619,647

 
35,942,041

 
41,516,333

 
35,772,182

Diluted earnings per share
$
0.34

 
$
0.27

 
$
0.64

 
$
0.44

Anti-dilutive shares

 
245,583

 
9,102

 
983,174

Note 4. Investment Securities
The carrying amount of investment securities and their approximate fair values are reflected in the following table:
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
June 30, 2018
 
 
 
 
 
 
 
US treasury securities
$
4,961

 
$

 
$
9

 
$
4,952

US government agencies
32,896

 

 
395

 
32,501

Residential mortgage-backed securities
351,556

 
14

 
6,133

 
345,437

Mutual fund
2,129

 

 
76

 
2,053

Total
$
391,542

 
$
14

 
$
6,613

 
$
384,943

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
US government agencies
$
22,778

 
$
3

 
$
157

 
$
22,624

Residential mortgage-backed securities
70,167

 
1

 
1,472

 
68,696

Mutual fund
2,090

 

 
55

 
2,035

Total
$
95,035

 
$
4

 
$
1,684

 
$
93,355

There were no sales of securities during the three and six months ended June 30, 2018 and 2017.

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Table of Contents

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

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, 2018
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
US treasury securities
$
4,952

 
$
9

 
$

 
$

 
$
4,952

 
$
9

US government agencies
21,045

 
343

 
6,462

 
52

 
27,507

 
395

Residential mortgage-backed securities
292,323

 
4,083

 
41,850

 
2,050

 
334,173

 
6,133

Mutual fund

 

 
2,053

 
76

 
2,053

 
76

Total
$
318,320

 
$
4,435

 
$
50,365

 
$
2,178

 
$
368,685

 
$
6,613

 
Less Than 12 Months
 
12 Months or More
 
Total
December 31, 2017
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
US government agencies
$
14,842

 
$
100

 
$
6,465

 
$
57

 
$
21,307

 
$
157

Residential mortgage-backed securities
23,481

 
439

 
40,648

 
1,033

 
64,129

 
1,472

Mutual fund

 

 
2,035

 
55

 
2,035

 
55

Total
$
38,323

 
$
539

 
$
49,148

 
$
1,145

 
$
87,471

 
$
1,684

At June 30, 2018, there were twenty-five residential mortgage-backed securities, three US government agency securities and the 504 Fund mutual fund in unrealized loss positions for greater than 12 months and one US treasury security, forty residential mortgage-backed securities and seven US government agency securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2017 were comprised of twenty-three residential mortgage-backed securities, three US government agencies and the 504 mutual fund in unrealized loss positions for greater than 12 months and five US government agency securities and eight residential mortgage-backed securities in unrealized loss positions 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, 2018 and December 31, 2017 were backed by U.S. government sponsored enterprises (“GSEs”).

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Table of Contents

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

The following is a summary of investment securities by maturity:
 
June 30, 2018
 
Available-for-Sale
 
Amortized
cost
 
Fair
value
US treasury securities
 
 
 
One to five years
$
4,961

 
$
4,952

Total
4,961

 
4,952

 
 
 
 
US government agencies
 
 
 
Within one year
6,323

 
6,300

One to five years
26,573

 
26,201

Total
32,896

 
32,501

 
 
 
 
Residential mortgage-backed securities
 
 
 
One to five years
4,298

 
4,121

Five to ten years
51,439

 
50,648

After 10 years
295,819

 
290,668

Total
351,556

 
345,437

 
 
 
 
Total
$
389,413

 
$
382,890

The table above reflects contractual maturities. Actual results will differ as the loans underlying the residential mortgage-backed securities may repay sooner than scheduled. This table excludes the 504 Fund mutual fund investment.
At June 30, 2018 and December 31, 2017, 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 were pledged to the Company's trust department for uninsured trust assets held by the trust department.


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Table of Contents

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

Note 5. 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
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.

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Table of Contents

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

Loans and leases consist of the following:
 
June 30,
2018
 
December 31,
2017
Commercial & Industrial
 
 
 
Agriculture
$
5,813

 
$
3,274

Death Care Management
15,720

 
13,495

Healthcare
44,524

 
43,301

Independent Pharmacies
102,995

 
99,920

Registered Investment Advisors
96,473

 
93,770

Veterinary Industry
49,156

 
46,387

Other Industries
217,551

 
184,903

Total
532,232

 
485,050

Construction & Development
 
 
 
Agriculture
34,971

 
34,188

Death Care Management
7,542

 
6,119

Healthcare
61,114

 
49,770

Independent Pharmacies
2,186

 
1,496

Registered Investment Advisors
1,286

 
376

Veterinary Industry
18,198

 
13,184

Other Industries
74,450

 
58,120

Total
199,747

 
163,253

Commercial Real Estate
 
 
 
Agriculture
49,009

 
46,717

Death Care Management
66,671

 
67,381

Healthcare
152,025

 
126,631

Independent Pharmacies
19,368

 
19,028

Registered Investment Advisors
11,040

 
11,789

Veterinary Industry
122,593

 
113,932

Other Industries
194,266

 
134,172

Total
614,972

 
519,650

Commercial Land
 
 
 
Agriculture
193,613

 
178,897

Total
193,613

 
178,897

Total Loans and Leases1
1,540,564

 
1,346,850

Net Deferred Costs
8,470

 
8,545

Discount on SBA 7(a) and USDA Unguaranteed2
(14,666
)
 
(11,422
)
Loans and Leases, Net of Unearned
$
1,534,368

 
$
1,343,973

1
Total loans and leases include $141.5 million and $99.7 million of U.S. government guaranteed loans as of June 30, 2018 and December 31, 2017, 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.

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Table of Contents

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.

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Table of Contents

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, 2018
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
Agriculture
$
5,596

 
$
217

 
$

 
$
5,813

Death Care Management
15,517

 
197

 
6

 
15,720

Healthcare
36,461

 
3,256

 
4,807

 
44,524

Independent Pharmacies
88,684

 
6,554

 
7,757

 
102,995

Registered Investment Advisors
92,254

 
1,420

 
2,799

 
96,473

Veterinary Industry
44,754

 
1,649

 
2,753

 
49,156

Other Industries
203,813

 
12,366

 
1,372

 
217,551

Total
487,079

 
25,659

 
19,494

 
532,232

Construction & Development
 
 
 
 
 
 
 
Agriculture
32,431

 

 
2,540

 
34,971

Death Care Management
7,542

 

 

 
7,542

Healthcare
56,542

 
2,534

 
2,038

 
61,114

Independent Pharmacies
2,186

 

 

 
2,186

Registered Investment Advisors
1,286

 

 

 
1,286

Veterinary Industry
17,012

 
1,186

 

 
18,198

Other Industries
72,558

 
1,892

 

 
74,450

Total
189,557

 
5,612

 
4,578

 
199,747

Commercial Real Estate
 
 
 
 
 
 
 
Agriculture
49,009

 

 

 
49,009

Death Care Management
59,696

 
3,862

 
3,113

 
66,671

Healthcare
129,714

 
9,378

 
12,933

 
152,025

Independent Pharmacies
13,603

 
2,930

 
2,835

 
19,368

Registered Investment Advisors
10,908

 
132

 

 
11,040

Veterinary Industry
103,055

 
3,655

 
15,883

 
122,593

Other Industries
192,441

 
1,825

 

 
194,266

Total
558,426

 
21,782

 
34,764

 
614,972

Commercial Land
 
 
 
 
 
 
 
Agriculture
183,117

 
5,371

 
5,125

 
193,613

Total
183,117

 
5,371

 
5,125

 
193,613

Total1
$
1,418,179

 
$
58,424

 
$
63,961

 
$
1,540,564


18


Table of Contents

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

 
Risk Grades
1 - 4
 
Risk Grade
5
 
Risk Grades
6 - 8
 
Total
December 31, 2017
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
Agriculture
$
3,052

 
$
222

 
$

 
$
3,274

Death Care Management
13,371

 
117

 
7

 
13,495

Healthcare
36,530

 
2,246

 
4,525

 
43,301

Independent Pharmacies
86,152

 
5,541

 
8,227

 
99,920

Registered Investment Advisors
90,911

 
2,134

 
725

 
93,770

Veterinary Industry
42,313

 
1,704

 
2,370

 
46,387

Other Industries
184,540

 
363

 

 
184,903

Total
456,869

 
12,327

 
15,854

 
485,050

Construction & Development
 
 
 
 
 
 
 
Agriculture
31,738

 
2,450

 

 
34,188

Death Care Management
6,119

 

 

 
6,119

Healthcare
47,813

 
699

 
1,258

 
49,770

Independent Pharmacies
1,496

 

 

 
1,496

Registered Investment Advisors
376

 

 

 
376

Veterinary Industry
13,184

 

 

 
13,184

Other Industries
58,120

 

 

 
58,120

Total
158,846

 
3,149

 
1,258

 
163,253

Commercial Real Estate
 
 
 
 
 
 
 
Agriculture
46,717

 

 

 
46,717

Death Care Management
60,671

 
3,881

 
2,829

 
67,381

Healthcare
112,321

 
9,992

 
4,318

 
126,631

Independent Pharmacies
15,641

 
1,825

 
1,562

 
19,028

Registered Investment Advisors
11,649

 
140

 

 
11,789

Veterinary Industry
97,065

 
2,948

 
13,919

 
113,932

Other Industries
133,493

 
679

 

 
134,172

Total
477,557

 
19,465

 
22,628

 
519,650

Commercial Land
 
 
 
 
 
 
 
Agriculture
176,811

 
2,086

 

 
178,897

Total
176,811

 
2,086

 

 
178,897

Total1
$
1,270,083

 
$
37,027

 
$
39,740

 
$
1,346,850

1
Total loans and leases include $141.5 million of U.S. government guaranteed loans as of June 30, 2018, segregated by risk grade as follows: Risk Grades 1 – 4 = $84.8 million, Risk Grade 5 = $12.0 million, Risk Grades 6 – 8 = $44.7 million. As of December 31, 2017, total loans and leases include $99.7 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $65.0 million, Risk Grade 5 = $6.7 million, Risk Grades 6 – 8 = $28.0 million.

19


Table of Contents

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, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
$

 
$

 
$

 
$

 
$

 
$
5,813

 
$
5,813

 
$

Death Care Management

 

 

 

 

 
15,720

 
15,720

 

Healthcare

 
49

 
757

 
2,287

 
3,093

 
41,431

 
44,524

 

Independent Pharmacies
338

 

 

 
7,308

 
7,646

 
95,349

 
102,995

 

Registered Investment Advisors

 
577

 
2,102

 

 
2,679

 
93,794

 
96,473

 

Veterinary Industry
170

 
126

 
620

 
1,072

 
1,988

 
47,168

 
49,156

 

Other Industries
596

 
615

 

 

 
1,211

 
216,340

 
217,551

 

Total
1,104

 
1,367

 
3,479

 
10,667

 
16,617

 
515,615

 
532,232

 

Construction & Development
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 
2,539

 
2,539

 
32,432

 
34,971

 

Death Care Management

 

 

 

 

 
7,542

 
7,542

 

Healthcare

 

 

 

 

 
61,114

 
61,114

 

Independent Pharmacies

 

 

 

 

 
2,186

 
2,186

 

Registered Investment Advisors

 

 

 

 

 
1,286

 
1,286

 

Veterinary Industry

 
1,186

 

 

 
1,186

 
17,012

 
18,198

 

Other Industries

 
37

 

 

 
37

 
74,413

 
74,450

 

Total

 
1,223

 

 
2,539

 
3,762

 
195,985

 
199,747

 

Commercial Real Estate
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
49,009

 
49,009

 

Death Care Management
158

 
1,447

 

 
1,358

 
2,963

 
63,708

 
66,671

 

Healthcare
2,334

 

 
37

 
6,596

 
8,967

 
143,058

 
152,025

 

Independent Pharmacies
2,835

 

 

 

 
2,835

 
16,533

 
19,368

 

Registered Investment Advisors

 

 

 

 

 
11,040

 
11,040

 

Veterinary Industry
1,867

 
3,185

 
2,506

 
5,500

 
13,058

 
109,535

 
122,593

 

Other Industries

 

 

 

 

 
194,266

 
194,266

 

Total
7,194

 
4,632

 
2,543

 
13,454

 
27,823

 
587,149

 
614,972

 

Commercial Land
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
5,125

 

 

 

 
5,125

 
188,488

 
193,613

 

Total
5,125

 

 

 

 
5,125

 
188,488

 
193,613

 

Total1
$
13,423

 
$
7,222

 
$
6,022

 
$
26,660

 
$
53,327

 
$
1,487,237

 
$
1,540,564

 
$


20


Table of Contents

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, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial & Industrial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture
$

 
$

 
$

 
$

 
$

 
$
3,274

 
$
3,274

 
$

Death Care Management

 

 

 

 

 
13,495

 
13,495

 

Healthcare
788

 
131

 
14

 
3,004

 
3,937

 
39,364

 
43,301

 

Independent Pharmacies
236

 
2,930

 
1,349

 
3,376

 
7,891

 
92,029

 
99,920

 

Registered Investment Advisors

 
321

 

 

 
321

 
93,449

 
93,770

 

Veterinary Industry
212

 
594

 
508

 
797

 
2,111

 
44,276

 
46,387

 

Other Industries

 

 

 

 

 
184,903

 
184,903

 

Total
1,236

 
3,976

 
1,871

 
7,177

 
14,260

 
470,790

 
485,050

 

Construction & Development
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
34,188

 
34,188

 

Death Care Management

 

 

 

 

 
6,119

 
6,119

 

Healthcare

 

 

 

 

 
49,770

 
49,770

 

Independent Pharmacies

 

 

 

 

 
1,496

 
1,496

 

Registered Investment Advisors

 

 

 

 

 
376

 
376

 

Veterinary Industry

 

 

 

 

 
13,184

 
13,184

 

Other Industries

 

 

 

 

 
58,120

 
58,120

 

Total

 

 

 

 

 
163,253

 
163,253

 

Commercial Real Estate
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
46,717

 
46,717

 

Death Care Management

 

 
168

 
1,391

 
1,559

 
65,822

 
67,381

 

Healthcare
40

 
54

 
1,916

 
1,550

 
3,560

 
123,071

 
126,631

 

Independent Pharmacies

 

 

 
1,562

 
1,562

 
17,466

 
19,028

 

Registered Investment Advisors

 

 

 

 

 
11,789

 
11,789

 

Veterinary Industry
1,804

 
3,226

 

 
4,765

 
9,795

 
104,137

 
113,932

 

Other Industries

 

 

 

 

 
134,172

 
134,172

 

Total
1,844

 
3,280

 
2,084

 
9,268

 
16,476

 
503,174

 
519,650

 

Commercial Land
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 

 

 
178,897

 
178,897

 

Total

 

 

 

 

 
178,897

 
178,897

 

Total1
$
3,080

 
$
7,256

 
$
3,955

 
$
16,445

 
$
30,736

 
$
1,316,114

 
$
1,346,850

 
$

1
Total loans and leases include $141.5 million of U.S. government guaranteed loans as of June 30, 2018, of which $21.7 million is greater than 90 days past due, $9.2 million is 30-89 days past due and $110.6 million is included in current loans and leases as presented above. As of December 31, 2017, total loans and leases include $99.7 million of U.S. government guaranteed loans, of which $15.0 million is greater than 90 days past due, $7.4 million is 30-89 days past due and $77.3 million is included in current loans and leases as presented above.

21


Table of Contents

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 $588 thousand and $306 thousand for the three months ended June 30, 2018 and 2017, respectively, and for the six months ended June 30, 2018 and 2017 interest income would have increased approximately $1.0 million and $582 thousand, respectively. All nonaccrual loans and leases are included in the held for investment portfolio.
Nonaccrual loans and leases as of June 30, 2018 and December 31, 2017 are as follows:
June 30, 2018
Loan and Lease Balance
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Healthcare
$
3,044

 
$
2,735

 
$
309

Independent Pharmacies
7,646

 
6,919

 
727

Registered Investment Advisors
2,102

 
1,577

 
525

Veterinary Industry
1,862

 
1,827

 
35

Other Industries
596

 

 
596

Total
15,250

 
13,058

 
2,192

Construction & Development
 
 
 
 
 
    Agriculture
2,539

 
1,904

 
635

     Total
2,539

 
1,904

 
635

Commercial Real Estate

 
 
 
 
Death Care Management
1,516

 
1,210

 
306

Healthcare
8,967

 
6,080

 
2,887

Independent Pharmacies
2,835

 
2,126

 
709

Veterinary Industry
9,873

 
8,531

 
1,342

Total
23,191

 
17,947

 
5,244

Commercial Land


 
 
 
 
    Agriculture
5,125

 
1,730

 
3,395

     Total
5,125

 
1,730

 
3,395

Total
$
46,105

 
$
34,639

 
$
11,466

December 31, 2017
Loan and Lease Balance
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Healthcare
$
3,806

 
$
3,235

 
$
571

Independent Pharmacies
4,961

 
3,906

 
1,055

Veterinary Industry
1,517

 
1,478

 
39

Total
10,284

 
8,619

 
1,665

Commercial Real Estate
 
 
 
 
 
Death Care Management
1,559

 
1,237

 
322

Healthcare
3,506

 
2,719

 
787

Independent Pharmacies
1,562

 
1,562

 

Veterinary Industry
6,569

 
5,733

 
836

Total
13,196

 
11,251

 
1,945

Total
$
23,480

 
$
19,870

 
$
3,610


22


Table of Contents

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).
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.

23


Table of Contents

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, 2018
 
 
 
 
 
 
 
 
 
Beginning Balance
$
2,428

 
$
11,244

 
$
12,201

 
$
2,177

 
$
28,050

Charge offs

 
(419
)
 
(549
)
 

 
(968
)
Recoveries

 
29

 
152

 

 
181

Provision
(201
)
 
554

 
1,573

 
161

 
2,087

Ending Balance
$
2,227

 
$
11,408

 
$
13,377

 
$
2,338

 
$
29,350

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

Six months ended
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
June 30, 2018
 
 
 
 
 
 
 
 
 
Beginning Balance
$
2,030

 
$
9,180

 
$
10,751

 
$
2,229

 
$
24,190

Charge offs

 
(419
)
 
(1,221
)
 

 
(1,640
)
Recoveries

 
33

 
288

 

 
321

Provision
197

 
2,614

 
3,559

 
109

 
6,479

Ending Balance
$
2,227

 
$
11,408

 
$
13,377

 
$
2,338

 
$
29,350

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

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, 2018
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
Allowance for Loan and Lease Losses:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$
365

 
$
2,601

 
$
2,597

 
$
1,355

 
$
6,918

Loans and leases collectively evaluated for impairment2
1,862

 
8,807

 
10,780

 
983

 
22,432

Total allowance for loan and lease losses
$
2,227

 
$
11,408

 
$
13,377

 
$
2,338

 
$
29,350

Loans and leases receivable1:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$
4,557

 
$
28,966

 
$
10,836

 
$
5,116

 
$
49,475

Loans and leases collectively evaluated for impairment2
195,190

 
586,006

 
521,396

 
188,497

 
1,491,089

Total loans and leases receivable
$
199,747

 
$
614,972

 
$
532,232

 
$
193,613

 
$
1,540,564


24


Table of Contents

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

December 31, 2017
Construction &
Development
 
Commercial
Real Estate
 
Commercial
& Industrial
 
Commercial
Land
 
Total
Allowance for Loan and Lease Losses:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$
157

 
$
1,502

 
$
1,126

 
$

 
$
2,785

Loans and leases collectively evaluated for impairment2
1,873

 
7,678

 
9,625

 
2,229

 
21,405

Total allowance for loan and lease losses
$
2,030

 
$
9,180

 
$
10,751

 
$
2,229

 
$
24,190

Loans and leases receivable1:
 
 
 
 
 
 
 
 
 
Loans and leases individually evaluated for impairment
$
1,237

 
$
17,105

 
$
8,672

 
$

 
$
27,014

Loans and leases collectively evaluated for impairment2
162,016

 
502,545

 
476,378

 
178,897

 
1,319,836

Total loans and leases receivable
$
163,253

 
$
519,650

 
$
485,050

 
$
178,897

 
$
1,346,850

1
Loans and leases receivable includes $141.5 million of U.S. government guaranteed loans as of June 30, 2018, of which $45.2 million are impaired. As of December 31, 2017, loans and leases receivable includes $99.7 million of U.S. government guaranteed loans, of which $28.1 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, 2018, these balances totaled $15.7 million, of which $14.4 million are guaranteed by the U.S. government and $1.3 million are unguaranteed. As of December 31, 2017, these balances totaled $14.8 million, of which $13.2 million are guaranteed by the U.S. government and $1.6 million are unguaranteed. The allowance for loan and lease losses associated with these loans and leases totaled $510 thousand and $279 thousand as of June 30, 2018 and December 31, 2017, respectively.

25


Table of Contents

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, 2018
Recorded
Investment
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Death Care Management
$
6

 
$

 
$
6

Healthcare
4,836

 
3,468

 
1,368

Independent Pharmacies
8,054

 
6,918

 
1,136

Registered Investment Advisors
2,807

 
1,577

 
1,230

Veterinary Industry
2,900

 
2,328

 
572

Other Industries
1,371

 
163

 
1,208

Total
19,974

 
14,454

 
5,520

Construction & Development
 
 
 
 
 
Agriculture
2,534

 
1,905

 
629

Healthcare
2,023

 
1,528

 
495

Total
4,557

 
3,433

 
1,124

Commercial Real Estate
 
 
 
 
 
Death Care Management
3,137

 
2,296

 
841

Healthcare
13,573

 
9,241

 
4,332

Independent Pharmacies
2,834

 
2,126

 
708

Veterinary Industry
15,947

 
11,916

 
4,031

Total
35,491

 
25,579

 
9,912

Commercial Land
 
 
 
 
 
Agriculture
5,116

 
1,730

 
3,386

Total
5,116

 
1,730

 
3,386

Total
$
65,138

 
$
45,196

 
$
19,942

December 31, 2017
Recorded
Investment
 
Guaranteed
Balance
 
Unguaranteed
Exposure
Commercial & Industrial
 
 
 
 
 
Death Care Management
$
7

 
$

 
$
7

Healthcare
4,551

 
3,235

 
1,316

Independent Pharmacies
8,571

 
6,356

 
2,215

Registered Investment Advisors
733

 

 
733

Veterinary Industry
2,762

 
2,001

 
761

Total
16,624

 
11,592

 
5,032

Construction & Development
 
 
 
 
 
Healthcare
1,237

 
944

 
293

Total
1,237

 
944

 
293

Commercial Real Estate
 
 
 
 
 
Death Care Management
2,831

 
1,237

 
1,594

Healthcare
4,315

 
2,967

 
1,348

Independent Pharmacies
1,562

 
1,562

 

Veterinary Industry
15,266

 
9,768

 
5,498

Total
23,974

 
15,534

 
8,440

Commercial Land
 
 
 
 
 
Agriculture

 

 

Total

 

 

Total
$
41,835

 
$
28,070

 
$
13,765


26


Table of Contents

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, 2018
 
Recorded Investment
 
 
 
 
 
With a
Recorded
Allowance
 
With No
Recorded
Allowance
 
Total
 
Unpaid
Principal
Balance
 
Related
Allowance
Recorded
Commercial & Industrial
 
 
 
 
 
 
 
 
 
Death Care Management
$
6

 
$

 
$
6

 
$
6

 
$
1

Healthcare
4,081

 
755

 
4,836

 
5,221

 
378

Independent Pharmacies
7,639

 
415

 
8,054

 
9,183

 
400

Registered Investment Advisors
2,807

 

 
2,807

 
2,799

 
1,012

Veterinary Industry
2,900

 

 
2,900

 
3,279

 
194

Other Industries
1,371

 

 
1,371

 
1,372

 
757

Total
18,804

 
1,170

 
19,974

 
21,860

 
2,742

Construction & Development
 
 
 
 
 
 
 
 
 
Agriculture
2,534

 

 
2,534

 
2,539

 
17

Healthcare
2,023

 

 
2,023

 
2,038

 
348

Total
4,557

 

 
4,557

 
4,577

 
365

Commercial Real Estate
 
 
 
 
 
 
 
 
 
Death Care Management
2,980

 
157

 
3,137

 
3,248

 
160

Healthcare
13,202

 
371

 
13,573

 
13,566

 
1,242

Independent Pharmacies
2,834

 

 
2,834

 
2,835

 
288

Veterinary Industry
15,947

 

 
15,947

 
16,956

 
1,276

Total
34,963

 
528

 
35,491

 
36,605

 
2,966

Commercial Land
 
 
 
 
 
 
 
 
 
Agriculture
5,116

 

 
5,116

 
5,125

 
1,355

Total
5,116

 

 
5,116

 
5,125

 
1,355

Total Impaired Loans and Leases
$
63,440

 
$
1,698

 
$
65,138

 
$
68,167

 
$
7,428


27


Table of Contents

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

 
December 31, 2017
 
Recorded Investment
 
 
 
 
 
With a
Recorded
Allowance
 
With No
Recorded
Allowance
 
Total
 
Unpaid
Principal
Balance
 
Related
Allowance
Recorded
Commercial & Industrial
 
 
 
 
 
 
 
 
 
Death Care Management
$

 
$
7

 
$
7

 
$
7

 
$

Healthcare
3,521

 
1,030

 
4,551

 
5,643

 
165

Independent Pharmacies
8,154

 
417

 
8,571

 
9,078

 
521

Registered Investment Advisors
662

 
71

 
733

 
725

 
504

Veterinary Industry
2,505

 
257

 
2,762

 
3,113

 
182

Total
14,842

 
1,782

 
16,624

 
18,566

 
1,372

Construction & Development
 
 
 
 
 
 
 
 
 
Healthcare
1,237

 

 
1,237

 
1,258

 
157

Total
1,237

 

 
1,237

 
1,258

 
157

Commercial Real Estate
 
 
 
 
 
 
 
 
 
Death Care Management
2,221

 
610

 
2,831

 
2,964

 
260

Healthcare
3,717

 
598

 
4,315

 
4,332

 
192

Independent Pharmacies
1,562

 

 
1,562

 
1,933

 
8

Veterinary Industry
13,711

 
1,555

 
15,266

 
16,584

 
1,075

Total
21,211

 
2,763

 
23,974

 
25,813

 
1,535

Commercial Land
 
 
 
 
 
 
 
 
 
Agriculture

 

 

 
58

 

Total

 

 

 
58

 

Total Impaired Loans and Leases
$
37,290

 
$
4,545

 
$
41,835

 
$
45,695

 
$
3,064


28


Table of Contents

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, 2018
 
Three months ended
June 30, 2017
 
Average
Balance
 
Interest
Income
Recognized
 
Average
Balance
 
Interest
Income
Recognized
Commercial & Industrial
 
 
 
 
 
 
 
Death Care Management
$
7

 
$

 
$
111

 
$
2

Healthcare
5,094

 
19

 
6,708

 
19

Independent Pharmacies
7,978

 
7

 
5,647

 
23

Registered Investment Advisors
2,818

 
12

 
2,100

 
15

Veterinary Industry
2,930

 
18

 
2,448

 
10

Other Industries
1,373

 
5

 

 

Total
20,200

 
61

 
17,014

 
69

Construction & Development
 
 
 
 
 
 
 
Agriculture
2,526

 

 

 

Healthcare
1,799

 
28

 

 

Total
4,325

 
28

 

 

Commercial Real Estate
 
 
 
 
 
 
 
Death Care Management
3,122

 
27

 
2,536

 
14

Healthcare
12,852

 
64

 
1,808

 
12

Independent Pharmacies
2,836

 
1

 
2,169

 

Veterinary Industry
16,135

 
98

 
14,777

 
133

Total
34,945

 
190

 
21,290

 
159

Commercial Land
 
 
 
 
 
 
 
Agriculture
5,138

 
25

 
196

 

Total
5,138

 
25

 
196

 

Total
$
64,608

 
$
304

 
$
38,500

 
$
228


29


Table of Contents

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

 
Six months ended
June 30, 2018
 
Six months ended
June 30, 2017
 
Average
Balance
 
Interest
Income
Recognized
 
Average
Balance
 
Interest
Income
Recognized
Commercial & Industrial
 
 
 
 
 
 
 
Death Care Management
$
7

 
$

 
$
1,776

 
$
3

Healthcare
5,188

 
31

 
5,054

 
41

Independent Pharmacies
8,038

 
27

 
5,050

 
37

Registered Investment Advisors
2,825

 
24

 
1,740

 
30

Veterinary Industry
2,917

 
38

 
8,663

 
21

Other Industries
1,373

 
5

 

 

Total
20,348

 
125

 
22,283

 
132

Construction & Development
 
 
 
 
 
 
 
Agriculture
2,509

 
5

 

 

Healthcare
1,579

 
51

 

 

Total
4,088

 
56

 

 

Commercial Real Estate
 
 
 
 
 
 
 
Death Care Management
3,133

 
64

 
6,637

 
19

Healthcare
12,486

 
80

 
1,642

 
24

Independent Pharmacies
2,836

 
1

 
1,176

 

Veterinary Industry
16,159

 
235

 
6,663

 
238

Total
34,614

 
380

 
16,118

 
281

Commercial Land
 
 
 
 
 
 
 
Agriculture
5,138

 
25

 
466

 

Total
5,138

 
25

 
466

 

Total
$
64,188

 
$
586

 
$
38,867

 
$
413

During the six months ended June 30, 2018, there was one construction and development healthcare loan modified to extend the interest only period. The TDR had a pre-modification and post-modification recorded investment of $612 thousand. There were no TDRs modified during the three months ended June 30, 2018. There was one TDR made for payment deferral and extension of amortization during the three and six months ended June 30, 2017. The TDR has a pre-modification and post-modification recorded investment of $262 thousand.
Concessions made to improve a loan and lease’s performance have varying degrees of success. No TDRs that were modified within the twelve months ended June 30, 2018 subsequently defaulted during the three and six months ended June 30, 2018.
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.


30


Table of Contents

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

Note 6. 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 3-7 years which is consistent with the useful life of the equipment with no residual value.  The gross lease payments receivable and the net investment included in accounts receivable for such leases are as follows:
 
As of
 
June 30, 2018
 
December 31, 2017
Gross direct finance lease payments receivable
$
4,880

 
$
2,399

Less – unearned interest
(795
)
 
(373
)
Net investment in direct financing leases
$
4,085

 
$
2,026

Future minimum lease payments under finance leases are as follows:
As of June 30, 2018
 
Amount
2018
 
$
487

2019
 
1,009

2020
 
998

2021
 
916

2022
 
733

Thereafter
 
737

Total
 
$
4,880

Interest income of $73 thousand and $7 thousand was recognized in the three months ended June 30, 2018 and 2017. Interest income of $120 thousand and $7 thousand was recognized in the six months ended June 30, 2018 and 2017.
Operating Leases
The term of each operating lease is generally 10 to 15 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 generally range from 20 to 25 years and residual values generally range from 20% to 40%, 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.

31


Table of Contents

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

As of June 30, 2018, the Company had a net investment of $129.7 million in assets included in premises and equipment that are subject to operating leases. Of the net investment, the gross balance of the assets was $135.6 million and accumulated depreciation was $5.9 million as of June 30, 2018. Depreciation expense recognized on these assets for the three and six months ended June 30, 2018 was $2.0 million and $3.7 million, respectively. Depreciation expense recognized for the three and six months ended June 30, 2017 was $297 thousand.
A maturity analysis of future minimum lease payments under non-cancelable operating leases is as follows:
As of June 30, 2018
 
Amount
2018
 
$
3,200

2019
 
7,486

2020
 
7,536

2021
 
7,572

2022
 
7,599

Thereafter
 
49,337

Total
 
$
82,730

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 $2.58 billion and $2.44 billion at June 30, 2018 and December 31, 2017, respectively. The unpaid principal balance for all loans serviced for others was $2.67 billion and $2.54 billion at June 30, 2018 and December 31, 2017, respectively.
The following summarizes the activity pertaining to servicing rights:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2018
 
2017
 
2018
 
2017
Balance at beginning of period
$
53,120

 
$
53,584

 
$
52,298

 
$
51,994

Additions, net
4,202

 
2,503

 
9,076

 
5,885

Fair value changes:
 
 
 
 
 
 
 
Due to changes in valuation inputs or assumptions
(552
)
 
365

 
(553
)
 
861

Decay due to increases in principal paydowns or runoff
(4,081
)
 
(2,777
)
 
(8,132
)
 
(5,065
)
Balance at end of period
$
52,689

 
$
53,675

 
$
52,689

 
$
53,675

The fair value of servicing rights was determined using discount rates ranging from 10.1% to 15.4% on June 30, 2018 and 9.0% to 13.2% on June 30, 2017. The fair value of servicing rights was determined using prepayment speeds ranging from 3.1% to 23.3% on June 30, 2018 and 3.1% to 10.2% on June 30, 2017, 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.


32


Table of Contents

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

Note 8. Borrowings
Total outstanding short and long term borrowings consisted of the following:
 
June 30,
2018
 
December 31,
2017
Short term borrowings
 
 
 
On October 20, 2017, the Company entered into a revolving line of credit of $20 million with an unaffiliated commercial bank. The note is unsecured and accrues interest at LIBOR plus 1.750% for a term of 12 months. Payments are interest only with all principal and accrued interest due on October 19, 2018. The terms of this loan require the Company to maintain minimum capital and debt service coverage ratios. No advances have been made to this line of credit and there is $20 million of available credit remaining at June 30, 2018.
$

 
$

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. This line of credit was paid in full on August 25, 2017, and there is $25 million of available credit remaining at June 30, 2018.

 

Total short term borrowings
$

 
$

 
June 30,
2018
 
December 31,
2017
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. This note was repaid in full on January 31, 2018.
$

 
$
22,990

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, 2018 is 5.75%. The maturity date is October 5, 2019. The pledged collateral is classified in other assets with a fair value of $3.4 million at June 30, 2018. Underlying loans carry a risk grade of 3 and are current with no delinquencies.
3,368

 
3,574

In October 2017, the Company entered into a capital lease of $19 thousand with an unaffiliated equipment lease company, secured by fitness equipment which is included in premises and equipment on the consolidated balance sheet. Payments are principal and interest due monthly starting December 15, 2017 over a term of 60 months. At the end of the lease term there is a $1.00 bargain purchase option.
17

 

Total long term borrowings
$
3,385

 
$
26,564

The Company may purchase federal funds through unsecured federal funds lines of credit with various correspondent banks, which totaled $72.5 million and $47.5 million as of June 30, 2018 and December 31, 2017, 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 no outstanding balances on the lines of credit as of June 30, 2018 and December 31, 2017.
The Company has entered into a repurchase agreement with a third party for $5 million as of June 30, 2018 and December 31, 2017. 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, 2018 and December 31, 2017.

33


Table of Contents

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

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 $370.3 million and $348.5 million as of June 30, 2018 and December 31, 2017, respectively. At June 30, 2018 and December 31, 2017, the Company had approximately $204.1 million and $189.1 million, respectively, in borrowing capacity available under these arrangements with no outstanding balance as of June 30, 2018 and December 31, 2017.
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 2018. 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.
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 U.S. 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.

34


Table of Contents

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

Equity warrant assets: Fair value measurements of equity warrant assets of private companies are priced based on a Black-Scholes option pricing model to estimate the asset value by using stated strike prices, option expiration dates, risk-free interest rates and option volatility assumptions. Option volatility assumptions used in the Black-Scholes model are based on public companies that operate in similar industries as the companies in our private company portfolio. Option expiration dates are modified to account for estimates to actual life relative to stated expiration. Values are further adjusted for a general lack of liquidity due to the private nature of the associated underlying company. The Company classifies equity warrant assets within Level 3 of the valuation hierarchy.
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.
Recurring Fair Value
The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.
June 30, 2018
Total
 
Level 1
 
Level 2
 
Level 3
Investment securities available-for-sale
 
 
 
 
 
 
 
US treasury securities
$
4,952

 
$

 
$
4,952

 
$

US government agencies
32,501

 

 
32,501

 

Residential mortgage-backed securities
345,437

 

 
345,437

 

Mutual fund
2,053

 

 
2,053

 

Servicing assets1
52,689

 

 

 
52,689

Equity warrant assets
399

 

 

 
399

Total assets at fair value
$
438,031

 
$

 
$
384,943

 
$
53,088

 
 
 
 
 
 
 
 
Contingent consideration liability2
$
1,640

 
$

 
$

 
$
1,640

Total liabilities at fair value
$
1,640

 
$

 
$

 
$
1,640

December 31, 2017
Total
 
Level 1
 
Level 2
 
Level 3
Investment securities available-for-sale
 
 
 
 
 
 
 
US government agencies
$
22,624

 
$

 
$
22,624

 
$

Residential mortgage-backed securities
68,696

 

 
68,696

 

Mutual fund
2,035

 

 
2,035

 

Servicing assets1
52,298

 

 

 
52,298

Total assets at fair value
$
145,653

 
$

 
$
93,355

 
$
52,298

 
 
 
 
 
 
 
 
Contingent consideration liability2
$
1,900

 
$

 
$

 
$
1,900

Total liabilities at fair value
$
1,900

 
$

 
$

 
$
1,900

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
Activity for the contingent consideration liability during the six months ended June 30, 2018 consisted of a $260 thousand negative fair value adjustment. There was no activity for the contingent consideration liability during the three months ended June 30, 2018. During the three months ended June 30, 2017, the Company recorded a $150 thousand positive fair value adjustment. During the six months ended June 30, 2017, $4.3 million of contingent consideration was recorded upon the acquisition of Reltco as well as $350 thousand positive fair value adjustments.

35


Table of Contents

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

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, 2018
Total
 
Level 1
 
Level 2
 
Level 3
Impaired loans and leases
$
56,012

 
$

 
$

 
$
56,012

Foreclosed assets
1,725

 

 

 
1,725

Total assets at fair value
$
57,737

 
$

 
$

 
$
57,737

December 31, 2017
Total
 
Level 1
 
Level 2
 
Level 3
Impaired loans and leases
$
34,493

 
$

 
$

 
$
34,493

Foreclosed assets
1,281

 

 

 
1,281

Total assets at fair value
$
35,774

 
$

 
$

 
$
35,774

Level 3 Analysis
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2018 and December 31, 2017 the significant unobservable inputs used in the fair value measurements were as follows:
June 30, 2018
Level 3 Assets with Significant
Unobservable Inputs
 
Fair Value
 
Valuation Technique
 
Significant
Unobservable
Inputs
 
Range
Impaired loans and leases
 
$
56,012

 
Discounted appraisals
Discounted expected cash flows
 
Appraisal adjustments (1)
Interest rate & repayment term
 
10% to 48% Weighted average discount rate 6.93%
Foreclosed assets
 
$
1,725

 
Discounted appraisals
 
Appraisal adjustments (1)
 
9% to 37%
Equity warrant assets
 
$
399

 
Black-Scholes option pricing model

 
Volatility
Risk-free interest rate
Marketability discount
Remaining life
 
20.10%
2.85%
20%
9 years
Contingent consideration liability
 
$
1,640

 
Monte Carlo simulation
 
Volatility
Risk-free rate of return
Dividend yield
Remaining life
 
25.00%
2.09%
0.43%
2.75 years
December 31, 2017
Level 3 Assets with Significant
Unobservable Inputs
 
Fair Value
 
Valuation Technique
 
Significant
Unobservable
Inputs
 
Range
Impaired loans and leases
 
$
34,493

 
Discounted appraisals
Discounted expected cash flows
 
Appraisal adjustments (1)
Interest rate & repayment term
 
10% to 25% Weighted average discount rate 6.26%
Foreclosed assets
 
$
1,281

 
Discounted appraisals
 
Appraisal adjustments (1)
 
10% to 37%
Contingent consideration liability
 
$
1,900

 
Monte Carlo simulation
 
Volatility
Risk-free rate of return
Dividend yield
Remaining life
 
25.00%
1.43%
0.51%
3.00 years
(1)
Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments.

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

Estimated Fair Value of Other Financial Instruments
GAAP also requires disclosure of the fair value of financial instruments carried at book value on the consolidated balance sheet. The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:
June 30, 2018
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
$
392,941

 
$
392,941

 
$

 
$

 
$
392,941

Certificates of deposit with other banks
2,250

 
2,243

 

 

 
2,243

Investment securities, available-for-sale
384,943

 

 
384,943

 

 
384,943

Loans held for sale(1)
757,494

 

 

 
772,006

 
772,006

Loans and leases, net of allowance for loan and lease losses(1)
1,505,018

 

 

 
1,500,415

 
1,500,415

Servicing assets
52,689

 

 

 
52,689

 
52,689

Accrued interest receivable
13,807

 
13,807

 

 

 
13,807

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
2,969,236

 

 
2,910,479

 

 
2,910,479

Accrued interest payable
534

 
534

 

 

 
534

Long term borrowings
3,385

 

 

 
3,399

 
3,399

December 31, 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
$
295,271

 
$
295,271

 
$

 
$

 
$
295,271

Certificates of deposit with other banks
3,000

 
2,993

 

 

 
2,993

Investment securities, available-for-sale
93,355

 

 
93,355

 

 
93,355

Loans held for sale (1)
680,454

 

 

 
706,972

 
706,972

Loans and leases, net of allowance for loan and lease losses(1)
1,319,783

 

 

 
1,319,615

 
1,319,615

Servicing assets
52,298

 

 

 
52,298

 
52,298

Accrued interest receivable
10,160

 
10,160

 

 

 
10,160

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
2,260,263

 

 
2,232,370

 

 
2,232,370

Accrued interest payable
367

 
367

 

 

 
367

Long term borrowings
26,564

 

 

 
27,390

 
27,390

(1)
In accordance with the adoption of ASU 2016-01, as of June 30, 2018, the fair value of loans and leases were measured using an exit price notion. As of December 31, 2017, the fair value of loans and leases were measured using an entry price notion.
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.

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

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,
2018
 
December 31,
2017
Commitments to extend credit
$
1,349,217

 
$
1,701,137

Standby letters of credit
2,636

 
2,298

Solar purchase commitments
49,844

 
106,921

Airplane purchase agreement commitments
19,450

 
25,450

Total unfunded off-balance-sheet credit risk
$
1,421,147

 
$
1,835,806

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.
Solar purchase commitments are to purchase solar assets to fulfill leasing obligations.
As of June 30, 2018 and December 31, 2017, the Company had unfunded commitments to provide capital contributions for on-balance sheet investments in the amount of $3.3 million and $3.5 million, respectively.
Concentrations of Credit Risk
Although the Company is not subject to any geographic concentrations, a substantial amount of the Company’s loans, leases, 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 5. 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 $7.5 million, except for nine relationships that have a retained unguaranteed exposure of $109.3 million of which $100.3 million of the unguaranteed exposure has been disbursed.
Additionally, the Company has future minimum lease payments due under non-cancelable operating leases totaling $82.7 million, of which $62.1 million is due from four relationships.
The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.


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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. On May 15, 2018, the Amended and Restated 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 8,750,000 common voting shares. 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, 2018 and 2017, the Company recognized $347 thousand and $468 thousand in compensation expense for stock options, respectively. For the six months ended June 30, 2018 and 2017, the Company recognized $780 thousand and $882 thousand in compensation expense for stock options, respectively.
Stock option activity under the Plan during the six month periods ended June 30, 2018 and 2017 is summarized below.
 
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at December 31, 2017
3,058,459

 
$
11.30

 
 
 
 
Exercised
144,671

 
8.66

 
 
 
 
Forfeited
134,623

 
14.11

 
 
 
 
Granted

 

 
 
 
 
Outstanding at June 30, 2018
2,779,165

 
$
11.30

 
6.54 years
 
$
53,786,948

Exercisable at June 30, 2018
727,697

 
$
9.83

 
6.27 years
 
$
15,148,795

 
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


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

The following is a summary of non-vested stock option activity for the Company for the six months ended June 30, 2018 and 2017.
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Non-vested at December 31, 2017
2,364,999

 
$
4.65

Granted

 

Vested
(178,908
)
 
2.95

Forfeited
(134,623
)
 
6.26

Non-vested at June 30, 2018
2,051,468

 
4.79

 
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

The total intrinsic value of options exercised at June 30, 2018 and 2017 was $2.9 million and $867 thousand, respectively.
At June 30, 2018, unrecognized compensation costs relating to stock options amounted to $7.2 million which will be recognized over a weighted average period of 2.42 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, 2018 or 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 $48.00 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.

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

RSU stock activity under the Plan during the first six months of 2018 is summarized below.
 
Shares
 
Weighted
Average Grant
Date Fair Value
Non-vested at December 31, 2017
181,814

 
$
20.03

Granted
152,422

 
28.01

Vested
(56,799
)
 
26.54

Forfeited
(11,320
)
 
23.36

Non-vested at June 30, 2018
266,117

 
23.07

For the three months ended June 30, 2018 and 2017, the Company recognized $921 thousand and $167 thousand in compensation expense for RSUs, respectively. For the six months ended June 30, 2018 and 2017, the Company recognized $1.8 million and $326 thousand in compensation expense for RSUs, respectively.
At June 30, 2018, unrecognized compensation costs relating to RSUs amounted to $5.3 million which will be recognized over a weighted average period of 4.78 years.
Market RSU stock activity under the Plan during the first six months of 2018 is summarized below.
 
Shares
 
Weighted
Average Grant
Date Fair Value
Non-vested at December 31, 2017
2,532,808

 
$
8.78

Granted
75,000

 
17.51

Vested

 

Forfeited
(216,019
)
 
9.06

Non-vested at June 30, 2018
2,391,789

 
9.03

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 75,000 Market RSUs granted on May 14, 2018, 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 3.3 years. The Monte Carlo Simulation used various assumptions that included a risk free rate of return of 2.96%, expected volatility of 27.00% and a dividend yield of 0.42%.
For the three months ended June 30, 2018 and 2017, the Company recognized $947 thousand and $1.2 million in compensation expense for Market RSUs, respectively. For the six months ended June 30, 2018 and 2017, the Company recognized $1.9 million and $2.4 million in compensation expense for Market RSUs, respectively.
At June 30, 2018, unrecognized compensation costs relating to Market RSUs amounted to $13.5 million which will be recognized over a weighted average period of 2.56 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. There was no expense recognized in relation to the ESPP for the three months ended June 30, 2018 and 2017. For the six months ended June 30, 2018 and 2017 the Company recognized $29 thousand and $43 thousand expense, respectively.


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

Note 13. Subsequent Event
On August 1, 2018, the Company financed the sale of its entire interest in Reltco, Inc. and National Assurance Title, Inc. for $3.0 million.  Finalization of Reltco's financial records as of August 1, 2018, is still in process.  Accordingly, accounting for the financial impact of this divestiture is still in process.  Based on initial estimates, the Company anticipates this sale to result in a net cost of approximately $2.5 million

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Table of Contents

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, 2017 (the "2017 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;

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Table of Contents

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 2017 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. The Bank identifies and grows within selected industry sectors, or verticals, by leveraging expertise within those industries, and more broadly to select borrowers outside of 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 2017, the Bank entered into a joint venture, Apiture LLC (“Apiture”), with First Data Corporation for the purpose of creating next generation technology for financial institutions. 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. (formerly known as “Canapi, 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. In addition, the Company owned Reltco Inc. and National Assurance Title, Inc. (collectively referred to as “Reltco”) until the Company sold Reltco on August 1, 2018. See Note 13 - Subsequent Event for more information.

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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 net 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 with a secondary offering completed in August of 2017.
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 the loan and lease portfolio to continue to grow and to maintain an effective tax rate in the very low single digit range for the full year of 2018.
Results of Operations
Performance Summary
Three months ended June 30, 2018 compared with three months ended June 30, 2017
For the three months ended June 30, 2018, the Company reported net income of $14.3 million, or $0.34 per diluted share, as compared to $9.8 million, or $0.27 per diluted share, for the three months ended June 30, 2017. This increase in net income is primarily due to the following items:
Increased net interest income of $8.7 million, or 47.1%, predominately driven by significant growth in the combined held for sale and held for investment loan and lease portfolios;
Increased net gains on sales of loans of $4.9 million, or 26.9%, as a result of higher loan sale volumes partially offset by lower average premiums;
Increased lease income of $1.9 million for lease activities that began in the second quarter of 2017; and
Increased loan servicing revenue of $791 thousand, or 12.8%, attributable to a higher serviced loan portfolio.
Partially offsetting the above factors was a decline in title insurance income of $1.4 million combined with increases in various cost factors as follows: $531 thousand in the provision expense for loan and lease losses, $2.5 million in the loan servicing asset revaluation loss, $4.2 million in salaries and employee benefits, $1.0 million in data processing expense, and $1.7 million in equipment expense.
Six months ended June 30, 2018 compared with six months ended June 30, 2017
For the six months ended June 30, 2018, the Company reported net income of $26.7 million, or $0.64 per diluted share, as compared to $15.9 million, or $0.44 per diluted share, for the six months ended June 30, 2017. This increase in net income is primarily attributable to the following items:
Increased net interest income of $17.5 million, or 51.4%, predominately driven by significant growth in the loans and leases held for sale and held for investment portfolios;
Increased loan servicing revenue of $1.8 million, or 14.6%, as a result of continued growth in the servicing portfolio due to ongoing loan sales;
Increased net gains on sales of loans of $10.4 million, or 27.9%, due to a higher year-to-date sale volume partially offset by a slight decrease in the average net gain per loan sold; and
Increased lease income of $3.5 million for operating lease activities that began in the second quarter of 2017.
Partially offsetting the above factors that contributed to increased levels of net income was a $3.4 million increase in provision expense for loan and lease losses, $12.6 million increase in noninterest expense, largely comprised of the effects of continued investments to support growing levels of business and business diversification, an increase of $5.6 million in the loan servicing asset revaluation loss, and a $1.5 million decrease in title insurance income.

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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 it incurs on 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, 2018 compared with three months ended June 30, 2017
For the three months ended June 30, 2018, net interest income increased $8.7 million, or 47.1%, to $27.0 million compared to $18.4 million for the three months ended June 30, 2017. This increase was principally due to the significant growth in average interest earning assets, predominately loans and leases, and to a lesser extent by higher yields on these assets which outpaced the growth and change in the cost of interest bearing liabilities, primarily related to deposits. Average interest earning assets increased by $1.26 billion, or 66.7%, to $3.14 billion for the three months ended June 30, 2018, compared to $1.88 billion for the three months ended June 30, 2017, while the yield on average interest earning assets increased five basis points to 5.24%. The cost of funds on interest bearing liabilities for the three months ended June 30, 2018 increased fifty-two basis points to 1.86%, and the average balance of interest bearing liabilities increased by $1.21 billion, or 68.2%, over the same period in 2017. As indicated in the rate/volume table below, the increase in interest earning assets and corresponding yields outpaced the higher volume of interest bearing liabilities along with an increasing cost of funds, resulting in increased interest income of $16.6 million and increased interest expense of $8.0 million for the three months ended June 30, 2018 compared to the three months ended June 30, 2017. For the three months ended June 30, 2018 compared to the three months ended June 30, 2017, net interest margin declined from 3.92% to 3.46%, respectively, principally due to the narrowing of the interest rate spread during the quarter. This short-term compression of the spread was largely the result of strategic liquidity initiatives which were accomplished during the first quarter of 2018 which led to much higher levels of investment securities and cash balances held with other banks.
Six months ended June 30, 2018 compared with six months ended June 30, 2017
For the six months ended June 30, 2018, net interest income increased $17.5 million, or 51.4%, to $51.5 million compared to $34.0 million for the six months ended June 30, 2017. This increase was 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 $1.12 billion, or 62.8%, to $2.91 billion for the six months ended June 30, 2018 compared to $1.79 billion for the six months ended June 30, 2017, while the yield on average interest earning assets increased by twenty-one basis points to 5.27%. The cost of funds on interest bearing liabilities for the six months ended June 30, 2018 increased by fifty basis points to 1.79%, and the average balance of interest bearing liabilities increased by $1.09 billion, or 65.0%, 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 $31.2 million and increased interest expense of $13.7 million for the six months ended June 30, 2018. For the six months ended June 30, 2018 compared to the six months ended June 30, 2017, net interest margin declined from 3.84% to 3.58% due to the aforementioned effects.

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Table of Contents

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,
 
 
2018
 
2017
 
 
Average Balance
 
 Interest
 
Average Yield/Rate
 
Average Balance
 
 Interest
 
Average Yield/Rate
Interest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
 
$
505,351

 
$
2,179

 
1.73
%
 
$
199,904

 
$
470

 
0.94
%
Investment securities
 
383,154

 
2,530

 
2.65

 
69,544

 
316

 
1.82

Loans held for sale
 
744,789

 
11,937

 
6.43

 
562,984

 
8,226

 
5.86

Loans and leases held for investment (1)
 
1,504,738

 
24,330

 
6.49

 
1,050,074

 
15,333

 
5.86

Total interest earning assets
 
3,138,032

 
40,976

 
5.24

 
1,882,506

 
24,345

 
5.19

Less: allowance for loan and lease losses
 
(27,930
)
 
 
 
 
 
(18,198
)
 
 
 
 
Non-interest earning assets
 
424,100

 
 
 
 
 
209,484

 
 
 
 
Total assets
 
$
3,534,202

 
 
 
 
 
$
2,073,792

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
 
$
36,926

 
$
100

 
1.09
%
 
$
40,541

 
$
57

 
0.56
%
Savings
 
998,521

 
4,061

 
1.63

 
3,809

 
12

 
1.26

Money market accounts
 
151,880

 
463

 
1.22

 
475,265

 
1,114

 
0.94

Certificates of deposit
 
1,806,063

 
9,303

 
2.07

 
1,219,542

 
4,409

 
1.45

Total deposits
 
2,993,390

 
13,927

 
1.87

 
1,739,157

 
5,592

 
1.29

Other borrowings
 
3,488

 
1

 
0.11

 
42,765

 
361

 
3.39

Total interest bearing liabilities
 
2,996,878

 
13,928

 
1.86

 
1,781,922

 
5,953

 
1.34

Non-interest bearing deposits
 
53,922

 
 
 
 
 
32,718

 
 
 
 
Non-interest bearing liabilities
 
21,217

 
 
 
 
 
22,165

 
 
 
 
Shareholders' equity
 
462,185

 
 
 
 
 
236,987

 
 
 
 
Total liabilities and shareholders' equity
 
$
3,534,202

 
 
 
 
 
$
2,073,792

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and interest rate spread
 
 
 
$
27,048

 
3.38
%
 

 
$
18,392

 
3.85
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
 
3.46

 
 
 
 
 
3.92

 
 
 
 
 
 
 
 
 
 
 
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
 
 
 
 
 
104.71
%
 
 
 
 
 
105.64
%
(1)
Average loan and lease balances include non-accruing loans.

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Table of Contents

 
 
Six months ended June 30,
 
 
2018
 
2017
 
 
Average Balance
 
Interest
 
Average Yield/Rate
 
Average Balance
 
Interest
 
Average Yield/Rate
Interest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
 
$
430,107

 
$
3,394

 
1.59
%
 
$
197,056

 
$
812

 
0.83
%
Investment securities
 
283,083

 
3,647

 
2.60

 
70,306

 
639

 
1.83

Loans held for sale
 
736,323

 
23,085

 
6.32

 
514,920

 
14,777

 
5.79

Loans and leases held for investment(1)
 
1,456,659

 
45,873

 
6.35

 
1,002,932

 
28,536

 
5.74

Total interest earning assets
 
2,906,172

 
75,999

 
5.27

 
1,785,214

 
44,764

 
5.06

Less: allowance for loan and lease losses
 
(26,085
)
 
 
 
 
 
(18,199
)
 
 
 
 
Non-interest earning assets
 
410,585

 
 
 
 
 
188,679

 
 
 
 
Total assets
 
$
3,290,672

 
 
 
 
 
$
1,955,694

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
 
$
40,243

 
$
203

 
1.02
%
 
$
42,436

 
$
121

 
0.57
%
Savings
 
910,880

 
7,179

 
1.59

 
1,915

 
12

 
1.26

Money market accounts
 
160,370

 
983

 
1.24

 
477,393

 
2,062

 
0.87

Certificates of deposit
 
1,640,479

 
15,980

 
1.96

 
1,115,307

 
7,940

 
1.44

Total deposits
 
2,751,972

 
24,345

 
1.78

 
1,637,051

 
10,135

 
1.25

Other borrowings
 
7,336

 
130

 
3.57

 
35,457

 
596

 
3.39

Total interest bearing liabilities
 
2,759,308

 
24,475

 
1.79

 
1,672,508

 
10,731

 
1.29

Non-interest bearing deposits
 
55,252

 
 
 
 
 
30,713

 
 
 
 
Non-interest bearing liabilities
 
20,125

 
 
 
 
 
22,104

 
 
 
 
Shareholders’ equity
 
455,987

 
 
 
 
 
230,369

 
 
 
 
Noncontrolling interest
 

 
 
 
 
 

 
 
 
 
Total liabilities and shareholders’ equity
 
$
3,290,672

 
 
 
 
 
$
1,955,694

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and interest rate spread
 
 
 
$
51,524

 
3.48
%
 
 
 
$
34,033

 
3.77
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
 
3.58

 
 
 
 
 
3.84

 
 
 
 
 
 
 
 
 
 
 
 
 
Ratio of average interest-earning assets to average interest-bearing liabilities
 
 
 
 
 
105.32
%
 
 
 
 
 
106.74
%
(1)
Average loan and lease balances include non-accruing loans.

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Table of Contents

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,
 
2018 vs. 2017
 
2018 vs. 2017
 
Increase (Decrease) Due to
 
Increase (Decrease) Due to
 
Rate
 
Volume
 
Total
 
Rate
 
Volume
 
Total
Interest income:
 
 
 
 
 
 
 
 
 
 
 
Interest earning balances in other banks
$
691

 
$
1,018

 
$
1,709

 
$
1,182

 
$
1,400

 
$
2,582

Investment securities
466

 
1,748

 
2,214

 
670

 
2,338

 
3,008

Loans held for sale
926

 
2,785

 
3,711

 
1,660

 
6,648

 
8,308

Loans and leases held for investment
2,002

 
6,995

 
8,997

 
3,738

 
13,599

 
17,337

Total interest income
4,085

 
12,546

 
16,631

 
7,250

 
23,985

 
31,235

Interest expense:
 
 
 
 
 
 
 
 
 
 
 
Interest bearing checking
50

 
(7
)
 
43

 
91

 
(9
)
 
82

Savings
459

 
3,590

 
4,049

 
737

 
6,430

 
7,167

Money market accounts
221

 
(872
)
 
(651
)
 
577

 
(1,656
)
 
(1,079
)
Certificates of deposit
2,323

 
2,571

 
4,894

 
3,613

 
4,427

 
8,040

Other borrowings
(177
)
 
(183
)
 
(360
)
 
13

 
(479
)
 
(466
)
Total interest expense
2,876

 
5,099

 
7,975

 
5,031

 
8,713

 
13,744

Net interest income
$
1,209

 
$
7,447

 
$
8,656

 
$
2,219

 
$
15,272

 
$
17,491

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.
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 serve to reduce 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.
The provision for loan and lease losses for the second quarter of 2018 was $2.1 million compared to $1.6 million for the same period in 2017, an increase of $531 thousand, or 34.1%. For the six months ended June 30, 2018 the provision was $6.5 million compared to $3.1 million for the same period in 2017, an increase of $3.4 million, or 112.1%. The increase in the provision for loan and lease losses for both quarter over quarter and year to year periods was largely driven by overall loan and lease growth and higher levels of loans with classified risk grades.
Loans and leases held for investment of $1.53 billion as of June 30, 2018 increased by $449.9 million, or 41.5%, compared to June 30, 2017. This growth was fueled by strong loan origination volumes and continued disbursements for loans in the construction portfolio over the past year in conjunction with the Company's prior decision to retain a greater portion of loans on its consolidated balance sheet.
Net charge-offs were $787 thousand, or 0.21% of average quarterly loans and leases held for investment on an annualized basis, for the three months ended June 30, 2018, compared to net charge-offs of $191 thousand, or 0.07%, for the three months ended June 30, 2017. Net charge-offs for the first six months of 2018 and 2017 totaled $1.3 million and $1.7 million, respectively. Year to date net charge-offs as a percentage of year to date average loans held for investment were 0.09% and 0.17% at June 30, 2018 and 2017, 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, 2018, nonperforming loans and leases not guaranteed by the SBA totaled $11.5 million, which was 0.75% of the held-for-investment loan and lease portfolio compared to $3.6 million, or 0.33% of loans and leases held for investment at June 30, 2017.

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Table of Contents

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. Noninterest income also commonly includes lease income, construction supervision fee income and title insurance income. 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)
 
2018
 
2017
 
Amount
 
Percent
Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
$
6,965

 
$
6,174

 
$
791

 
12.81
 %
Loan servicing asset revaluation
(3,670
)
 
(1,164
)
 
(2,506
)
 
(215.29
)
Net gains on sales of loans
23,061

 
18,176

 
4,885

 
26.88

Lease income
1,920

 
9

 
1,911

 
21,233.33

Construction supervision fee income
597

 
286

 
311

 
108.74

Title insurance income
996

 
2,397

 
(1,401
)
 
(58.45
)
Other noninterest income
744

 
789

 
(45
)
 
(5.70
)
Total noninterest income
$
30,613

 
$
26,667

 
$
3,946

 
14.80
 %
 
Six Months Ended
June 30,
 
Increase (Decrease)
 
2018
 
2017
 
Amount
 
Percent
Noninterest income
 
 
 
 
 
 
 
Loan servicing revenue
$
13,863

 
$
12,097

 
$
1,766

 
14.60
 %
Loan servicing asset revaluation
(8,758
)
 
(3,173
)
 
(5,585
)
 
(176.02
)
Net gains on sales of loans
47,479

 
37,128

 
10,351

 
27.88

Lease income
3,528

 
9

 
3,519

 
39,100.00

Construction supervision fee income
1,376

 
715

 
661

 
92.45

Title insurance income
2,296

 
3,835

 
(1,539
)
 
(40.13
)
Other noninterest income
1,585

 
1,809

 
(224
)
 
(12.38
)
Total noninterest income
$
61,369

 
$
52,420

 
$
8,949

 
17.07
 %
For the three months ended June 30, 2018, noninterest income increased by $3.9 million, or 14.8%, compared to the three months ended June 30, 2017. The increase from the prior year is primarily the result of net gains on sales of loans increasing $4.9 million to $23.1 million in the second quarter of 2018 compared to $18.2 million in the second quarter of 2017, as a function of higher volume of guaranteed loan sales offset by a lower average net gain on sale of guaranteed loans. The latter is primarily a function of the mix of loans sold. Lease income of $1.9 million related to renewable energy initiatives that began in the second quarter of 2017 and increased loan servicing revenues of $791 thousand arising from growth in the serviced loan portfolio also contributed to higher levels of noninterest income in the second quarter of 2018. Partially offsetting the overall increase in noninterest income was a higher negative loan servicing revaluation adjustment of $2.5 million and a decrease in title insurance income of $1.4 million.
For the six months ended June 30, 2018, noninterest income increased by $8.9 million, or 17.1%, compared to the six months ended June 30, 2017. 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 $1.8 million of increased servicing revenue and $10.4 million of increased net gains on sale of loans. Also contributing to increased levels of noninterest income was $3.5 million of operating lease income. Partly offsetting the overall increase in noninterest income was a higher negative loan servicing revaluation adjustment of $5.6 million and a decline in title insurance income of $1.5 million.

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Table of Contents

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,
 
2018
 
2017
 
2018
 
2017
Amount of loans and leases originated
$
491,797

 
$
586,471

 
$
397,559

 
$
468,663

Guaranteed portions of loans sold
295,216

 
203,714

 
247,243

 
208,715

Outstanding balance of guaranteed loans sold (1)
2,951,379

 
2,521,506

 
2,812,108

 
2,410,791

 
Six months ended June 30,
 
For years ended December 31,
 
2018
 
2017
 
2017
 
2016
 
2015
 
2014
Amount of loans and leases originated
$
889,356

 
$
1,055,134

 
$
1,934,238

 
$
1,537,010

 
$
1,158,640

 
$
848,090

Guaranteed portions of loans sold
542,459

 
412,429

 
787,926

 
761,933

 
640,886

 
433,912

Outstanding balance of guaranteed loans sold (1)
2,951,379

 
2,521,506

 
2,680,641

 
2,278,618

 
1,779,989

 
1,302,828

(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, 2018, loan servicing revenue increased $791 thousand, or 12.8%, and $1.8 million, or 14.6%, respectively, as compared to the three and six months ended June 30, 2017, as a result of an increase in the average outstanding balance of guaranteed loans sold. At June 30, 2018, the outstanding balance of government guaranteed loans sold in the secondary market was $2.95 billion. At June 30, 2017, the outstanding balance of SBA guaranteed loans sold was $2.52 billion.
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, 2018, there was a net negative loan servicing revaluation adjustment of $3.7 million compared to a net negative revaluation adjustment of $1.2 million for the three months ended June 30, 2017. For the six months ended June 30, 2018, there was a net negative loan servicing revaluation adjustment of $8.8 million compared to a net negative revaluation adjustment of $3.2 million for the six months ended June 30, 2017. The higher negative loan servicing revaluation amount for the second quarter of 2018 as compared to the second quarter of 2017 was principally driven by amortization of the serviced portfolio during that period.
Net Gains on Sale of Loans: For the three and six months ended June 30, 2018, net gains on sales of loans increased $4.9 million, or 26.9%, and $10.4 million, or 27.9%, compared to the three and six months ended June 30, 2017. For the three months ended June 30, 2018, the volume of guaranteed loans sold increased $91.5 million, or 44.9%, to $295.2 million from $203.7 million for the three months ended June 30, 2017. For the six months ended June 30, 2018, the volume of guaranteed loans sold increased $130.0 million, or 31.5%, to $542.5 million from $412.4 million for the six months ended June 30, 2017. The volume-driven increases in the year-to-date net gain on loan sale comparisons were partially offset by lower average premiums paid in the secondary market primarily due to changes in the mix of loans sold. The average net gain on sale of loans for the three and six months ended June 30, 2018 was lower at $83 thousand and $90 thousand of revenue for each $1 million in loans sold, respectively, compared to $92 thousand and $91 thousand of revenue for each $1 million in loans sold for the three and six months ended June 30, 2017.

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Table of Contents

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)
 
2018
 
2017
 
Amount
 
Percent
Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
$
22,146

 
$
17,968

 
$
4,178

 
23.25
 %
Non-staff expenses:
 
 
 
 
 
 
 
Travel expense
2,041

 
2,148

 
(107
)
 
(4.98
)
Professional services expense
1,119

 
1,424

 
(305
)
 
(21.42
)
Advertising and marketing expense
1,868

 
1,976

 
(108
)
 
(5.47
)
Occupancy expense
1,882

 
1,350

 
532

 
39.41

Data processing expense
2,906

 
1,858

 
1,048

 
56.40

Equipment expense
3,368

 
1,703

 
1,665

 
97.77

Other loan origination and maintenance expense
1,414

 
981

 
433

 
44.14

FDIC insurance
1,010

 
724

 
286

 
39.50

Title insurance closing services expense
372

 
785

 
(413
)
 
(52.61
)
Other expense
2,704

 
2,383

 
321

 
13.47

Total non-staff expenses
18,684

 
15,332

 
3,352

 
21.86

Total noninterest expense
$
40,830

 
$
33,300

 
$
7,530

 
22.61
 %
 
Six Months Ended
June 30,
 
Increase (Decrease)
 
2018
 
2017
 
Amount
 
Percent
Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
$
42,355

 
$
36,650

 
$
5,705

 
15.57
 %
Non-staff expenses:
 
 
 
 
 
 
 
Travel expense
3,884

 
3,746

 
138

 
3.68

Professional services expense
2,417

 
3,160

 
(743
)
 
(23.51
)
Advertising and marketing expense
3,530

 
3,461

 
69

 
1.99

Occupancy expense
3,739

 
2,545

 
1,194

 
46.92

Data processing expense
5,743

 
3,554

 
2,189

 
61.59

Equipment expense
6,445

 
2,777

 
3,668

 
132.08

Other loan origination and maintenance expense
2,743

 
1,986

 
757

 
38.12

FDIC insurance
1,582

 
1,450

 
132

 
9.10

Title insurance closing services expense
798

 
1,190

 
(392
)
 
(32.94
)
Other expense
5,666

 
5,766

 
(100
)
 
(1.73
)
Total non-staff expenses
36,547

 
29,635

 
6,912

 
23.32

Total noninterest expense
$
78,902

 
$
66,285

 
$
12,617

 
19.03
 %
Total noninterest expense for the three and six months ended June 30, 2018 increased $7.5 million, or 22.6%, and $12.6 million or 19.0%, compared to the same periods in 2017. The increase in noninterest expense was principally comprised of increased personnel, occupancy, data processing and equipment expense driven by the significant growth of the Company's core business. Changes in various components of noninterest expense are discussed below.

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Salaries and employee benefits: Total personnel expense for the three and six months ended June 30, 2018 increased by $4.2 million, or 23.3%, and $5.7 million, or 15.6%, respectively, compared to the same periods in 2017. The primary drivers for this increase was the continued investment in human capital to support the growing loan and lease production from new and existing verticals partially offset by transferring the recognition of costs associated with software development to data processing expense with the formation of Apiture. Total full-time equivalent employees increased from 517 at June 30, 2017 to 522 at June 30, 2018. Salaries and employee benefits expense included $2.2 million and $1.9 million of stock-based compensation in the three months ended June 30, 2018 and 2017, respectively and $4.6 million and $3.9 million for the six months ended June 30, 2018 and 2017, respectively. Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.
Of the total stock-based compensation, $357 thousand for the second quarter and $709 thousand for the first half of 2018 and $378 thousand for the second quarter and $724 thousand for the first half 2017, respectively, included in salaries and employee benefits were related to restricted stock unit ("RSU") awards for key employee retention with an effective grant date of May 24, 2016.
Occupancy expense: For the three and six months ended June 30, 2018, total occupancy expense increased $532 thousand, or 39.4%, and $1.2 million, or 46.9%, respectively, compared to the same periods in 2017. This increase was driven by continued investment in facilities and infrastructure to support the Company's growth initiatives.
Data processing expense: For the three and six months ended June 30, 2018, total data processing expense increased $1.1 million, or 56.4%, and $2.2 million, or 61.6%, respectively, compared to the same periods in 2017. Largely influencing this increase in data processing was the contribution of software development resources to Apiture which transferred the recognition of costs associated with the Company’s technology development from salaries and employee benefits to data processing.
Equipment expense: For the three and six months ended June 30, 2018, the total costs associated with equipment increased $1.7 million, or 97.8%, and $3.7 million, or 132.1%, respectively, compared to the same periods in 2017. A major factor behind this increase was the depreciation of solar panels arising from operating lease activities that began in the second quarter of 2017.
Income Tax Expense
The effective tax rates for the three and six months ended June 30, 2018 was 3.3% and 2.9%, respectively, compared to the effective rates of 4.0% and 7.0% for the three and six months ended June 30, 2017, respectively. The tax rate 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.
Discussion and Analysis of Financial Condition
June 30, 2018 vs. December 31, 2017
Total assets at June 30, 2018 were $3.47 billion, an increase of $714.5 million, or 25.9%, compared to total assets of $2.76 billion at December 31, 2017. The growth in total assets was principally driven by the following:
Increased cash and due from banks largely due to the significant growth from deposit gathering campaigns that generated $709.0 million in new deposits and were designed to strengthen the liquidity profile;
Increased investment in securities available-for-sale of $291.6 million which was driven by the Company's strategic plan to enhance contingency funding sources;
Growth in loan and lease portfolio of $267.4 million due to newly originated loans combined with longer retention times of loans held for sale; and
Increased premises and equipment of $56.0 million related primarily to expansion of facilities to accommodate Company growth and the addition of solar panels to meet leasing commitments.
Cash and cash equivalents were $392.9 million at June 30, 2018, an increase of $97.7 million, or 33.1%, compared to $295.3 million at December 31, 2017. This increase primarily reflected the results of successful deposit gathering campaigns and the sale of loans.
Total investment securities increased $291.6 million during the first six months of 2018, from $93.4 million at December 31, 2017, to $384.9 million at June 30, 2018, an increase of 312.3%. The Company increased its investment securities during the first and second quarter of 2018 as part of the aforementioned strategic plan to enhance contingent funding sources. The investment portfolio is comprised of U.S. government agency securities, residential mortgage-backed securities and a mutual fund.

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Loans held for sale increased $77.1 million, or 11.3%, during the first six months of 2018, from $680.5 million at December 31, 2017, to $757.5 million at June 30, 2018. The increase was primarily the result of loan origination activities and the strategy to enhance interest income by increasing the retention time of guaranteed loans along with growth in certain loans that take time to fully fund.
Loans and leases held for investment increased $190.4 million, or 14.2%, during the first six months of 2018, from $1.34 billion at December 31, 2017, to $1.53 billion at June 30, 2018. The increase was primarily the result of continued loan and lease growth from origination activities during the first and second quarter of 2018 combined with greater retention of loans on the consolidated balance sheet.
Premises and equipment, net increased $56.0 million, or 31.3%, during the first six months of 2018. This increase was primarily driven by construction of new facilities to accommodate Company growth and the addition of solar panels to meet leasing commitments.
Other assets increased $6.9 million, or 5.1%, during the first six months of 2018, from $134.2 million at December 31, 2017 to $141.1 million at June 30, 2018. The increase in other assets was primarily comprised of $3.6 million in accrued interest receivable and a $3.0 million cost method investment by Canapi in a financial services startup.
Total deposits were $2.97 billion at June 30, 2018, an increase of $709.0 million, or 31.4%, from $2.26 billion at December 31, 2017. The increase in deposits was driven by the combined success of deposit gathering campaigns to support the growth in loan and lease originations and strategic liquidity initiatives.
Long term borrowings decreased $23.2 million, or 87.3%, during the first six months of 2018, from $26.6 million at December 31, 2017 to $3.4 million at June 30, 2018. The decrease in long term borrowings was primarily the result of significant debt reductions during the first quarter of 2018, largely funded by capital raised in the third quarter of 2017.
Shareholders’ equity at June 30, 2018 was $463.0 million as compared to $436.9 million at December 31, 2017. The book value per share was $11.55 at June 30, 2018 compared to $10.95 at December 31, 2017. Average equity to average assets was 13.9% for the six months ended June 30, 2018 compared to 13.5% for the year ended December 31, 2017. The increase in shareholders’ equity was principally the result of net income to common shareholders for the six months ended June 30, 2018 of $26.7 million combined with stock-based compensation expense of $4.6 million, partially offset by other comprehensive losses of $4.0 million and $2.4 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).

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The following table provides information with respect to nonperforming assets and troubled debt restructurings at the dates indicated.
 
June 30, 2018
 
December 31, 2017
Nonperforming assets:
 
 
 
Total nonperforming loans (all on nonaccrual)
$
46,105

 
$
23,480

Total accruing loans past due 90 days or more

 

Foreclosed assets
1,725

 
1,281

Total troubled debt restructurings
11,241

 
10,223

Less nonaccrual troubled debt restructurings
(7,628
)
 
(8,129
)
Total performing troubled debt restructurings
3,613

 
2,094

Total nonperforming assets and troubled debt restructurings
$
51,443

 
$
26,855

Total nonperforming loans to total loans and leases held for investment
3.00
%
 
1.75
%
Total nonperforming loans to total assets
1.33
%
 
0.85
%
Total nonperforming assets and troubled debt restructurings to total assets
1.48
%
 
0.97
%
 
June 30, 2018
 
December 31, 2017
Nonperforming assets guaranteed by U.S. government:
 
 
 
Total nonperforming loans guaranteed by the SBA (all on nonaccrual)
$
34,639

 
$
19,870

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

 

Foreclosed assets guaranteed by the SBA
1,528

 
1,191

Total troubled debt restructurings guaranteed by the SBA
8,257

 
7,178

Less nonaccrual troubled debt restructurings guaranteed by the SBA
(6,800
)
 
(7,099
)
Total performing troubled debt restructurings guaranteed by SBA
1,457

 
79

Total nonperforming assets and troubled debt restructurings guaranteed by the SBA
$
37,624

 
$
21,140

Total nonperforming loans not guaranteed by the SBA to total held for investment loans and leases
0.75
%
 
0.27
%
Total nonperforming loans not guaranteed by the SBA to total assets
0.33
%
 
0.13
%
Total nonperforming assets and troubled debt restructurings not guaranteed by the SBA to total assets
0.40
%
 
0.21
%
Total nonperforming assets and troubled debt restructurings at June 30, 2018 were $51.4 million, which represented a $24.6 million, or 91.6%, increase from December 31, 2017. Total nonperforming assets at June 30, 2018 were comprised of $46.1 million in nonaccrual loans and $1.7 million in foreclosed assets. Of the $51.4 million of nonperforming assets and troubled debt restructurings ("TDRs"), $37.6 million carried an SBA guarantee, leaving an unguaranteed exposure of $13.8 million in total nonperforming assets and TDRs at June 30, 2018. The unguaranteed exposure in total nonperforming assets and TDRs at December 31, 2017 was $5.7 million. Unguaranteed exposure relating to nonperforming assets and TDRs at June 30, 2018 increased by $8.1 million, or 141.8%, compared to December 31, 2017. Almost all of this increase in nonperforming assets and TDRs arose from our mature verticals. See the below discussion related to the change in potential problem and impaired loans for management’s overall observations in regard to growth in this area.
As a percentage of the Bank’s total capital, nonperforming loans represented 12.7% at June 30, 2018, compared to nonperforming loans of 7.8% of the Bank’s total capital at December 31, 2017. 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, 2018 and December 31, 2017 were 3.2% and 1.2%, respectively.

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As of June 30, 2018 and December 31, 2017, potential problem and impaired loans and leases totaled $122.4 million and $76.8 million, respectively. Risk Grades 5 through 8 represent the spectrum of criticized and impaired loans and leases. At June 30, 2018, the portion of criticized loans and leases guaranteed by the SBA or USDA totaled $56.6 million resulting in unguaranteed exposure risk of $65.7 million, or 4.7% of total held for investment unguaranteed exposure. This compares to the December 31, 2017 portion of criticized loans and leases guaranteed by the SBA or USDA which totaled $34.7 million resulting in unguaranteed exposure risk of $42.1 million, or 3.4% of total held for investment unguaranteed exposure. As of June 30, 2018 loans and leases in Healthcare, Veterinary and Independent Pharmacies industry verticals comprise the largest portion of the total potential problem and impaired loans at 20.5%, 28.6% and 16.4%, respectively. As of December 31, 2017 loans in the Healthcare and Veterinary industries comprised the largest portion of the total potential problem and impaired loans and leases at 30.0% and 27.3%, respectively. No systemic issues were identified in the first half of 2018 increase in potential problem and impaired loans and leases which were comprised of a relatively small number of borrowers largely concentrated in our more mature verticals. Furthermore, the Company believes that its underwriting and credit quality standards have improved as the business has matured.
The Bank does not classify loans and leases 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 or lease 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 problem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted. Management implements a proactive approach to identifying and classifying loans and leases as criticized, Risk Grade 5. For example, at June 30, 2018 and December 31, 2017, Risk Grade 5 loans and leases totaled $58.4 million and $37.0 million, respectively. The increase in Risk Grade 5 loans from December 31, 2017 to June 30, 2018 was principally confined to four verticals; Government Contracting ($10.9 million or 51.2% of increase), Wine and Craft Beverage ($2.9 million or 13.4% of increase), Healthcare ($2.2 million or 10.4% of increase) and Independent Pharmacies ($2.1 million or 9.9%). The majority of the Government Contracting loans downgraded to Risk Grade 5 in the first half of 2018 are asset-based, collateral intensive loans.  During the second quarter, management enhanced the risk grading methodology for these types of loans.  The enhanced methodology includes more robust collateral centric loss given default measures.   As these loans come up for renewal and reapproval, additional servicing controls can be enhanced and appropriately measured, which is expected to improve the overall risk grades for some of these loans.  This will be a process over the next several quarters. The first half of 2018 increase in Risk Grade 5 loans related to Wine and Craft Beverage, Healthcare, and Independent Pharmacies was due to the ongoing maturity of larger existing verticals. At June 30, 2018, approximately 97.2% 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 collectability 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.

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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.
The ALLL of $24.2 million at December 31, 2017 increased by $5.2 million, or 21.3%, to $29.4 million at June 30, 2018. The ALLL, as a percentage of loans and leases held for investment, amounted to 1.9% at June 30, 2018 and 1.8% at December 31, 2017. The increase in the allowance for loan and lease losses was largely attributable to continued growth in the loan and lease portfolio, 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 1.50% at June 30, 2018 and 1.62% December 31, 2017. 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 held for investment loans and leases have increased by $12.3 million since December 31, 2017. Of this increase, $10.2 million, or 83.4%, is over 90 days past due with $3.4 million of that amount being comprised of unguaranteed loans and leases. At June 30, 2018 and December 31, 2017 total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases was 0.65% and 0.43%, respectively. The growth in past dues during the first half of 2018 is reflected in the earlier discussed increase in classified loans during the same period. Management continues to actively monitor and work to improve asset quality. Management believes the ALLL of $29.4 million at June 30, 2018 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 5 - 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, 2018, the total amount of these four items was $1.10 billion, or 31.8% of total assets, an increase of $430.0 million from $674.2 million, or 24.4% of total assets, at December 31, 2017.
Loans and other assets are funded by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and an increased long term wholesale deposit base have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. Additionally, an increased investment securities portfolio is available for both immediate and secondary liquidity purposes.
At June 30, 2018, 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 $382.3 million available as lendable collateral.


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Table of Contents

Contractual Obligations
The following table presents the Company’s significant fixed and determinable contractual obligations by payment date as of June 30, 2018. 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
$
1,203,260

 
$
1,203,260

 
$

 
$

 
$

Time deposits
1,765,976

 
999,604

 
622,724

 
67,482

 
76,166

Long term borrowings
3,385

 
3

 
3,376

 
6

 

Operating lease obligations1
3,096

 
1,501

 
979

 
489

 
127

Total
$
2,975,717

 
$
2,204,368

 
$
627,079

 
$
67,977

 
$
76,293

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.
As of June 30, 2018 and December 31, 2017, the Company had unfunded commitments to provide capital contributions for on-balance sheet investments in the amount of $3.3 million and $3.5 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 asset and liability repricing timing differences as of the report date and does not address earnings, market value nor growth. 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 2.5% at June 30, 2018. Loan growth during the quarter contributed to the asset sensitivity of the Company in the current period. 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 by matching funding assets and liabilities with similar 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.


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Table of Contents

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.

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Table of Contents

Capital amounts and ratios as of June 30, 2018 and December 31, 2017, 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, 2018
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
413,433

 
16.78
%
 
$
110,877

 
4.50
%
 
N/A

 
N/A

Total Capital (to Risk-Weighted Assets)
$
442,783

 
17.97
%
 
$
197,115

 
8.00
%
 
N/A

 
N/A

Tier 1 Capital (to Risk-Weighted Assets)
$
413,433

 
16.78
%
 
$
147,836

 
6.00
%
 
N/A

 
N/A

Tier 1 Capital (to Average Assets)
$
413,433

 
11.81
%
 
$
140,067

 
4.00
%
 
N/A

 
N/A

Bank - June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
332,848

 
13.71
%
 
$
109,266

 
4.50
%
 
$
157,829

 
6.50
%
Total Capital (to Risk-Weighted Assets)
$
362,309

 
14.92
%
 
$
194,251

 
8.00
%
 
$
242,813

 
10.00
%
Tier 1 Capital (to Risk-Weighted Assets)
$
332,848

 
13.71
%
 
$
145,688

 
6.00
%
 
$
194,251

 
8.00
%
Tier 1 Capital (to Average Assets)
$
332,848

 
9.65
%
 
$
137,905

 
4.00
%
 
$
172,381

 
5.00
%
Consolidated - December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
390,816

 
17.81
%
 
$
98,764

 
4.50
%
 
N/A

 
N/A

Total Capital (to Risk-Weighted Assets)
$
415,006

 
18.91
%
 
$
175,580

 
8.00
%
 
N/A

 
N/A

Tier 1 Capital (to Risk-Weighted Assets)
$
390,816

 
17.81
%
 
$
131,685

 
6.00
%
 
N/A

 
N/A

Tier 1 Capital (to Average Assets)
$
390,816

 
15.50
%
 
$
100,828

 
4.00
%
 
N/A

 
N/A

Bank - December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 (to Risk-Weighted Assets)
$
277,943

 
12.89
%
 
$
97,060

 
4.50
%
 
$
140,197

 
6.50
%
Total Capital (to Risk-Weighted Assets)
$
302,385

 
14.02
%
 
$
172,551

 
8.00
%
 
$
215,688

 
10.00
%
Tier 1 Capital (to Risk-Weighted Assets)
$
277,943

 
12.89
%
 
$
129,413

 
6.00
%
 
$
172,551

 
8.00
%
Tier 1 Capital (to Average Assets)
$
277,943

 
11.36
%
 
$
97,864

 
4.00
%
 
$
122,330

 
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 and lease losses;
Valuation of servicing assets;
Income taxes;
Restricted stock unit awards with market price conditions;
Valuation of foreclosed assets;
Business combination and goodwill; and

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Unconsolidated joint ventures.
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.
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, 2018, 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, 2018 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, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.


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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, 2018, any pending legal proceedings other than nonmaterial proceedings occurring in the ordinary course of business.
Item 1A. Risk Factors
There have been no material changes to the risk factors that have been previously disclosed in the Company’s 2017 Annual Report filed with the SEC.
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.

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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, 2018
By:
/s/  S. Brett Caines
 
 
S. Brett Caines
 
 
Chief Financial Officer

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INDEX TO EXHIBITS
Exhibit
No.
 
Description of Exhibit
 
 
 
3.1

 
3.2

 
4.1

 
4.2

 
10.1

 
31.1

 
31.2

 
32

 
101

 
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets as of June 30, 2018 and December 31, 2017; (ii) Consolidated Statements of Income for the Three and Six Months Ended June 30, 2018 and 2017; (iii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2018 and 2017; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the Six Months Ended June 30, 2018 and 2017; (v) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2018 and 2017; 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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