Edgar Filing: Live Oak Bancshares, Inc.

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Smaller Reporting Company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2015

¨	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

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 x NO ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 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 x

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 November 12, 2015, there were approximately 29,447,381 shares of the registrant’s voting common stock outstanding and approximately 4,723,530 shares of the registrant’s non-voting common stock outstanding.

Live Oak Bancshares, Inc. and Subsidiaries

Form 10-Q

For the Quarterly Period Ended September 30, 2015

TABLE OF CONTENTS


		Page

	PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)		1

	Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014		1

	Consolidated Statements of Income for Three and Nine Months Ended September 30, 2015 and 2014		2

	Consolidated Statements of Comprehensive Income for the Three and Nine Months ended September 30, 2015 and 2014		3

	Consolidated Statements of Shareholders’ Equity for the Nine Months Ended September 30, 2015 and 2014		4

	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014		5

	Notes to Unaudited Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		39

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		59

Item 4.	Controls and Procedures		59

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings		60

Item 1 A.	Risk Factors		60

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		60

Item 3.	Defaults Upon Senior Securities		60

Item 4.	Mine Safety Disclosures		60

Item 5.	Other Information		60

Item 6.	Exhibits		60

	Signatures		61

PART I. FINANCIAL INFORMATION

Item 1.

Financial Statements

Live Oak Bancshares, Inc.

Consolidated Balance Sheets

As of September 30, 2015 (unaudited) and December 31, 2014*

(Dollars in thousands)


	September 30, 2015			December 31, 2014*
Assets
Cash and due from banks	$	129,881		$	29,902
Certificates of deposit with other banks		10,000			10,000
Investment securities available-for-sale		51,628			49,318
Loans held for sale		443,871			295,180
Loans held for investment		259,552			203,936
Allowance for loan losses		(6,153	)		(4,407	)

Net loans		253,399			199,529
Premises and equipment, net		62,641			35,279
Foreclosed assets		48			371
Servicing assets		40,590			34,999
Investments in non-consolidated affiliates		—			6,345
Other assets		20,708			12,392

Total assets	$	1,012,766		$	673,315

Liabilities and Shareholders’ Equity
*Liabilities*
Deposits:
Noninterest-bearing	$	20,365		$	14,728
Interest-bearing		742,263			507,352

Total deposits		762,628			522,080
Short term borrowings		—			6,100
Long term borrowings		42,079			41,849
Other liabilities		13,963			11,472

Total liabilities		818,670			581,501

*Shareholders’ equity*
Non-cumulative perpetual preferred stock (Series A), 6,800 shares authorized, issued and outstanding		—			—
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at September 30, 2015 and December 31, 2014		—			—
Class A common stock, no par value, 100,000,000 shares authorized, 29,443,970 and 23,896,400, shares issued and outstanding at September 30, 2015 and December 31, 2014, respectively		136,852			48,657
Class B common stock, no par value, 10,000,000 shares authorized, 4,723,530 shares issued and outstanding at September 30, 2015 and December 31, 2014		50,015			50,015
Retained earnings (accumulated deficit)		7,108			(6,943	)
Accumulated other comprehensive income		87			85

Total shareholders’ equity attributed to Live Oak Bancshares, Inc.		194,062			91,814

Noncontrolling interest		34			—

Total equity		194,096			91,814

Total liabilities and shareholders’ equity	$	1,012,766		$	673,315

*	Derived from audited consolidated financial statements.

See Notes to Consolidated Financial Statements

Live Oak Bancshares, Inc.

Consolidated Statements of Income

For the three and nine months ended September 30, 2015 and 2014 (unaudited)

(Dollars in thousands, except per share data)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2015		2014			2015			2014
*Interest income*
Loans and fees on loans	$	8,704	$	5,189		$	22,811		$	14,040
Investment securities, taxable		211		93			587			292
Other interest earning assets		84		38			220			102

Total interest income		8,999		5,320			23,618			14,434
*Interest expense*
Deposits		1,997		1,172			5,274			3,401
Borrowings		395		254			1,280			611

Total interest expense		2,392		1,426			6,554			4,012
Net interest income		6,607		3,894			17,064			10,422

*Provision for loan losses*		1,212		512			2,339			1,411

Net interest income after provision for loan losses		5,395		3,382			14,725			9,011

*Noninterest income*
Loan servicing revenue and revaluation		1,566		3,230			7,444			9,515
Net gains on sales of loans		15,424		13,108			46,604			35,465
Equity in loss of non-consolidated affiliates		—		(177	)		(26	)		(2,379	)
Gain on sale of investment in non-consolidated affiliate		—		—			3,782			—
Gain on sale of investment securities available-for-sale		12		—			12			—
Other noninterest income		768		342			2,144			1,215

Total noninterest income		17,770		16,503			59,960			43,816

*Noninterest expense*
Salaries and employee benefits		9,949		6,120			27,623			21,828
Travel expense		2,180		1,791			5,852			3,879
Professional services expense		597		1,758			2,129			3,364
Advertising and marketing expense		1,051		763			3,177			2,283
Occupancy expense		699		518			1,887			1,384
Data processing expense		773		730			2,388			1,787
Equipment expense		584		433			1,338			999
Other expense		2,206		1,154			5,132			3,726

Total noninterest expense		18,039		13,267			49,526			39,250

*Income before taxes*		5,126		6,618			25,159			13,577
Income tax expense		2,228		5,977			10,272			5,977

Net income		2,898		641			14,887			7,600
Net loss attributable to noncontrolling interest		3		—			23			—

Net income attributable to Live Oak Bancshares, Inc.	$	2,901	$	641		$	14,910		$	7,600

Basic earnings per share	$	0.09	$	0.03		$	0.50		$	0.34

Diluted earnings per share	$	0.09	$	0.02		$	0.48		$	0.33

See Notes to Consolidated Financial Statements

Live Oak Bancshares, Inc.

Consolidated Statements of Comprehensive Income

For the three and nine months ended September 30, 2015 and 2014 (unaudited)

(Dollars in thousands)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2015			2014			2015			2014
Net income	$	2,898		$	641		$	14,887		$	7,600
Other comprehensive income (loss) before tax:
Net unrealized gain (loss) on investment securities arising during the period		151			(11	)		15			192
Reclassification adjustment for (gain) loss on sale of securities available-for-sale included in net income		(12	)		—			(12	)		—

Other comprehensive income (loss) before tax		139			(11	)		3			192
Income tax expense		(53	)		—			(1	)		—

Other comprehensive income (loss), net of tax		86			(11	)		2			192

Total comprehensive income	$	2,984		$	630		$	14,889		$	7,792

See Notes to Consolidated Financial Statements

Live Oak Bancshares, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

For the nine months ended September 30, 2015 and 2014 (unaudited)

(Dollars in thousands, except per share data)


	Common stock							Retained earnings (accumulated deficit)			Accumulated other comprehensive income (loss)			Non- controlling interest			Total equity
	Shares
	Class A		Class B		Amount

Balance at December 31, 2013		20,318,330		—	$	18,319		$	30,262		$	(191	)	$	—		$	48,390
Net income		—		—		—			7,600			—			—			7,600
Other comprehensive income		—		—		—			—			192			—			192
Reclass from redeemable equity securities		—		—		3,605			—			—			—			3,605
Sales of common stock		45,440		—		200			—			—			—			200
Stock option exercises		191,660		—		177			—			—			—			177
Issuance of common stock grants		685,700		—		2,992			—			—			—			2,992
Common stock issued in private placement, net of offering cost		2,324,770		4,723,530		74,631			—			—			—			74,631
Debt conversion to common stock		287,020		—		3,052			—			—			—			3,052
Stock option based compensation expense		—		—		112			—			—			—			112
Reclassification adjustment for change in taxable status		—		—		(5,123	)		5,123			—			—			—
Restricted stock expense		—		—		143			—			—			—			143
Dividends (distributions to shareholders)		—		—		—			(44,150	)		—			—			(44,150	)

Balance at September 30, 2014		23,852,920		4,723,530	$	98,108		$	(1,165	)	$	1		$	—		$	96,944

Balance at December 31, 2014		23,896,400		4,723,530	$	98,672		$	(6,943	)	$	85		$	—		$	91,814
Net income (loss)		—		—		—			14,910			—			(23	)		14,887
Other comprehensive income		—		—		—			—			2			—			2
Consolidation of investment with non-controlling interest		—		—		—			—			—			35			35
Stock option exercises		47,570		—		215			—			—			—			215
Stock option based compensation expense		—		—		726			—			—			—			726
Restricted stock expense		—		—		83			—			—			—			83
Capital contribution from non-controlling interest		—		—		—			—			—			22			22
Issuance of common stock in connection with initial public offering, net of issue costs		5,500,000		—		87,171			—			—			—			87,171
Dividends (distributions to shareholders)		—		—		—			(859	)		—			—			(859	)

Balance at September 30, 2015		29,443,970		4,723,530	$	186,867		$	7,108		$	87		$	34		$	194,096

See Notes to Consolidated Financial Statements

Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows

For the nine months ended September 30, 2015 and 2014 (unaudited)

(Dollars in thousands)


	Nine Months Ended September 30,
	2015			2014
*Cash flows from operating activities*
Net income	$	14,887		$	7,600
Adjustments to reconcile net income to net cash used by operating activities:
Depreciation and amortization		1,917			1,612
Provision for loan losses		2,339			1,411
Amortization of premium on securities, net of accretion		36			69
Amortization (accretion) of discount (premium) on unguaranteed loans, net		1,650			(376	)
Deferred tax expense		936			3,253
Originations of loans held for sale		(740,378	)		(531,717	)
Proceeds from sales of loans held for sale		508,322			391,626
Net loss on sale of foreclosed assets		12			—
Net increase in servicing assets		(5,591	)		(6,046	)
Net gains on sale of loans held for sale		(46,604	)		(35,465	)
Gain on sale of securities available-for-sale		(12	)		—
Gain on sale of investment in non-consolidated affiliate		(3,782	)		—
Net loss (gain) on disposal of premises and equipment		16			(256	)
Stock option based compensation expense		726			112
Restricted stock expense		83			143
Stock grants		—			2,992
Equity in loss of non-consolidated affiliates		26			2,379
Changes in assets and liabilities:
Accounts receivable and other assets		(2,269	)		(2,620	)
Accrued expenses and other liabilities		2,025			12,198

Net cash used by operating activities		(265,661	)		(153,085	)

*Cash flows from investing activities*
Purchases of securities available-for-sale		(15,437	)		(31,482	)
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale		13,106			1,875
Proceeds from sale of foreclosed assets		352			—
Investment in certificates of deposit		—			(9,250	)
Investments in non-consolidated affiliates		—			(6,114	)
Proceeds from sale of investment in non-consolidated affiliate		9,896			—
Capital investments in non-consolidated affiliates		—			(500	)
Net cash acquired in consolidation of equity method investment		319			—
Capital contribution from non-controlling interest		22			—
Loan originations and principal collections, net		66,835			53,415
Proceeds from sale of premises and equipment		—			2,200
Purchases of premises and equipment, net		(29,295	)		(11,303	)

Net cash provided (used) by investing activities		45,798			(1,159	)

See Notes to Consolidated Financial Statements

Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows (Continued)

For the nine months ended September 30, 2015 and 2014 (unaudited)

(Dollars in thousands)


	Nine Months Ended September 30,
	2015			2014
*Cash flows from financing activities*
Net increase in deposits		240,548			85,990
Proceeds from long term borrowings		12,960			20,305
Repayment of long term borrowings		(12,730	)		(2,447	)
Proceeds from short term borrowings		—			15,066
Repayment of short term borrowings		(6,100	)		—
Stock option exercises		215			177
Sale of common stock, net		87,171			74,831
Shareholder dividend distributions		(2,222	)		(38,280	)

Net cash provided by financing activities		319,842			155,642

Net increase in cash and cash equivalents		99,979			1,398
*Cash and cash equivalents, beginning*		29,902			37,244

*Cash and cash equivalents, ending*	$	129,881		$	38,642

*Supplemental disclosure of cash flow information*
Interest paid	$	6,501		$	3,970
Income tax		11,312			3,253
*Supplemental disclosures of noncash operating, investing, and financing activities*
Unrealized holding gains on available-for-sale securities, net of taxes	$	2		$	192
Conversion of convertible subordinated debt into common stock		—			3,052
Transfers from loans to foreclosed real estate and other repossessions		700			327
Transfers from foreclosed real estate to SBA receivable		659			289
Transfers of loans accounted for as secured borrowing collateral to other assets		4,575			—
Transfer of loans held for sale to loans held for investment		7,410			8,937
Transfer of loans held for investment to loans held for sale		2,129			16,428
Contingent consideration in acquisition of controlling interest in equity method of investment		170			—
Non-cash dividend		—			9,514

See Notes to Consolidated Financial Statements

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 established in May 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within credit-worthy industries through expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 7(a) program. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank. On July 23, 2015 the Company closed on its initial public offering.

In addition to the Bank, the Company owns Independence Aviation, LLC, which was formed for the purpose of purchasing and operating aircraft used for business purposes of the Company, 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 advisor to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.

The Company acquired control over 504FA, previously carried as an equity method investment, on February 2, 2015 by increasing its ownership from 50.0% to 91.3%. The acquisition of an additional 41.3% of ownership occurred in exchange for contingent consideration estimated to total $170 thousand. Transactions in the third quarter of 2015 increased the Company’s ownership to 92.4%. With 7.6% of ownership remaining with a third party investor, amounts of earnings and equity in 504FA attributable to the third party investor are now disclosed in the Company’s consolidated financial statements as related to a noncontrolling interest.

The Company earns revenue primarily from the sale of SBA-guaranteed loans. This income is comprised of net gains on the sale of loans, revenues on the servicing of sold loans and valuation of loan servicing rights. Net interest income is another contributor to earnings. Offsetting these revenues are the cost of funding sources, provision for loan losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.

General

In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all intercompany transactions have been eliminated in consolidation. Results of operations for the nine months ended September 30, 2015 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2015. The consolidated balance sheet as of December 31, 2014 has been derived from the audited consolidated financial statements contained in the Company’s registration statement on Form S-1 (File No. 333-205126), as amended. 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 registration statement on Form S-1, as amended.

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.

Stock Split

On September 23, 2014, the Board of Directors declared a ten-for-one stock split of the Company’s Class A and Class B common shares, which was effected in the form of a common stock dividend distributed on October 10, 2014. Except for the amount of authorized shares, all references to share and per share amounts in the consolidated financial statements and accompanying notes to the consolidated financial statements have been retroactively restated to reflect the stock split.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 1. Basis of Presentation (Continued)

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.

Reclassifications

Certain reclassifications have been made to the prior period’s consolidated financial statements to place them on a comparable basis with the current year. Net income and shareholders’ equity previously reported were not affected by these reclassifications.

Note 2 - Recent Accounting Pronouncements

In January 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2015-01, “Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items” (“ASU 2015-01”). ASU 2015-01 eliminated from U.S. GAAP the concept of an extraordinary item, which is an event or transaction that is both unusual in nature and infrequently occurring. The guidance will be effective for the Company for interim and annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect this guidance to have a material effect on its consolidated financial statements.

In February 2015, the FASB issued Accounting Standards Update No. 2015-02, “Amendments to the Consolidation Analysis” (“ASU 2015-02”). ASU 2015-02 amended the consolidation requirements in Accounting Standards Codification (“ASC”) 810 Consolidation. The amendments change the consolidation analysis required under U.S. GAAP, and modify how variable interests held by a reporting entity’s related parties affect its consolidation conclusions. The amendments will be effective for the Company for interim and annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) – Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” ASU 2015-05 addresses accounting for fees paid by a customer in cloud computing arrangements such as (i) software as a service, (ii) platform as a service, (iii) infrastructure as a service and (iv) other similar hosting arrangements. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 will be effective for the Company on January 1, 2016 and is not expected to have a significant impact on its consolidated financial statements.

In May 2015, the FASB issued ASU 2015-07, “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent) (a Consensus of the Emerging Issues Task Force).” The new guidance eliminates the requirement to classify in the fair value hierarchy any investments for which fair value is measured at net asset value per share using the practical expedient. This guidance is effective for interim and annual periods beginning after December 15, 2015. The adoption of this guidance is not expected to be material to the consolidated financial statements.

In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805) – Simplifying the Accounting for Measurement-Period Adjustments.” ASU 2015-16 requires that adjustments to provisional amounts that are identified during the measurement period of a business combination be recognized in the reporting period in which the adjustment amounts are determined. Furthermore, the income statement effects of such adjustments, if any, must be calculated as if the accounting had been completed at the acquisition date. The portion of the amount recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. Under previous guidance, adjustments to provisional amounts identified during the measurement period are to be recognized retrospectively. ASU 2015-16 will be effective for the Company on January 1, 2016 and is not expected to have a significant impact on the consolidated financial statements.

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 September 30,				Nine Months Ended September 30,
	2015		2014		2015		2014
Basic earnings per share:
Net income available to common shareholders	$	2,901	$	641	$	14,910	$	7,600

Weighted-average basic shares outstanding		32,824,587		25,632,505		30,037,436		22,412,646

Basic earnings per share	$	0.09	$	0.03	$	0.50	$	0.34

Diluted earnings per share:
Net income available to common shareholders, for diluted earnings per share	$	2,901	$	641	$	14,910	$	7,600

Total weighted-average basic shares outstanding		32,824,587		25,632,505		30,037,436		22,412,646
Add effect of dilutive stock options and restricted stock grants		1,092,695		603,195		892,794		286,789

Total weighted-average diluted shares outstanding		33,917,282		26,235,700		30,930,230		22,699,435

Diluted earnings per share	$	0.09	$	0.02	$	0.48	$	0.33

Anti-dilutive shares		1,391,828		328,210		1,562,168		328,210

Pro forma earnings per share

Because the Company was not a taxable entity prior to August 3, 2014, pro forma amounts for income tax expense and basic and diluted earnings per share have been presented below assuming the Company’s effective tax rate of 38.5% for the three and nine months ended September 30, 2014.


	Three Months Ended		Nine Months Ended
Pro forma net income available to common shareholders, after tax	$	4,071	$	8,349

Pro forma basic earnings per share	$	0.16	$	0.37

Pro forma diluted earnings per share	$	0.16	$	0.37

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 4. Securities

The carrying amount of securities and their approximate fair values are reflected in the following table:


	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
September 30, 2015
US government agencies	$	26,987	$	226	$	—	$	27,213
Residential mortgage-backed securities		22,570		32		136		22,466
Mutual fund		1,930		19		—		1,949

	$	51,487	$	277	$	136	$	51,628

December 31, 2014
US government agencies	$	35,207	$	127	$	25	$	35,309
Residential mortgage-backed securities		13,973		92		56		14,009

	$	49,180	$	219	$	81	$	49,318

During the three months ended September 30, 2015, the Company sold three US government agency securities for $8.3 million at a gain of $12 thousand and purchased four mortgage-backed securities totaling $9.5 million in a transaction designed to enhance cashflow and yield. In addition, during the first and second quarters of 2015, the Company sold six mortgage-backed securities at their carrying amount for $3.4 million in an odd-lot consolidation and purchased two mortgage-backed securities for $4.0 million for the purpose of complying with the Community Reinvestment Act. The Company also invested $1.9 million in the 504 Fund mutual fund. The investment in this mutual fund was purchased at current market value (190,380.762 shares at $9.98 per share). During the nine months ending September 30, 2015, there was $30 thousand of dividend reinvestment in the 504 Fund mutual fund as well. There were no calls or maturities of securities during the three and nine months ending September 30, 2015.

During the three months and nine months ended September 30, 2014, there were purchases of five US government agency securities for $29.9 million as part of a strategic investment plan to utilize excess cash from the $74.6 million private placement capital raise that took place in August 2014 and one mortgage-backed security purchased for $1.6 million for the purpose of complying with the Community Reinvestment Act. There were no calls, sales or maturities of securities during the three and nine months ended September 30, 2014.

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
September 30, 2015	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Residential mortgage-backed securities	$	14,453	$	114	$	3,269	$	22	$	17,722	$	136

Total	$	14,453	$	114	$	3,269	$	22	$	17,722	$	136


	Less Than 12 Months				12 Months or More				Total
December 31, 2014	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
US government agencies	$	—	$	—	$	1,224	$	25	$	1,224	$	25
Residential mortgage-backed securities		2,234		4		5,158		52		7,392		56

Total	$	2,234	$	4	$	6,382	$	77	$	8,616	$	81

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 4. Securities (Continued)

At September 30, 2015, there were three mortgage-backed securities in unrealized loss positions for greater than 12 months and nine mortgage-backed securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2014, were comprised of six securities, consisting of one US government agency security and five mortgage-backed securities, in unrealized loss positions for greater than 12 months and one mortgage-backed security in an unrealized loss position for less than 12 months.

These unrealized losses are primarily the result of volatility in the market and are related to market interest rates. Since none of the unrealized losses relate to marketability of the securities or the issuer’s ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired.

All residential mortgage-backed securities in the Company’s portfolio at September 30, 2015 and December 31, 2014 were backed by US government sponsored enterprises (“GSEs”).

The following is a summary of investment securities by maturity:


	September 30, 2015 Available-for-sale
	Amortized cost		Fair value
One to five years	$	26,987	$	27,213
Five to ten years		10,052		10,057
After 10 years		12,518		12,409

	$	49,557	$	49,679

The table above reflects contractual maturities. Actual results will differ as the loans underlying the mortgage-backed securities may repay sooner than scheduled. This table excludes the 504 Fund mutual fund investment.

At September 30, 2015 and December 31, 2014, investment securities with a fair market value of $1.3 million were pledged to secure a line of credit with the Company’s correspondent bank.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses

Loan Portfolio Segments

The following describes the risk characteristics relevant to each of the portfolio segments. Each loan 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 “Owner Occupied 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.

Owner Occupied Commercial Real Estate

Owner occupied commercial real estate loans are extensions of credit secured by 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 owner-occupied 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 loan 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.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Loans consist of the following:


	September 30, 2015			December 31, 2014
Commercial & Industrial
Agriculture	$	30		$	—
Death Care Management		4,831			3,603
Healthcare		13,563			12,319
Independent Pharmacies		41,123			34,079
Registered Investment Advisors		16,304			9,660
Veterinary Industry		20,985			20,902
Other Industries		1,216			494

Total		98,052			81,057
Construction & Development
Agriculture		12,233			3,910
Death Care Management		991			92
Healthcare		7,722			2,957
Independent Pharmacies		687			215
Registered Investment Advisors		75			—
Veterinary Industry		3,038			2,207
Other Industries		679			145

Total		25,425			9,526
Owner Occupied Commercial Real Estate
Agriculture		125			259
Death Care Management		19,575			18,879
Healthcare		33,342			26,173
Independent Pharmacies		5,752			4,750
Registered Investment Advisors		2,981			2,161
Veterinary Industry		61,092			57,934
Other Industries		3,585			1,464

Total		126,452			111,620
Commercial Land
Agriculture		9,354			1,248

Total		9,354			1,248
Total Loans ¹		259,283			203,451
Net Deferred Costs		2,685			2,060
Discount on SBA 7(a) Unguaranteed ²		(2,416	)		(1,575	)

Loans, Net of Unearned	$	259,552		$	203,936

¹	Total loans include $21.8 million and $21.3 million of U.S. government guaranteed loans as of September 30, 2015 and December 31, 2014, 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.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Credit Risk Profile

The Bank uses internal loan reviews to assess the performance of individual loans by industry segment. An independent review of the loan portfolio is performed annually by an external firm. The goal of the Bank’s annual review of each borrower’s 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. The grade is periodically evaluated and adjusted as performance dictates. Loan grades 1 through 4 are passing grades and grade 5 is special mention. Collectively, grades 6 through 8 represent classified loans in the Bank’s portfolio. The following guidelines govern the assignment of these risk grades:

Exceptional Loans (1 Rated): These loans 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 Loans (2 Rated): These loans 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 Loans (3 rated): These loans 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 Loans (4 rated): These loans are considered very weak pass. These loans 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 that may be put in this category include start-up loans and loans with less than 1:1 cash flow coverage with other sources of repayment.

Special mention (5 rated): These loans are considered as emerging problems, with potentially unsatisfactory characteristics. These loans require greater management attention. A loan 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 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 graded Doubtful have inherent weaknesses that make collection or liquidation in full questionable. Loans graded Doubtful must be placed on non-accrual status.

Loss (8 rated): Loss rated loans 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.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

The following tables summarize the risk grades of each category:


	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total¹
September 30, 2015
Commercial & Industrial
Agriculture	$	30	$	—	$	—	$	30
Death Care Management		4,727		104		—		4,831
Healthcare		8,007		556		5,000		13,563
Independent Pharmacies		34,795		2,173		4,155		41,123
Registered Investment Advisors		15,952		352		—		16,304
Veterinary Industry		15,873		566		4,546		20,985
Other Industries		1,070		146		—		1,216

Total		80,454		3,897		13,701		98,052
Construction & Development
Agriculture		12,141		92		—		12,233
Death Care Management		991		—		—		991
Healthcare		7,722		—		—		7,722
Independent Pharmacies		687		—		—		687
Registered Investment Advisors		75		—		—		75
Veterinary Industry		3,038		—		—		3,038
Other Industries		679		—		—		679

Total		25,333		92		—		25,425
Owner Occupied Commercial Real Estate
Agriculture		125		—		—		125
Death Care Management		17,041		832		1,702		19,575
Healthcare		28,804		1,716		2,822		33,342
Independent Pharmacies		5,355		397		—		5,752
Registered Investment Advisors		2,981		—		—		2,981
Veterinary Industry		43,754		2,690		14,648		61,092
Other Industries		3,585		—		—		3,585

Total		101,645		5,635		19,172		126,452
Commercial Land
Agriculture		9,354		—		—		9,354

Total		9,354		—		—		9,354
Total	$	216,786	$	9,624	$	32,873	$	259,283

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)


	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total¹
December 31, 2014
Commercial & Industrial
Death Care Management	$	3,603	$	—	$	—	$	3,603
Healthcare		6,995		538		4,786		12,319
Independent Pharmacies		27,673		2,726		3,680		34,079
Registered Investment Advisors		9,660		—		—		9,660
Veterinary Industry		15,513		1,121		4,268		20,902
Other Industries		333		161		—		494

Total		63,777		4,546		12,734		81,057
Construction & Development
Agriculture		3,910		—		—		3,910
Death Care Management		92		—		—		92
Healthcare		2,957		—		—		2,957
Independent Pharmacies		215		—		—		215
Veterinary Industry		2,207		—		—		2,207
Other Industries		145		—		—		145

Total		9,526		—		—		9,526
Owner Occupied Commercial Real Estate
Agriculture		259		—		—		259
Death Care Management		16,519		639		1,721		18,879
Healthcare		22,778		938		2,457		26,173
Independent Pharmacies		4,709		41		—		4,750
Registered Investment Advisors		2,161		—		—		2,161
Veterinary Industry		40,281		3,601		14,052		57,934
Other Industries		1,176		—		288		1,464

Total		87,883		5,219		18,518		111,620
Commercial Land
Agriculture		1,248		—		—		1,248

Total		1,248		—		—		1,248
Total	$	162,434	$	9,765	$	31,252	$	203,451

Total loans include $21.8 million of U.S. government guaranteed loans as of September 30, 2015, segregated by risk grade as follows: Risk Grades 1 – 4 = $0, Risk Grade 5 = $1.1 million, Risk Grades 6 – 8 = $20.7 million. As of December 31, 2014 total loans include $21.3 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $0, Risk Grade 5 = $1.1 million, Risk Grades 6 – 8 = $20.2 million.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Past Due Loans

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans less than 30 days past due and accruing are included within current loans shown below. The following tables show an age analysis of past due loans 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 Loans		Current Loans		Total Loans		Loans 90 Days or More Past Due & Still Accruing
September 30, 2015
Commercial & Industrial
Agriculture	$	—	$	—	$	—	$	—	$	—	$	30	$	30	$	—
Death Care Management		—		—		—		—		—		4,831		4,831		—
Healthcare		—		277		—		2,321		2,598		10,965		13,563		—
Independent Pharmacies		313		615		—		1,170		2,098		39,025		41,123		—
Registered Investment Advisors		—		—		—		—		—		16,304		16,304		—
Veterinary Industry		114		110		646		2,257		3,127		17,858		20,985		—
Other Industries		—		—		—		—		—		1,216		1,216		—

Total		427		1,002		646		5,748		7,823		90,229		98,052		—
Construction & Development
Agriculture		—		—		—		—		—		12,233		12,233		—
Death Care Management		—		—		—		—		—		991		991		—
Healthcare		—		46		—		—		46		7,676		7,722		—
Independent Pharmacies		—		—		—		—		—		687		687		—
Registered Investment Advisors		—		—		—		—		—		75		75		—
Veterinary Industry		—		—		—		—		—		3,038		3,038		—
Other Industries		—		—		—		—		—		679		679		—

Total		—		46		—		—		46		25,379		25,425		—
Owner Occupied Commercial Real Estate
Agriculture		—		—		—		—		—		125		125		—
Death Care Management		1,479		—		—		—		1,479		18,096		19,575		—
Healthcare		—		—		—		2,308		2,308		31,034		33,342		—
Independent Pharmacies		—		—		—		—		—		5,752		5,752		—
Registered Investment Advisors		—		—		—		—		—		2,981		2,981		—
Veterinary Industry		2,959		5,279		165		4,651		13,054		48,038		61,092		—
Other Industries		—		—		—		—		—		3,585		3,585		—

Total		4,438		5,279		165		6,959		16,841		109,611		126,452		—
Commercial Land
Agriculture		—		—		—		—		—		9,354		9,354		—

Total		—		—		—		—		—		9,354		9,354		—

Total¹	$	4,865	$	6,327	$	811	$	12,707	$	24,710	$	234,573	$	259,283	$	—

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)


	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 Loans		Current Loans		Total Loans		Loans 90 Days or More Past Due & Still Accruing
December 31, 2014
Commercial & Industrial
Death Care Management	$	—	$	—	$	—	$	—	$	—	$	3,603	$	3,603	$	—
Healthcare		—		1,059		232		2,420		3,711		8,608		12,319		—
Independent Pharmacies		—		98		—		1,224		1,322		32,757		34,079		—
Registered Investment Advisors		—		—		—		—		—		9,660		9,660		—
Veterinary Industry		1,025		276		4		2,228		3,533		17,369		20,902		—
Other Industries		—		—		—		—		—		494		494		—

Total		1,025		1,433		236		5,872		8,566		72,491		81,057		—
Construction & Development
Agriculture		—		—		—		—		—		3,910		3,910		—
Death Care Management		—		—		—		—		—		92		92		—
Healthcare		—		—		—		—		—		2,957		2,957		—
Independent Pharmacies		—		—		—		—		—		215		215		—
Veterinary Industry		—		—		—		—		—		2,207		2,207		—
Other Industries		—		—		—		—		—		145		145		—

Total		—		—		—		—		—		9,526		9,526		—
Owner Occupied Commercial Real Estate
Agriculture		—		—		—		—		—		259		259		—
Death Care Management		—		—		—		1,721		1,721		17,158		18,879		—
Healthcare		—		145		230		2,082		2,457		23,716		26,173		—
Independent Pharmacies		—		—		—		—		—		4,750		4,750		—
Registered Investment Advisors		—		—		—		—		—		2,161		2,161		—
Veterinary Industry		2,464		5,101		1,951		2,836		12,352		45,582		57,934		—
Other Industries		—		—		—		275		275		1,189		1,464		—

Total		2,464		5,246		2,181		6,914		16,805		94,815		111,620		—
Commercial Land
Agriculture		—		—		—		—		—		1,248		1,248		—

Total		—		—		—		—		—		1,248		1,248		—

Total¹	$	3,489	$	6,679	$	2,417	$	12,786	$	25,371	$	178,080	$	203,451	$	—

Total loans include $21.8 million of U.S. government guaranteed loans as of September 30, 2015, of which $11.1 million is greater than 90 days past due, $3.1 million is 30-89 days past due and $7.6 million is included in current loans as presented above. As of December 31, 2014, total loans include $21.3 million of U.S. government guaranteed loans, of which $11.7 million is greater than 90 days past due, $3.5 million is 30-89 days past due and $6.1 million is included in current loans as presented above.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Nonaccrual Loans

Loans 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 had been accrued in accordance with the original terms, interest income would have increased by approximately $358 thousand and $56 thousand for the three months ended September 30, 2015 and 2014, respectively, and for the nine months ended September 30, 2015 and 2014 interest income would have increased approximately $665 thousand and $147 thousand, respectively. All nonaccrual loans are included in the held for investment portfolio.

Nonaccrual loans as of September 30, 2015 and December 31, 2014 are as follows:


September 30, 2015	Loan Balance		Guaranteed Balance		Unguaranteed Exposure
Commercial & Industrial
Healthcare	$	2,321	$	2,136	$	185
Independent Pharmacies		1,483		1,344		139
Veterinary Industry		3,017		2,979		38

Total		6,821		6,459		362
Owner Occupied Commercial Real Estate
Death Care Management		1,479		1,309		170
Healthcare		2,308		1,990		318
Veterinary Industry		7,775		6,063		1,712

Total		11,562		9,362		2,200
Total	$	18,383	$	15,821	$	2,562



December 31, 2014	Loan Balance		Guaranteed Balance		Unguaranteed Exposure
Commercial & Industrial
Healthcare	$	2,652	$	2,368	$	284
Independent Pharmacies		1,224		1,139		85
Veterinary Industry		3,257		3,113		144

Total		7,133		6,620		513
Owner Occupied Commercial Real Estate
Death Care Management		1,721		1,505		216
Healthcare		2,312		1,919		393
Veterinary Industry		7,251		5,236		2,015
Other Industries		275		275		—

Total		11,559		8,935		2,624
Total	$	18,692	$	15,555	$	3,137

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Allowance for Loan Loss Methodology

The methodology and the estimation process for calculating the Allowance for Loan Losses (“ALL”) is described below:

Estimated credit losses should meet the criteria for accrual of a loss contingency, i.e., a provision to the ALL, set forth in GAAP. The Company’s methodology for determining the ALL 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 ALL is determined by the sum of three separate components: (i) the impaired loan component, which addresses specific reserves for impaired loans; (ii) the general reserve component, which addresses reserves for pools of homogeneous loans; and (iii) an unallocated reserve component (if any) based on management’s judgment and experience. The loan pools and impaired loans are mutually exclusive; any loan that is impaired is excluded from its homogenous pool for purposes of that pool’s reserve calculation, regardless of the level of impairment.

The ALL policy for pooled loans is governed in accordance with banking regulatory guidance for homogenous pools of non-impaired loans that have similar risk characteristics. The Company follows a consistent and structured approach for assessing the need for reserves within each individual loan pool.

Loans 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 agreement. The Company has determined that loans that meet the criteria defined below must be reviewed quarterly to determine if they are impaired.

•

All commercial loans classified substandard or worse.

•

Any other delinquent loan that is in a nonaccrual status, or any loan that is delinquent more than 89 days and still accruing interest.

•

Any loan which has been modified such that it meets the definition of a Troubled Debt Restructuring (TDR).

Any loan determined to be impaired is subjected to an impairment analysis, which is a calculation of the probable loss on the loan. This portion is the loan’s “impairment,” and is established as a specific reserve against the loan, or charged against the ALL.

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 ALL, 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 ALL and the individual specific reserve reduced by a corresponding amount.

For impaired loans, the reserve amount is calculated on a loan-specific basis. The Company utilizes two methods of analyzing impaired loans 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 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.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

The following tables detail activity in the allowance for loan losses by portfolio segment allowance for the periods presented:


Three months ended:	Construction & Development		Owner Occupied Commercial Real Estate			Commercial & Industrial			Commercial Land		Total
September 30, 2015
Beginning Balance	$	844	$	2,346		$	1,653		$	340	$	5,183
Charge offs		—		(7	)		(280	)		—		(287	)
Recoveries		—		12			33			—		45
Provision		336		(260	)		830			306		1,212

Ending Balance	$	1,180	$	2,091		$	2,236		$	646	$	6,153

September 30, 2014
Beginning Balance	$	300	$	1,931		$	1,312		$	25	$	3,568
Charge offs		—		(227	)		(294	)		—		(521	)
Recoveries		—		5			13			—		18
Provision		159		316			(24	)		61		512

Ending Balance	$	459	$	2,025		$	1,007		$	86	$	3,577


Nine months ended:	Construction & Development		Owner Occupied Commercial Real Estate			Commercial & Industrial			Commercial Land		Total
September 30, 2015
Beginning Balance	$	586	$	2,291		$	1,369		$	161	$	4,407
Charge offs		—		(128	)		(638	)		—		(766	)
Recoveries		—		100			73			—		173
Provision		594		(172	)		1,432			485		2,339

Ending Balance	$	1,180	$	2,091		$	2,236		$	646	$	6,153

September 30, 2014
Beginning Balance	$	350	$	1,511		$	862		$	—	$	2,723
Charge offs		—		(346	)		(302	)		—		(648	)
Recoveries		—		72			19			—		91
Provision		109		788			428			86		1,411

Ending Balance	$	459	$	2,025		$	1,007		$	86	$	3,577

The following tables detail the recorded allowance for loan losses and the investment in loans related to each portfolio segment, disaggregated on the basis of impairment evaluation methodology:


September 30, 2015	Construction & Development		Owner Occupied Commercial Real Estate		Commercial & Industrial		Commercial Land		Total
Allowance for Loan Losses:
Loans individually evaluated for impairment	$	—	$	1,032	$	924	$	—	$	1,956
Loans collectively evaluated for impairment		1,180		1,059		1,312		646		4,197

Total allowance for loan losses	$	1,180	$	2,091	$	2,236	$	646	$	6,153

Loans receivable ¹:
Loans individually evaluated for impairment	$	—	$	15,164	$	9,824	$	—	$	24,988
Loans collectively evaluated for impairment		25,425		111,288		88,228		9,354		234,295

Total loans receivable	$	25,425	$	126,452	$	98,052	$	9,354	$	259,283

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)


December 31, 2014	Construction & Development		Owner Occupied Commercial Real Estate		Commercial & Industrial		Commercial Land		Total
Allowance for Loan Losses:
Loans individually evaluated for impairment	$	—	$	1,051	$	676	$	—	$	1,727
Loans collectively evaluated for impairment		586		1,240		693		161		2,680

Total allowance for loan losses	$	586	$	2,291	$	1,369	$	161	$	4,407

Loans Receivable ¹:
Loans individually evaluated for impairment	$	—	$	15,018	$	9,984	$	—	$	25,002
Loans collectively evaluated for impairment		9,526		96,602		71,073		1,248		178,449

Total loans receivable	$	9,526	$	111,620	$	81,057	$	1,248	$	203,451

Loans receivable includes $21.8 million of U.S. government guaranteed loans as of September 30, 2015, of which $19.5 million are included in loans individually evaluated for impairment and $2.3 million are included in loans collectively evaluated for impairment, as presented above. As of December 31, 2014, loans receivable includes $21.3 million of U.S. government guaranteed loans, of which $19.5 million are included in loans individually evaluated for impairment and $2.0 million are included in loans collectively evaluated for impairment, as presented above.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Loans individually evaluated for impairment as of the dates presented are summarized in the following tables.


September 30, 2015	Recorded Investment		Guaranteed Balance		Unguaranteed Exposure
Commercial & Industrial
Healthcare	$	4,155	$	3,290	$	865
Independent Pharmacies		2,279		1,679		600
Veterinary Industry		3,390		2,979		411

Total		9,824		7,948		1,876
Owner Occupied Commercial Real Estate
Death Care Management		1,477		1,309		168
Healthcare		2,498		1,990		508
Veterinary Industry		11,189		8,252		2,937

Total		15,164		11,551		3,613
Total	$	24,988	$	19,499	$	5,489


December 31, 2014	Recorded Investment		Guaranteed Balance		Unguaranteed Exposure
Commercial & Industrial
Healthcare	$	4,205	$	3,540	$	665
Independent Pharmacies		2,199		1,492		707
Veterinary Industry		3,580		3,113		467

Total		9,984		8,145		1,839
Owner Occupied Commercial Real Estate
Death Care Management		1,720		1,505		215
Healthcare		2,309		1,919		390
Veterinary Industry		10,715		7,456		3,259
Other Industries		274		274		—

Total		15,018		11,154		3,864
Total	$	25,002	$	19,299	$	5,703

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

The following table presents evaluated balances of loans 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 fees or costs.


	September 30, 2015
	Recorded Investment
	With a Recorded Allowance		With No Recorded Allowance		Total		Unpaid Principal Balance		Related Allowance Recorded
Commercial & Industrial
Healthcare	$	4,152	$	3	$	4,155	$	4,324	$	483
Independent Pharmacies		2,091		188		2,279		2,668		335
Veterinary Industry		3,352		38		3,390		4,069		106

Total Commercial & Industrial		9,595		229		9,824		11,061		924
Owner Occupied Commercial Real Estate
Death Care Management		1,477		—		1,477		1,613		11
Healthcare		2,361		137		2,498		2,606		65
Veterinary Industry		10,743		446		11,189		12,042		956

Total Owner Occupied Commercial Real Estate		14,581		583		15,164		16,261		1,032

Total Impaired Loans	$	24,176	$	812	$	24,988	$	27,322	$	1,956


	December 31, 2014
	Recorded Investment
	With a Recorded Allowance		With No Recorded Allowance		Total		Unpaid Principal Balance		Related Allowance Recorded
Commercial & Industrial
Healthcare	$	4,202	$	3	$	4,205	$	4,854	$	361
Independent Pharmacies		2,005		194		2,199		2,497		206
Veterinary Industry		3,540		40		3,580		4,062		109

Total Commercial & Industrial		9,747		237		9,984		11,413		676
Owner Occupied Commercial Real Estate
Death Care Management		1,720		—		1,720		1,856		20
Healthcare		2,268		41		2,309		2,413		82
Veterinary Industry		9,796		919		10,715		11,571		947
Other Industries		274		—		274		367		2

Total Owner Occupied Commercial Real Estate		14,058		960		15,018		16,207		1,051

Total Impaired Loans	$	23,805	$	1,197	$	25,002	$	27,620	$	1,727

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)


	Three months ended September 30, 2015				Three months ended September 30, 2014
	Average Balance		Interest Income Recognized		Average Balance		Interest Income Recognized
Commercial & Industrial
Healthcare	$	3,460	$	24	$	2,783	$	—
Independent Pharmacies		2,395		13		818		5
Veterinary Industry		3,790		5		2,910		36

Total Commercial & Industrial		9,645		42		6,511		41
Owner Occupied Commercial Real Estate
Death Care Management		1,412		—		—		—
Healthcare		2,474		—		2,426		—
Veterinary Industry		11,412		42		10,217		81

Total Owner Occupied Commercial Real Estate		15,298		42		12,643		81

Total	$	24,943	$	84	$	19,154	$	122


	Nine months ended September 30, 2015				Nine months ended September 30, 2014
	Average Balance		Interest Income Recognized		Average Balance		Interest Income Recognized
Commercial & Industrial
Healthcare	$	3,388	$	72	$	2,051	$	1
Independent Pharmacies		2,524		38		361		8
Veterinary Industry		3,482		13		3,714		63

Total Commercial & Industrial		9,394		123		6,126		72
Owner Occupied Commercial Real Estate
Death Care Management		1,461		—		—		—
Healthcare		2,372		—		2,047		—
Veterinary Industry		11,357		132		10,971		252

Total Owner Occupied Commercial Real Estate		15,190		132		13,018		252

Total	$	24,584	$	255	$	19,144	$	324

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

The following table represent the types of TDRs that were made during the periods presented:


	Three months ended September 30, 2015						Three months ended September 30, 2014
	All Restructurings						All Restructurings
	Number of Loans		Pre- modification Recorded Investment		Post- modification Recorded Investment		Number of Loans		Pre- modification Recorded Investment		Post- modification Recorded Investment
Interest Only
Commercial & Industrial
Independent Pharmacies		—	$	—	$	—		1	$	144	$	143

Total Interest Only		—		—		—		1		144		143
Extended Amortization
Commercial & Industrial
Independent Pharmacies		2		322		313		—		—		—

Total Extended Amortization		2		322		313		—		—		—
Payment Deferral
Owner Occupied Commercial Real Estate
Deathcare Management		—		—		—		1		353		217

Total Payment Deferral		—		—		—		1		353		217

Total		2	$	322	$	313		2	$	497	$	360


	Nine months ended September 30, 2015						Nine months ended September 30, 2014
	All Restructurings						All Restructurings
	Number of Loans		Pre- modification Recorded Investment		Post- modification Recorded Investment		Number of Loans		Pre- modification Recorded Investment		Post- modification Recorded Investment
Interest Only
Commercial & Industrial
Healthcare		3	$	1,093	$	1,093		—	$	—	$	—
Independent Pharmacies		—		—		—		1		144		143
Owner Occupied Commercial Real Estate
Healthcare		1		95		95		—		—		—
Veterinary Industry		—		—		—		1		8		8

Total Interest Only		4		1,188		1,188		2		152		151
Extended Amortization
Commercial & Industrial
Independent Pharmacies		2		322		313		2		379		367

Total Extended Amortization		2		322		313		2		379		367
Payment Deferral
Commercial & Industrial
Veterinary Industry		—		—		—		3		219		216
Owner Occupied Commercial Real Estate
Deathcare Management		—		—		—		1		353		217

Total Payment Deferral		—		—		—		4		572		433

Total		6	$	1,510	$	1,501		8	$	1,103	$	951

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans and Allowance for Loan Losses (Continued)

Concessions made to improve a loan’s performance have varying degrees of success. No TDRs that were modified within the twelve months ended September 30, 2015 subsequently defaulted during the three and nine months ended September 30, 2015. During the three and nine months ended September 30, 2014, one TDR that was modified within the twelve months ended September 30, 2014 subsequently defaulted. This TDR was an owner occupied commercial real estate deathcare management loan that was previously modified for payment deferral. The recorded investment for this TDR at September 30, 2014 was $217 thousand.

Note 6. Servicing Assets

Loans serviced for others are not included in the accompanying balance sheet. The unpaid principal balances of loans serviced for others were $1.79 billion and $1.47 billion at September 30, 2015 and December 31, 2014, respectively.

The following summarizes the activity pertaining to servicing rights:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2015			2014			2015			2014
Balance at beginning of period	$	39,983		$	33,181		$	34,999		$	29,053
Additions, net		3,613			2,902			10,322			7,653
Changes in fair value		(3,006	)		(984	)		(4,731	)		(1,607	)

Balance at end of period	$	40,590		$	35,099		$	40,590		$	35,099

The fair value of servicing rights was determined using discount rates ranging from 9.23% to 13.52% on September 30, 2015, and 6.45% to 12.52% on September 30, 2014. The fair value of servicing rights was determined using prepayment speeds ranging from 4.05% to 9.90% on September 30, 2015 and 1.89% to 9.24% on September 30, 2014, depending on the stratification of the specific right. Changes to fair value are reported in loan servicing revenue and revaluation.

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.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 7. Borrowings

Total outstanding short and long term borrowings consisted of the following:


	September 30, 2015		December 31, 2014
Short term borrowings
On September 18, 2014, the Company entered into a line of credit of $6.1 million with an unaffiliated commercial bank, secured by 1,900,000 shares of common stock of nCino, Inc., a former subsidiary of the Company. At December 31, 2014 there was $6.1 million advanced on the line of credit. Interest accrues at 30 day LIBOR (0.16% at December 31, 2014) plus 3.50% for a term of 12 months. Payments are interest only with all principal and accrued interest due on September 18, 2015. This loan was repaid in full on February 23, 2015.	$	—	$	6,100

Total short term borrowings	$	—	$	6,100

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 7. Borrowings (Continued)


	September 30, 2015		December 31, 2014
Long term borrowings
In April 2011, the Company elected to participate in the U.S. Treasury’s Small Business Lending Fund program (“SBLF”) whereby the U.S. Treasury agreed to purchase $6.8 million in senior securities. During the initial interest period the applicable interest rate was set at 1.5%. For all remaining interest periods, which commenced on January 1, 2012, the interest rate is determined based on a formula which encompasses the percentage change in qualified lending as well as a non-qualifying portion percentage. This rate can range from 1.5% to 10.8%. At September 30, 2015 the interest rate was 1.50%. Interest is payable quarterly in arrears. With the approval of the Company’s regulator, the Company may exit the Small Business Lending Fund at any time simply by repaying the funding provided along with any accrued but unpaid interest. If the institution wishes to repay its SBLF funding in partial payments, each partial payment must be at least 25% of the original funding amount. All senior securities will mature on September 13, 2021 at which time all principal and accrued interest will be due.	$	6,800	$	6,800
On May 12, 2014, Independence Aviation financed the purchase of an airplane by entering into a promissory note with an unaffiliated commercial bank in the amount of $6 million which carries a fixed rate of 4.97% for a term of 59 months. Monthly payments are set at $48 thousand with all principal and accrued interest due on May 12, 2019.		5,631		5,842
On September 11, 2014, the Company financed the construction of an additional building located on the Company’s Tiburon Drive main campus for a $24 million construction line of credit with an unaffiliated commercial bank, secured by both properties at its Tiburon Drive main facility location. Payments are interest only through September 11, 2016 at a fixed rate of 3.95% for a term of 84 months. Monthly principal and interest payments beginning in October 2016 will be $146 thousand with all principal and accrued interest due on September 11, 2021. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios. The construction line is fully disbursed and there was no remaining available credit on this construction line at September 30, 2015.		24,000		16,914

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 7. Borrowings (Continued)


	September 30, 2015		December 31, 2014
On September 18, 2014, the Company entered into a note payable revolving line of credit of $8.1 million with an unaffiliated commercial bank, with the first advance of $5 million on December 14, 2014. The note is unsecured and accrues interest at LIBOR plus 3.50% for a term of 36 months. The current rate is 3.693%. Payments are interest only with all principal and accrued interest due on September 18, 2017. There is no outstanding balance at September 30, 2015; therefore, there is $8.1 million of available credit on this note at September 30, 2015.		—		5,000
On August 1, 2014, the Company entered into a note payable line of credit of $15 million with an unaffiliated commercial bank, secured by 100% of Live Oak Banking Company’s outstanding common stock. Interest accrues at LIBOR plus 4.00% for a term of 36 months. Payments are interest only with all principal and accrued interest due on August 1, 2017. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios. This note was repaid in full on July 29, 2015.		—		7,210
On March 10, 2015, Independence Aviation refinanced an existing loan with Live Oak Banking Company and entered into a new loan with an unaffiliated commercial bank in the amount of $1.2 million which carries a fixed rate of 4.96% for a term of 51 months. Monthly payments are set at $9 thousand with all principal and accrued interest due on June 10, 2019.		1,173		—
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 September 30, 2015 is 4.25%. The maturity date is October 5, 2019. The pledged collateral is classified in other assets with a fair value of $4.5 million at September 30, 2015. Underlying loans carry a risk grade of 3 and are current with no delinquencies. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios.		4,475		—
With the acquisition of GLS on September 1, 2013, the Company assumed the obligation to pay a former GLS partner $250 thousand at $10 thousand a month over a 24 month period. This obligation was paid in full on August 17, 2015.		—		83

Total long term borrowings	$	42,079	$	41,849

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 8. Fair Value of Financial Instruments

Fair Value Hierarchy

There are three levels of inputs in the fair value hierarchy that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.

Financial Instruments Measured at Fair Value

The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the fair value hierarchy:

Investment Securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, discounted cash flow or at net asset value per share. Level 2 securities would include US government agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed 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.

The Company invested $1.9 million in the 504 Fund mutual fund on March 31, 2015 and accordingly identified it as a Level 1 investment on that date. During the second quarter of 2015, the Company transferred this $1.9 million investment from Level 1 to Level 2, where it continues to be classified.

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. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records foreclosed real estate as nonrecurring Level 3. Foreclosed assets classified as Level 3 are based on management’s judgment and estimation.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 8. Fair Value of Financial Instruments (Continued)

Recurring Fair Value

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.


September 30, 2015	Total		Level 1		Level 2		Level 3
Investment securities available-for-sale
US government agencies	$	27,213	$	—	$	27,213	$	—
Residential mortgage-backed securities		22,466		—		22,466		—
Mutual fund		1,949		—		1,949		—
Servicing assets¹		40,590		—		—		40,590

Total assets at fair value	$	92,218	$	—	$	51,628	$	40,590


December 31, 2014	Total		Level 1		Level 2		Level 3
Investment securities available-for-sale
US government agencies	$	35,309	$	—	$	35,309	$	—
Residential mortgage-backed securities		14,009		—		14,009		—
Servicing assets¹		34,999		—		—		34,999

Total assets at fair value	$	84,317	$	—	$	49,318	$	34,999

¹	See Note 6 for a rollforward of recurring Level 3 fair values for servicing assets.

Non-recurring Fair Value

The tables below present the recorded amount of assets and liabilities measured at fair value on a non-recurring basis.


September 30, 2015	Total		Level 1		Level 2		Level 3
Impaired loans	$	22,224	$	—	$	—	$	22,224
Foreclosed assets		48		—		—		48

Total assets at fair value	$	22,272	$	—	$	—	$	22,272


December 31, 2014	Total		Level 1		Level 2		Level 3
Impaired loans	$	24,016	$	—	$	—	$	24,016
Foreclosed assets		371		—		—		371

Total assets at fair value	$	24,387	$	—	$	—	$	24,387

Level 3 Analysis

For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of September 30, 2015 and December 31, 2014 the significant unobservable inputs used in the fair value measurements were as follows:

September 30, 2015

Level 3 Assets with Significant
Unobservable Inputs

Fair Value

Valuation Technique

Significant
Unobservable
Inputs

Range

Impaired Loans

22,224

Discounted appraisals
Discounted expected cash flows

Appraisal adjustments ⁽¹⁾
Interest rate & repayment term

10% to 20%
Weighted
average discount
rate 5.97%

Foreclosed Assets

Discounted appraisals

Appraisal adjustments ⁽¹⁾

10% to 20%

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 8. Fair Value of Financial Instruments (Continued)

December 31, 2014

Level 3 Assets with Significant
Unobservable Inputs

Fair Value

Valuation Technique

Significant
Unobservable
Inputs

Range

Impaired Loans

24,016

Discounted appraisals
Discounted expected cash flows

Appraisal adjustments ⁽¹⁾
Interest rate & repayment term

10% to 20%
Weighted
average discount
rate 4.88%

Foreclosed Assets

371

Discounted appraisals

Appraisal adjustments ⁽¹⁾

10% to 20%

(1)	Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments.

Estimated Fair Value of Other Financial Instruments

GAAP also requires disclosure of fair value information about financial instruments carried at book value on the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments not measured at fair value on the balance sheets:

Cash and due from banks: The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.

Certificates of deposit with other banks: The fair value of certificates of deposit with other banks is estimated based on discounting cash flows using the rates currently offered for instruments of similar remaining maturities.

Loans held for sale: The fair values of loans held for sale are based on quoted market prices, where available, and determined by discounting estimated cash flows using interest rates approximating the Company’s current origination rates for similar loans adjusted to reflect the inherent credit risk.

Loans: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.

Accrued Interest: The carrying amounts of accrued interest approximate fair value.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 8. Fair Value of Financial Instruments (Continued)

Short and long term borrowings: The fair values of the Company’s short term borrowings approximate fair value while long term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental debt rates for similar types of debt arrangements.

The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:


September 30, 2015	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	$	129,881	$	129,881	$	—	$	—	$	129,881
Certificates of deposit with other banks		10,000		9,984		—		—		9,984
Investment securities, available-for-sale		51,628		—		51,628		—		51,628
Loans held for sale		443,871		—		—		458,780		458,780
Loans, net of allowance for loan losses		253,399		—		—		247,906		247,906
Servicing assets		40,590		—		—		40,590		40,590
Accrued interest receivable		4,841		4,841		—		—		4,841
*Financial liabilities*
Deposits		762,628		—		754,715		—		754,715
Accrued interest payable		243		243		—		—		243
Long term borrowings		42,079		—		—		44,987		44,987

December 31, 2014	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	$	29,902	$	29,902	$	—	$	—	$	29,902
Certificates of deposit with other banks		10,000		9,861		—		—		9,861
Investment securities, available-for-sale		49,318		—		49,318		—		49,318
Loans held for sale		295,180		—		—		304,504		304,504
Loans, net of allowance for loan losses		199,529		—		—		194,007		194,007
Servicing assets		34,999		—		—		34,999		34,999
Accrued interest receivable		3,059		3,059		—		—		3,059
*Financial liabilities*
Deposits		522,080		—		522,058		—		522,058
Accrued interest payable		190		190		—		—		190
Short term borrowings		6,100		—		—		6,100		6,100
Long term borrowings		41,849		—		—		44,738		44,738

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 9. Commitments and Contingencies

Litigation

In the normal course of business the Company is involved in various legal proceedings. Management believes that the outcome of such proceedings will not materially affect the financial position, results of operations or cash flows of the Company.

Financial Instruments with Off-balance-sheet Risk

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheet.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments is as follows:


	September 30, 2015		December 31, 2014
Commitments to extend credit	$	747,909	$	537,951
Plexus Capital - Fund II Investment Commitment		100		100
Plexus Capital - Fund III Investment Commitment		300		350

Total unfunded off-balance sheet credit risk	$	748,309	$	538,401

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. There were no standby letters of credit for the periods presented.

Concentrations of Credit Risk

Although the Company is not subject to any geographic concentrations, a substantial amount of the Company’s loans and commitments to extend credit have been granted to customers in the independent pharmacy 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 exposure exceeds $2.0 million, except for one relationship that has a retained exposure of $2.8 million.

The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 10. 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. The 2015 Omnibus Plan authorized awards covering a maximum of 4,300,000 common voting shares and has an expiration date of March 20, 2025. Options or restricted shares granted under this plan expire no more than 10 years from 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 September 30, 2015 and 2014, the Company recognized $431 thousand and $33 thousand in compensation expense for stock options, respectively. For the nine months ended September 30, 2015 and 2014, the Company recognized $726 thousand and $112 thousand in compensation expense for stock options, respectively.

Stock option activity under the plan during the nine month periods ended September 30, 2015 and 2014 is summarized below.


	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Outstanding at December 31, 2014		1,737,570	$	5.51
Exercised		47,570		4.52
Forfeited		192,671		8.38
Granted		1,829,748		15.52

Outstanding at September 30, 2015		3,327,077	$	10.86		9.16 years	$	29,197,309

Exercisable at September 30, 2015		158,950	$	4.65		8.05 years	$	2,382,744


	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Terms		Aggregate Intrinsic Value
Outstanding at December 31, 2013		225,000	$	1.01
Exercised		191,660		0.92
Forfeited		170,590		4.40
Granted		1,874,820		5.48

Outstanding at September 30, 2014		1,737,570	$	5.51		9.54 years	$	8,902,969

Exercisable at September 30, 2014		22,227	$	1.52		7.04 years	$	202,486

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 10. Stock Plans (Continued)

The following is a summary of non-vested stock option activity for the Company for the nine months ended September 30, 2015 and 2014.


	Shares		Weighted Average Grant Date Fair Value
Non-vested at December 31, 2014		1,704,230	$	1.18
Granted		1,829,748		6.79
Vested		173,180		0.97
Forfeited		192,671		2.63

Non-vested at September 30, 2015		3,168,127	$	4.35


	Shares		Weighted Average Grant Date Fair Value
Non-vested at December 31, 2013		91,754	$	0.44
Granted		1,874,820		1.13
Vested		80,641		0.44
Forfeited		170,590		0.58

Non-vested at September 30, 2014		1,715,343	$	1.18

The total intrinsic value of options exercised at September 30, 2015 and 2014 was $392 thousand and $771 thousand, respectively.

At September 30, 2015, unrecognized compensation costs relating to stock options amounted to $13.1 million which will be expensed over the next 7 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. Weighted average assumptions used for options granted during 2015 were as follows: risk free rate of 1.96%, dividend yield of 1.00%, volatility of 43.38% and average life of 4-7 years.

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 10. Stock Plans (Continued)

Restricted Stock

Restricted stock activity under the plan during the first nine months of 2015 is summarized below.


	Shares		Weighted Average Grant Date Fair Value
Outstanding at December 31, 2014		—	$	—
Granted		65,122		16.10
Vested		—		—
Exercised		—		—
Forfeited		607		10.63

Non-vested at September 30, 2015		64,515	$	16.15

For the three months ended September 30, 2015 and 2014, the Company recognized $67 thousand and a credit of ($19) thousand in compensation expense due to forfeited shares for restricted stock, respectively. For the nine months ended September 30, 2015 and 2014, the Company recognized $83 thousand and $143 thousand in compensation expense for restricted stock, respectively.

At September 30, 2015, unrecognized compensation costs relating to restricted stock amounted to $959 thousand which will be expensed over the next 3.75 years.

The fair value of each restricted stock unit is based on the market value of the Company’s stock on the date of the grant.

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 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. Results of operations for the periods included in this review 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,” “may,” “should,” “could,” “would,” “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 losses and provisions for those losses and other adverse impacts to results of operations and financial condition;

•

changes in SBA loan products, including specifically the Section 7(a) program, or changes in SBA standard operating procedures;

•

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 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 reduced rates of business formation and growth, demand for the Company’s products and services, commercial and residential real estate development, real estate prices, 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;

•

governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA lending programs;

•

changes in political and economic conditions, including continuing political and economic effects of the global economic downturn and other major developments;

•

the impact of heightened regulatory scrutiny of financial products, primarily led by the Consumer Financial Protection Bureau;

•

the ability to comply with any requirements imposed on the Company or the Bank by respective regulators, and the potential negative consequences that may result;

•

Operational, compliance and other factors, including conditions in local areas in which we conduct 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 that the Company or Bank acquire;

•

other risk factors listed from time to time in reports that the Company files with the SEC, including in the Company’s registration statement on Form S-1 (File No. 333-205126), as amended; 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 LOB 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.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements for the year ended December 31, 2014 and accompanying notes and other detailed information appearing in the Company’s registration statement on Form S-1(File No. 333-205126), as amended, filed with the SEC.

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

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 established in May 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within selected industry sectors, or verticals, by leveraging expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 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.

In addition to the Bank, the Company owns Independence Aviation, LLC, which was formed for the purpose of purchasing and operating aircraft used for the Company’s business purposes, 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”), 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.

The Company earns revenue primarily from the sale of SBA-guaranteed loans. This income is comprised of loan servicing revenue and revaluation and net gains on sales of loans. Net interest income is another contributor to earnings. Offsetting these revenues are the cost of funding sources, provision for loan 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.

Conversion from S Corporation to C Corporation

Effective August 3, 2014, the Company terminated its status as an “electing small business corporation,” or S corporation, under Subchapter S of the Internal Revenue Code of 1986, or the Code, and became a C corporation under the Code for income tax purposes. As a result of the conversion to a C corporation, the Company recorded a net deferred tax liability of $3.3 million on the balance sheet. Upon recognition of the deferred tax liability the Company also recorded an offsetting adjustment to income tax expense of $3.3 million, which decreased after-tax earnings and shareholders’ equity by the same amount.

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.

Third quarter 2015 results demonstrated solid underlying financial performance and growth momentum for the Company. Management is focused not only on building out existing verticals but incrementally adding new verticals to the loan portfolio. The Company expects to originate approximately $1.1 billion in loans for the year 2015. Personnel and travel expenses increased during the first nine months of 2015 primarily due to further investment to support the growing loan production as well as development of a new small loan platform and other infrastructure costs, and the Company expects noninterest expense to increase consistent with the growth stage of its lifecycle.

During the first three quarters of 2015, the percentage of loans that the Company originated representing multi-advance loans increased, and the Company expects that percentage to continue on an upward trend over the next several quarters. The Company anticipates this trend will drive growth in the portfolio of loans held for sale, and a consequence of this growth will likely be an increase in the time period before gain-on-sale and servicing revenue on these loans can be realized. The Company expects a growing portfolio of loans held for sale to have a positive impact on net interest income and to partially offset the impact of the increased timing to the recognition of noninterest income. In addition, if loan production continues to increase with an increased focus on multi-advance loans, the Company also anticipates a decline over the next several quarters in the amount of loans sold as a percentage of the loans the Company originates.

Net gains on sale of loans is primarily driven by the volume of loans sold and the premium paid in the secondary market for these loans. During the third quarter of 2015, the average net gain on sale for loans sold decreased below prior quarters’ gains, which management believes was driven primarily by market conditions. There has been some stabilization in the market since the end of the third quarter, with average net gain on sale trending up from these lower levels. Market conditions indicate that trend will continue in the fourth quarter, though it is uncertain whether the premiums paid for loans that the Company sells will return to prior levels or, if so, when that may occur.

Results of Operations

Performance Summary

Three months ended September 30, 2015 compared with three months ended September 30, 2014

For the three months ended September 30, 2015, the Company reported net income of $2.9 million, or $0.09 per diluted share, as compared to $641 thousand, or $0.02 per diluted share, for the three months ended September 30, 2014. This $2.3 million increase in quarterly net income is principally due to the following items:

•

Increased net interest income of $2.7 million, or 69.7%, arising primarily from an increase in levels of loans held for sale related to originations in newer verticals that require a period of loan advances before being sold, which loans are sometimes referred to as “multi-advance loans” in this Report;

•

Increased noninterest income of $1.3 million, or 7.7%, related principally to increased gains on sales of loans of $2.3 million, or 17.7%, partially offset by a $1.7 million, or 51.5%, decrease in loan servicing revenue and revaluation arising from increased negative servicing asset valuation adjustments of $2.0 million in the third quarter of 2015; and

•

Decreased income tax expense of $3.7 million, or 62.7%. The higher level of income tax expense in the third quarter of 2014 was related to a one-time $3.3 million deferred tax liability recorded upon conversion from an S to C corporation.

Partially offsetting the above items which contributed to increased levels of net income was increased noninterest expense of $4.8 million, or 36.0%. The increased level of noninterest expense was principally driven by costs underlying increased loan production and the build out of new initiatives of the Company, including increased salaries of $3.8 million, or 62.6%, and travel expense of $389 thousand, or 21.7%.

Nine months ended September 30, 2015 compared with nine months ended September 30, 2014

For the nine months ended September 30, 2015, the Company reported net income of $14.9 million, or $0.48 per diluted share, as compared to $7.6 million, or $0.33 per diluted share, for the nine months ended September 30, 2014. This increase in net income is primarily attributable to the following items:

•

Increased net interest income of $6.6 million, or 63.7%, arising primarily from an increase in levels of loans held for sale related to originations in newer verticals that require a period of loan advances before being sold; and

•

Increased noninterest income of $16.1 million, or 36.8%, predominately comprised of $11.1 million, or 31.4%, growth in net gains on sale of loans, the absence of (i) $2.4 million in one-time losses on investments in non-consolidated affiliates and (ii) a one-time gain of $3.8 million related to the sale of an investment in nCino, Inc., a former subsidiary of the Company (“nCino”), partially offset by a $2.1 million, or 21.8%, decrease in loan servicing revenue and revaluation arising from increased negative servicing asset valuation adjustments of $3.1 million in the nine months ended September 30, 2015.

Partially offsetting the above items which contributed to increased levels of net income was increased noninterest expense of $10.3 million, or 26.2%. The increased level of noninterest expense was principally driven by costs underlying increased loan production and the build out of new initiatives of the Company, including increases to salaries of $5.8 million, or 26.5%, and to travel expense of $2.0 million, or 50.9%. Also partially offsetting the contributors to increased levels of net income was an increase to income tax expense of $4.3 million, or 71.9%, arising from the Company’s status as a C Corporation commencing on August 3, 2014.

Net Interest Income and Margin

Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers 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 the Bank offer are generally above the industry average.

Three months ended September 30, 2015 compared with three months ended September 30, 2014

For the three months ended September 30, 2015, net interest income increased $2.7 million, or 69.7%, to $6.6 million compared to the three months ended September 30, 2014. This increase was due to growth in average interest earning assets. Average interest earning assets increased by $349.1 million, or 70.7%, to $842.9 million for the three months ended September 30, 2015 compared to $493.9 million for the three months ended September 30, 2014, while the yield on average interest earning assets decreased slightly by three basis points to 4.24%. The cost of funds on interest bearing liabilities for the three months ended September 30, 2015 increased slightly by three basis points to 1.22%, and the average balance in interest bearing liabilities increased by $299.7 million, or 62.9%, over the same period. As indicated in the rate/volume table below, the slight increase in the cost of funds was outpaced by the effects of the increased volume of interest earning assets, resulting in increased interest income of $3.7 million and increased interest expense of $966 thousand for the three months ended September 30, 2015. For the three months ended September 30, 2015 compared to the three months ended September 30, 2014, net interest margin decreased from 3.13% to 3.11% due to the aforementioned effects.

Nine months ended September 30, 2015 compared with nine months ended September 30, 2014

For the nine months ended September 30, 2015, net interest income increased $6.6 million, or 63.7%, to $17.1 million compared to the nine months ended September 30, 2014. This increase was also due to growth in average interest earning assets. Average interest earning assets increased by $303.9 million, or 67.2%, to $756.5 million for the nine months ended September 30, 2015 compared to $452.5 million for the nine months ended September 30, 2014, while the yield on average interest earning assets decreased by nine basis points to 4.17%. The cost of funds on interest bearing liabilities for the nine months ended September 30, 2015 increased slightly by four basis points to 1.23%, and the average balance in interest bearing liabilities increased by $263.9 million, or 58.6% during the same period. As indicated in the rate/volume table below, the slight increase in the cost of funds was outpaced by the effects of the increased volume of interest earning assets, resulting in increased interest income of $9.2 million and increased interest expense of $2.5 million for the nine months ended September 30, 2015. For the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, net interest margin decreased from 3.08% to 3.02% due to the aforementioned effects.

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. Loan fees are included in interest income on loans.


	Three Months Ended September 30,
	2015								2014
	Average Balance			Interest		Average Yield/ Rate			Average Balance			Interest		Average Yield/ Rate
Interest earning assets:
Interest earning balances in other banks	$	110,425		$	84		0.30	%	$	70,155		$	38		0.21	%
Investment securities		60,192			211		1.39			21,655			93		1.70
Loans held for sale		428,940			5,622		5.20			229,634			2,990		5.17
Loans held for investment⁽¹⁾		243,346			3,082		5.02			172,407			2,199		5.06

Total interest earning assets		842,903			8,999		4.24			493,851			5,320		4.27

Less: allowance for loan losses		(5,202	)							(3,544	)
Non-interest earning assets		142,414								89,437

Total assets	$	980,115							$	579,744

Interest bearing liabilities:
Money market accounts	$	376,495		$	684		0.72	%	$	217,532		$	539		0.98	%
Certificates of deposit		358,738			1,313		1.45			230,068			633		1.09

Total deposits		735,233			1,997		1.08			447,600			1,172		1.04

Small business lending fund		6,800			26		1.52			6,800			26		1.52
Notes payable to investors		—			—		—			3,623			91		9.97
Other borrowings		34,612			369		4.23			18,877			137		2.88

Total interest bearing liabilities		776,645			2,392		1.22			476,900			1,426		1.19

Non-interest bearing deposits		14,086								10,746
Non-interest bearing liabilities		19,716								8,893
Redeemable equity		—								2,390
Shareholders’ equity		169,639								80,815
Noncontrolling interest		29								—

Total liabilities and shareholders’ equity	$	980,115							$	579,744

Net interest income and interest rate spread				$	6,607		3.02	%				$	3,894		3.08	%

Net interest margin							3.11								3.13

Ratio of average interest-earning assets to average interest-bearing liabilities							108.53	%							103.55	%

⁽¹⁾	Average loan balances include non-accruing loans.


	Nine Months Ended September 30,
	2015								2014
	Average Balance			Interest		Average Yield/ Rate			Average Balance			Interest		Average Yield/ Rate
Interest earning assets:
Interest earning balances in other banks	$	90,981		$	220		0.32	%	$	60,836		$	102		0.22	%
Investment securities		59,773			587		1.31			19,970			292		1.95
Loans held for sale		393,791			15,001		5.09			221,337			8,429		5.09
Loans held for investment⁽¹⁾		211,906			7,810		4.93			150,398			5,611		4.99

Total interest earning assets		756,451			23,618		4.17			452,541			14,434		4.26

Less: allowance for loan losses		(4,943	)							(3,160	)
Non-interest earning assets		117,186								83,720

Total assets	$	868,694							$	533,101

Interest bearing liabilities:
Money market accounts	$	342,270		$	1,919		0.75	%	$	214,910		$	1,732		1.08	%
Certificates of deposit		326,968			3,355		1.37			214,340			1,669		1.04

Total deposits		669,238			5,274		1.05			429,250			3,401		1.06

Small business lending fund		6,800			77		1.51			6,800			76		1.49
Notes payable to investors		—			—		—			3,623			272		10.04
Other borrowings		38,393			1,203		4.19			10,892			263		3.23

Total interest bearing liabilities		714,431			6,554		1.23			450,565			4,012		1.19

Non-interest bearing deposits		13,659								11,136
Non-interest bearing liabilities		17,096								8,186
Redeemable equity		—								3,196
Shareholders’ equity		123,494								60,018
Noncontrolling interest		14								—

Total liabilities and shareholders’ equity	$	868,694							$	533,101

Net interest income and interest rate spread				$	17,064		2.94	%				$	10,422		3.07	%

Net interest margin							3.02								3.08

Ratio of average interest-earning assets to average interest-bearing liabilities							105.88	%							100.44	%

⁽¹⁾	Average loan balances include non-accruing loans.

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 current 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, changes 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 September 30,

Nine Months Ended September 30,

2015 vs. 2014

Increase (Decrease) Due to

Rate

Volume

Total

Rate

Volume

Total

Interest income: