Edgar Filing: Live Oak Bancshares, Inc.

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q



ý	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2016



¨	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 ý NO ¨

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions 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 ý

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of November 7, 2016, there were 29,509,945 shares of the registrant’s voting common stock outstanding and 4,723,530 shares of the registrant’s non-voting common stock outstanding.

Table of Contents

Live Oak Bancshares, Inc. and Subsidiaries

Form 10-Q

For the Quarterly Period Ended September 30, 2016

TABLE OF CONTENTS



		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)	1
	Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015	1
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2016 and 2015	2
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2016 and 2015	3
	Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months Ended September 30, 2016 and 2015	4
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2016 and 2015	5
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	54
Item 4.	Controls and Procedures	54
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	55
Item 1A.	Risk Factors	55
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	55
Item 3.	Defaults Upon Senior Securities	55
Item 4.	Mine Safety Disclosures	55
Item 5.	Other Information	55
Item 6.	Exhibits	55
	Signatures	56
	Index to Exhibits	57

Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Live Oak Bancshares, Inc.

Consolidated Balance Sheets

As of September 30, 2016 (unaudited) and December 31, 2015*

(Dollars in thousands)



	September 30, 2016			December 31, 2015*
Assets
Cash and due from banks	$	355,485		$	102,607
Certificates of deposit with other banks	7,500			10,250
Investment securities available-for-sale	70,334			53,762
Loans held for sale	345,277			480,619
Loans held for investment	766,977			279,969
Allowance for loan losses	(15,178		)	(7,415		)
Net loans	751,799			272,554
Premises and equipment, net	60,646			62,653
Foreclosed assets	2,235			2,666
Servicing assets	49,729			44,230
Other assets	26,735			23,281
Total assets	$	1,669,740		$	1,052,622
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing	$	28,461		$	21,502
Interest-bearing	1,374,556			783,286
Total deposits	1,403,017			804,788
Long term borrowings	28,074			28,375
Other liabilities	24,497			19,971
Total liabilities	1,455,588			853,134
Shareholders’ equity
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at September 30, 2016 and December 31, 2015	—			—
Class A common stock, no par value, 100,000,000 shares authorized, 29,491,520 and 29,449,369 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively	145,284			137,492
Class B common stock, no par value, 10,000,000 shares authorized, 4,723,530 shares issued and outstanding at September 30, 2016 and December 31, 2015	50,015			50,015
Retained earnings	18,723			12,140
Accumulated other comprehensive income (loss)	130			(192		)
Total shareholders’ equity attributed to Live Oak Bancshares, Inc.	214,152			199,455
Noncontrolling interest	—			33
Total equity	214,152			199,488
Total liabilities and shareholders’ equity	$	1,669,740		$	1,052,622

* Derived from audited consolidated financial statements.

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Income

For the three and nine months ended September 30, 2016 and 2015 (unaudited)

(Dollars in thousands, except per share data)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
Interest income
Loans and fees on loans	$	14,961		$	8,728		$	38,868		$	22,866
Investment securities, taxable	337			211			840			587
Other interest earning assets	264			84			650			220
Total interest income	15,562			9,023			40,358			23,673
Interest expense
Deposits	3,689			1,997			9,376			5,274
Borrowings	242			395			725			1,280
Total interest expense	3,931			2,392			10,101			6,554
Net interest income	11,631			6,631			30,257			17,119
Provision for loan losses	3,806			1,212			8,692			2,339
Net interest income after provision for loan losses	7,825			5,419			21,565			14,780
Noninterest income
Loan servicing revenue	5,860			4,216			15,725			11,678
Loan servicing asset revaluation	(3,421		)	(2,650		)	(5,051		)	(4,234		)
Net gains on sales of loans	21,833			15,424			52,813			46,604
Equity in loss of non-consolidated affiliates	—			—			—			(26		)
Gain on sale of investment in non-consolidated affiliate	—			—			—			3,782
Gain on sale of investment securities available-for-sale	1			12			1			12
Construction supervision fee income	502			344			1,799			877
Other noninterest income	657			424			1,925			1,267
Total noninterest income	25,432			17,770			67,212			59,960
Noninterest expense
Salaries and employee benefits	17,471			9,949			45,875			27,623
Travel expense	2,218			2,200			6,394			5,914
Professional services expense	907			493			2,345			1,891
Advertising and marketing expense	1,097			1,051			3,425			3,177
Occupancy expense	1,058			703			3,306			1,920
Data processing expense	1,252			773			3,864			2,388
Equipment expense	611			642			1,696			1,473
Other loan origination and maintenance expense	806			673			2,001			1,384
Other expense	1,798			1,579			5,155			3,811
Total noninterest expense	27,218			18,063			74,061			49,581
Income before taxes	6,039			5,126			14,716			25,159
Income tax expense	2,561			2,228			6,432			10,272
Net income	3,478			2,898			8,284			14,887
Net loss attributable to noncontrolling interest	1			3			9			23
Net income attributable to Live Oak Bancshares, Inc.	$	3,479		$	2,901		$	8,293		$	14,910
Basic earnings per share	$	0.10		$	0.09		$	0.24		$	0.50
Diluted earnings per share	$	0.10		$	0.09		$	0.24		$	0.48

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Comprehensive Income

For the three and nine months ended September 30, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
Net income	$	3,478		$	2,898		$	8,284		$	14,887
Other comprehensive (loss) income before tax:
Net unrealized (loss) gain on investment securities arising during the period	(115		)	151			525			15
Reclassification adjustment for (gain) loss on sale of securities available-for-sale included in net income	(1		)	(12		)	(1		)	(12		)
Other comprehensive (loss) income before tax	(116		)	139			524			3
Income tax benefit (expense)	45			(53		)	(202		)	(1		)
Other comprehensive (loss) income, net of tax	(71		)	86			322			2
Total comprehensive income	$	3,407		$	2,984		$	8,606		$	14,889

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

For the nine months ended September 30, 2016 and 2015 (unaudited)

(Dollars in thousands)



	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, 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
Balance at December 31, 2015	29,449,369	4,723,530	$	187,507	$	12,140		$	(192	)	$	33		$	199,488
Net income (loss)	—	—	—		8,293			—			(9		)	8,284
Other comprehensive income	—	—	—		—			322			—			322
Issuance of restricted stock	16,745	—	—		—			—			—			—
Stock option exercises	25,406	—	147		—			—			—			147
Stock option based compensation expense	—	—	1,752		—			—			—			1,752
Restricted stock expense	—	—	5,893		—			—			—			5,893
Acquisition of non-controlling interest	—	—	—		—			—			(24		)	(24		)
Dividends (distributions to shareholders)	—	—	—		(1,710		)	—			—			(1,710		)
Balance at September 30, 2016	29,491,520	4,723,530	$	195,299	$	18,723		$	130		$	—		$	214,152

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows

For the nine months ended September 30, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Nine Months Ended September 30,
	2016			2015
Cash flows from operating activities
Net income	$	8,284		$	14,887
Adjustments to reconcile net income to net cash used by operating activities:
Depreciation and amortization	3,201			1,917
Provision for loan losses	8,692			2,339
Amortization of premium on securities, net of accretion	135			36
Amortization (accretion) of discount on unguaranteed loans, net	773			1,650
Deferred tax (benefit) expense	(510		)	936
Originations of loans held for sale	(701,415		)	(740,378		)
Proceeds from sales of loans held for sale	555,192			508,322
Net gains on sale of loans held for sale	(52,813		)	(46,604		)
Net loss on sale of foreclosed assets	61			12
Net increase in servicing assets	(5,499		)	(5,591		)
Gain on sale of securities available-for-sale	(1		)	(12		)
Gain on sale of investment in non-consolidated affiliate	—			(3,782		)
Net loss on disposal of premises and equipment	—			16
Stock option based compensation expense	1,752			726
Restricted stock expense	5,893			83
Equity in loss of non-consolidated affiliates	—			26
Changes in assets and liabilities:
Other assets	(858		)	(2,431		)
Other liabilities	2,652			2,025
Net cash used by operating activities	(174,461		)	(265,823		)
Cash flows from investing activities
Purchases of securities available-for-sale	(24,946		)	(15,437		)
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale	8,764			13,106
Proceeds from sale/collection of foreclosed assets	680			514
Maturities of certificates of deposit with other banks	2,750			—
Proceeds from sale of investment in non-consolidated affiliate	—			9,896
Net cash acquired in consolidation of equity method investment	—			319
Capital contribution from non-controlling interest	—			22
Loan originations and principal collections, net	(154,738		)	66,835
Purchases of premises and equipment, net	(1,194		)	(29,295		)
Net cash (used in) provided by investing activities	(168,684		)	45,960

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows (Continued)

For the nine months ended September 30, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Nine Months Ended September 30,
	2016			2015
Cash flows from financing activities
Net increase in deposits	598,229			240,548
Proceeds from long term borrowings	—			12,960
Repayment of long term borrowings	(301		)	(12,730		)
Repayment of short term borrowings	—			(6,100		)
Stock option exercises	147			215
Sale of common stock, net	—			87,171
Shareholder dividend distributions	(2,052		)	(2,222		)
Net cash provided by financing activities	596,023			319,842
Net increase in cash and cash equivalents	252,878			99,979
Cash and cash equivalents, beginning	102,607			29,902
Cash and cash equivalents, ending	$	355,485		$	129,881

Supplemental disclosure of cash flow information
Interest paid	$	10,120		$	6,501
Income tax	5,739			11,312

Supplemental disclosures of noncash operating, investing, and financing activities
Unrealized holding gains on available-for-sale securities, net of taxes	$	322		$	2
Transfers from loans to foreclosed real estate and other repossessions	406			700
Transfers from foreclosed real estate to SBA receivable	96			—
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	339,322			7,410
Transfer of loans held for investment to loans held for sale	2,296			2,129
Contingent consideration in acquisition of controlling interest in equity method investment	24			170

See Notes to Unaudited Consolidated Financial Statements

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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. On July 28, 2015 the Company completed its initial public offering. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank.

During 2011, the Company formed Independence Aviation, LLC, a wholly-owned subsidiary, for the purpose of purchasing and operating aircraft used for business purposes of the Company. The net assets of Independence Aviation, LLC were transferred to the Company and the Bank effective December 31, 2015 resulting in its dissolution.

In addition to the Bank, the Company owns Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location, Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans, and 504 Fund Advisors, LLC (“504FA”), formed to serve as the investment adviser to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.

The Company acquired control over 504FA, previously carried as an equity method investment, on February 2, 2015 by increasing its ownership from 50.0% to 91.3%. The acquisition of an additional 41.3% of ownership occurred in exchange for contingent consideration estimated to total $170 thousand. Transactions in the third quarter of 2015 and first quarter of 2016 increased the Company’s ownership to 92.9%. On September 1, 2016, the Company acquired the remaining 7.1% ownership from a third party investor in exchange for contingent consideration estimated to total $24 thousand.

In August 2016, the Company formed Live Oak Ventures, Inc. for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in online banking for small businesses.

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, 2016 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2016. The consolidated balance sheet as of December 31, 2015 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the Securities Exchange Commission on March 14, 2016 (SEC File No. 001-37497) (the "2015 Annual Report"). A summary description of the significant accounting policies followed by the Company is set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2015 Annual Report. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes in the Company's 2015 Annual Report.

The preparation of financial statements in conformity with United States generally accepted accounting principles, or GAAP, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.

Amounts in all tables in the Notes to Unaudited Consolidated Financial Statements have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Business Segments

Management has determined that the Company has one significant operating segment, which is providing a lending platform for small businesses nationwide. In determining the appropriateness of segment definition, the Company considers the materiality of a potential segment, the components of the business about which financial information is available, and components for which management regularly evaluates relative to resource allocation and performance assessment.

Loans Reclassified to Held for Investment

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are classified as held for investment ("HFI") and reported at their outstanding principal amount adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premium or discount on purchased loans. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Loans originated and intended for sale are classified as held for sale ("HFS") and carried at the lower of cost or estimated fair value.

During the second quarter of 2016, the Bank transferred $318.8 million in unguaranteed loans from the HFS category to the HFI category to better reflect current intentions of the Company.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

Upon transfer from held for sale classification, loans held for investment become subject to the allowance for loan loss review process. As a result of this process, the above mentioned $318.8 million loan reclassification resulted in a $4.0 million increase in the provision for loan losses during the second quarter of 2016.

During the second quarter of 2016, the Company also implemented enhancements to the methodology for estimating the allowance for loan losses, including refinements to the measurement of qualitative factors in the estimation process. Management believes these enhancements will improve the precision of the process for estimating the allowance, but did not fundamentally change the Company's approach. These revisions resulted in a $390 thousand reduction in the provision for loan losses during the second quarter of 2016.

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 March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” (“ASU 2016-08”). This guidance amends the previously issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASU 2016-08 clarifies the implementation guidance on principal versus agent considerations in order to determine if revenue will be recognized on a gross or net basis. This guidance is effective for the Company on January 1, 2018 and is not expected to have a material impact on the consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”). ASU 2016-09 simplifies the accounting for share-based payment transactions for items including income tax consequences, classification of awards as equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company on January 1, 2017 and the Company is currently assessing the impact the adoption of this standard will have on the consolidated financial statements. Early adoption is permitted.

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

In April 2016, the FASB issued ASU No. 2016-10, "Identifying Performance Obligations and Licensing" ("ASU 2016-10"). This guidance amends the previously issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)" ("ASU 2014-09"). ASU 2016-10 clarifies the guidance related to identifying performance obligations and accounting for licenses of intellectual property. The amendments will be effective for the Company on January 1, 2018. The Company does not expect these amendments to have a material effect on its consolidated financial statements.

In May 2016, the FASB issued ASU No. 2016-12, "Narrow-Scope Improvements and Practical Expedients" ("ASU 2016-12"). This guidance also amends the previously issued ASU No. 2014-09 to clarify guidance related to collectibility, noncash consideration, presentation of sales tax and transition. The amendments will be effective for the Company on January 1, 2018. The Company does not expect these amendments to have a material effect on its consolidated financial statements.

In June 2016, the FASB issued ASU No. 2016-13, "Measurement of Credit Losses on Financial Instruments" ("ASU 2016-13"). This new guidance replaces the incurred loss impairment methodology in current standards with an expected credit loss methodology and requires consideration of a broader range of information to determine credit loss estimates. ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 will be effective for the Company on January 1, 2020. The Company is currently evaluating the effect the implementation of the new standard will have on its consolidated financial statements.

In August 2016, the FASB issued ASU No. 2016-15, "Classification of Certain Cash Receipts and Cash Payments" ("ASU 2016-15"). This guidance amends the Accounting Standards Codification 230, "Statement of Cash Flows," to clarify how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The ASU addresses cash flow issues including: (i) debt prepayment or debt extinguishment costs, (ii) zero-coupon bonds, (iii) settlement of a contingent consideration liability, (iv) proceeds from the settlement of insurance claims, (v) proceeds from corporate-owned life insurance, (vi) distributions received from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) the "predominance principle." ASU 2016-15 will be effective for the Company on January 1, 2018. The Company does not expect these amendments to have a material effect on its consolidated financial statements.

Note 3. Earnings Per Share

Basic and diluted earnings per share are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur, upon the exercise of stock options or upon the vesting of restricted stock grants, any of which would result in the issuance of common stock that would then be shared in the net income of the Company.



	Three Months Ended September 30,				Nine Months Ended September 30,
	2016		2015		2016		2015
Basic earnings per share:
Net income available to common shareholders	$	3,479	$	2,901	$	8,293	$	14,910
Weighted-average basic shares outstanding	34,206,943		32,824,587		34,191,014		30,037,436
Basic earnings per share	$	0.10	$	0.09	$	0.24	$	0.50
Diluted earnings per share:
Net income available to common shareholders, for diluted earnings per share	$	3,479	$	2,901	$	8,293	$	14,910
Total weighted-average basic shares outstanding	34,206,943		32,824,587		34,191,014		30,037,436
Add effect of dilutive stock options and restricted stock grants	794,874		1,092,695		812,408		892,794
Total weighted-average diluted shares outstanding	35,001,817		33,917,282		35,003,422		30,930,230
Diluted earnings per share	$	0.10	$	0.09	$	0.24	$	0.48
Anti-dilutive shares	1,778,995		1,391,828		1,778,995		1,562,168

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 4. Investment Securities

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



	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
September 30, 2016
US government agencies	$	20,770	$	98	$	7	$	20,861
Residential mortgage-backed securities	47,356		184		89		47,451
Mutual fund	1,997		25		—		2,022
Total	$	70,123	$	307	$	96	$	70,334

December 31, 2015
US government agencies	$	21,992	$	81	$	5	$	22,068
Residential mortgage-backed securities	30,131		1		374		29,758
Mutual fund	1,951		—		15		1,936
Total	$	54,074	$	82	$	394	$	53,762

During the three and nine months ended September 30, 2016, the Company sold one mortgage-backed security for $1.9 million at a gain of $1 thousand.

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. 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.

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, 2016	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
US government agencies	$	1,515	$	7	$	—	$	—	$	1,515	$	7
Residential mortgage-backed securities	20,696		76		1,676		13		22,372		89
Total	$	22,211	$	83	$	1,676	$	13	$	23,887	$	96
	Less Than 12 Months				12 Months or More				Total
December 31, 2015	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
US government agencies	$	7,990	$	5	$	—	$	—	$	7,990	$	5
Residential mortgage-backed securities	26,015		333		3,019		41		29,034		374
Mutual fund	1,936		15		—		—		1,936		15
Total	$	35,941	$	353	$	3,019	$	41	$	38,960	$	394

At September 30, 2016, there were two mortgage-backed securities in unrealized loss positions for greater than 12 months and seven mortgage-backed securities and one US government agency security in an unrealized loss position for less than 12 months. Unrealized losses at December 31, 2015 were comprised of three mortgage-backed securities in unrealized loss positions for greater than 12 months and one US government agency security, twelve mortgage-backed securities and the 504 Fund mutual fund investment in an unrealized loss position for less than 12 months.

These unrealized losses are primarily the result of volatility in the market and are related to market interest rates. Since none of the unrealized losses relate to marketability of the securities or the issuer’s ability to honor redemption obligations, 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, 2016 and December 31, 2015 were backed by US government sponsored enterprises (“GSEs”).

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

The following is a summary of investment securities by maturity:



	September 30, 2016
	Available-for-Sale
	Amortized cost		Fair value
US government agencies
Within one year	$	7,998	$	8,007
One to five years	12,772		12,854
Total	20,770		20,861

Residential mortgage-backed securities
Five to ten years	7,817		7,872
After 10 years	39,539		39,579
Total	47,356		47,451

Total	$	68,126	$	68,312

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, 2016 and December 31, 2015, an investment security with a fair market value of $1.5 million and $1.3 million, respectively, was pledged to secure a line of credit with the Company’s correspondent bank. At September 30, 2016, an investment security with a fair market value of $101 thousand was pledged to the Ohio State Treasurer to allow the Company's trust department to conduct business in the state of Ohio and an investment security with a fair market value of $1.2 million was pledged to the Company's trust department for uninsured trust assets held by the trust department.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans Held for Investment 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 “Commercial Real Estate” segment. Underwriting of construction and development loans typically includes analysis of not only the borrower’s financial condition and ability to meet the required debt obligations, but also the general market conditions associated with the area and type of project being funded.

Commercial Real Estate

Commercial real estate loans are extensions of credit secured by owner occupied and non-owner occupied collateral. Underwriting generally involves intensive analysis of the financial strength of the borrower and guarantor, liquidation value of the subject collateral, the associated unguaranteed exposure, and any available secondary sources of repayment, with the greatest emphasis given to a borrower’s capacity to meet cash flow coverage requirements as set forth by Bank policies. Such repayment of commercial real estate loans is commonly derived from the successful ongoing operations of the business occupying the property. These typically include small businesses and professional practices.

Commercial Land

Commercial land loans are extensions of credit secured by farmland. Such loans are often for land improvements related to agricultural endeavors that may include construction of new specialized facilities. These loans are usually repaid through the conversion to permanent financing, or if scheduled 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.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Loans consist of the following:



	September 30, 2016			December 31, 2015
Commercial & Industrial
Agriculture	$	1,503		$	30
Death Care Management	9,584			4,832
Healthcare	33,822			15,240
Independent Pharmacies	80,317			41,588
Registered Investment Advisors	61,521			18,358
Veterinary Industry	34,922			21,579
Other Industries	41,660			3,230
Total	263,329			104,857
Construction & Development
Agriculture	34,867			11,351
Death Care Management	2,500			769
Healthcare	28,454			7,231
Independent Pharmacies	2,387			101
Registered Investment Advisors	900			378
Veterinary Industry	11,662			3,834
Other Industries	20,080			658
Total	100,850			24,322
Commercial Real Estate
Agriculture	5,637			1,863
Death Care Management	50,611			20,327
Healthcare	99,519			37,684
Independent Pharmacies	14,697			7,298
Registered Investment Advisors	8,388			2,808
Veterinary Industry	98,003			59,999
Other Industries	30,713			4,752
Total	307,568			134,731
Commercial Land
Agriculture	94,111			16,036
Total	94,111			16,036
Total Loans¹	765,858			279,946
Net Deferred Costs	7,613			3,056
Discount on SBA 7(a) Unguaranteed²	(6,494		)	(3,033		)
Loans, Net of Unearned	$	766,977		$	279,969


1	Total loans include $29.6 million and $17.2 million of U.S. government guaranteed loans as of September 30, 2016 and December 31, 2015, 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.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

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 select borrowers' financial performance is to validate the adequacy of the risk grade assigned.

The Bank uses a grading system to rank the quality of each loan. 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.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

The following tables summarize the risk grades of each category:



	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total
September 30, 2016
Commercial & Industrial
Agriculture	$	1,445	$	58	$	—	$	1,503
Death Care Management	9,351		225		8		9,584
Healthcare	26,658		1,497		5,667		33,822
Independent Pharmacies	73,847		4,790		1,680		80,317
Registered Investment Advisors	58,427		2,730		364		61,521
Veterinary Industry	30,736		1,980		2,206		34,922
Other Industries	41,660		—		—		41,660
Total	242,124		11,280		9,925		263,329
Construction & Development
Agriculture	34,867		—		—		34,867
Death Care Management	2,500		—		—		2,500
Healthcare	26,042		2,412		—		28,454
Independent Pharmacies	2,387		—		—		2,387
Registered Investment Advisors	900		—		—		900
Veterinary Industry	10,177		1,485		—		11,662
Other Industries	20,080		—		—		20,080
Total	96,953		3,897		—		100,850
Commercial Real Estate
Agriculture	5,637		—		—		5,637
Death Care Management	45,801		3,228		1,582		50,611
Healthcare	93,248		5,270		1,001		99,519
Independent Pharmacies	12,613		2,084		—		14,697
Registered Investment Advisors	8,388		—		—		8,388
Veterinary Industry	83,540		3,787		10,676		98,003
Other Industries	30,713		—		—		30,713
Total	279,940		14,369		13,259		307,568
Commercial Land
Agriculture	92,379		1,582		150		94,111
Total	92,379		1,582		150		94,111
Total¹	$	711,396	$	31,128	$	23,334	$	765,858

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements



	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total
December 31, 2015
Commercial & Industrial
Agriculture	$	30	$	—	$	—	$	30
Death Care Management	4,728		104		—		4,832
Healthcare	8,334		2,160		4,746		15,240
Independent Pharmacies	36,704		3,430		1,454		41,588
Registered Investment Advisors	17,508		850		—		18,358
Veterinary Industry	16,800		1,817		2,962		21,579
Other Industries	3,089		141		—		3,230
Total	87,193		8,502		9,162		104,857
Construction & Development
Agriculture	11,194		157		—		11,351
Death Care Management	769		—		—		769
Healthcare	7,231		—		—		7,231
Independent Pharmacies	101		—		—		101
Registered Investment Advisors	378		—		—		378
Veterinary Industry	2,581		1,253		—		3,834
Other Industries	658		—		—		658
Total	22,912		1,410		—		24,322
Commercial Real Estate
Agriculture	1,863		—		—		1,863
Death Care Management	18,223		425		1,679		20,327
Healthcare	33,529		2,930		1,225		37,684
Independent Pharmacies	6,210		1,088		—		7,298
Registered Investment Advisors	2,808		—		—		2,808
Veterinary Industry	45,453		3,171		11,375		59,999
Other Industries	4,752		—		—		4,752
Total	112,838		7,614		14,279		134,731
Commercial Land
Agriculture	16,036		—		—		16,036
Total	16,036		—		—		16,036
Total¹	$	238,979	$	17,526	$	23,441	$	279,946

Total loans include $29.6 million of U.S. government guaranteed loans as of September 30, 2016, segregated by risk grade as follows: Risk Grades 1 – 4 = $8.8 million, Risk Grade 5 = $7.0 million, Risk Grades 6 – 8 = $13.8 million. As of December 31, 2015, total loans include $17.2 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $0, Risk Grade 5 = $2.6 million, Risk Grades 6 – 8 = $14.6 million.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

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, 2016
Commercial & Industrial
Agriculture	$	—	$	—	$	—	$	—	$	—	$	1,503	$	1,503	$	—
Death Care Management	—		—		—		—		—		9,584		9,584		—
Healthcare	212		623		1,377		2,589		4,801		29,021		33,822		—
Independent Pharmacies	—		327		288		421		1,036		79,281		80,317		—
Registered Investment Advisors	—		—		—		—		—		61,521		61,521		—
Veterinary Industry	41		31		1,238		573		1,883		33,039		34,922		—
Other Industries	—		—		—		—		—		41,660		41,660		—
Total	253		981		2,903		3,583		7,720		255,609		263,329		—
Construction & Development
Agriculture	—		—		—		—		—		34,867		34,867		—
Death Care Management	—		—		—		—		—		2,500		2,500		—
Healthcare	—		—		—		—		—		28,454		28,454		—
Independent Pharmacies	—		—		—		—		—		2,387		2,387		—
Registered Investment Advisors	—		—		—		—		—		900		900		—
Veterinary Industry	—		—		—		—		—		11,662		11,662		—
Other Industries	—		—		—		—		—		20,080		20,080		—
Total	—		—		—		—		—		100,850		100,850		—
Commercial Real Estate
Agriculture	—		—		—		—		—		5,637		5,637		—
Death Care Management	—		—		204		1,423		1,627		48,984		50,611		—
Healthcare	—		201		127		46		374		99,145		99,519		—
Independent Pharmacies	—		550		—		—		550		14,147		14,697		—
Registered Investment Advisors	—		—		—		—		—		8,388		8,388		—
Veterinary Industry	1,119		3,460		2,178		2,037		8,794		89,209		98,003		—
Other Industries	—		—		—		—		—		30,713		30,713		—
Total	1,119		4,211		2,509		3,506		11,345		296,223		307,568		—
Commercial Land
Agriculture	150		—		—		—		150		93,961		94,111		—
Total	150		—		—		—		150		93,961		94,111		—
Total¹	$	1,522	$	5,192	$	5,412	$	7,089	$	19,215	$	746,643	$	765,858	$	—

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements



	Less Than 30 Days Past Due & Not Accruing		30-89 Days Past Due & Accruing		30-89 Days Past Due & Not Accruing		Greater Than 90 Days Past Due		Total Not Accruing & Past Due Loans		Current Loans		Total Loans		Loans 90 Days or More Past Due & Still Accruing
December 31, 2015
Commercial & Industrial
Agriculture	$	—	$	—	$	—	$	—	$	—	$	30	$	30	$	—
Death Care Management	—		—		—		—		—		4,832		4,832		—