S-1 1 e21201_fsbc-s1.htm

 

As filed with the United States Securities and Exchange Commission on April 9, 2021.

 

Registration No. 333-

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM S-1
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

 

 

 

Five Star Bancorp

(Exact name of registrant as specified in its charter)

 

 

 

California

(State or other jurisdiction of

incorporation or organization)

6022

(Primary Standard Industrial

Classification Code Number)

75-3100966

(I.R.S. Employer

Identification Number)

     
 

3100 Zinfandel Drive

Suite 100
Rancho Cordova, CA 95670
(916) 626-5000

 

(Address, including zip code and telephone number, including area code, of registrant’s principal executive offices)

 

James Beckwith
President and Chief Executive Officer
Five Star Bancorp
3100 Zinfandel Drive

Suite 650
Rancho Cordova, CA 95670
(916) 626-5000
(Name, address, including zip code and telephone number, including area code, of agent for service)

 

 

 

With copies to:

Frank M. Conner III

Christopher J. DeCresce
Charlotte May
Covington & Burling LLP
One CityCenter

850 Tenth Street, NW
Washington, DC 20001
(202) 662-6000

Steven B. Stokdyk

Brent T. Epstein
Latham & Watkins LLP
355 South Grand Avenue
Suite 100

Los Angeles, California 90071
(213) 485-1234

 

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. o

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

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

Large accelerated filer   o Accelerated filer o
Non-accelerated filer x Smaller reporting company  x
  Emerging growth company x
       

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. o

 

CALCULATION OF REGISTRATION FEE

Title of Each Class of Securities to be Registered   Proposed Maximum
Aggregate Offering
Price(1)(2)
  Amount of
Registration Fee
Common stock, no par value per share   $ 100,000,000   $ 10,910
(1)Includes the aggregate offering price of additional shares that the underwriters have an option to purchase.
(2)Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, as amended.
 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 
 

The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities or accept your offer to buy any of them until the registration statement filed with the Securities and Exchange Commission is declared effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

SUBJECT TO COMPLETION, DATED APRIL 9, 2021

PRELIMINARY PROSPECTUS 

 

(LOGO)

                              Shares

Common Stock

This prospectus relates to the initial public offering of shares of common stock of Five Star Bancorp, a California corporation and the bank holding company for Five Star Bank, our principal subsidiary and a California state-chartered bank.

We are offering                shares of our common stock. Prior to this offering, there has been no public market for our common stock. We currently expect the initial public offering price per share of our common stock to be between $                and $                . We have applied to list our common stock on the Nasdaq Global Select Market under the symbol “FSBC.”

In connection with the termination of our status as an S Corporation, we intend to use a portion of the net proceeds to us from this offering to fund a cash distribution to our existing shareholders, following the completion of this offering, in an amount equal to the balance of our federal accumulated adjustments account for federal income tax purposes. This amount is generally the cumulative amount of our taxable income that has been included in the taxable income of our shareholders but not yet distributed to them prior to the completion of this offering and is estimated to be $                . See the section entitled “Use of Proceeds.”

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 and, as a result, are subject to reduced public company disclosure standards. See the section entitled “Implications of Being an Emerging Growth Company.”

Investing in our common stock involves risks. See the section entitled “Risk Factors,” beginning on page 22 to read about factors you should consider before investing in our common stock.

  Per Share Total
Initial public offering price $ $
Underwriting discount(1) $ $
Proceeds before expenses, to us $ $

 

(1) See the section entitled “Underwriting” for additional information regarding underwriting compensation.

 

 

 

The underwriters have an option to purchase up to an additional                shares of our common stock at the initial public offering price less the underwriting discount within 30 days of the date of this prospectus.

None of the United States Securities and Exchange Commission, any state securities commission, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

These securities are not deposits, savings accounts or other obligations of any bank or savings association and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency and are subject to investment risks, including the possible loss of the entire amount you invest.

The underwriters expect to deliver the shares of our common stock to purchasers on or about               , 2021, subject to customary closing conditions.

 

 

 

Sole Bookrunner

Keefe, Bruyette & Woods
A Stifel Company

 

Co-Managers

Stephens Inc.

D.A. Davidson & Co.

 

The date of this prospectus is               , 2021.

 
 

(Inside front cover)

 
 

TABLE OF CONTENTS

 

  Page
About This Prospectus i
Prospectus Summary 1
The Offering 11
Selected Historical Financial Data 13
Non-GAAP Financial Measures 16
Unaudited Pro Forma Condensed Financial Information 17
Summary of Risk Factors 21
Risk Factors 22
Cautionary Note Regarding Forward-Looking Statements 52
Use of Proceeds 54
Capitalization 55
Dilution 57
Market for Common Stock and Dividend Policy 58
Management’s Discussion and Analysis of Financial Condition and Results of Operations 60
Business 90
Supervision and Regulation 107
Management 116
Executive Compensation 123
Certain Relationships and Related Party Transactions 130
Security Ownership of Certain Beneficial Owners and Management 136
Description of Capital Stock 139
Shares Eligible for Future Sale 144
Material U.S. Federal Income Tax Considerations to Non-U.S. Holders 146
Underwriting 150
Legal Matters 156
Experts 156
Where You Can Find More Information 156
Index to Consolidated Financial Statements F-1

 
 

ABOUT THIS PROSPECTUS

In this prospectus, “we,” “our,” “us,” “Five Star Bancorp” or “the Company” refers to Five Star Bancorp, a California corporation, and our consolidated subsidiaries, including Five Star Bank, a California state-chartered bank, unless the context indicates that we refer only to the parent company, Five Star Bancorp. In this prospectus, the “Bank” refers to Five Star Bank, our banking subsidiary.

Neither we nor the underwriters have authorized anyone to provide you with different or additional information other than what is contained in this prospectus and in the registration statement of which this prospectus forms a part. Neither we nor the underwriters take responsibility for, or can provide any assurance as to the reliability of, any different or additional information that others may give you. If anyone provides you with different or inconsistent information, you should not rely on it.

We are not, and the underwriters are not, making an offer to sell our common stock in any jurisdiction where the offer or sale is not permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of the delivery of this prospectus or any sale of our common stock. Our business, financial condition, results of operations and growth prospects may have changed since that date. Any references to our website herein are not intended to be active links and the information on, or that can be accessed through, our website is not, and you must not consider the information to be, a part of this prospectus or any other filings we make with the United States Securities and Exchange Commission, or the SEC.

You should not interpret the contents of this prospectus or any free writing prospectus to be legal, business, investment or tax advice. You should consult with your own advisors for that type of advice and consult with them about the legal, tax, business, financial and other issues that you should consider before investing in our common stock.

Our and the Bank’s logos and other trademarks referred to and included in this prospectus belong to us. Solely for convenience, we refer to our trademarks in this prospectus without the “®”, “SM” or the “TM” symbols, but such references are not intended to indicate that we will not assert, to the fullest extent under applicable law, our rights to our trademarks. Other service marks, trademarks and trade names referred to in this prospectus, if any, are the property of their respective owners, although for presentation convenience we may not use the “®”, “SM” or the “TM” symbols to identify such trademarks.

S CORPORATION STATUS

Since our inception, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation under the provisions of Sections 1361 through 1379 of the Internal Revenue Code of 1986, as amended, or the Code. As a result, our earnings have not been subject to, and we have not paid, U.S. federal income tax, and no provision or liability for U.S. federal income tax has been included in our consolidated financial statements. Instead, for U.S. federal income tax purposes our taxable income is “passed through” to our shareholders. Unless specifically noted otherwise, no amount of our consolidated net income or our earnings per share presented in this prospectus, including in our consolidated financial statements and the accompanying notes appearing in this prospectus, reflects any provision for or accrual of any expense for U.S. federal income tax liability for any period presented. In connection with this offering, our status as an S Corporation will terminate. Thereafter, our taxable earnings will be subject to U.S. federal income tax and we will bear the liability for those taxes.

i
 

INDUSTRY AND MARKET DATA

This prospectus includes statistical and other industry and market data that we obtained from government reports and other third-party sources. Our internal data, estimates and forecasts are based on information obtained from government reports, trade and business organizations and other contacts in the markets in which we operate and our management’s understanding of industry conditions. Although we believe that this information (including the industry publications and third party research, surveys and studies) is accurate and reliable, we have not independently verified such information. In addition, estimates, forecasts and assumptions are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in the section entitled “Risk Factors” and elsewhere in this prospectus. Finally, forward-looking information obtained from these sources is subject to the same qualifications and the additional uncertainties regarding the other forward-looking statements in this prospectus.

IMPLICATIONS OF BEING AN EMERGING GROWTH COMPANY

We qualify as an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of specified reduced reporting requirements and is relieved of other significant requirements that are otherwise generally applicable to other public companies. Among other factors, as an emerging growth company:

  · we may present only two years of audited financial statements and discuss only our results of operations for two years in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”;
  · we are exempt from the requirement to provide an opinion from our auditors on the design and operating effectiveness of our internal control over financial reporting pursuant to the Sarbanes-Oxley Act of 2002, as amended, or the Sarbanes-Oxley Act;
  · we may choose not to comply with any new requirements adopted by the Public Company Accounting Oversight Board, or PCAOB, requiring mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and our audited financial statements;
  · we are permitted to provide less extensive disclosure regarding our executive compensation arrangements pursuant to the rules applicable to smaller reporting companies, which means we are not required to include a compensation discussion and analysis and other disclosure regarding our executive compensation in this prospectus; and
  · we are not required to hold nonbinding advisory votes on executive compensation or golden parachute arrangements.

We may take advantage of these provisions for up to five years unless we earlier cease to qualify as an emerging growth company. We would cease to be an emerging growth company upon the earliest of: (i) the first fiscal year following the fifth anniversary of this offering; (ii) the first fiscal year after our annual gross revenues are $1.07 billion or more; (iii) the date on which we have during the previous three-year period, issued more than $1 billion in non-convertible debt securities; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC. We have elected to adopt the reduced disclosure requirements described above regarding the number of periods for which we are providing audited financial statements and selected financial data, and our executive compensation arrangements for purposes of the registration statement of which this prospectus is a part. In addition, we expect to take advantage of the reduced reporting and other requirements under the JOBS Act with respect to the periodic reports we will file with the SEC and proxy statements that we use to solicit proxies from our shareholders. Accordingly, the information contained herein may be different than the information you receive from other public companies in which you invest.

ii
 

The JOBS Act exempts emerging growth companies from compliance with new or revised financial accounting standards until private companies (that is, those that have not had a registration statement declared effective under the Securities Act of 1933, as amended, or the Securities Act, or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended, or the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of this extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. We have elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make our consolidated financial statements not comparable with those of a public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period because of the potential differences in accounting standards used. We cannot predict if investors will find our common stock less attractive as a result of our election to rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.

iii
 

PROSPECTUS SUMMARY

This summary highlights selected information contained in this prospectus. This summary does not contain all the information that you should consider before investing in our common stock. You should read the entire prospectus carefully, including the sections entitled “Risk Factors,” “Cautionary Note Regarding Forward-Looking Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our historical financial statements and the accompanying notes included in this prospectus.

Company Overview

Headquartered in the greater Sacramento metropolitan area of California, we are a bank holding company that operates through our wholly owned subsidiary, Five Star Bank, or the Bank, a California state-chartered bank. We provide a broad range of banking products and services to small and medium-sized businesses, professionals, and individuals primarily in Northern California through seven branch offices and two loan production offices. Our mission is to strive to become the top business bank in all markets we serve through exceptional service, deep connectivity and customer empathy. We are dedicated to serving real estate, agricultural, faith based and small to medium-sized enterprises. We aim to consistently deliver value that meets or exceeds expectations of our shareholders, customers, employees, business partners and community. In summary, we refer to our mission as “purpose-driven and integrity-centered banking.” As of December 31, 2020, we had total assets of $2.0 billion, total loans of $1.5 billion and total deposits of $1.8 billion.

We were organized as an S Corporation in 1999 by a group of long-time, Sacramento-based entrepreneurs deeply invested in the community who envisioned a community business bank that would provide the kind of exceptional banking services they desired themselves. A leader of the founding group was Marvin “Buzz” Oates, a decorated World War II veteran and widely recognized commercial real estate developer. We believe that our board of directors’ vision for the Bank coupled with its diverse business acumen and community engagement have contributed materially to the development of our expansive referral network and recognition as a committed leader to the economic development of our market. We further believe that these attributes have built a foundation for continuing growth and profitability.

We have experienced significant growth as reflected by a compound annual growth rate, or CAGR, of 23.5% in total assets, 23.8% in total loans, 23.7% in total deposits and 31.2% in noninterest-bearing, or NIB, deposits from 2016 to 2020. We believe that our operating model has resulted in strong profitability, with C Corporation return on average assets, or ROAA C-Corp, of 1.42% and C Corporation return on average equity, or ROAE C-Corp, of 22.75% in 2020. Since 2016, our market share of the total deposits in the Sacramento area has more than doubled, according to the Federal Deposit Insurance Corporation, or FDIC, Deposit Market Share Reports. We believe that our market growth confirms the quality of the purpose-driven and integrity-centered banking that we strive to deliver to our customers.

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In connection with this offering, we intend to terminate our S Corporation status. We calculate ROAA C-Corp and ROAE C-Corp by using a combined statutory tax rate for federal and state income taxes of 42.00% prior to January 1, 2018 and 29.56% after January 1, 2018.

 

While we were initially founded to support owner-occupied and investor-owned commercial real estate, we have expanded our product offerings, services and expertise to additional industry sectors to meet client demand. Our primary focus remains commercial real estate lending including commercial secured lending. We are a strong commercial real estate mini-perm lender across several commercial real estate asset classes, and we have strong asset-backed lending capabilities. We emphasize the depth and scope of our market knowledge and focus on connectivity and a relationship-based banking approach to ensure client expectations are met or exceeded. We coordinate and target loan opportunities with a team of 18 business development officers who are supported by relationship managers who ensure each client receives “Five Star” service and we support the business development officers to scale their business in an efficient manner. Business development officers are incentivized to develop deep customer relationships and make all of our products, services and expertise available. Our business development officers are held to account with regular tracking of their business development efforts and achievement relative to their target requirements.

2
 

This approach creates efficiency in the client acquisition and loan approval processes. We have maintained a stable net interest margin over the past five years by successfully competing in our market and effectively managing our earning assets and funding sources while limiting credit risk and interest rate sensitivity. Net interest margin is net interest income divided by total interest-earning assets.

 

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Detailed breakdowns of our loan portfolio for our loans held for investment, or HFI, as of December 31, 2020 are below.

 

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Note: “CML” means “Commercial,” “CRE” means “Commercial Real Estate,” “NOO” means “Non-Owner Occupied,” “OO” means “Owner Occupied” and “RE” means “Real Estate.”

3
 

Additionally, our lending relationships are conditioned on the client maintaining a deposit relationship with us. Our deposit composition as of December 31, 2020 was as follows:

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Our loan origination effort works together with disciplined credit administration and risk management with oversight from our management and board of directors. Our team has a proven track record of strong asset quality through various economic cycles. We also have a long history of working together in a synergistic and collaborative manner that we believe contributes to sound practices that benefit asset quality. We extend credit through a well-informed origination effort, coupled with regional underwriting support with oversight by a two-tiered loan committee system: a Management Loan Committee, which meets once a week, and a Director Loan Committee, which meets twice a month. This frequency of loan committee review promotes our certainty of execution and speed-to-serve. This structure helps us mitigate risk by making well-informed credit decisions, structuring loans in a manner that best suit our clients’ needs and minimizing loan loss exposure by mentoring junior members of our team to develop institutional knowledge of our clients. Although we have experienced relatively low levels of loan losses, we have maintained our discipline of having an appropriate allowance for loan losses. As of December 31, 2020, our allowance for loan losses, or ALLL, to total loans HFI, was 1.47% and our allowance for loan losses to nonperforming loans was 4,909.07%. Our ratio of nonperforming assets, or NPAs, to total assets was 0.02% and net charge-offs, or NCOs, as a percent of average loans was 0.12% for the year ended December 31, 2020. Through our loan committees, we maintain a multi-faceted loan monitoring process that regularly evaluates loan grading and monitoring systems.

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We have built a culture focused on prudent expense management. We believe efficiency and operating leverage are key drivers of operating performance and profitability. Our operating leverage and operating performance are driven by our focus on larger, more sophisticated customers and the ability of our professionals to manage high volumes of assets. This ability is aided by our extensive use of what we believe to be best-in-class customer management software. Despite our growth and increasing regulatory and compliance costs, we have successfully maintained low expense ratios. For the year ended December 31, 2020, we reported noninterest expense (or operating expense) of $28.3 million, operating revenue of $74.5 million and adjusted operating revenue of $73.1 million. This resulted in an efficiency ratio of 37.92% and noninterest expense to average assets ratio of 1.53% for the year ended December 31, 2020. Efficiency ratio is defined as the ratio of noninterest expense to net interest income plus noninterest income. We have achieved a positive operating leverage with a CAGR in operating revenue and adjusted operating revenue of 25.6% and 25.1%, respectively, from 2016 to 2020 and a CAGR in operating expense of 23.7% during the same period. Adjusted operating revenue excludes gains/losses on available for sale securities. Adjusted operating revenue is considered a non-GAAP financial measure. See the section entitled “Non-GAAP Financial Measures” for a reconciliation to the most directly comparable GAAP financial measure. The ratio of our assets to full-time equivalent employees was $13.9 million as of December 31, 2020.

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We have invested heavily in personnel and infrastructure over the last five years and believe we are positioned for continued growth without significant additional investment in the near term. Our strategic focus is to continue to grow organically by leveraging our existing core competencies and positioning our business for success in the evolving banking landscape. In leveraging our core competencies we intend to:

  · continue our organic lending growth in our market through our “purpose-driven and integrity-centered” approach to banking;
  · continue to focus and grow each of the diverse industry clusters throughout our market areas;
  · build upon the strength of our brand to deepen and broaden client relationships and grow our deposit base;
  · attract additional banking professionals with track records of driving revenue growth;
  · maintain our disciplined credit underwriting and robust risk management;
  · enhance our disciplined cost management culture;
  · leverage our technology platform, particularly our relationship with nCino, the provider of our bank operating system, to improve our efficiency; and
  · further engage in the economic development of our communities and market areas.

Competitive Strengths

We believe we have a number of competitive strengths, which include the following:

Experienced Board of Directors and Management Team. Our board of directors and executive officers are founders and key executives of established and profitable companies and own or otherwise control 42.72% of our outstanding common stock as of March 31, 2021. They each have unique business expertise in various industries and are strong local advocates who have contributed to our expansive referral network. Our executive management team is led by James Beckwith, our President and Chief Executive Officer, whose banking career spans nearly 30 years. Mr. Beckwith joined the Bank in 2003 and has enhanced the management team by recruiting financial services professionals who have demonstrated their ability to drive organic growth, improve operating efficiencies and establish a robust risk management framework. Our leadership team has an average of nine years of experience with us and over 19 years of experience in banking. They are supported by an engaged employee base comprised of 138 full-time employees and six part-time employees as of December 31, 2020. Results of the most recent third-party survey of our employee base reflected that we were in the 99th percentile for employee engagement compared to other participating organizations. Our senior management includes highly connected community stewards with most serving on nonprofit boards and/or as active members of economic development organizations.

 

Proven Organic Growth Capabilities. We have demonstrated an ability to grow our loans and deposits organically. Our team of professionals has been an important driver of our organic growth by developing banking relationships with current and potential clients. We believe the strength of our culture and brand has been the core of our success in attracting talented professionals and banking relationships. We have implemented compensation systems that incentivize our professionals to increase the size of their loan and deposit portfolios and generate fee income while maintaining credit quality.

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Attractive Core Deposit Franchise. We have a valuable deposit franchise supported by a substantial level of core deposits and a high level of noninterest-bearing accounts. As of December 31, 2020, 39.0% of our total deposits were noninterest-bearing deposits and none of our deposits were brokered or internet-sourced deposits. We believe our deposit generation is powered by our strong personal service with emphasis on developing the total customer relationship, brand recognition and visibility in our communities.

 

Scalable and Efficient Operating Model. We have invested in infrastructure and employees to enhance and expand our capabilities and support the growth of our franchise. In particular, we have invested in new technologies to better serve our customer base and improve our operational efficiency. Our investments in personnel include increasing staffing of our credit administration, finance and information technology departments, and developing a full range of commercial and consumer banking services. We offer our retail customers internet and mobile banking with peer-to-peer payments. We offer our commercial customers internet banking, remote deposit capture and online treasury management tools. Our investments in technology and infrastructure have provided us with a scalable operating platform and organizational infrastructure that we believe will allow us to continue to improve our operating leverage and continue our growth without significant additional investments in the near term.

 

Market Opportunities. We provide financial services to customers who are predominately small and medium-sized businesses, professionals and individuals residing in the Northern California region. Our principal geographic market is the Roseville/Sacramento/Rancho Cordova/Elk Grove area, which we collectively refer to as the Greater Sacramento Area, and which is the source of approximately 86.3% of our total deposits. The Greater Sacramento Area has a population of approximately 2.6 million, includes two major universities: University of California, Davis and California State University, Sacramento, and serves as the home of the California State Capitol. Commercial banking in the Greater Sacramento Area is dominated by money center institutions, of which the largest six control 74.1% of the Sacramento-Roseville-Folsom metropolitan statistical area, or the Sacramento MSA, market share of deposits as of June 30, 2020. We believe this provides business development opportunities for us to provide a level of service that money center institutions are constrained to replicate to small and medium-sized businesses, professionals and individuals.

Opportunistic Execution. Critical components of our purpose-driven and integrity-centered banking are the responsiveness and certainty of execution that we strive to provide to our customers’ needs. We focus on bringing solutions one customer at a time. We believe that the extraordinary demands of the COVID-19 pandemic and U.S. government encouragement to extend additional loans provided us a unique opportunity to demonstrate our agility in assisting existing and new customers. As of December 31, 2020, we have provided approximately $264.8 million in loans under the Paycheck Protection Program, or PPP, created by the Coronavirus Aid, Relief and Economic Security Act, or CARES Act, passed in March 2020. We provided these loans to 1,124 customers, approximately 35% of which were new customers. Because of our relationship-based banking approach, the influx of new customers contributed to a corresponding increase in deposits in the year ended December 31, 2020. We expect these trends to continue as we extend additional loans under the PPP in 2021.

Our History

Five Star Bank was chartered as a California S Corporation on October 26, 1999 and began operations on December 20, 1999. In 2002, Five Star Bancorp was incorporated in California and subsequently became the bank holding company for Five Star Bank. We have funded our growth since inception with our earnings and capital raises, which have been substantially supported by our founding shareholders and directors. During the past 20 years, we have developed our franchise by growing our asset size to $2.0 billion, opening seven branch offices and two loan production offices and developing a reputation as an institution committed to our clients’ success and the economic development of our market. The chart below sets forth the milestones of our organic growth as well as the recognition we have garnered for our community commitment.

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(Front Cover)

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Our Market

Through Five Star Bank, we provide financial services to customers who are predominately small to medium-sized businesses, professionals and individuals residing in the Northern California region. Our primary loan products are commercial real estate and commercial secured loans. Our primary deposit products are money market, noninterest-bearing and interest checking accounts. We believe our current market areas provide abundant opportunities to continue to grow our client base, increase loans and deposits and expand our overall market share.

The Greater Sacramento Area has a profitable and productive economy driven by the governmental, education, technology, health care, agricultural and manufacturing sectors. While many areas of California have experienced declining populations over the last five years, the region where we operate represents approximately 1.0% of the United States population and is expected to grow by 3.6% and median household income is expected to grow by 13% over the next 5 years, compared to 2.9% and 9.0%, respectively, for the United States as a whole during the same period. California’s unemployment rate was 9.0% in December 2020, compared to 3.9% in December 2019, due in large part to the COVID-19 pandemic. While the unemployment rate has persisted into 2021, as of December 2020 California has regained more than 44% of the 2,615,800 non-farm jobs that were lost due to the COVID-19 pandemic in March and April 2020. We anticipate that unemployment will begin to normalize as businesses reopen, the commercial real estate market recovers and the COVID-19 vaccine is distributed in the coming months.

The Greater Sacramento Area is a large, innovative economy with 2.6 million residents. The region’s growing millennial workforce makes it the third-ranked location in the country (and top-ranked in California) for net millennial migration and the 11th best city for STEM jobs in the nation. Growth of bachelor’s degree holders in the Greater Sacramento area is 60% faster than the rate in the United States as a whole during 2014 to 2019. Additionally, the emerging trend of the work-from-home business model, which has accelerated due to the impact of the COVID-19 pandemic, is driving significant migration within California creating both immediate and long-term economic benefits for the Greater Sacramento Area in particular. A recent study by Redfin, which sampled more than 1.5 million consumers who searched for homes across 87 metro areas nationwide, showed Sacramento as the most popular metro area destination for homebuyers looking to move to a different metro area, with the majority of those homebuyers seeking to relocate from elsewhere in California. A study undertaken by LinkedIn examined where several hundred thousand tech workers in the United States were moving and found that Sacramento is one of the top five destinations in the nation in 2020. These trends are having a positive economic impact in the region and we believe could lead to lasting economic benefit from the increased tech and startup activity.

   Population   Household Income 
Metropolitan Statistical Area  2020
Total
Population
   ’16 - ’21
Actual
Growth
   ’21 - ’26
Projected
Growth
   Median
Household
Income
   ’16 - ’21
Actual
Growth
   ’21 - ’26
Projected
Growth
 
Sacramento-Roseville-Folsom, CA   2,369,724    4.7%   3.6%  $74,374    32.1%   13.0%
Redding, CA   179,521    (1.1%)   0.9%  $58,932    40.4%   12.7%
Chico, CA   231,807    (5.1%)   (0.2%)  $54,480    26.0%   12.2%
Yuba City, CA   176,777    4.1%   2.7%  $63,037    23.7%   8.3%
United States of America   330,342,293    2.6%   2.9%  $66,010    22.0%   9.0%

Source: S&P Global. Information as of October 2020.

   Employment   Businesses 
State  Unemployment
Rate (Oct. 2020)
   Net New
Jobs
   1-19 Employees
# of Small Firms
   YoY
Growth
   1-499 Employees
# of Small Firms
   YoY
Growth
   Total
# of Small Firms
   YoY
Growth
 
California   9.0%   214,569    676,913    1.5%   757,458    1.6%   4,131,508    2.7%
United States of America   6.6%   ~1.6 million    5,339,918    0.6%   5,976,761    0.7%   31,678,432    3.0%

Source: S&P Global; State Small Business Profiles (U.S. Small Business Administration).

9
 

Termination of S Corporation Election

We have historically been treated as an S Corporation for U.S. federal income tax purposes, as a result of which, our existing shareholders have been taxed on our net income directly. We have historically made tax distributions to our shareholders that were generally intended to equal the amount of tax our shareholders were required to pay with respect to our net income. We intend to use a portion of the net proceeds to us from this offering to fund a cash distribution to our existing shareholders following the completion of this offering in the amount of $             . This distribution is intended to represent an estimate of the balance of our federal accumulated adjustments account for federal income tax purposes, which is generally the cumulative amount of our taxable income that has been included in the taxable income of our shareholders but not yet distributed to them, prior to the completion of this offering. This distribution is subject to adjustment as provided in an S Corporation Termination and Tax Sharing Agreement, or the Tax Sharing Agreement, we will enter into with most or all of our existing shareholders to be effective immediately prior to completion of this offering. Following our conversion to a C Corporation, our accumulated adjustments account will no longer be applicable and will be fully paid out to shareholders. We have received consents from the requisite number of our shareholders to terminate our S Corporation election shortly before the completion of this offering. Immediately prior to the completion of this offering, we expect to file such consents to the revocation of our S Corporation election with the Internal Revenue Service, or the IRS, and commence C Corporation status effective as of the date of termination  of our S Corporation election, which is expected to be           , 2021. Thereafter, we will be subject to U.S. federal income taxes and increased state income taxes. The Tax Sharing Agreement also provides for the cash distributions to be made to our existing shareholders described in this prospectus.

In the event of an adjustment to our reported taxable income for periods prior to termination of our S Corporation status, it is possible that our existing shareholders would be liable for additional income taxes for those prior periods. Pursuant to the Tax Sharing Agreement, upon our filing any tax return (amended or otherwise), in the event of any restatement of our taxable income or pursuant to a determination by, or a settlement with, a taxing authority, for any period during which we were an S Corporation, depending on the nature of the adjustment, we may be required to make a payment to our existing shareholders, who accept distribution of the estimated balance of our federal accumulated adjustments account under the Tax Sharing Agreement, in an amount equal to such shareholders’ incremental tax liability (including interest and penalties), which amount may be material. In addition, the Tax Sharing Agreement provides that we will indemnify such shareholders with respect to unpaid income tax liabilities (including interest and penalties) to the extent that such unpaid income tax liabilities are attributable to an adjustment to our taxable income for any period after our S Corporation status terminates. In both cases the amount of the payment will be based on the assumption that our existing shareholders are taxed at the highest federal and state income tax rates applicable to married individuals filing jointly and residing in California for the relevant periods. Our existing shareholders who accept distribution of the estimated balance of our federal accumulated adjustments account under the Tax Sharing Agreement will, severally and not jointly, indemnify us with respect to our unpaid income tax liabilities (including interest and penalties) to the extent that such unpaid income tax liabilities are attributable to a decrease in any such shareholder’s taxable income for any tax period and a corresponding increase in our taxable income for any period (but only to the extent of the amount by which the shareholder’s tax liability is reduced). For a discussion of risks related to the termination of our S Corporation election, see the section entitled “Risk Factors.”

 

Corporate Information

Our principal executive office is located at 3100 Zinfandel Drive, Suite 100, Rancho Cordova, CA 95670, and our telephone number is (916) 626-5000. We maintain a website at www.fivestarbank.com. This reference to our website is included for the convenience of investors only and our website and the information contained therein or limited thereto is not incorporated into this prospectus or the registration statement of which it forms a part.

10
 

THE OFFERING

The following summary of the offering contains basic information about the offering and our common stock and is not intended to be complete. It does not contain all the information that may be important to you. For a more complete description of our common stock, see the section entitled “Description of Capital Stock.”

Issuer Five Star Bancorp
Common Stock Offered           shares (or        shares including the underwriters’ option to purchase additional shares)
Shares Outstanding After the Offering            shares (or        shares if the underwriters’ option to purchase additional shares is exercised in full)
Price Per Share We currently expect the initial public offering price per share of our common stock to be between $           and $              .
Use of Proceeds

Assuming an initial public offering price of $                per share (the midpoint of the price range set forth on the cover page of this prospectus), we estimate that the net proceeds to us from this offering, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us, will be approximately $                , or approximately $                if the underwriters’ option to purchase additional shares is exercised in full.

We intend to use the net proceeds to us from this offering (i) to fund a cash distribution to our existing shareholders (detailed further below) following the completion of this offering in the amount of $                (purchasers of our common stock in this offering will not be entitled to receive any portion of this distribution), subject to adjustment as provided in the Tax Sharing Agreement; and (ii) to use the remainder of the net proceeds, which we expect to be approximately $               , to increase the capital of the Bank in order to support our organic growth strategies, including expanding our overall market share, to strengthen our regulatory capital and for working capital and other general corporate purposes.

Our management will have broad discretion in the application of the net proceeds from this offering to us, and investors will be relying on the judgment of our management regarding the application of the proceeds. See the section entitled “Use of Proceeds.”
 

Distribution to Our Existing Shareholders

Since December 31, 2020, we have made aggregate distributions to our existing shareholders of $19.8 million pursuant to dividends declared on January 5, 2021, January 21, 2021 and April 6, 2021.

We intend to use a portion of the net proceeds to us from this offering to fund a cash distribution to our existing shareholders following the completion of this offering in the amount of $                , which is intended to represent an estimate of, generally, the cumulative amount of our taxable income that has been included in the taxable income of our shareholders but not yet distributed to them, prior to the completion of this offering, and subject to adjustment as provided in the Tax Sharing Agreement. Purchasers of our common stock in this offering will not be entitled to receive any portion of this distribution.

11
 

Dividend Policy The declaration of all future dividends, if any, will be at the discretion of our board of directors and will depend on many factors, including the financial condition, earnings and liquidity requirements applicable to us and the Bank, regulatory constraints, and any other factors that our board of directors deems relevant in making such a determination. Our ability to pay dividends is subject to restrictions under applicable banking laws and regulations. In addition, dividends from the Bank are the principal source of funds for the payment of dividends on our stock. The Bank is subject to certain restrictions under banking laws and regulations that may limit its ability to pay dividends to us. Therefore, there can be no assurance that we will pay any dividends to holders of our stock, or as to the amount of any such dividends.
Exchange Listing We have applied to list our common stock on the Nasdaq Global Select Market under the symbol “FSBC.”
Directed Share Program At our request, the underwriters have reserved up to 5% of the shares of our common stock offered by this prospectus for sale, at the initial public offering price, to our directors, officers, principal shareholders, employees, business associates, and related persons who have expressed an interest in purchasing our common stock in this offering. We will offer these shares to the extent permitted under applicable regulations in the United States through a directed share program. See the section entitled “Underwriting—Directed Share Program.”
Risk Factors Investing in our common stock involves risks. See the sections entitled “Risk Factors,” “Summary of Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” for a discussion of factors that you should carefully consider before making an investment decision.

Unless otherwise noted, references in this prospectus to the number of shares of our common stock outstanding after this offering are based on 11,000,273 shares of our common stock issued and outstanding as of December 31, 2020. Except as otherwise indicated, the information in this prospectus:

  · includes unvested portions of stock awards granted to certain of our executive officers;
  · excludes 1,700,000 shares of our common stock reserved for issuance under the Five Star Bancorp 2021 Equity Incentive Plan, or the Equity Plan;
  · assumes no exercise of the underwriters’ option to purchase additional shares of our common stock;
  · assumes an initial public offering price of $              per share, which is the midpoint of the price range set forth on the cover page of this prospectus; and
  · does not attribute to any director, officer, principal shareholder or related person any purchases of shares of our common stock in this offering, including through the directed share program described in the section entitled “Underwriting⸻Directed Share Program.”
12
 

SELECTED HISTORICAL FINANCIAL DATA

The following tables set forth our selected consolidated financial data for the periods ended on and as of the dates indicated. We derived the selected consolidated statements of operations data for the years ended December 31, 2020 and 2019 and the selected consolidated balance sheet data as of December 31, 2020 and 2019 from our audited consolidated financial statements included elsewhere in this prospectus. The historical financial information as of and for the years ended December 31, 2018, 2017 and 2016, except for the selected ratios, is derived from our audited financial statements not included in this prospectus. Our historical results are not necessarily indicative of the results to be expected in any future period.

The selected consolidated financial data below should be read together with, and are qualified by reference to, the information in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus. The selected consolidated financial data in this section are not intended to replace the consolidated financial statements and are qualified in their entirety by our consolidated financial statements and related notes included elsewhere in this prospectus. The historical financial information presented below contains financial measures that are not presented in accordance with accounting principles generally accepted in the United States, or GAAP, and which have not been audited. See the section entitled “Non-GAAP Financial Measures.”

  As of and for the years ended, 
(Dollars in thousands,
except per share amounts)
  2020   2019   2018   2017   2016 
Income Statement Data                         
Total interest income  $74,390   $64,678   $50,970   $38,636   $30,234 
Total interest expense   9,180    11,635    7,253    3,210    1,778 
Net interest income   65,210    53,043    43,717    35,426    28,456 
Provision for loan losses   9,000    5,500    4,000    1,500    1,500 
Total noninterest income   9,302    5,393    3,819    2,649    1,476 
Total noninterest expense   28,257    22,575    20,093    14,445    12,069 
Income before income taxes   37,255    30,361    23,443    22,130    16,363 
Provision for income taxes   1,327    1,061    815    779    590 
Net income  $35,928   $29,300   $22,628   $21,351   $15,773 
                          
Pre-tax, pre-provision earnings(1)  $46,255   $35,861   $27,443   $23,630   $17,863 
                          
Balance Sheet Data                         
Cash and cash equivalents  $290,493   $177,366   $203,292   $100,741   $93,993 
Securities held to maturity  $7,979   $8,962   $9,448   $9,909   $10,346 
Securities available for sale  $114,949   $77,198   $70,228   $74,536   $71,397 
Loans held for sale  $4,820   $6,527   $6,315   $3,898   $450 
Loans held-for investment(2)  $1,503,159   $1,180,313   $960,231   $771,610   $641,385 
Allowance for loan losses  $(22,189)  $(14,915)  $(11,639)  $(9,629)  $(8,344)
Total assets  $1,953,765   $1,479,859   $1,272,090   $972,830   $840,369 
Deposits  $1,784,001   $1,311,750   $1,161,394   $864,502   $761,188 
FHLB advances  $   $25,000   $   $3,748   $ 
Subordinated notes  $28,320   $28,253   $24,446   $24,382   $ 
Total liabilities  $1,819,990   $1,370,982   $1,191,774   $892,632   $763,749 
Total shareholders’ equity  $133,775   $108,877   $80,316   $80,198   $76,620 

13
 

  As of and for the years ended, 
(Dollars in thousands,
except per share amounts)
  2020   2019   2018   2017   2016 
Selected Per Share Data                         
Earnings per common share - basic and diluted - S Corp  $3.57   $3.40   $3.08   $2.92   $2.60 
Earnings per common share - basic and diluted - C Corp(3)  $2.60   $2.48   $2.24   $1.75   $1.56 
Book value per share  $12.16   $11.25   $10.88   $10.93   $10.48 
Tangible book value per share(1)   $12.16   $11.25   $10.88   $10.93   $10.48 
Common shares outstanding at end of period   11,000,273    9,674,875    7,383,801    7,338,010    7,308,172 
Dividends per common share  $2.63   $3.05   $3.05   $2.60   $2.40 
                          
Selected Financial Information                         
Net income - S Corp  $35,928   $29,300   $22,628   $21,351   $15,773 
Net income - C Corp(3)  $26,228   $21,374   $16,504   $12,835   $9,491 
Return on average:                         
Assets - S Corp   1.95%   2.15%   1.99%   2.34%   1.99%
Assets - C Corp(3)   1.42%   1.57%   1.45%   1.41%   1.20%
Shareholders’ equity - S Corp   31.16%   31.40%   29.28%   27.80%   24.57%
Shareholders’ equity - C Corp(3)   22.75%   22.91%   21.36%   16.71%   14.78%
Average shareholders’ equity to average assets   6.25%   6.84%   6.80%   8.42%   8.10%
Total shareholders’ equity to total assets   6.85%   7.36%   6.31%   8.24%   9.12%
Tangible shareholders’ equity to tangible assets(1)   6.85%   7.36%   6.31%   8.24%   9.12%
Dividend payout ratio   73.39%   89.69%   99.37%   89.21%   92.06%
Efficiency ratio   37.92%   38.63%   42.27%   37.94%   40.32%
Noninterest income to average assets   0.50%   0.40%   0.34%   0.29%   0.19%
Noninterest expense to average assets   1.53%   1.65%   1.77%   1.58%   1.52%
Net interest margin(4)   3.68%   3.98%   3.93%   3.99%   3.72%
Yield on interest-earning assets   4.20%   4.86%   4.58%   4.35%   3.95%
Yield on loans   4.96%   5.45%   5.28%   4.93%   4.86%
Cost of interest-bearing liabilities   0.78%   1.26%   0.97%   0.55%   0.35%
Net interest income to average assets   3.53%   3.89%   3.85%   3.88%   3.59%
Cost of total deposits   0.54%   0.94%   0.70%   0.39%   0.24%
Loan to deposit ratio   84.5%   90.5%   83.2%   89.7%   84.3%
Noninterest-bearing deposits to total deposits   39.0%   29.5%   28.9%   30.5%   30.9%
                          
Selected Financial Information                         
Nonperforming loans to loans   0.03%   0.07%   0.22%   0.41%   0.23%
Nonperforming assets to total assets   0.02%   0.05%   0.16%   0.32%   0.18%
Net charge-offs (recoveries) to average loans   0.12%   0.21%   0.23%   0.03%   (0.01)%
Allowance for loan losses to loans held-for-investment(2)   1.47%   1.26%   1.21%   1.25%   1.30%
                          
Capital Ratios(5)                         
Tier 1 capital to average assets   6.58%   7.51%   6.81%   8.26%   9.66%
Common Equity Tier 1 to RWA   8.98%   8.21%   7.48%   9.32%   10.81%
Tier 1 Capital to RWA   8.98%   8.21%   7.48%   9.32%   10.81%
Total capital to RWA   12.18%   11.52%   10.79%   13.23%   11.97%

14
 

  As of and for the years ended, 
(Dollars in thousands,
except per share amounts)
  2020   2019   2018   2017   2016 
Loan Composition                         
Real estate:                         
Commercial  $1,002,497   $817,365   $697,958   $561,941   $461,688 
Commercial land and development  $10,600   $16,328   $11,053   $8,583   $4,888 
Commercial construction  $91,760   $98,989   $37,728   $36,617   $19,987 
Residential construction  $11,914   $17,423   $3,590   $4,359   $3,856 
Residential  $30,431   $33,572   $36,991   $28,373   $30,712 
Farmland  $50,164   $72,090   $55,076   $39,431   $33,969 
Commercial:                         
Secured  $138,676   $106,981   $99,842   $86,455   $71,880 
Unsecured  $17,526   $9,549   $4,607   $3,718   $11,000 
Paycheck Protection Program  $147,965   $   $   $   $ 
Consumer and other  $4,921   $8,945   $14,078   $2,630   $3,636 
                          
Deposit Composition                         
Noninterest-bearing transaction  $695,687   $386,802   $335,257   $263,973   $235,020 
Interest-bearing transaction  $146,553   $118,644   $123,835   $106,745   $102,553 
Money market and savings  $894,159   $709,794   $602,233   $398,609   $350,289 
Time  $47,602   $96,510   $100,069   $95,175   $73,326 

 

*RWA = risk weighted assets

(1) Considered a non-GAAP financial measure. See the section entitled “Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to the most directly comparable GAAP financial measure. Pre-tax, pre-provision net earnings is defined as net income plus income tax expense and provision for (recapture of) loan losses. The most directly comparable GAAP financial measure is net income. Net tangible book value per share is defined as book value per share less goodwill and other intangible assets, divided by the outstanding number of common shares at the end of each period. The most directly comparable GAAP financial measure is book value per share. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible book value per share is the same as book value per share as of each of the dates indicated. Tangible shareholders’ equity to tangible assets is defined as total shareholders’ equity less goodwill and other intangible assets, divided by total assets less goodwill and other intangible assets. The most directly comparable GAAP financial measure is total shareholders’ equity to total assets. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible shareholders’ equity to tangible assets is the same as total shareholders’ equity to total assets as of each of the dates indicated.
(2) Loans held-for-investment include unamortized deferred fees/costs.
(3) The Company calculates its C Corporation net income, return on average assets, return on average shareholders’ equity and earnings per common share by using a combined statutory tax rate for federal and state income taxes of 42.00% prior to January 1, 2018 and 29.56% after January 1, 2018. This calculation reflects only the expected change in the Company’s status from an S Corporation and does not give effect to any other transaction.
(4) Net interest margin is defined as net interest income divided by total interest-earning assets.
(5) For a discussion of the capital level requirements applicable to us, see the section entitled “Supervision and Regulation—Supervision and Regulation of the Company—Capital Adequacy.”
15
 

NON-GAAP FINANCIAL MEASURES

Some of the financial measures discussed herein, including in our selected historical consolidated financial data, are non-GAAP financial measures. In accordance with SEC rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP in our statements of income, balance sheets or statements of cash flows.

Adjusted operating revenue, pre-tax, pre-provision net earnings, net tangible book value per share and tangible shareholders’ equity to tangible assets are non-GAAP financial measures. We define “adjusted operating revenue” as operating revenue (net interest income plus noninterest income) minus net gains/losses on sales of securities. The most directly comparable GAAP financial measure is operating revenue. We define “pre-tax, pre-provision net earnings” as net income plus income tax expense and provision for (recapture of) loan losses. The most directly comparable GAAP financial measure is net income. We define “net tangible book value per share” as book value per share less goodwill and other intangible assets, divided by the outstanding number of common shares at the end of each period. The most directly comparable GAAP financial measure is book value per share. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible book value and net tangible book value per share is the same as total shareholders’ equity and book value per share as of each of the dates indicated, respectively. We define “tangible shareholders’ equity to tangible assets” as total shareholders’ equity less goodwill and other intangible assets, divided by total assets less goodwill and other intangible assets. The most directly comparable GAAP financial measure is total shareholders’ equity to total assets. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible shareholders’ equity to tangible assets is the same as total shareholders’ equity to total assets as of each of the dates indicated.

We believe that these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations and cash flows computed in accordance with GAAP. However, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other banking companies use. Other banking companies may use names similar to those we use for the non-GAAP financial measures we disclose, but may calculate them differently. You should understand how we and other companies each calculate their non-GAAP financial measures when making comparisons.

The following reconciliation table provides a more detailed analysis of these non-GAAP financial measures along with their most directly comparable financial measures calculated in accordance with GAAP.

  As of and for the years ended, 
(Dollars in thousands)  2020   2019   2018   2017   2016 
Pre-Tax, Pre-Provision Net Earnings                         
Net income  $35,928   $29,300   $22,628   $21,351   $15,773 
Plus: Provision for income taxes   1,327    1,061    815    779    590 
Plus: Provision for loan losses   9,000    5,500    4,000    1,500    1,500 
Pre-tax, pre-provision net earnings  $46,255   $35,861   $27,443   $23,630   $17,863 
                     
Adjusted Operating Revenue                         
Net interest income  $65,210   $53,043   $43,717   $35,426   $28,456 
Noninterest income   9,302    5,393    3,819    2,649    1,476 
Net gains (losses) on sales of securities   (1,438)   66    241    37    (60)
Adjusted operating revenue  $73,074   $58,502   $47,777   $38,112   $29,872 
16
 

UNAUDITED PRO FORMA CONDENSED FINANCIAL INFORMATION

The following tables set forth unaudited pro forma condensed financial information for the year ended December 31, 2020, which has been derived from the historical consolidated financial information contained in our consolidated financial statements and related notes included elsewhere in this prospectus and gives effect to the following transactions, or the Transactions:

  · the offering and sale of                 shares of our common stock at the assumed initial public offering price per share of $                 , which is the midpoint of the price range set forth on the cover page of this prospectus, resulting in net proceeds to us, after deducting underwriting discounts and estimated offering expenses payable by us of approximately $                 ;
  · cash distributions of $19.8 million in the aggregate to our existing shareholders pursuant to dividends declared on January 5, 2021, January 21, 2021 and April 6, 2021;
  · a cash distribution of $                 to our existing shareholders following the completion of this offering using a portion of the net proceeds of this offering; and
  · termination of our election to be taxed as an S Corporation.

The unaudited pro forma condensed income statement for the year ended December 31, 2020 gives effect to the Transactions as if they occurred on January 1, 2020. The unaudited pro forma condensed balance sheet as of December 31, 2020 gives effect to the Transactions as if they occurred on December 31, 2020.

The historical financial statements have been adjusted in the unaudited pro forma condensed financial information to give effect to transaction accounting adjustments to account for the Transactions.

The unaudited pro forma financial information is presented for informational purposes only and is not necessarily indicative of the actual financial position and results of operations had the Transactions been effective at the dates indicated, or of future performance. The unaudited pro forma financial information was prepared using assumptions and information existing at the time of this prospectus, which is subject to change.

The unaudited pro forma condensed financial information should be read together with the historical consolidated financial information contained in our consolidated financial statements and related notes included in this prospectus.

If we gave effect to our planned cash distributions of $                 described above to our existing shareholders while not giving effect to any other transaction, our pro forma shareholders’ equity would be $                 as of December 31, 2020. In addition, our pro forma book value per share would be $                 as of the same date. Actual cash dividends for the 12 months ended December 31, 2020 together with the $             distributions described above to our existing shareholders exceed net income for the 12 months ended December 31, 2020 by $                 . Based on the assumed initial public offering price of $                 , which is the midpoint of the price range set forth on the cover page of this prospectus, after deducting underwriting discounts and estimated offering expenses payable by us,                 shares would have to be sold to pay the $                 balance.

17
 

Five Star Bancorp and Subsidiaries

Unaudited Pro Forma Condensed Balance Sheet

As of December 31, 2020

  Historical       Pro Forma 
(Dollars in thousands)  As of
December 31,
2020
   Transaction
Accounting

Adjustment
   As of
December 31,
2020
 
ASSETS               
Cash and due from financial institutions  $46,028     (1)  $  
          (2)     
Interest-bearing deposits in bank   244,465           
Cash and cash equivalents   290,493           
Time deposits in banks   23,705           
Securities - available for sale, at fair value   114,949           
Securities - held to maturity, at cost   7,979           
Loans held for sale   4,820           
Loans, net   1,480,970           
Federal Home Loan Bank stock   6,232           
Premises and equipment, net   1,663           
Bank owned life insurance   8,662           
Interest receivable and other assets   14,292     (3)     
Total assets  $1,953,765        $  
                
LIABILITIES AND SHAREHOLDERS’ EQUITY               
Deposits:               
Noninterest-bearing  $695,687        $  
Interest-bearing   1,088,314           
Total deposits   1,784,001          
Subordinated notes, net   28,320           
Interest payable and other liabilities   7,669           
Total liabilities   1,819,990          
                
Common stock, no par value; 50,000,000 shares authorized; 11,000,273 shares issued and outstanding – historical; and               shares issued and outstanding – pro forma   110,082     (1)     
          (4)     
Retained earnings   22,348     (2)     
          (3)     
          (4)     
Accumulated other comprehensive income, net   1,345           
Total shareholders’ equity   133,775           
Total liabilities and shareholders’ equity  $1,953,765        $              
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Notes to the unaudited pro forma condensed balance sheet as of December 31, 2020

(1) Reflects the sale of                shares of our common stock at an estimated price of $                 per share, which is the midpoint of the price range on the cover of this prospectus, after underwriting discounts and commissions and estimated offering expenses.
(2) Reflects payments of (i) cash distributions of $19.8 million in the aggregate to our existing shareholders pursuant to dividends declared on January 5, 2021, January 21, 2021 and April 6, 2021; and (ii) a $                cash distribution to our existing shareholders using a portion of the net proceeds from this offering.
(3) Reflects the increase in our net deferred tax assets and a corresponding increase in equity of $                million at December 31, 2020 giving effect for the termination of our status as a S Corporation.
(4) Reflects reclassification of retained deficit, given effect of the planned cash distribution  of the accumulated adjustments account of $                 following the completion of this offering to our existing shareholders, in excess of distributions, to common stock.
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Five Star Bancorp and Subsidiaries

Unaudited Pro Forma Condensed Statement of Income

For the Year Ended December 31, 2020

  For the year ended December 31, 2020 
(Dollars in thousands)  Historical   Transaction
Accounting

Adjustment
   Pro Forma 
INCOME STATEMENT               
Interest and dividend income               
Loans, including fees  $71,405        $  
Taxable securities   1,287           
Nontaxable securities   500           
Interest-bearing deposits in other banks   1,198           
    74,390          
Interest expense               
Deposits   7,407           
Subordinated notes   1,773           
    9,180          
Net interest income   65,210          
Provision for loan losses   9,000          
Net interest income after provision for loan losses   56,210          
Noninterest income   9,302           
Noninterest expense   28,257           
Income before provision for income taxes   37,255          
Provision for income taxes   1,327     (1)     
          (2)     
Net income  $35,928        $  
                
Basic and diluted earnings per share  $3.57        $  
Weighted average common shares outstanding - basic and diluted   10,063,183     (3)     
                

Notes to the unaudited pro forma statement of income as of December 31, 2020

(1) Reflects the increase in our net deferred tax asset and a corresponding decrease in tax expense of $             million at January 1, 2020 giving effect for the termination of our status as a S Corporation.
(2) Reflects tax provision giving effect for the termination of our status as a S Corporation. We calculate our pro forma tax provision by adding back our S Corporation franchise tax to net income and using a combined effective tax rate for Federal and California income taxes of 29.56%.
(3) Reflects the offering and sale of             shares of our common stock at an estimated price of $             per share, which is the midpoint of the price range on the cover of this prospectus, after underwriting discounts and commissions and estimated offering expenses. For purposes of the pro forma calculation of earnings per share, the shares are considered issued and outstanding as of January 1, 2020.
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SUMMARY OF RISK FACTORS

This offering involves various risks, and the following is a summary of some of these risks. You should carefully read and consider the matters discussed in the section entitled “Risk Factors” for a more thorough description of these and other risks.

  · We are subject to risks associated with the COVID-19 pandemic, which could have an adverse effect on our business, financial condition and results of operations.
  · Our business and operations are concentrated in Northern California and we are sensitive to adverse changes in the local economy.
  · We operate in a highly competitive market and face increasing competition from traditional and new financial services providers.
  · We are subject to the various risks associated with our banking business and operations, including, among others, credit, market, liquidity, interest rate and compliance risks, which may have an adverse effect on our business, financial condition and results of operations if we are unable to manage such risks.
  · We may be unable to effectively manage our growth, which could have an adverse effect on our business, financial condition and results of operations.
  · We operate in a highly regulated industry, and the current regulatory framework and any future legislative and regulatory changes, may have an adverse effect on our business, financial condition and results of operations.
  · We are subject to regulatory requirements, including stringent capital requirements, consumer protection laws, and anti-money laundering laws, and failure to comply with these requirements could have an adverse effect on our business, financial condition and results of operations.
  · We are subject to laws regarding privacy, information security and protection of personal information and any violation of these laws or incidents involving personal, confidential or proprietary information of individuals, including, among others, system failures or cybersecurity breaches of our network security, could damage our reputation and otherwise adversely affect our business, financial condition and results of operation.
  · We are terminating our status as an S Corporation for federal income tax purposes in connection with this offering and may be subject to claims from taxing authorities related to our prior S Corporation status.
  · Our charter documents contain certain provisions, including anti-takeover and exclusive forum provisions, that limit the ability of our shareholders to take certain actions and could delay or discourage takeover attempts that shareholders may consider favorable.
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RISK FACTORS

An investment in our common stock involves a significant degree of risk. The material risks and uncertainties that management believes affect us are described below. Before you decide to invest in our common stock, you should carefully read and consider the risk factors described below as well as the other information included in this prospectus, including our consolidated financial statements and the related notes included elsewhere in this prospectus. Any of these risks, if they are realized, could have an adverse effect on our business, financial condition and results of operations, and consequently, the value of our common stock. In any such case, you could lose all or a portion of your original investment. Further, additional risks and uncertainties not currently known to us or that we currently believe to be immaterial may also adversely affect us. This prospectus also contains forward-looking statements that involve risks and uncertainties. See the section entitled “Cautionary Note Regarding Forward-Looking Statements.”

Risks Related to Our Business

Our business and operations are concentrated in California, specifically Northern California, and we are more sensitive than our more geographically diversified competitors to adverse changes in the local economy.

Unlike many of our larger competitors that maintain significant operations located outside our market, substantially all of our customers are individuals and businesses located and doing business in the state of California. As of December 31, 2020, approximately 83.9% of our real estate loans measured by dollar amount were secured by collateral located in California, substantially all of which is in Northern California. Therefore, our success will depend upon the general economic conditions and real estate activity in these areas, which we cannot predict with certainty. As a result, our operations and profitability may be more adversely affected by a local economic downturn than those of large, more geographically diverse competitors. A downturn in the local economy could make it more difficult for our borrowers to repay their loans, may lead to loan losses that are not offset by operations in other markets, and may also reduce the ability of depositors to make or maintain deposits with us. In addition, businesses operating in Northern California, and Sacramento in particular, depend on California state government employees for business, and reduced spending activity by such employees in the event of furloughing or termination of such employees could have an adverse impact on the success or failure of these businesses, some of which are current or could become future customers of the Bank. For these reasons, any regional or local economic downturn could have an adverse effect on our business, financial condition and results of operations.

The small to medium-sized businesses to which we lend may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan.

We target our business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities, frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete, and may experience substantial volatility in operating results, any of which may impair their ability as a borrower to repay a loan. These factors may be especially true given the effects of the COVID-19 pandemic. In addition, the success of small and medium-sized businesses often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have an adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact the markets in which we operate or any of our borrowers otherwise are affected by adverse business developments, our small to medium-sized borrowers may be disproportionately affected and their ability to repay outstanding loans may be negatively affected, resulting in an adverse effect on our business, financial condition and results of operations.

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Our business is significantly dependent on the real estate markets in which we operate, as a significant percentage of our loan portfolio is secured by real estate.

As of December 31, 2020, approximately 79.2% of our loan portfolio was comprised of loans with real estate as a primary or secondary component of collateral, with substantially all of these real estate loans concentrated in Northern California. Real property values in our market may be different from, and in some instances worse than, real property values in other markets or in the United States as a whole and may be affected by a variety of factors outside of our control and the control of our borrowers, including national and local economic conditions, generally. Declines in real estate values, including prices for homes and commercial properties, could result in a deterioration of the credit quality of our borrowers, an increase in the number of loan delinquencies, defaults and charge-offs, and reduced demand for our products and services, generally. Our commercial real estate loans may have a greater risk of loss than residential mortgage loans, in part because these loans are generally larger or more complex to underwrite. In particular, real estate construction and acquisition and development loans have risks not present in other types of loans, including risks associated with construction cost overruns, project completion risk, general contractor credit risk and risks associated with the ultimate sale or use of the completed construction. In addition, declines in real property values in California could reduce the value of any collateral we realize following a default on these loans and could adversely affect our ability to continue to grow our loan portfolio consistent with our underwriting standards. We may have to foreclose on real estate assets if borrowers default on their loans, in which case we are required to record the related asset to the then fair market value of the collateral, which may ultimately result in a loss. An increase in the level of nonperforming assets increases our risk profile and may affect the capital levels regulators believe are appropriate in light of the ensuing risk profile. Our failure to effectively mitigate these risks could have an adverse effect on our business, financial condition and results of operations.

We are subject to interest rate risk, which could adversely affect our profitability.

Our profitability, like that of most financial institutions of our type, depends to a large extent on our net interest income, which is the difference between our interest income on interest-earning assets, such as loans and investment securities, and our interest expense on interest-bearing liabilities, such as deposits and borrowings. Changes in interest rates can increase or decrease our net interest income, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes.

Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System, or the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the interest we pay on deposits and borrowings, but such changes could affect our ability to originate loans and obtain deposits, the fair value of our financial assets and liabilities, and the average duration of our assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Any substantial, unexpected or prolonged change in market interest rates could have an adverse effect on our business, financial condition and results of operations. As of December 31, 2020, 75.3% of our earning assets and 95.7% of our interest-bearing liabilities were variable rate, where our variable rate liabilities reprice at a slower rate than our variable rate assets. Our interest sensitivity profile was asset sensitive as of December 31, 2020.

In addition, an increase in interest rates could also have a negative impact on our results of operations by reducing the demand for loans, decreasing the ability of borrowers to repay their current loan obligations, and increase early withdrawals on term deposits. These circumstances could not only result in increased loan defaults, foreclosures and charge-offs, but also reduce collateral values and necessitate further increases to the allowance for loan losses, which could have an adverse effect on our business, financial condition and results of operations. The Federal Reserve has indicated that it will maintain the target range for the federal funds rate at low levels

23
 

for some time to come, but changes to the target range are unpredictable. A decrease in the general level of interest rates, including the Federal Reserve’s sharp reduction in interest rates in response to the economic and financial effects of the COVID-19 pandemic, may affect us through, among other things, increased prepayments on our loan portfolio, and our cost of funds may not fall as quickly as yields on earning assets. Our asset-liability management strategy may not be effective in mitigating exposure to the risks related to changes in market interest rates.

We operate in a highly competitive market and face increasing competition from a variety of traditional and new financial services providers.

We have many competitors. Our principal competitors are commercial and community banks, credit unions, savings and loan associations, mortgage banking firms and online mortgage lenders and consumer finance companies, including large national financial institutions that operate in our market. Many of these competitors are larger than us, have significantly more resources, greater brand recognition and more extensive and established branch networks or geographic footprints than we do, and may be able to attract customers more effectively than we can. Because of their scale, many of these competitors can be more aggressive than we can on loan and deposit pricing, and may better afford and make broader use of media advertising, support services and electronic technology than we do. Also, many of our non-bank competitors have fewer regulatory constraints and may have lower cost structures. We compete with these other financial institutions both in attracting deposits and making loans. We expect competition to continue to increase as a result of legislative, regulatory and technological changes, the continuing trend of consolidation in the financial services industry and the emergence of alternative banking sources. Our profitability in large part depends upon our continued ability to compete successfully with traditional and new financial services providers, some of which maintain a physical presence in our market and others of which maintain only a virtual presence. Increased competition could require us to increase the rates we pay on deposits or lower the rates that we offer on loans, which could reduce our profitability.

Additionally, like many of our competitors, we rely on customer deposits as our primary source of funding for our lending activities, and we continue to seek and compete for customer deposits to maintain this funding base. Our future growth will largely depend on our ability to retain and grow our deposit base. As of December 31, 2020, we had $1.8 billion in deposits and a loan to deposit ratio of 84.5%. As of the same date, using deposit account related information such as tax identification numbers, account vesting and account size, we estimated that $1.1 billion of our deposits exceeded the insurance limits established by the FDIC. Additionally, we have $287.3 million of governmental deposits secured by collateral. Although we have historically maintained a high deposit customer retention rate, these deposits are subject to potentially dramatic fluctuations in availability or price due to certain factors outside of our control, such as increasing competitive pressures for deposits, changes in interest rates and returns on other investment classes, customer perceptions of our financial health and general reputation, or a loss of confidence by customers in us or the banking sector generally, which could result in significant outflows of deposits within short periods of time or significant changes in pricing necessary to maintain current customer deposits or attract additional deposits. Additionally, any such loss of funds could result in lower loan originations, which could have an adverse effect on our business, financial condition and results of operations. Our failure to compete effectively in our market could restrain our growth or cause us to lose market share, which could have an adverse effect on our business, financial condition and results of operations.

Failure to keep up with the rapid technological changes in the financial services industry could have an adverse effect on our competitive position and profitability.

The financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and reduce costs. Our future success will depend, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements than we have. We may not be able to implement new technology-driven products and services effectively or be successful in marketing these products

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and services to our customers. Failure to keep pace successfully with technological change affecting the financial services industry could harm our ability to compete effectively and could have an adverse effect on our business, financial condition and results of operations. As these technologies improve in the future, we may be required to make significant capital expenditures in order to remain competitive, which may increase our overall expenses and have an adverse effect on our business, financial condition and results of operations.

We are dependent on the use of data and modeling in both our management’s decision-making generally and in meeting regulatory expectations in particular.

The use of statistical and quantitative models and other quantitatively-based analyses is endemic to bank decision making and regulatory compliance processes, and the employment of such analyses is becoming increasingly widespread in our operations. Liquidity stress testing, interest rate sensitivity analysis, allowance for loan loss measurement, portfolio stress testing and the identification of possible violations of anti-money laundering regulations are examples of areas in which we are dependent on models and the data that underlie them. We anticipate that model-derived insights will be used more widely in our decision making in the future. While these quantitative techniques and approaches improve our decision making, they also create the possibility that faulty data or flawed quantitative approaches could yield adverse outcomes or regulatory scrutiny. Secondarily, because of the complexity inherent in these approaches, misunderstanding or misuse of their outputs could similarly result in suboptimal decision making, which could have an adverse effect on our business, financial condition and results of operations.

We may not be able to measure and limit our credit risk adequately, which could adversely affect our profitability.

Our business depends on our ability to successfully measure and manage credit risk. As a lender, we are exposed to the risk that the principal of, or interest on, a loan will not be paid timely or at all or that the value of any collateral supporting a loan will be insufficient to cover our outstanding exposure. In addition, we are exposed to risks with respect to the period of time over which the loan may be repaid, risks relating to proper loan underwriting, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual loans and borrowers. The creditworthiness of a borrower is affected by many factors, including local market conditions and general economic conditions. Many of our loans are made to small to medium-sized businesses that are less able to withstand competitive, economic and financial pressures than larger borrowers. If the overall economic climate in the United States, generally, or in our market specifically, experiences material disruption, particularly due to the continuing effects of the COVID-19 pandemic, our borrowers may experience difficulties in repaying their loans, the collateral we hold may decrease in value or become illiquid, and the level of nonperforming loans, charge-offs and delinquencies could rise and require significant additional provisions for loan losses. Additional factors related to the credit quality of multifamily residential, real estate construction and other commercial real estate loans include the quality of management of the business and tenant vacancy rates.

Our risk management practices, such as monitoring the concentration of our loans within specific markets and our credit approval, review and administrative practices, may not adequately reduce credit risk, and our credit administration personnel, policies and procedures may not adequately adapt to changes in economic or any other conditions affecting customers and the quality of the loan portfolio. A failure to effectively measure and limit the credit risk associated with our loan portfolio may result in loan defaults, foreclosures and additional charge-offs, and may necessitate that we significantly increase our allowance for loan losses, each of which could adversely affect our net income. As a result, our inability to successfully manage credit risk could have an adverse effect on our business, financial condition and results of operations.

We are exposed to higher credit risk by our commercial real estate and commercial land development loans.

Commercial real estate, commercial land and construction, commercial construction and farmland based lending usually involve higher credit risks than other types of mortgage loans. As of December 31, 2020, the following loan types accounted for the stated percentages of our loan portfolio: commercial real estate (both

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owner-occupied and non-owner occupied)—66.3%; and commercial land and construction—6.8%. These types of loans also involve larger loan balances to a single borrower or groups of related borrowers. These higher credit risks are further heightened when the loans are concentrated in a small number of larger borrowers leading to relationship exposure.

Non-owner occupied commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, in addition to the factors affecting residential real estate borrowers. These loans also involve greater risk because they generally are not fully amortizing over the loan period, but have a balloon payment due at maturity. A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or sell the underlying property in a timely manner.

Banking regulators closely supervise banks’ commercial real estate lending activities, and may require banks with higher levels of commercial real estate loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital levels as a result of commercial real estate lending growth and exposures.

Commercial land development loans and owner-occupied commercial real estate loans are typically based on the borrowers’ ability to repay the loans from the cash flow of their businesses. These loans may involve greater risk because the availability of funds to repay each loan depends substantially on the success of the business itself. In addition, the assets securing the loans have the following characteristics: (i) they depreciate over time, (ii) they are difficult to appraise and liquidate, and (iii) they fluctuate in value based on the success of the business.

Commercial real estate loans, commercial and industrial loans and construction loans are more susceptible to a risk of loss during a downturn in the business cycle. In particular, the COVID-19 pandemic could have adverse effects on our loans for office and hospitality space, which are dependent for repayment on the successful operation and management of the associated commercial real estate. Our underwriting, review and monitoring cannot eliminate all of the risks related to these loans.

We also make both secured and unsecured loans to our commercial clients. Secured commercial loans are generally collateralized by real estate, accounts receivable, inventory, equipment or other assets owned by the borrower or may include a personal guaranty of the business owner. Unsecured loans generally involve a higher degree of risk of loss than do secure loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Because of this lack of collateral, we are limited in our ability to collect on defaulted unsecured loans. Furthermore, the collateral that secures our secured commercial and industrial loans typically includes inventory, accounts receivable and equipment, which if the business is unsuccessful, usually has a value that is insufficient to satisfy the loan without a loss.

Real estate construction loans are based upon estimates of costs and values associated with the complete project. These estimates may be inaccurate, and we may be exposed to significant losses on loans for these projects.

As of December 31, 2020, real estate construction loans comprised 6.9% of our total loan portfolio and such lending involves additional risks because funds are advanced based on the security of the project, which is of uncertain value prior to its completion, and costs may exceed realizable values in declining real estate markets. Because of the uncertainties inherent in estimating construction costs and the realizable market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated or market values or rental rates decline, we may have inadequate security for the repayment of the loan upon completion of construction of the project. If we are forced to foreclose on a project

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prior to or at completion due to a default, we may not be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs. In addition, we may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time while we attempt to dispose of it.

The non-guaranteed portion of SBA loans that we retain on our balance sheet as well as the guaranteed portion of SBA loans that we sell could expose us to various credit and default risks.

As of December 31, 2020, our total commercial U.S. Small Business Administration, or SBA, portfolio HFI, excluding PPP loans, was $51.2 million, representing 3.4% of total loans HFI. In 2020, we sold 373 SBA loans with government guaranteed portions totaling $71.3 million. The non-guaranteed portion of SBA loans have a higher degree of risk of loss as compared to the guaranteed portion of such loans, and these non-guaranteed loans make up a substantial majority of our remaining SBA loans.

When we sell the guaranteed portion of SBA loans in the ordinary course of business, we are required to make certain representations and warranties to the purchaser about the SBA loan and the manner in which they were originated. Under these agreements, we may be required to repurchase the guaranteed portion of the SBA loan if we have breached any of these representations or warranties, in which case we may record a loss. In addition, if repurchase and indemnity demands increase on loans that we sell from our portfolios, our liquidity, results of operations and financial condition could be adversely affected. Further, we generally retain the non-guaranteed portions of the SBA loans that we originate and sell, and to the extent the borrowers of such loans experience financial difficulties, our financial condition and results of operations could be adversely impacted.

Curtailment of government-guaranteed loan programs could affect a segment of our business.

A significant segment of our business consists of originating and periodically selling U.S. government guaranteed loans, in particular those guaranteed by the SBA. Presently, pursuant to the Consolidated Appropriations Act, 2021, the SBA guarantees 90% of the principal amount of each qualifying SBA loan originated under the SBA’s 7(a) loan program (excluding PPP loans) through October 1, 2021. After this date, the SBA will guarantee 75% to 85% of the principal amount of qualifying loans originated under the 7(a) loan program (excluding PPP loans). The U.S. government may not maintain the SBA 7(a) loan program, and even if it does, such guaranteed portion may not remain at its current or anticipated level. In addition, from time to time, the government agencies that guarantee these loans reach their internal limits and cease to guarantee future loans. In addition, these agencies may change their rules for qualifying loans or Congress may adopt legislation that would have the effect of discontinuing or changing the loan guarantee programs. Non-governmental programs could replace government programs for some borrowers, but the terms might not be equally acceptable. Therefore, if these changes occur, the volume of loans to small business and industrial borrowers of the types that now qualify for government guaranteed loans could decline. Also, the profitability of the sale of the guaranteed portion of these loans could decline as a result of market displacements due to increases in interest rates, and premiums realized on the sale of the guaranteed portions could decline from current levels. As the funding and sale of the guaranteed portion of SBA 7(a) loans is a major portion of our business and a significant portion of our noninterest income, any significant changes to the SBA 7(a) loan program, such as its funding or eligibility requirements, may have an unfavorable impact on our prospects, future performance and results of operations. The aggregate principal balance of SBA 7(a) guaranteed portions sold during the year ended December 31, 2020 was $71.3 million compared to $70.6 million in 2019.

As a participating lender in the SBA’s PPP, we are subject to added risks, including credit, fraud, and litigation risks.

In April 2020, we began processing loan applications under the PPP as an eligible lender with the benefit of a government guarantee of loans to small business clients, many of whom may face difficulties even after being granted such a loan. PPP loans have contributed to our loan growth since December 31, 2019. However, PPP loan growth depends on governmental action to renew and fund the program.

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As a participant in the PPP, we face increased risks, particularly in terms of credit, fraud and litigation risks. The PPP opened to borrower applications shortly after the enactment of its authorizing legislation, and, as a result, there is some ambiguity in the laws, rules and guidance regarding the program’s operation. Subsequent rounds of legislation and associated agency guidance have not provided needed clarity and in certain instances have potentially created additional inconsistencies and ambiguities. Accordingly, we are exposed to risks relating to compliance with PPP requirements, including the risk of becoming the subject of governmental investigations, enforcement actions, private litigation and negative publicity.

We have additional credit risk with respect to PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded or serviced, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by us, the SBA may deny its liability under the guaranty, reduce the amount of the guarantee or, if it has already paid under the guarantee, seek recovery of any loss related to the deficiency from the Bank.

Also, PPP loans are fixed, low interest rate loans that are guaranteed by the SBA and subject to numerous other regulatory requirements, and a borrower may apply to have all or a portion of the loan forgiven. If PPP borrowers fail to qualify for loan forgiveness, we face a heightened risk of holding these loans at unfavorable interest rates for an extended period of time.

Furthermore, since the launch of the PPP, several larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP, and we may be exposed to the risk of litigation, from both customers and non-customers that approached us regarding PPP loans, relating to these or other matters. Also, many financial institutions throughout the country have been named in putative class actions regarding the alleged nonpayment of fees that may be due to certain agents who facilitated PPP loan applications. The costs and effects of litigation related to PPP participation could have an adverse effect on our business, financial condition and results of operations.

Farmland real estate loans and volatility in commodity prices may adversely affect our financial condition and results of operations.

As of December 31, 2020, farmland loans were $50.1 million, or 3.3% of our total loan portfolio. Farmland lending involves a greater degree of risk and typically involves higher principal amounts than many other types of loans. Repayment is dependent upon the successful operation of the business, which is greatly dependent on many things outside the control of either us or the borrowers. These factors include adverse weather conditions that prevent the planting of crops or limit crop yields (such as hail, drought, fires and floods), loss of livestock due to disease or other factors, declines in market prices for agricultural products (both domestically and internationally) and the impact of government regulations (including changes in price supports, subsidies and environmental regulations). Volatility in commodity prices could adversely impact the ability of borrowers in these industries to perform under the terms of their borrowing arrangements with us, and as a result, a severe and prolonged decline in commodity prices may have an adverse effect on our business, financial condition and results of operations. It is also difficult to project future commodity prices as they are dependent upon many different factors beyond our control. In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. Consequently, farmland real estate loans may involve a greater degree of risk than other types of loans.

Liquidity risk could impair our ability to fund operations and meet our obligations as they become due.

Liquidity is essential to our business and we monitor our liquidity and manage our liquidity risk at the holding company and bank level. We require sufficient liquidity to fund asset growth, meet customer loan requests, customer deposit maturities and withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances, including

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events causing industry or general financial market stress. Liquidity risk can increase due to a number of factors, which include, but are not limited to, an over-reliance on a particular source of funding, changes in the liquidity needs of our depositors, adverse regulatory actions against us, or a downturn in the markets in which our loans are concentrated.

Market conditions or other events could also negatively affect the level or cost of funding, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner, and without adverse consequences. Our inability to raise funds through deposits, borrowings, the sale of loans, and other sources could have an adverse effect on our business, financial condition and results of operations, and could result in the closure of the Bank.

Other primary sources of funds consist of cash flows from operations, maturities and sales of investment securities and proceeds from issuance and sale of our equity and debt securities. Additional liquidity is provided by the ability to borrow from the Federal Home Loan Bank of San Francisco, or FHLB, and the Federal Reserve Bank of San Francisco to fund our operations. We may also borrow funds from third-party lenders, such as other financial institutions, and have access to other funding avenues, including the PPP Liquidity Facility through which the Federal Reserve extends credit to eligible financial institutions that originate PPP loans by taking PPP loans as collateral. We have not used the PPP Liquidity Facility to date. Our access to funding sources in amounts adequate to finance our activities or on acceptable terms could be impaired by factors that affect our organization specifically or the financial services industry or economy in general. Our access to funding sources could also be affected by a decrease in the level of our business activity as a result of a downturn in our primary market or by one or more adverse regulatory actions against us.

Any substantial, unexpected, and/or prolonged change in the level or cost of liquidity could impair our ability to fund operations and meet our obligations as they become due and could have an adverse effect on our business, financial condition and results of operations. Although we have historically been able to replace maturing deposits and advances if desired, we may not be able to replace such funds in the future if our financial condition, the financial condition of the FHLB or market conditions change. FHLB borrowings and other current sources of liquidity may not be available or, if available, sufficient to provide adequate funding for operations and to support our continued growth. The unavailability of a sufficient funding could have an adverse effect on our business, financial condition and results of operations.

We may be adversely affected by the soundness of other financial institutions.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies may be interrelated as a result of trading, clearing, counterparty, and other relationships. We have exposure to different industries and counterparties, and through transactions with counterparties in the financial services industry, including broker-dealers, commercial banks, investment banks, and other financial intermediaries. As a result, defaults by, declines in the financial condition of, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by us or other institutions. These losses could have an adverse effect on our business, financial condition and results of operations.

Our risk management framework may not be effective in mitigating risks and/or losses to us.

Our risk management framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance. Our framework also includes financial or other modeling methodologies that involve management assumptions and judgment. Our risk management framework may not be effective under all circumstances. Our risk management framework may not adequately mitigate any risk or loss to us. If our risk management framework is not effective, we could suffer unexpected losses and our business, financial condition and results of operations could be adversely affected. We may also be subject to potentially adverse regulatory consequences.

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We engage in lending secured by real estate and may be forced to foreclose on the collateral and own the underlying real estate, subjecting us to the costs and potential risks associated with the ownership of real property, or consumer protection initiatives or changes in state or federal law may substantially raise the cost of foreclosure or prevent us from foreclosing at all.

Since we originate loans secured by real estate, we may have to foreclose on the collateral property to protect our investment and may thereafter own and operate such property, in which case we would be exposed to the risks inherent in the ownership of real estate. The amount that we, as a mortgagee, may realize after a foreclosure depends on factors outside of our control, including, but not limited to, general or local economic conditions, environmental cleanup liabilities, assessments, interest rates, real estate tax rates, operating expenses of the mortgaged properties, our ability to obtain and maintain adequate occupancy of the properties, zoning laws, governmental and regulatory rules, and natural disasters. Our inability to manage the amount of costs or size of the risks associated with the ownership of real estate, or write-downs in the value of other real estate owned, or OREO, could have an adverse effect on our business, financial condition and results of operations.

Additionally, consumer protection initiatives or changes in state or federal law may substantially increase the time and expenses associated with the foreclosure process or prevent us from foreclosing at all. A number of states in recent years have either considered or adopted foreclosure reform laws that make it substantially more difficult and expensive for lenders to foreclose on properties in default. Additionally, federal and state regulators have prosecuted or pursued enforcement action against a number of mortgage servicing companies for alleged consumer law violations. If new federal or state laws or regulations are ultimately enacted that significantly raise the cost of foreclosure or raise outright barriers to foreclosure, they could have an adverse effect on our business, financial condition and results of operations.

Regulatory requirements affecting our loans secured by commercial real estate could limit our ability to leverage our capital and adversely affect our growth and profitability.

The federal banking agencies have issued guidance regarding concentrations in commercial real estate lending for institutions that are deemed to have particularly high concentrations of commercial real estate loans within their lending portfolios. Under this guidance, an institution that has (i) total reported loans for construction, land development, and other land which represent 100% or more of the institution’s total risk-based capital; or (ii) total commercial real estate loans representing 300% or more of the institution’s total risk-based capital, where the outstanding balance of the institution’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months, is identified as having potential commercial real estate concentration risk. An institution that is deemed to have concentrations in commercial real estate lending is expected to employ heightened levels of risk management with respect to its commercial real estate portfolios, and may be required to maintain higher levels of capital. We have a concentration in commercial real estate loans and we have experienced significant growth in our commercial real estate portfolio in recent years. From December 31, 2019 through December 31, 2020, our commercial real estate loan balances have increased by $172.2 million. As of December 31, 2020, commercial real estate loans represent 624.7% of our total risk-based capital. We cannot guarantee that any risk management practices we implement will be effective to prevent losses relating to our commercial real estate portfolio. Management has extensive experience in commercial real estate lending, and has implemented and continues to maintain heightened portfolio monitoring and reporting, and strong underwriting criteria with respect to our commercial real estate portfolio. Nevertheless, we could be required to maintain higher levels of capital as a result of our commercial real estate concentration, which could limit our growth, require us to obtain additional capital, and have an adverse effect on our business, financial condition and results of operations.

 

We could be subject to environmental risks and associated costs on our foreclosed real estate assets.

Our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing loans. There is a risk that hazardous or toxic substances could be found on these properties and that we could be liable for remediation costs, as well as personal injury and property damage. Environmental

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laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to sell the affected property. The remediation costs and any other financial liabilities associated with an environmental hazard could have an adverse effect on our business, financial condition and results of operations.

 

Our recovery on commercial real estate loans could be further reduced by a lack of a liquid secondary market for such mortgage loans and mortgage backed securities.

Our current business strategy includes an emphasis on commercial real estate lending. Although we sold $104.0 million of loans in 2020, two of which were commercial real estate loans, we may decide to sell more loans in the future. A secondary market for most types of commercial real estate loans is not readily liquid, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans. As a result of these characteristics, if we foreclose on a commercial real estate loan, our holding period for the collateral typically is longer than for residential mortgage loans because there are fewer potential purchasers of the collateral. Accordingly, charge-offs on commercial real estate loans may be larger as a percentage of the total principal outstanding than those incurred with our residential or consumer loan portfolios.

The appraisals and other valuation techniques we use in evaluating and monitoring loans secured by real property and other real estate owned may not accurately reflect the net value of the asset.

In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values may change significantly in value in relatively short periods of time (especially in periods of heightened economic uncertainty), this estimate may not accurately reflect the net value of the collateral after the loan is made. As a result, we may not be able to realize the full amount of any remaining indebtedness when we foreclose on and sell the relevant property. In addition, we rely on appraisals and other valuation techniques to establish the value of OREO, that we acquire through foreclosure proceedings and to determine loan impairments. If any of these valuations are inaccurate, our consolidated financial statements may not reflect the correct value of our OREO, if any, and our allowance for loan losses may not reflect accurate loan impairments. Inaccurate valuation of OREO or inaccurate provisioning for loan losses could have an adverse effect on our business, financial condition and results of operations.

Federal, state and local consumer lending laws may restrict our or our partners’ ability to originate certain loans or increase our risk of liability with respect to such loans.

Federal, state and local laws have been adopted that are intended to prevent certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. It is our policy not to make predatory loans and to determine borrowers’ ability to repay. Nonetheless, the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. Compliance with these laws increases our cost of doing business.

Additionally, consumer protection initiatives or changes in state or federal law, including the CARES Act and its automatic loan forbearance provisions, may substantially increase the time and expenses associated with the foreclosure process or prevent us from foreclosing at all. A number of states in recent years have either considered or adopted foreclosure reform laws that make it substantially more difficult and expensive for lenders to foreclose on properties in default, and we cannot be certain that the state in which we operate will not adopt similar legislation in the future. Additionally, federal regulators have prosecuted or pursued enforcement actions against a number of mortgage servicing companies for alleged consumer law violations. If new state or federal laws or regulations are ultimately enacted that significantly raise the cost of foreclosure or raise outright barriers to foreclosure, such laws or regulations could have an adverse effect on our business, financial condition and results of operations.

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Our largest loan relationships make up a material percentage of our total loan portfolio and credit risks relating to these would have a disproportionate impact.

As of December 31, 2020, our 30 largest borrowing relationships ranged from approximately $10.2 million to $35.5 million (including unfunded commitments) and totaled approximately $539.1 million in total commitments (representing, in the aggregate, 31.1% of our total outstanding commitments as of December 31, 2020). Each of the loans associated with these relationships has been underwritten in accordance with our underwriting policies and limits. Along with other risks inherent in these loans, such as the deterioration of the underlying businesses or property securing these loans, this concentration of borrowers presents a risk that, if one or more of these relationships were to become delinquent or suffer default, we could be exposed to material losses. The allowance for loan losses may not be adequate to cover losses associated with any of these relationships, and any loss or increase in the allowance would negatively affect our earnings and capital. Even if these loans are adequately collateralized, an increase in classified assets could harm our reputation with our regulators and inhibit our ability to execute our business plan.

Our largest deposit relationships currently make up a material percentage of our deposits and the withdrawal of deposits by our largest depositors could force us to fund our business through more expensive and less stable sources.

At December 31, 2020, our 18 largest deposit relationships, each accounting for more than $10 million, accounted for $641.2 million, or 35.9% of our total deposits. This includes $318.4 million of our total deposits held by municipalities, of which we conduct a monthly review. Withdrawals of deposits by any one of our largest depositors or by one of our related customer groups could force us to rely more heavily on borrowings and other sources of funding for our business and withdrawal demands, adversely affecting our net interest margin and results of operations. If a significant amount of these deposits were withdrawn within a short period of time, it could have a negative impact on our short term liquidity and have an adverse impact on our earnings. We may also be forced, as a result of withdrawals of deposits, to rely more heavily on other, potentially more expensive and less stable funding sources. Additionally, such circumstances could require us to raise deposit rates in an attempt to attract new deposits, which would adversely affect our results of operations. Under applicable regulations, if the Bank were no longer “well capitalized,” the Bank would not be able to accept brokered deposits without the approval of the FDIC.

Our allowance for loan losses may be inadequate to absorb losses inherent in the loan portfolio.

Experience in the banking industry indicates that a portion of our loans will become delinquent, and that some may only be partially repaid or may never be repaid at all. We may experience losses for reasons beyond our control, such as the impact of general economic conditions on customers and their businesses. Accordingly, we maintain an allowance for loan losses that represents management’s judgment of probable losses and risks inherent in our loan portfolio. In determining the size of our allowance for loan losses, we rely on an analysis of our loan portfolio considering historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and nonaccruals, economic conditions and other pertinent information. The determination of the appropriate level of the allowance for loan losses is inherently highly subjective and requires us to make significant estimates of and assumptions regarding current credit risk and future trends, all of which may change materially. Although we endeavor to maintain our allowance for loan losses at a level adequate to absorb any inherent losses in the loan portfolio, these estimates of loan losses are necessarily subjective and their accuracy depends on the outcome of future events. As of December 31, 2020, the allowance for loan losses was $22.2 million.

Deterioration of economic conditions affecting borrowers, new information regarding existing loans, inaccurate management assumptions, identification of additional problem loans, temporary modifications, loan forgiveness, automatic forbearance and other factors, both within and outside of our control, may result in our experiencing higher levels of nonperforming assets and charge-offs, and incurring loan losses in excess of our current allowance for loan losses, requiring us to make material additions to our allowance for loan losses, which could have an adverse effect on our business, financial condition and results of operations.

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Additionally, federal and state banking regulators, as an integral part of their supervisory function, periodically review the allowance for loan losses. These regulatory agencies may require us to increase our provision for loan losses or to recognize further loan charge-offs based upon their judgments, which may be different from ours. If we need to make significant and unanticipated increases in the loss allowance in the future, or to take additional charge-offs for which we have not established adequate reserves, our business, financial condition and results of operations could be adversely affected at that time.

Finally, the Financial Accounting Standards Board, or FASB, has issued a new accounting standard that will replace the current approach under GAAP, for establishing allowances for loan and lease losses, which generally considers only past events and current conditions, with a forward-looking methodology that reflects the expected credit losses over the lives of financial assets, starting when such assets are first originated or acquired. As an emerging growth company relying on the extended transition period for new accounting standards, this standard, referred to as Current Expected Credit Loss, or CECL, will be effective for us in 2023. The CECL standard will require us to record, at the time of origination, credit losses expected throughout the life of the asset portfolio on loans and held to maturity securities, as opposed to the current practice of recording losses when it is probable that a loss event has occurred. We are currently evaluating the impact the CECL standard will have on our accounting and regulatory capital position. The adoption of the CECL standard will materially affect how we determine allowance for loan losses and could require us to significantly increase the allowance. Moreover, the CECL standard may create more volatility in the level of allowance for loan losses. If we are required to materially increase the level of our allowance for loan losses for any reason, such increase could have an adverse effect on our business, financial condition and results of operations.

We could recognize losses on investment securities held in our securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.

As of December 31, 2020, the book value of our investment securities portfolio was approximately $122.9 million. As of the same date, 25.9% of our investments were U.S. government or U.S. government agency securities. Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by the issuer or with respect to the underlying securities, and changes in market interest rates and instability in the capital markets. Any of these factors, among others, could cause other-than-temporary impairments, or OTTI, and realized and/or unrealized losses in future periods and declines in other comprehensive income, which could have an adverse effect on our business, financial condition and results of operations. The process for determining whether impairment of a security is OTTI usually requires complex, subjective judgments about the future financial performance and liquidity of the issuer, any collateral underlying the security and our intent and ability to hold the security for a sufficient period of time to allow for any anticipated recovery in fair value, in order to assess the probability of receiving all contractual principal and interest payments on the security. Our failure to correctly and timely assess any impairments or losses with respect to our securities could have an adverse effect on our business, financial condition and results of operations.

 

We depend on the accuracy and completeness of information provided by customers and counterparties.

In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including financial information. We may also rely on representations of customers and counterparties as to the accuracy and completeness of that information. In deciding whether to extend credit, we may rely upon customers’ representations that their financial statements conform to GAAP and present fairly the financial condition, results of operations and cash flows of the customer. We also may rely on customer representations and certifications, or other audit or accountants’ reports, with respect to the business and financial condition of our customers. Our business, financial condition and results of operations could be adversely affected if we rely on misleading, false, inaccurate or fraudulent information.

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Risks Related to Our Industry and Regulation

 

Our industry is highly regulated, and the regulatory framework, together with any future legislative or regulatory changes, may have a materially adverse effect on our operations.

The banking industry is highly regulated and supervised under both federal and state laws and regulations that are intended primarily for the protection of depositors, customers, the public, the banking system as a whole or the FDIC Deposit Insurance Fund, or DIF, not for the protection of our shareholders and creditors. We are subject to regulation and supervision by the Federal Reserve, and our Bank is subject to regulation and supervision by the FDIC and the California Department of Financial Protection and Innovation, or the DFPI. Compliance with these laws and regulations can be difficult and costly, and changes to laws and regulations can impose additional compliance costs. The Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act, which imposed significant regulatory and compliance changes on financial institutions, is an example of this type of federal law. The laws and regulations applicable to us govern a variety of matters, including permissible types, amounts and terms of loans and investments we may make, the maximum interest rate that may be charged, the amount of reserves we must hold against deposits we take, the types of deposits we may accept and the rates we may pay on such deposits, maintenance of adequate capital and liquidity, changes in control of us and our Bank, transactions between us and our Bank, handling of nonpublic information, restrictions on dividends and establishment of new offices. We must obtain approval from our regulators before engaging in certain activities, and there is risk that such approvals may not be granted, either in a timely manner or at all. These requirements may constrain our operations, and the adoption of new laws and changes to or repeal of existing laws may have an adverse effect on our business, financial condition and results of operations. Also, the burden imposed by those federal and state regulations may place banks in general, including our Bank in particular, at a competitive disadvantage compared to their non-bank competitors. Compliance with current and potential regulation, as well as supervisory scrutiny by our regulators, may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital, and limit our ability to pursue business opportunities in an efficient manner by requiring us to expend significant time, effort and resources to ensure compliance and respond to any regulatory inquiries or investigations. Our failure to comply with any applicable laws or regulations, or regulatory policies and interpretations of such laws and regulations, could result in sanctions by regulatory agencies, civil money penalties or damage to our reputation, all of which could have an adverse effect on our business, financial condition and results of operations.

Applicable laws, regulations, interpretations, enforcement policies and accounting principles have been subject to significant changes in recent years, and may be subject to significant future changes. Additionally, federal and state regulatory agencies may change the manner in which existing regulations are applied. We cannot predict the substance or effect of pending or future legislation or regulation or changes to the application of laws and regulations to us. Future changes may have an adverse effect on our business, financial condition and results of operations.

In addition, given the current economic and financial environment, regulators may elect to alter standards or the interpretation of the standards used to measure regulatory compliance or to determine the adequacy of liquidity, risk management or other operational practices for financial service companies in a manner that impacts our ability to implement our strategy and could affect us in substantial and unpredictable ways, and could have an adverse effect on our business, financial condition and results of operations. Furthermore, the regulatory agencies have broad discretion in their interpretation of laws and regulations and their assessment of the quality of our loan portfolio, securities portfolio and other assets. Based on our regulators’ assessment of the quality of our assets, operations, lending practices, investment practices, capital structure or other aspects of our business, we may be required to take additional charges or undertake, or refrain from taking, actions that could have an adverse effect on our business, financial condition and results of operations.

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Monetary policies and regulations of the Federal Reserve could have an adverse effect on our business, financial condition and results of operations.

Our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market purchases and sales of U.S. government securities, adjustments of the discount rate and changes in banks’ reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.

The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our business, financial condition and results of operations cannot be predicted.

Federal and state regulators periodically examine our business and may require us to remediate adverse examination findings or may take enforcement action against us.

The Federal Reserve, the FDIC and the DFPI periodically examine our business, including our compliance with laws and regulations. If, as a result of an examination, the Federal Reserve, the FDIC, or the DFPI were to determine that our financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we were in violation of any law or regulation, they may take a number of different remedial actions as they deem appropriate. These actions may include requiring us to remediate any such adverse examination findings.

In addition, these agencies have the power to take enforcement action against us to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation of law or regulation or unsafe or unsound practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to direct the sale of subsidiaries or other assets, to limit dividends and distributions, to restrict our growth, to assess civil money penalties against us or our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is imminent risk of loss to depositors, to terminate our deposit insurance and place our Bank into receivership or conservatorship. Any regulatory enforcement action against us could have an adverse effect on our business, financial condition and results of operations.

We are subject to stringent capital requirements, which could have an adverse effect on our operations.

Federal regulations establish minimum capital requirements for insured depository institutions, including minimum risk-based capital and leverage ratios, and defines “capital” for calculating these ratios. The capital rules require bank holding companies and banks to maintain a common equity Tier 1 capital to risk-weighted assets ratio of at least 7.0% (a minimum of 4.5% plus a capital conservation buffer of 2.5%), a Tier 1 capital to risk-weighted assets ratio of at least 8.5% (a minimum of 6.0% plus a capital conservation buffer of 2.5%), a total capital to risk-weighted assets ratio of at least 10.5% (a minimum of 8% plus a capital conservation buffer of 2.5%), and a leverage ratio of Tier 1 capital to total consolidated assets of at least 4.0%. An institution’s failure to exceed the capital conservation buffer with common equity Tier 1 capital would result in limitations on an institution’s ability to make capital distributions and discretionary bonus payments. In addition, for an insured depository institution to be “well-capitalized” under the banking agencies’ prompt corrective action framework, it must have a common equity Tier 1 capital ratio of at least 6.5%, Tier 1 capital ratio of at least 8.0%, a total capital ratio of at least 10.0%, and a leverage ratio of at least 5.0%, and must not be subject to any written agreement, order or capital directive, or prompt corrective action directive issued by its primary federal or state banking regulator to meet and maintain a specific capital level for any capital measure.

We operate under the Federal Reserve’s Small Bank Holding Company Policy Statement, which exempts from the Federal Reserve’s risk-based-capital and leverage rules bank holding companies with assets of less than $3.0 billion that are not engaged in significant nonbanking activities, do not conduct significant off-balance sheet

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activities and that do not have a material amount of debt or equity securities registered with the SEC. Historically, the Federal Reserve has not usually deemed a bank holding company ineligible for application of this policy statement solely because its common stock is registered under the Exchange Act. However, there can be no assurance that the Federal Reserve will continue this practice, and as a result the IPO may result in the loss of our status as a small bank holding company for these purposes.

Any new or revised standards adopted in the future may require us to maintain materially more capital, with common equity as a more predominant component, or manage the configuration of our assets and liabilities to comply with formulaic capital requirements. We may not be able to raise additional capital at all, or on terms acceptable to us. Failure to maintain capital to meet current or future regulatory requirements could have an adverse effect on our business, financial condition and results of operations.

We are subject to numerous “fair and responsible banking” laws and other laws and regulations designed to protect consumers, and failure to comply with these laws could lead to a wide variety of sanctions.

The Equal Credit Opportunity Act, or ECOA, the Fair Housing Act and other fair lending laws and regulations, including state laws and regulations, prohibit discriminatory lending practices by financial institutions. The Federal Trade Commission Act prohibits unfair or deceptive acts or practices, and the Dodd-Frank Act prohibits unfair, deceptive, or abusive acts or practices by financial institutions. The U.S. Department of Justice federal and state banking agencies, and other federal and state agencies, including the Consumer Financial Protection Bureau, or CFPB, are responsible for enforcing these fair and responsible banking laws and regulations. Smaller banks, including the Bank, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking agencies for compliance with federal consumer protection laws and regulations. Accordingly, CFPB rulemaking has the potential to have a significant impact on the operations of the Bank.

A challenge to an institution’s compliance with fair and responsible banking laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions activity, restrictions on expansion, and restrictions on entering new business lines. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private litigation, including through class action litigation. Such actions could have an adverse effect on our business, financial condition and results of operations.

We are subject to laws regarding the privacy, information security and protection of personal information and any violation of these laws or another incident involving personal, confidential, or proprietary information of individuals could damage our reputation and otherwise adversely affect our business.

Our business requires the collection and retention of large volumes of customer data, including personally identifiable information, or PII, in various information systems that we maintain and in those maintained by third party service providers. We also maintain important internal company data such as PII about our employees and information relating to our operations. We are subject to complex and evolving laws and regulations governing the privacy and protection of PII of individuals (including customers, employees, and other third parties). For example, our business is subject to the Gramm-Leach-Bliley Act, or the GLB Act, which, among other things: (i) imposes certain limitations on our ability to share nonpublic PII about our customers with nonaffiliated third parties; (ii) requires that we provide certain disclosures to customers about our information collection, sharing and security practices and afford customers the right to “opt out” of any information sharing by us with nonaffiliated third parties (with certain exceptions); and (iii) requires that we develop, implement and maintain a written comprehensive information security program containing appropriate safeguards based on our size and complexity, the nature and scope of our activities, and the sensitivity of customer information we process, as well as plans for responding to data security breaches. Various federal and state banking regulators and states have also enacted data breach notification requirements with varying levels of individual, consumer, regulatory or law enforcement notification in the event of a security breach. The California Consumer Privacy Act grants California residents the rights to know about personal information collected about them, to delete certain of this personal information, to opt-out of the sale of personal information, and to non-discrimination for exercising these rights.

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Ensuring that our collection, use, transfer and storage of PII complies with all applicable laws and regulations can increase our costs. Furthermore, we may not be able to ensure that customers and other third parties have appropriate controls in place to protect the confidentiality of the information that they exchange with us, particularly where such information is transmitted by electronic means. If personal, confidential or proprietary information of customers or others were to be mishandled or misused (in situations where, for example, such information was erroneously provided to parties who are not permitted to have the information, or where such information was intercepted or otherwise compromised by third parties), we could be exposed to litigation or regulatory sanctions under privacy and data protection laws and regulations. Concerns regarding the effectiveness of our measures to safeguard PII, or even the perception that such measures are inadequate, could cause us to lose customers or potential customers and thereby reduce our revenues. Accordingly, any failure or perceived failure to comply with applicable privacy or data protection laws and regulations may subject us to inquiries, examinations and investigations that could result in requirements to modify or cease certain operations or practices or in significant liabilities, fines or penalties, and could damage our reputation and otherwise adversely affect our business, financial condition and results of operations.

We are a bank holding company and are dependent upon the Bank for cash flow, and the Bank’s ability to make cash distributions is restricted.

We are a bank holding company with no material activities other than activities incidental to holding the common stock of the Bank. Our principal source of funds to pay distributions on our common stock and service any of our obligations, other than further issuances of securities, is dividends received from the Bank. Furthermore, the Bank is not obligated to pay dividends to us, and any dividends paid to us would depend on the earnings or financial condition of the Bank, various business considerations and applicable law and regulation. As is generally the case for banking institutions, the profitability of the Bank is subject to the fluctuating cost and availability of money, changes in interest rates and economic conditions in general. In addition, various federal and state statutes and regulations limit the amount of dividends that the Bank may pay to the Company without regulatory approval.

The Federal Reserve may require us to commit capital resources to support the Bank.

The Federal Reserve requires a bank holding company to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. Under the “source of strength” doctrine that was codified by the Dodd-Frank Act, the Federal Reserve may require a bank holding company to make capital injections into a subsidiary bank at times when the bank holding company may not be inclined to do so and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. Accordingly, we could be required to provide financial assistance to the Bank if it experiences financial distress.

A capital injection may be required at a time when our resources are limited, and we may be required to borrow the funds or raise capital to make the required capital injection. Any loan by a bank holding company to its subsidiary bank is subordinate in right of payment to deposits and certain other indebtedness of such subsidiary bank. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of any note obligations. Thus, any borrowing by a bank holding company for the purpose of making a capital injection to a subsidiary bank may become more difficult and expensive relative to other corporate borrowings.

We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

The Bank Secrecy Act of 1970, or the BSA, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the Patriot Act, and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and to file reports such as suspicious activity reports and currency transaction reports. We are required to comply

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with these and other anti-money laundering requirements. Our federal and state banking regulators, the Financial Crimes Enforcement Network, or FinCEN, and other government agencies are authorized to impose significant civil money penalties for violations of anti-money laundering requirements. We are also subject to increased scrutiny of compliance with the regulations issued and enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, which is responsible for helping to ensure that U.S. entities do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. If our program is deemed deficient, we could be subject to liability, including fines, civil money penalties and other regulatory actions, which may include restrictions on our business operations and our ability to pay dividends, restrictions on mergers and acquisitions activity, restrictions on expansion, and restrictions on entering new business lines. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have significant reputational consequences for us. Any of these circumstances could have an adverse effect on our business, financial condition and results of operations.

Our Bank’s FDIC deposit insurance premiums and assessments may increase.

Our Bank’s deposits are insured by the FDIC up to legal limits and, accordingly, our Bank is subject to insurance assessments based on our Bank’s average consolidated total assets less its average tangible equity. Our Bank’s regular assessments are determined by its CAMELS composite rating (a supervisory rating system developed to classify a bank’s overall condition by taking into account capital adequacy, assets, management capability, earnings, liquidity and sensitivity to market and interest rate risk), taking into account other factors and adjustments. In order to maintain a strong funding position and the reserve ratios of the DIF required by statute and FDIC estimates of projected requirements, the FDIC has the power to increase deposit insurance assessment rates and impose special assessments on all FDIC-insured financial institutions. Any future increases or special assessments could reduce our profitability and could have an adverse effect on our business, financial condition and results of operations.

The potential for the replacement or discontinuation of LIBOR as a benchmark interest and a transition to an alternative reference interest rate could present operational problems and result in market disruption.

Although we expect that the capital and debt markets will cease to use LIBOR as a benchmark in the near future and the administrator of LIBOR has announced its intention to extend the publication of most tenors of LIBOR for U.S. dollars through June 30, 2023, we cannot predict whether or when LIBOR will actually cease to be available, whether the Secured Overnight Funding Rate, or SOFR, will become the market benchmark in its place or what impact such a transition may have on our business, financial condition and results of operations.

The Federal Reserve, based on the recommendations of the New York Federal Reserve’s Alternative Reference Rate Committee, has begun publishing SOFR, which is intended to replace LIBOR, and has encouraged banks to transition away from LIBOR as soon as practicable. Although SOFR appears to be the preferred replacement rate for LIBOR, it is unclear if other benchmarks may emerge or if other rates will be adopted outside of the United States. The replacement of LIBOR also may result in economic mismatches between different categories of instruments that now consistently rely on the LIBOR benchmark. Markets are slowly developing in response to these new rates, and questions around liquidity in these rates and how to appropriately adjust these rates to eliminate any economic value transfer at the time of transition remain a significant concern.

Certain of our financial products are tied to LIBOR. Inconsistent approaches to a transition from LIBOR to an alternative rate among different market participants and for different financial products may cause market disruption and operational problems, which could adversely affect us, including by exposing us to increased basis risk and resulting costs in connection, and by creating the possibility of disagreements with counterparties.

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Risks Related to an Investment in Our Common Stock and the Offering

No public market exists for our common stock, and one may not develop.

Prior to this offering there has been no public market for our common stock. An active trading market for shares of our common stock may never develop or may not be sustained following this offering. If an active trading market does not develop, you may have difficulty selling your shares of common stock. The initial public offering price for our common stock will be determined by negotiations between us and the representatives of the underwriters. This price may not be indicative of the price at which our common stock will trade after the offering. The market price of our common stock may decline below the initial offering price, and you may not be able to sell your common stock at or above the price you paid in this offering, or at all. An inactive market may also impair our ability to raise capital by selling our common stock and may impair our ability to expand our business through acquisitions using our common stock as consideration, should we elect to do so.

Investors in this offering will experience immediate and substantial dilution.

The initial public offering price of our stock is substantially higher than the net tangible book value per share of our common stock immediately following the offering. Therefore, if you purchase shares in this offering, you will experience immediate and substantial dilution in net tangible book value per share in relation to the price that you paid for your shares. Based on an assumed initial public offering price of $              per share, which is the midpoint of the price range set forth on the cover of this prospectus, and our net tangible book value as of December 31, 2020, if you purchase our common stock in this offering, you will suffer immediate dilution of approximately $             per share in net tangible book value. As a result of this dilution, investors purchasing stock in this offering may receive significantly less than the full purchase price that they paid for the shares purchased in this offering in the event of a liquidation.

Future sales of our common stock could depress the market price of our common stock.

Following the completion of this offering, we will have             issued and outstanding shares of our common stock (              shares if the underwriters elect to their option to purchase additional shares of common stock in full), which will be freely transferable without restriction or further registration under the Securities Act. We, our executive officers, directors and certain of our holders of our currently outstanding shares of common stock holding, in the aggregate,               shares of our common stock as of March 31, 2021 (representing approximately           % of our outstanding common stock as of such date), have agreed not to sell any shares of our common stock for a period of 180 days from the date of this prospectus, subject to certain exceptions. See the section entitled “Underwriting.” Following the expiration of this lock-up period, all of these shares will be eligible for resale under Rule 144 of the Securities Act, subject to any remaining holding period requirements and, if applicable, volume limitations. See the section entitled “Shares Eligible for Future Sale.” Actual or anticipated issuances or sales of substantial amounts of our common stock following this offering could cause the market price of our common stock to decline significantly and make it more difficult for us to sell equity or equity-related securities in the future at a time and on favorable terms, or at all. We may issue all of these shares without any action or approval by our shareholders, and these shares, once issued (including upon exercise of outstanding options), will be available for sale into the public market, subject to the restrictions described in this registration statement, if applicable, for affiliate holders. The market price for our common stock may decline significantly when the restrictions on resale by our existing shareholders lapse. A decline in the price of our common stock might impede our ability to raise capital through the issuance of additional common stock or other equity securities.

Our stock price may be volatile, and you could lose part or all of your investment as a result.

Stock price volatility may negatively impact the price at which our common stock may be sold, and may also negatively impact the timing of any sale. Our stock price may fluctuate widely in response to a variety of factors including the risk factors described herein and, among other things:

  · actual or anticipated variations in quarterly or annual operating results, financial conditions or credit quality;
  · changes in business or economic conditions;
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  · changes in accounting standards, policies, guidance, interpretations or principles;
  · changes in recommendations or research reports about us or the financial services industry in general published by securities analysts;
  · the failure of securities analysts to cover, or to continue to cover, us after this offering;
  · changes in financial estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to us or other financial institutions;
  · news reports relating to trends, concerns and other issues in the financial services industry;
  · reports related to the impact of natural or manmade disasters in our market;
  · perceptions in the marketplace regarding us and or our competitors;
  · sudden increases in the demand for our common stock, including as a result of any “short squeezes;”
  · significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving us or our competitors;
  · additional investments from third parties;
  · additions or departures of key personnel;
  · future sales or issuance of additional shares of common stock;
  · fluctuations in the stock price and operating results of our competitors;
  · changes or proposed changes in laws or regulations, or differing interpretations thereof affecting our business, or enforcement of these laws or regulations;
  · new technology used, or services offered, by competitors;
  · additional investments from third parties; or
  · geopolitical conditions such as acts or threats of terrorism, pandemics or military conflicts.

In particular, the realization of any of the risks described in this section could have an adverse effect on the market price of our common stock and cause the value of your investment to decline. In addition, the stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock over the short, medium or long term, regardless of our actual performance.

We are an “emerging growth company,” as defined in the JOBS Act, and a “smaller reporting company,” as defined in Rule 12b-2 in the Exchange Act, and will be able to avail ourselves of reduced disclosure requirements applicable to emerging growth companies  and smaller reporting companies, which could make our common stock less attractive to investors and adversely affect the market price of our common stock.

We are an “emerging growth company,” as defined in the JOBS Act. For as long as we continue to be an emerging growth company we may take advantage of certain exemptions from various requirements generally applicable to public companies. These exemptions allow us, among other things, to present only two years of audited financial statements and discuss our results of operations for only two years in related Management’s Discussions and Analyses; not to provide an auditor attestation of our internal control over financial reporting; to take advantage of an extended transition period to comply with the new or revised accounting standards applicable to public companies; to provide reduced disclosure regarding our executive compensation arrangements pursuant to the rules applicable to smaller reporting companies, which means we do not have to include a compensation discussion and analysis and certain other disclosure regarding our executive compensation; and not to seek a non-binding advisory vote on executive compensation or golden parachute arrangements.

We may take advantage of these exemptions until we are no longer an emerging growth company. We would cease to be an emerging growth company upon the earliest of: (i) the first fiscal year following the fifth anniversary of this offering; (ii) the first fiscal year after our annual gross revenues are $1.07 billion or more; (iii) the date on which we have during the previous three-year period, issued more than $1 billion in non-convertible debt securities; or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.

Even after we no longer qualify as an emerging growth company, we may still qualify as a “smaller reporting company,” as defined in Rule 12b-2 in the Exchange Act, which would allow us to take advantage of many of the same exemptions from disclosure requirements, including not being required to provide an auditor attestation

 

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of our internal control over financial reporting and reduced disclosure regarding our executive compensation arrangements in our periodic reports and proxy statements.

We cannot predict whether investors will find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may a less active trading market for our common stock, and our stock price may be more volatile or decline.

 

Our significant shareholders will have the ability to control significant corporate activities after the completion of this offering and our significant shareholders’ interests may not coincide with yours.

As of March 31, 2021, our directors, executive officers and principal shareholders beneficially owned an aggregate of 5,881,683 shares of our common stock, or approximately 53.4% of our issued and outstanding shares of common stock. Following the completion of this offering, that same group will beneficially own in the aggregate approximately              % of our outstanding common stock (or              % if the underwriters exercise in full their option to purchase additional shares). Consequently, our directors, executive officers and principal shareholders will be able to significantly affect our affairs and policies, including the outcome of the election of directors and the potential outcome of other matters submitted to a vote of our shareholders, such as mergers, the sale of substantially all of our assets and other extraordinary corporate matters. This influence may also have the effect of delaying or preventing changes of control or changes in management, or limiting the ability of our other shareholders to approve transactions that they may deem to be in the best interests of our Company. The interests of these insiders could conflict with the interests of our other shareholders, including you.

Our management will have broad discretion in allocating the net proceeds of the offering. Our failure to effectively utilize such net proceeds may have an adverse effect on our financial performance and the value of our common stock.

We intend to use the net proceeds of this offering after the distributions to our existing shareholders to increase the capital of the Bank in order to support our organic growth strategies, including expanding our overall market share, to strengthen our regulatory capital and for working capital and other general corporate purposes. However, we are not required to apply any portion of the net proceeds of this offering for any particular purpose and our management could use them for purposes other than those contemplated at the time of this offering. Accordingly, our management will have broad discretion in the application of the net proceeds from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. You will not have the opportunity, as part of your investment decision, to assess whether we are using the proceeds appropriately. Our management might not apply our net proceeds in ways that ultimately increase the value of your investment. If we do not invest or apply the net proceeds from this offering in ways that enhance shareholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. We may be unable to attract or sustain research coverage by securities and industry analysts. If no securities or industry analysts commence coverage of our company, the trading price for our stock would be negatively impacted. If we obtain securities or industry analyst coverage and if one or more of the analysts who covers us downgrades our stock or publishes inaccurate or unfavorable research about our business, our stock price would likely decline. If we fail to meet the expectations of analysts for our operating results, our stock price would likely decline. If one or more of these analysts ceases coverage of us or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.

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We may not pay dividends on our common stock in the future, and our ability to pay dividends is subject to certain restrictions.

Holders of our common stock are entitled to receive only such dividends as our board of directors may declare out of funds legally available for such payments. Our board of directors may, in its sole discretion, change the amount or frequency of dividends or discontinue the payment of dividends entirely. In addition, we are a bank holding company, and our ability to declare and pay dividends is dependent on federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. It is the policy of the Federal Reserve that bank holding companies should generally pay dividends on common stock only out of earnings, and only if prospective earnings retention is consistent with the organization’s expected future needs, asset quality and financial condition, and that bank holding companies should inform and consult with the Federal Reserve in advance of declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid. We expect to consult the Federal Reserve in advance of our distribution of $              to existing shareholders from the net proceeds of this offering.

 

The holders of our debt obligations and preferred stock will have priority over our common stock with respect to payment in the event of liquidation, dissolution or winding up and with respect to the payment of interest and dividends.

In any liquidation, dissolution or winding up of the Company, our common stock would rank below all claims of debt holders against us as well as any preferred stock that has been issued. As of December 31, 2020, we had outstanding an aggregate of $28.3 million of subordinated notes, net of debt issuance costs, and we did not have any authorized preferred stock. We could incur such debt obligations or issue preferred stock in the future to raise additional capital. In such event, holders of our common stock will not be entitled to receive any payment or other distribution of assets upon the liquidation, dissolution or winding up of the Company until after all of our obligations to the debt holders are satisfied and holders of subordinated debt and senior equity securities, including preferred shares, if any, have received any payment or distribution due to them. In addition, we will be required to pay interest on the subordinated notes and dividends on the trust preferred securities and preferred stock before we will be able to pay any dividends on our common stock.

California law and the provisions of our amended and restated articles of incorporation and amended and restated bylaws may have an anti-takeover effect, and there are substantial regulatory limitations on changes of control of bank holding companies.

California corporate law and provisions of our amended and restated articles of incorporation to be in effect upon the completion of this offering, or our amended articles of incorporation, and our amended and restated bylaws to be in effect upon the completion of this offering, or our amended bylaws, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial by our shareholders. Furthermore, with certain limited exceptions, federal regulations prohibit a person or company or a group of persons deemed to be “acting in concert” from, directly or indirectly, acquiring 10% or more (5% or more if the acquirer is a bank holding company) of any class of our voting stock or obtaining the ability to control in any manner the election of a majority of our directors or otherwise direct the management or policies of our Company without prior notice or application to and the approval of the Federal Reserve. Accordingly, prospective investors must comply with these requirements, if applicable, in connection with any purchase of shares of our common stock. Collectively, provisions of our amended articles of incorporation and amended bylaws and other statutory and regulatory provisions may delay, prevent or deter a merger, acquisition, tender offer, proxy contest or other transaction that might otherwise result in our shareholders receiving a premium over the market price for their common stock. Moreover, the combination of these provisions effectively inhibits certain business combinations, which, in turn, could adversely affect the market price of our common stock.

Our amended bylaws have an exclusive forum provision, which could limit a shareholder’s ability to obtain a favorable judicial forum for disputes with us or our directors, officers or other employees.

Our amended bylaws have an exclusive forum provision providing that, unless we consent in writing to the selection of an alternative forum, the United States District Court for the Northern District of California (or, in

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the event that the United States District Court for the Northern District of California does not have jurisdiction, any federal or state court of California) shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of any duty owed by any director, or officer or other employee to us or to our shareholders, (iii) any action asserting a claim against us or any of our directors or officers or other employees arising pursuant to any provision of the General Corporation Law of California, or CGCL, or the amended articles of incorporation or the amended bylaws or (iv) any action asserting a claim against us or any of our directors or officers or other employees that is governed by the internal affairs doctrine. Any person purchasing or otherwise acquiring any interest in any shares of our capital stock will be deemed to have notice of and to have consented to this provision of our amended bylaws. The exclusive forum provision may limit a shareholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits. Alternatively, if a court were to find the exclusive forum provision to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could have an adverse effect on our business, financial condition, results of operations and growth prospects.

Prior to this offering, we were treated as an S Corporation, and claims of taxing authorities related to our prior status as an S Corporation could adversely affect us.

Immediately prior to the consummation of this offering, our status as an S Corporation will terminate and we will be treated as a C Corporation under the provisions of Sections 301 through 385 of the Code, which treat the corporation as an entity that is subject to U.S. federal income tax. If the unaudited, open tax years in which we were an S Corporation are audited by the IRS, and we are determined not to have qualified for, or to have violated any requirement for maintaining, our S Corporation status, we will be obligated to pay back taxes, interest and penalties. The amounts that we would be obligated to pay could include taxes on all our taxable income while we were an S Corporation. Any such claims could result in additional costs to us and could have an adverse effect on our business, financial condition and results of operations.

We intend to enter into a Tax Sharing Agreement with most or all of our existing shareholders and could become obligated to make payments to our existing shareholders for any additional federal, state or local income taxes assessed against them for tax periods prior to the completion of this offering.

We historically have been treated as an S Corporation for U.S. federal income tax purposes. Because we have been an S Corporation our existing shareholders have been taxed on our net income. Therefore, our existing shareholders have received distributions, referred to as tax distributions, from us that were generally intended to equal the amount of tax the existing shareholders were required to pay with respect to our income. In connection with this offering, our S Corporation status will terminate and we will thereafter be subject to federal and increased California income taxes. In the event of an adjustment to our reported taxable income for periods prior to termination of our S Corporation status, it is possible that our existing shareholders would be liable for additional income taxes for those prior periods. Pursuant to the Tax Sharing Agreement, upon our filing any tax return (amended or otherwise), in the event of any restatement of our taxable income or pursuant to a determination by, or a settlement with, a taxing authority, for any period during which we were an S Corporation, depending on the nature of the adjustment, we may be required to make a payment to our existing shareholders, who accept distribution of the estimated balance of our federal accumulated adjustments account under the Tax Sharing Agreement, in an amount equal to such shareholders’ incremental tax liability (including interest and penalties), which amount may be material. In addition, the Tax Sharing Agreement provides that we will indemnify such shareholders with respect to unpaid income tax liabilities (including interest and penalties) to the extent that such unpaid income tax liabilities are attributable to an adjustment to our taxable income for any period after our S Corporation status terminates. In both cases the amount of the payment will be based on the assumption that our existing shareholders are taxed at the highest federal and state income tax rates applicable to married individuals filing jointly and residing in California for the relevant periods. Our existing shareholders who accept distribution of the estimated balance of our federal accumulated adjustments account under the Tax Sharing Agreement will, severally and not jointly, indemnify us with respect to our unpaid income tax liabilities (including interest and penalties) to the extent that such unpaid income tax liabilities are attributable to a decrease

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in any such shareholder’s taxable income for any tax period and a corresponding increase in our taxable income for any period (but only to the extent of the amount by which the shareholder’s tax liability is reduced).

 

An investment in our common stock is not an insured deposit.

An investment in our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described herein, and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you could lose some or all of your investment.

 

The requirements of being a public company may strain our resources and divert management’s attention.

As a public company, we will incur significant legal, accounting, insurance and other expenses. We will be subject to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act and applicable securities rules and regulations. These laws and regulations increase the scope, complexity and cost of corporate governance, reporting and disclosure practices over those of non-public or non-reporting companies. Despite our conducting business in a highly regulated environment, these laws and regulations have different requirements for compliance than we have experienced prior to becoming a public company. Among other things, the Exchange Act requires that we file annual, quarterly and current reports with respect to our business and operating results and maintain effective disclosure controls and procedures and internal control over financial reporting. As a Nasdaq listed company, we will be required to prepare and file proxy materials which meet the requirements of the Exchange Act and the SEC’s proxy rules. Compliance with these rules and regulations will increase our legal and financial compliance costs, make some activities more difficult, time-consuming or costly, and increase demand on our systems and resources, particularly after we are no longer an “emerging growth company” as defined in the JOBS Act. In order to maintain, appropriately document and, if required, improve our disclosure controls and procedures and internal control over financial reporting to meet the standards required by the Sarbanes-Oxley Act, significant resources and management oversight may be required. As a result, management’s attention may be diverted from other business concerns, which could harm our business and operating results. Additionally, any failure by us to file our periodic reports with the SEC in a timely manner could harm our reputation and cause our investors and potential investors to lose confidence in us, and restrict trading in, and reduce the market price of, our common stock, and potentially our ability to access the capital markets.

If we fail to design, implement and maintain effective internal control over financial reporting or remediate any future material weakness in our internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud.

Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of the financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Effective internal control over financial reporting is necessary for us to provide reliable reports and prevent fraud. We may not be able to identify all significant deficiencies and/or material weaknesses in our internal control over financial reporting in the future, and our failure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have an adverse effect on our business, financial condition and results of operations.

In the normal course of our operations, we may identify deficiencies that would have to be remediated to satisfy the SEC rules for certification of our internal control over financial reporting. A material weakness is defined by the standards issued by the PCAOB, as a deficiency, or combination of deficiencies, in internal control over financial reporting that results in a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. As a consequence, we would have to disclose in periodic reports we file with the SEC any material weakness in our internal control over financial reporting. The existence of a material weakness would preclude management from concluding that our internal control over financial reporting is effective and, when we cease to be an emerging growth company under the JOBS Act, preclude our independent registered public accounting firm from rendering their report addressing

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an assessment of the effectiveness of our internal control over financial reporting. In addition, disclosures of deficiencies of this type in our SEC reports could cause investors to lose confidence in our financial reporting, and may negatively affect the market price of our common stock, and could result in the delisting of our securities from the securities exchanges on which they trade. Moreover, effective internal controls are necessary to produce reliable financial reports and to prevent fraud. If we have deficiencies in our disclosure controls and procedures or internal control over financial reporting, such deficiencies may adversely affect us.

 

General Risk Factors

The COVID-19 pandemic and the impact of actions to mitigate the spread of the virus could adversely affect our business, financial condition and results of operation.

Federal, state and local governments have enacted various restrictions in an attempt to limit the spread of COVID-19. Such measures have disrupted economic activity and contributed to job losses and reductions in consumer and business spending. In response to the economic and financial effects of COVID-19, the Federal Reserve has sharply reduced interest rates (which we expect will likely remain low for a considerable period) and instituted quantitative easing measures as well as domestic and global capital market support programs. In addition, the current and prior presidential administrations, Congress, various federal agencies and state governments have taken measures to address the economic and social consequences of the pandemic, including the passage of the CARES Act, which was enacted on March 27, 2020, and the Consolidated Appropriations Act, 2021, which was enacted on December 27, 2020. The CARES Act provides wide-ranging economic relief for individuals and businesses impacted by COVID-19, and the Consolidated Appropriations Act, 2021, extended some of these relief provisions in certain respects as well as provided other forms of relief.

The CARES Act established and provided $349 billion in funding for the PPP, a loan program administered by the SBA. Under the PPP, small businesses, sole proprietorships, independent contractors and self-employed individuals may apply for forgivable loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. Congress appropriated an additional $310 billion to the PPP on April 24, 2020, and amended the PPP on June 5, 2020 to make the terms of the PPP loans and loan forgiveness more flexible. The Consolidated Appropriations Act, 2021, provided additional funding for the PPP of approximately $284 billion and allows eligible borrowers, including certain borrowers who already received a PPP loan, to apply for PPP loans through March 31, 2021. In April 2020, we began processing loan applications under the PPP.

In addition, the CARES Act and related guidance from the federal banking agencies provide financial institutions the option to temporarily suspend requirements under GAAP related to classification of certain loan modifications as troubled debt restructurings, or TDRs, to account for the current and anticipated effects of COVID-19. The CARES Act, as amended by the Consolidated Appropriations Act, 2021, specified that COVID-19 related loan modifications executed between March 1, 2020 and the earlier of (i) 60 days after the date of termination of the national emergency declared by the President and (ii) January 1, 2022, on loans that were current as of December 31, 2019 are not TDRs. Additionally, under guidance from the federal banking agencies, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief are not TDRs under ASC Subtopic 310-40, “Troubled Debt Restructuring by Creditors.” These modifications include short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant. We are making a high level of loan modifications under our deferred payment program. Further, our loan portfolio includes loans that are in forbearance but which are not classified as TDRs because they were current at the time forbearance began. When the forbearance periods end, we may be required to classify a substantial portion of these COVID-19 deferments as TDRs.

The CARES Act and the Consolidated Appropriations Act, 2021, also include a range of other provisions designed to support the U.S. economy and mitigate the impact of COVID-19 on financial institutions and their customers, including through the authorization of various programs and measures that the U.S. Department of the Treasury, the Federal Reserve and other federal agencies may or are required to implement. Among other provisions, sections 4022 and 4023 of the CARES Act provide mortgage loan forbearance relief to certain

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borrowers experiencing financial hardship during the COVID-19 emergency. Further, in response to the COVID-19 outbreak, the Federal Reserve implemented a number of facilities to provide emergency liquidity to various segments of the U.S. economy and financial markets. Many of these facilities expired on December 31, 2020, or were extended for brief periods into 2021. The expiration of these facilities could have adverse effect on U.S. economy and ultimately on our business. Moreover, if federal stimulus measures and emergency lending programs and liquidity facilities are not effective in mitigating the effect of the COVID-19 pandemic, credit issues for our loan customers may be severe and adversely affect our business, results of operations, and financial condition more substantially over a longer period of time.

In response to the COVID-19 pandemic, all of the federal banking regulatory agencies have encouraged lenders to extend additional loans, and the federal government is considering additional stimulus and support legislation focused on providing aid to various sectors, including small businesses. The full impact on our lending and other business activities as a result of new government and regulatory policies, programs and guidelines, as well as regulators’ reaction to such activities, remains uncertain.

The continuation of the economic effects of the COVID-19 pandemic has had a destabilizing effect on financial markets, key market indices and overall economic activity. The uncertainty regarding the duration of the pandemic and the resulting economic disruption has caused increased market volatility and has led to an economic recession and a significant decrease in consumer confidence and business generally. The continuation of these conditions (including whether due to a resurgence or additional waves of COVID-19 infections, particularly as the geographic areas in which we operate determine whether and when to re-open, and how quickly and to what extent normal economic and operating conditions can resume, especially as a vaccine becomes widely available), as well as the impacts of the CARES Act and other federal and state measures, specifically with respect to loan forbearances, has adversely affected our business, financial condition and results of operations, and has and can be expected to further adversely impact our business, financial condition and results of operations and the operations of our borrowers, customers and business partners. In particular, these events have had, and/or can be expected to continue to have, the following effects, among other things:

 

  · impair the ability of borrowers to repay outstanding loans or other obligations, resulting in increases in delinquencies and modifications to loans;
  · impair the value of collateral securing loans (particularly with respect to real estate);
  · impair the value of our assets, including our securities portfolio, goodwill and intangible assets;
  · require an increase in our allowance for credit losses;
  · adversely affect the stability of our deposit base or otherwise impair our liquidity;
  · reduce our revenues from fee-based services;
  · negatively impact our self-insurance healthcare costs;
  · result in increased compliance risk as we become subject to new regulatory and other requirements, including new and changing guidance, associated with the PPP and other new programs in which we participate;
  · impair the ability of loan guarantors to honor commitments;
  · negatively impact our regulatory capital ratios;
  · negatively impact the productivity and availability of key personnel necessary to conduct our business, and of third-party service providers who perform critical services for us, or otherwise cause operational failures due to changes in our normal business practices necessitated by the pandemic and related governmental actions; and
  · increase cyber and payment fraud risk and other operational risks, given increased online and remote activity.

Prolonged measures by health or other governmental authorities encouraging or requiring significant restrictions on travel, assembly or other core business practices could further harm our business and those of our customers, in particular our small to medium-sized business customers. Although we have business continuity plans and other safeguards in place, there is no assurance that they will be effective.

Our results of operations have been adversely affected by the factors described above. For example, for the year ended December 31, 2020, these factors caused a substantial increase in our provision for loan losses and the increased amount of our problem loans. While the ultimate impact of these factors over the longer term is

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uncertain and we do not yet know the full extent of the impacts on our business, our operations or the global economy as a whole, nor the pace of economic recovery when the COVID-19 pandemic subsides, the decline in economic conditions generally and a prolonged negative impact on small to medium-sized businesses, in particular, due to COVID-19 is likely to result in an adverse effect on our business, financial condition and results of operations in future periods, and may heighten many of our known risks.

 

We are dependent on our management team and key employees.

Our success depends, in large part, on the retention of our management team and key employees. Our management team and other key employees, including those who conduct our loan origination and other business development activities, have significant industry experience. We cannot ensure that we will be able to retain the services of any members of our management team or other key employees. Though we have employment agreements in place with certain members of our management team they may still elect to leave at any time. The loss of any of our management team or our key employees could adversely affect our ability to execute our business strategy, and we may not be able to find adequate replacements on a timely basis, or at all.

Our future success also depends on our continuing ability to attract, develop, motivate and retain key employees. Qualified individuals are in high demand, and we may incur significant costs to attract and retain them. Because the market for qualified individuals is highly competitive, we may not be able to attract and retain qualified officers or candidates. Failure to attract and retain a qualified management team and qualified key employees could have an adverse effect on our business, financial condition and results of operations.

Our success is largely dependent upon our ability to successfully execute our business strategy.

There can be no assurance that we will be able to continue to grow and to remain profitable in future periods, or, if profitable, that our overall earnings will remain consistent with our prior results of operations, or increase in the future. A downturn in economic conditions in our market, particularly in the real estate market, heightened competition from other financial services providers, an inability to retain or grow our core deposit base, regulatory and legislative considerations, and failure to attract and retain high-performing talent, among other factors, could limit our ability to grow assets, or increase profitability, as rapidly as we have in the past. Sustainable growth requires that we manage our risks by following prudent loan underwriting standards, balancing loan and deposit growth without materially increasing interest rate risk or compressing our net interest margin, maintaining more than adequate capital at all times, managing a growing number of customer relationships, scaling technology platforms, hiring and retaining qualified employees and successfully implementing our strategic initiatives. We must also successfully implement improvements to, or integrate, our management information and control systems, procedures and processes in an efficient and timely manner and identify deficiencies in existing systems and controls. In particular, our controls and procedures must be able to accommodate an increase in loan volume in various markets and the infrastructure that comes with expanding operations, including new branches. Our growth strategy may require us to incur additional expenditures to expand our administrative and operational infrastructure. If we are unable to effectively manage and grow our banking franchise, we may experience compliance and operational problems, have to slow the pace of growth, or have to incur additional expenditures beyond current projections to support such growth. We may not have, or may not be able to develop, the knowledge or relationships necessary to be successful in new markets. Our failure to sustain our historical rate of growth, adequately manage the factors that have contributed to our growth or successfully enter new markets could have an adverse effect on our earnings and profitability and, therefore on our business, financial condition and results of operations.

We may pursue strategic acquisitions in the future, and we may not be able to overcome risks associated with such transactions.

Although we plan to continue to grow our business organically, we may explore opportunities to invest in, or to acquire, other financial institutions and businesses that we believe would complement our existing business. Our investment or acquisition activities could be material to our business and involve a number of risks including the following:

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  · investing time and incurring expense associated with identifying and evaluating potential investments or acquisitions and negotiating potential transactions, resulting in our attention being diverted from the operation of our existing business;
  · the lack of history among our management team in working together on acquisitions and related integration activities;
  · the time, expense and difficulty of integrating the operations and personnel of the combined businesses;
  · unexpected asset quality problems with acquired companies;
  · inaccurate estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution or assets;
  · risks of impairment to goodwill or other-than-temporary impairment of investment securities;
  · potential exposure to unknown or contingent liabilities of banks and businesses we acquire;
  · an inability to realize expected synergies or returns on investment;
  · potential disruption of our ongoing banking business; and
  · loss of key employees or key customers following our investment or acquisition.

We may not be successful in overcoming these risks or other problems encountered in connection with potential investments or acquisitions. Our inability to overcome these risks could have an adverse effect on our ability to implement our business strategy and enhance shareholder value, which, in turn, could have an adverse effect on our business, financial condition and results of operations. Additionally, if we record goodwill in connection with any acquisition, our business, financial condition and results of operations may be adversely affected if that goodwill is determined to be impaired, which would require us to take an impairment charge.

New lines of business, products, product enhancements or services may subject us to additional risk.

From time to time, we may implement new lines of business or offer new products and product enhancements as well as new services within our existing lines of business. There are substantial risks and uncertainties associated with these efforts. In developing, implementing or marketing new lines of business, products, product enhancements or services, we may invest significant time and resources. We may underestimate the appropriate level of resources or expertise necessary to make new lines of business or products successful or to realize their expected benefits. We may not achieve the milestones set in initial timetables for the development and introduction of new lines of business, products, product enhancements or services, and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences, may also impact the ultimate implementation of a new line of business or offerings of new products, product enhancements or services. Any new line of business, product, product enhancement or service could have a significant impact on the effectiveness of our system of internal controls. We may also decide to discontinue businesses or products, due to lack of customer acceptance or unprofitability. Failure to successfully manage these risks in the development and implementation of new lines of business or offerings of new products, product enhancements or services could have an adverse effect on our business, financial condition and results of operations.

Our reputation is critical to our business, and damage to it could have an adverse effect on us.

A key differentiating factor for our business is the strong reputation we are building in our market. Maintaining a positive reputation is critical to attracting and retaining customers and employees. Adverse perceptions of us could make it more difficult for us to execute on our strategy. Harm to our reputation can arise from many sources, including actual or perceived employee misconduct, errors or misconduct by our third party vendors or other counterparties, litigation or regulatory actions, our failure to meet our high customer service and quality standards and compliance failures.

In particular, it is not always possible to prevent employee error or misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon processing systems to record and process

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transactions and our large transaction volume may further increase the risk that employee errors, tampering or manipulation of those systems will result in losses that are difficult to detect. Employee error or misconduct could also subject us to financial claims. If our internal control systems fail to prevent or detect an occurrence, or if any resulting loss is not insured, exceeds applicable insurance limits or if insurance coverage is denied or not available, it could have an adverse effect on our business, financial condition and results of operations.

 

Additionally, as a financial institution, we are inherently exposed to operational risk in the form of theft and other fraudulent activity by employees, customers and other third parties targeting us and our customers or data. Such activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Although we devote substantial resources to maintaining effective policies and internal controls to identify and prevent such incidents, given the increasing sophistication of possible perpetrators, we may experience financial losses or reputational harm as a result of fraud.

Negative publicity about us, whether or not accurate, may also damage our reputation, which could have an adverse effect on our business, financial condition and results of operations.

Our operations could be interrupted if our third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations.

We outsource some of our operational activities and accordingly depend on relationships with third-party providers for services such as core systems support, informational website hosting, internet services, online account opening and other processing services. Our business depends on the successful and uninterrupted functioning of our information technology and telecommunications systems, many of which also depend on third party providers. The failure of these systems, a cybersecurity breach involving any of our third-party service providers or the termination or change in terms of a third-party software license or service agreement on which any of these systems is based could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. Replacing vendors or addressing other issues with our third-party service providers could entail significant delay, expense and disruption of service.

As a result, if these third-party service providers experience difficulties, are subject to cybersecurity breaches, or terminate their services, and we are unable to replace them with other service providers, particularly on a timely basis, our operations could be interrupted. If an interruption were to continue for a significant period of time, our business, financial condition and results of operations could be adversely affected. Even if we are able to replace third-party service providers, it may be at a higher cost to us, which could adversely affect our business, financial condition and results of operations.

Furthermore, third-party service providers, and banking organizations’ relationships with those providers, are subject to demanding regulatory requirements and attention by bank regulators. Our regulators may hold us responsible for any deficiencies in our oversight or control of our third-party service providers and in the performance of the parties with which we have these relationships. As a result, if our regulators assess that we have not exercised adequate oversight and control over our third-party service providers or that such providers have not performed adequately, we could be subject to administrative penalties, fines, or other forms of regulatory enforcement action as well as requirements for consumer remediation, any of which could have an adverse effect on our business, financial condition and results of operations.

System failure or cybersecurity breaches of our network security could subject us to increased operating costs as well as litigation, damage to our reputation and other potential losses.

Failures in, or breaches of, our computer systems and network infrastructure, or those of our third-party vendors or other service providers, including as a result of cyber-attacks, could disrupt our business, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. Our operations are dependent upon our ability to protect our computer equipment against damage

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from fire, power loss, telecommunications failure or a similar catastrophic event. Any damage or failure that causes an interruption in our operations could have an adverse effect on our business, financial condition and results of operations. In addition, our operations are dependent upon our ability to protect our computer systems and network infrastructure, including our internet banking activities, against damage from physical break-ins, cybersecurity breaches and other disruptive problems caused by the internet or other users. Cybersecurity breaches and other disruptions would jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and damage to our reputation, and may discourage current and potential customers from using our internet banking services. Our security measures, including firewalls and penetration testing, may not prevent or detect future potential losses from system failures or cybersecurity breaches.

In the normal course of business, we collect, process, and retain sensitive and confidential information regarding our customers. Although we devote significant resources and management focus to ensuring the integrity of our systems through information security and business continuity programs, our facilities and systems, and those of our third-party service providers, are vulnerable to external or internal security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming or human errors, or other similar events. We and our third-party service providers have experienced these types of events in the past and expect to continue to experience them in the future. These events could interrupt our business or operations, result in significant legal and financial exposure, supervisory liability, regulatory enforcement action, damage to our reputation, loss of customers and business or a loss of confidence in the security of our systems, products and services. Although the impact to date from these events has not had an adverse effect on us, we cannot be sure this will be the case in the future. Any of these occurrences could have an adverse effect on our business, financial condition and results of operations.

Information security risks for financial institutions like us have increased recently in part because of new technologies, the use of the internet and telecommunications technologies (including mobile devices) to conduct financial and other business transactions and the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, terrorists and others. In addition to cyber-attacks or other security breaches involving the theft of sensitive and confidential information, hackers recently have engaged in attacks against large financial institutions that are designed to disrupt key business services, such as consumer-facing web sites. We are not able to anticipate or implement effective preventive measures against all security breaches of these types, especially because the techniques used change frequently and because attacks can originate from a wide variety of sources. Our early detection and response mechanisms may be thwarted by sophisticated attacks and malware designed to avoid detection.

Our ability to conduct our business could be disrupted by natural or man-made disasters.

All of our offices, and a significant portion of the real estate securing loans we make, and our borrowers’ business operations in general, are located in California. California has had and will continue to have major earthquakes in areas where a significant portion of the collateral and assets of our borrowers are concentrated. California is also prone to fires, mudslides, floods and other natural disasters, such as the recent fires that impacted several counties in California, including Orange and Napa. Additionally, acts of terrorism, war, civil unrest, violence, or other man-made disasters could also cause disruptions to our business or to the economy as a whole. The occurrence of natural or man-made disasters could destroy, or cause a decline in the value of, mortgaged properties or other assets that serve as our collateral and increase the risk of delinquencies, defaults, foreclosures and losses on our loans, damage our banking facilities and offices, negatively impact regional economic conditions, result in a decline in loan demand and loan originations, result in drawdowns of deposits by customers impacted by disasters and negatively impact the implementation of our growth strategy. Natural or man-made disasters could also disrupt our business operations more generally. We have implemented a business continuity program that allows us to move critical functions to a backup data center in the event of a catastrophe. Although this program has been tested, we cannot guarantee its effectiveness in any disaster scenarios. Regardless of the effectiveness of our disaster recovery and business continuity plan, the occurrence of any natural or man-made disaster could have an adverse effect on our business, financial condition and results of operations.

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Litigation and regulatory actions, including possible enforcement actions, could subject us to significant fines, penalties, judgments or other requirements resulting in increased expenses or restrictions on our business activities.

In the normal course of business, from time to time, we have in the past and may in the future be named as a defendant in various legal actions, arising in connection with our current and/or prior business activities. Legal actions could include claims for substantial compensatory or punitive damages or claims for indeterminate amounts of damages. Further, in the future our regulators may impose consent orders, civil money penalties, matters requiring attention, or similar types of supervisory criticism. We may also, from time to time, be the subject of subpoenas, requests for information, reviews, investigations and proceedings (both formal and informal) by governmental agencies regarding our current and/or prior business activities. Any such legal or regulatory actions may subject us to substantial compensatory or punitive damages, significant fines, penalties, obligations to change our business practices or other requirements resulting in increased expenses, diminished income and damage to our reputation. Our involvement in any such matters, whether tangential or otherwise and even if the matters are ultimately determined in our favor, could also cause significant harm to our reputation and divert management attention from the operation of our business. Further, any settlement, consent order or adverse judgment in connection with any formal or informal proceeding or investigation by government agencies may result in litigation, investigations or proceedings as other litigants and government agencies begin independent reviews of the same activities. As a result, the outcome of legal and regulatory actions could have an adverse effect on our business, results of operations and results of operations.

 

We are subject to an extensive body of accounting rules and best practices. Periodic changes to such rules may change the treatment and recognition of critical financial line items.

The nature of our business makes us sensitive to the large body of accounting rules in the United States. From time to time, the governing bodies that oversee changes to accounting rules and reporting requirements may release new guidance for the preparation of our consolidated financial statements. These changes can materially impact how we record and report our financial condition and results of operations. In some instances, we could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements. Changes which have been approved for future implementation, or which are currently proposed or expected to be proposed or adopted include requirements that we: (i) calculate the allowance for loan losses on the basis of the current expected loan losses over the lifetime of our loans, which is expected to be applicable to us beginning in 2023, and may result in increases in our allowance for loan losses and future provisions for loan losses; and (ii) record the value of and liabilities relating to operating leases on our balance sheet, which is expected to be applicable beginning in 2022. These changes could adversely affect our capital, regulatory capital ratios, ability to make larger loans, earnings and performance metrics. Any such changes could have an adverse effect on our business, financial condition and results of operations.

The accuracy of our consolidated financial statements and related disclosures could be affected if the judgments, assumptions or estimates used in our critical accounting policies are inaccurate.

The preparation of financial statements and related disclosures in conformity with GAAP requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are included in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this prospectus, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider “critical” because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events or regulatory views concerning such analysis differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures, in each case resulting in our possible need to revise or, if in error, restate prior period financial statements, cause damage to our reputation and the price of our common stock and adversely affect our business, financial condition and results of operations.

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains, and future oral and written statements by us and our management may contain, forward-looking statements. These forward-looking statements represent plans, estimates, objectives, goals, guidelines, expectations, intentions, projections and statements of our beliefs concerning future events, business plans, objectives, expected operating results and the assumptions upon which those statements are based. Forward-looking statements include without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and are typically identified with words such as “may,” “could,” “should,” “will,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “aim,” “intend,” “plan” or words or phases of similar meaning. We caution that the forward-looking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Such forward-looking statements are based on various assumptions (some of which may be beyond our control) and are subject to risks and uncertainties, which change over time, and other factors which could cause actual results to differ materially from those currently anticipated. Such risks and uncertainties include, but are not limited to:

  · uncertain market conditions and economic trends nationally, regionally and particularly in Northern California and California, including as a result of the COVID-19 pandemic;
  · risks related to the concentration of our business in California, and specifically within Northern California, including risks associated with any downturn in the real estate sector;
  · the occurrence of significant natural disasters, including fires and earthquakes;
  · risks related to the impact of the COVID-19 pandemic on our business and operations;
  · changes in market interest rates that affect the pricing of our loans and deposits and our net interest income;
  · risks related to our strategic focus on lending to small to medium-sized businesses;
  · the sufficiency of the assumptions and estimates we make in establishing reserves for potential loan losses and the value of loan collateral and securities;
  · our ability to attract and retain executive officers and key employees and their customer and community relationships;
  · the risks associated with our loan portfolios, and specifically with our commercial real estate loans;
  · our level of nonperforming assets and the costs associated with resolving problem loans, if any, and complying with government-imposed foreclosure moratoriums;
  · our ability to maintain adequate liquidity (including in compliance with the U.S. rules finalizing the Basel Committee on Banking Supervision’s December 2010 capital framework, or Basel III) and to raise necessary capital to fund our growth strategy and operations or to meet increased minimum regulatory capital levels;
  · the effects of increased competition from a wide variety of local, regional, national and other providers of financial and investment services;
  · risks associated with unauthorized access, cyber-crime and other threats to data security;
  · our ability to comply with various governmental and regulatory requirements applicable to financial institutions, including supervisory actions by federal and state banking agencies;
  · the impact of recent and future legislative and regulatory changes, including changes in banking, securities and tax laws and regulations and their application by our regulators, and economic stimulus programs;
  · governmental monetary and fiscal policies, including the policies of the Federal Reserve;
  · our ability to implement, maintain, and improve effective internal controls;
  · our use of the net proceeds from this offering; and
  · other factors that are discussed in the sections entitled “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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The foregoing factors should not be considered exhaustive and should be read together with other cautionary statements that are included in this prospectus, including those discussed in the section entitled “Risk Factors.” New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence or how they will affect us. If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this prospectus. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We disclaim any duty to revise or update the forward-looking statements, whether written or oral, to reflect actual results or changes in the factors affecting the forward-looking statements, except as specifically required by law.

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USE OF PROCEEDS

Assuming an initial public offering price of $              per share (the midpoint of the price range set forth on the cover page of this prospectus), we estimate that the net proceeds to us from this offering, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us, will be approximately $              , or approximately $              if the underwriters exercise their option to purchase additional shares from us in full.

Each $1.00 increase (decrease) in the assumed initial public offering price per share of $              , which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our net proceeds, after deducting underwriting discounts and commissions and estimated offering expenses payable by us, by $              , or approximately $              if the underwriters exercise their option to purchase additional shares from us in full, assuming the number of shares we sell, as set forth on the cover of this prospectus, remains the same.

We may also increase or decrease the number of shares we are offering. Each increase (decrease) of in the number of shares offered by us would increase (decrease) the net proceeds to us from this offering by approximately $             , assuming no change in the assumed initial public offering price and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

We intend to use the net proceeds to us from this offering (i) to fund a cash distribution to our existing shareholders following the completion of this offering in the amount of $              (purchasers of our common stock in this offering will not be entitled to receive any portion of this distribution), subject to adjustment as provided in the Tax Sharing Agreement; and (ii) to use the remainder of the net proceeds, which we expect to be approximately $              , to  increase the capital of the Bank in order to support our organic growth strategies, including expanding our overall market share, to strengthen our regulatory capital and for working capital and other general corporate purposes.

We reserve the right to use the net proceeds we receive in this offering in any manner we consider to be appropriate. Although we do not contemplate changes in the proposed use of proceeds, to the extent we find that adjustment is required for other uses by reason of existing business conditions, the use of proceeds may be adjusted. The actual use of the proceeds of this offering could differ from those outlined above as a result of several factors including those set forth in the section entitled “Risk Factors” and elsewhere in this prospectus. Our management will have broad discretion in the application of the net proceeds from this offering, and investors will be relying on the judgment of our management regarding the application of the proceeds.

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CAPITALIZATION

The following table sets forth our capitalization and regulatory capital ratios on a consolidated basis as of December 31, 2020:

  · on an actual basis; and
  · on a pro forma basis after giving effect to:
  · the offering and sale of              shares of our common stock at the assumed initial public offering price per share of $           , which is the midpoint of the price range set forth on the cover page of this prospectus, resulting in net proceeds to us, after deducting underwriting discounts and estimated offering expenses payable by us of approximately $           ;
  · cash distributions of $19.8 million in the aggregate to our existing shareholders pursuant to dividends declared on January 5, 2021, January 21, 2021 and April 6, 2021;
  · a cash distribution of $              to our existing shareholders following the completion of this offering using a portion of the net proceeds of this offering; and
  · termination of our election to be taxed as an S Corporation.

Each $1.00 increase (decrease) in the assumed initial public offering price per share of $              , which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our total shareholders’ equity and total capitalization, after deducting underwriting discounts and commissions and estimated offering expenses payable by us, by $              , or approximately $              if the underwriters exercise their option to purchase additional shares from us in full, assuming the number of shares we sell, as set forth on the cover of this prospectus, remains the same.

We may also increase or decrease the number of shares we are offering. Each increase (decrease) of in the number of shares offered by us would increase (decrease) our total shareholders’ equity and total capitalization by $              , assuming no change in the assumed initial public offering price, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

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The following should be read together with the sections entitled “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Selected Historical Financial Data” and our consolidated financial statements and accompanying notes that are included elsewhere in this prospectus.

   As of December 31, 2020 
(Dollars in thousands)  Actual   Pro Forma 
Borrowings:          
Subordinated notes (due 2027)  $28,320   $ 
           
Shareholders’ equity:          
Common stock, no par value; 50,000,000 shares authorized; 11,000,273 shares issued and outstanding - actual and                shares issued and outstanding - pro forma   110,082      
Retained earnings   22,348      
Accumulated other comprehensive income   1,345      
Total shareholders’ equity   133,775   $  
           
Total capitalization  $162,095   $ 
Capital ratios:          
Tier 1 capital to average assets   6.58%     
Common Equity Tier 1 to RWA   8.98%     
Tier 1 capital to RWA   8.98%     
Total capital to RWA   12.18%     
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DILUTION

If you invest in our common stock, your interest will be immediately diluted to the extent of the difference between the initial public offering price per share of our common stock and the net tangible book value per share of common stock upon completion of this offering. Net tangible book value per common share represents the amount of our tangible assets less total liabilities, divided by the number of shares of common stock outstanding.

As of December 31, 2020, we had a net tangible book value of $133.8 million, or $12.16 per share. After giving effect to the issuance and sale of shares of our common stock in this offering (assuming the underwriters do not exercise their purchase option), based upon an assumed initial offering price of $              per share, which is the midpoint of the price range set forth on the cover page of this prospectus, the cash distributions to our existing shareholders in connection with our conversion to a C Corporation as described in this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma net tangible book value as of December 31, 2020 would have been approximately $              , or $              per share. This represents an immediate decrease in net tangible book value of $              per share to our existing shareholders and an immediate dilution of $              per share to new investors purchasing common stock in this offering.

Each $1.00 increase (decrease) in the assumed initial public offering price would increase (decrease) our pro forma net tangible book value after this offering by approximately $             , or approximately $              per share, and the dilution per share to new investors would increase (decrease) by approximately $              , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Each increase (decrease) of              in the number of shares offered by us would increase (decrease) our pro forma net tangible book value after this offering by approximately $             , or approximately $              per share, and the dilution per share to new investors would increase (decrease) by approximately $              , assuming the initial public offering price of $              per share of common stock, which is the midpoint of the price range set forth on the cover page of this prospectus, remains the same, the cash distributions to our existing shareholders in connection with our conversion to a C Corporation as described in this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. The pro forma information discussed above is illustrative only and will change based on the actual initial public offering price and other terms of this offering to be determined at pricing.

The following table illustrates this dilution on a per share basis:

   Per Share 
Initial public offering price per share of common stock  $ 
Net tangible book value per share as of December 31, 2020  $12.16 
Decrease in net tangible book value per share  $ 
Pro forma net tangible book value per share after this offering  $ 
Dilution per share to new investors  $ 

If the underwriters exercise in full their option to purchase additional shares of common stock in this offering, our pro forma net tangible book value per share would be $              per share of common stock and the dilution to new investors in this offering would be $              per share of common stock, assuming the initial public offering price of $              per share, which is the midpoint of the price range set forth on the cover page of this prospectus, remains the same, the cash distributions to our existing shareholders in connection with our conversion to a C Corporation as described in this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

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MARKET FOR COMMON STOCK AND DIVIDEND POLICY

Market for Common Stock

Prior to this offering, our common stock has not been traded on an established public trading market, and quotations for our common stock were not reported on any market. As a result, there has been no regular market for our common stock. As of December 31, 2020, there were 92 holders of record of our common stock.

We applied to list our common stock for trading on Nasdaq Global Select Market. However, we cannot assure you that a liquid trading market for our common stock will develop or be sustained after this offering. You may not be able to sell your shares quickly or at the market price if trading in our common stock is not active. See the section entitled “Underwriting” for more information regarding our arrangements with the underwriters and the factors considered in setting the initial public offering price.

Dividend Policy

Holders of our common stock are entitled to receive dividends only when, as and if declared by our board of directors out of funds legally available for dividends.

S Corporation Dividends and Distributions. Historically, we have been treated as an S Corporation for U.S. federal income tax purposes, and as such, we have paid distributions to our existing shareholders to assist them in paying the U.S. federal income taxes on our taxable income that is “passed through” to them, as well as additional amounts for returns on capital. Since December 31, 2020, as described in the table below, we have made aggregate distributions to our existing shareholders of $19.8 million. Prior to the completion of this offering, our board of directors intends to declare a cash distribution to our existing shareholders in an amount equal to an estimate of the balance of our federal accumulated adjustments account for federal income tax purposes. This amount is generally the cumulative amount of our taxable income that has been included in the taxable income of our shareholders but not yet distributed to them prior to the completion of this offering and is estimated to be $              . The distribution will be contingent upon, and payable to, our existing shareholders following the completion of this offering and will be funded by a portion of the net proceeds to us from this offering. This distribution will also be subject to adjustment as provided in the Tax Sharing Agreement. Purchasers of our common stock in this offering will not be entitled to receive any portion of this distribution.

The following table shows the cash dividends that have been paid on our common stock in the periods indicated below. The per share amounts are presented to the nearest cent.

Quarterly Period  Amount
per Share
  

Total Cash Dividend
(in thousands)

 
         
First quarter 2019  $0.70        $5,169 
Second quarter 2019  $0.80   $6,913 
Third quarter 2019  $0.80   $6,940 
Fourth quarter 2019  $0.75   $7,256 
           
First quarter 2020  $0.70   $6,772 
Second quarter 2020  $0.50   $4,842 
Third quarter 2020  $0.75   $7,275 
Fourth quarter 2020  $0.68   $7,480 
           
First quarter 2021  $1.00   $11,002 
Second quarter 2021  $0.80   $8,806

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Future Dividend Policy. Following this offering, our dividend policy and practice are expected to change. Following the offering, we will be taxed as a C Corporation and, therefore, we will no longer pay distributions to provide our shareholders with funds to pay U.S. federal income tax on their pro rata portion of our taxable income.

Any future determination relating to our dividend policy will be made by our board of directors and will depend on a number of factors, including general and economic conditions, industry standards, our financial condition and operating results, our available cash and current and anticipated cash needs, capital requirements, our ability to service debt obligations senior to our common stock, banking regulations, contractual, legal, tax and regulatory restrictions, and limitations on the payment of dividends by us to our shareholders or by the Bank to us, and such other factors as our board of directors may deem relevant. We cannot assure you that we will be able to pay dividends to holders of our common stock in the future. Because we are a bank holding company and do not engage directly in business activities of a material nature, our ability to pay any dividends on our common stock depends, in large part, upon our receipt of dividends from the Bank, which is also subject to numerous limitations on the payment of dividends under federal and state banking laws, regulations and policies.

Dividend Limitations. California law places limits on the amount of dividends the Bank may pay to the Company without prior approval. Prior regulatory approval is required to pay dividends which exceed the lesser of the Bank’s retained earnings or the Bank’s retained net income for the prior three fiscal years less the amount of any dividends made by the Bank or any majority-owned subsidiary of the Bank to shareholders during such period. State and federal bank regulatory agencies also have authority to prohibit a bank from paying dividends if such payment is deemed to be an unsafe or unsound practice, and the Federal Reserve has the same authority over bank holding companies. We would not be able to pay a dividend in excess of our retained earnings, or where our liabilities would exceed our assets.

The Federal Reserve has established requirements with respect to the maintenance of appropriate levels of capital by registered bank holding companies. Compliance with such standards, as presently in effect, or as they may be amended from time to time, could possibly limit the amount of dividends that we may pay in the future. Where a bank holding company intends to declare or pay a dividend that could raise safety and soundness concerns, it generally will be required to inform and consult with the Federal Reserve in advance. It is the policy of the Federal Reserve that a bank holding company should generally pay dividends on common stock only out of earnings, and only if prospective earnings retention is consistent with the company’s capital needs and overall current and prospective financial condition, and that bank holding companies should inform and consult with the Federal Reserve in advance of declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid. We expect to consult the Federal Reserve in advance of our distribution of $              to existing shareholders from the net proceeds of this offering. As a depository institution, the deposits of which are insured by the FDIC, the Bank may not pay dividends or make capital distributions if the Bank would thereafter be undercapitalized. In addition, the Bank may not pay dividends on its capital stock if it remains in default on any assessment due to the FDIC. The Bank currently is not in default under any of its obligations to the FDIC. See the section entitled “Supervision and Regulation” for more information regarding the regulatory limitations on our ability to declare and pay dividends.

Our ability to pay dividends may also be limited on account of our outstanding indebtedness. We currently have outstanding two series of subordinated notes. We must make the required payments on our subordinated notes before any cash dividends can be paid on our common stock.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes thereto and other financial information included elsewhere in this prospectus.

To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of our future financial outcomes. In addition to containing historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the sections entitled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” We assume no obligation to update any of these forward-looking statements, except to the extent required by law.

The following discussion presents management’s perspective on our results of operations and financial condition on a consolidated basis. However, because we conduct all of our material business operations through our bank subsidiary, Five Star Bank, the discussion and analysis relates to activities primarily conducted by the Bank.

Company Overview

Headquartered in the greater Sacramento metropolitan area of California, we are a bank holding company that operates through our wholly owned subsidiary, Five Star Bank, a California state-chartered bank. We provide a broad range of banking products and services to small and medium-sized businesses, professionals, and individuals primarily in Northern California through seven branch offices and two loan production offices. Our mission is to strive to become the top business bank in all markets we serve through exceptional service, deep connectivity and customer empathy. We are dedicated to serving real estate, agricultural, faith based and small to medium-sized enterprises. We aim to consistently deliver value that meets or exceeds expectations of our shareholders, customers, employees, business partners and community. In summary, we refer to our mission as “purpose-driven and integrity centered banking.” As of December 31, 2020, we had total assets of $2.0 billion, total loans of $1.5 billion and total deposits of $1.8 billion.

Factors Affecting Comparability of Financial Results

S Corporation Status

Since our inception, we have elected to be taxed for U.S. federal income tax purposes as an S Corporation. As a result, our earnings have not been subject to, and we have not paid, U.S. federal income tax, and we have not been required to make any provision or recognize any liability for U.S. federal income tax in our consolidated financial statements. While we are not subject to and have not paid U.S. federal income tax, we are subject to, and have paid, California S Corporation income tax at a current rate of 3.5%. Immediately prior to the completion of this offering and as authorized by the Tax Sharing Agreement, we expect to file consents from the requisite amount of our shareholders to terminate our S Corporation election with the IRS, which will result in the commencement of our taxation as a C Corporation for U.S. federal and California income tax purposes. Upon the termination of our status as an S Corporation, we will commence paying U.S. federal income tax and a higher California income tax on our taxable earnings for each year (including the short year beginning on the date our status as an S Corporation terminates), and our consolidated financial statements will reflect a provision for U.S. federal income tax. As a result of this change, the net income and earnings per share data presented in our historical financial statements and the other financial information set forth in this prospectus, which (unless otherwise specified) do not include any provision for U.S. federal income tax or the higher California income tax rate, will not be comparable with our future net income and earnings per share in periods after we commence to be taxed as a C Corporation. As a C Corporation, our net income will be calculated by including a provision for U.S. federal income tax and a higher California income tax rate at a combined statutory rate of 29.56%.

The termination of our status as an S Corporation may also affect our financial condition and cash flows. Historically, we have made quarterly cash distributions to our shareholders in amounts estimated by us to be

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sufficient for them to pay estimated individual U.S. federal and California income tax liabilities resulting from our taxable income that was “passed through” to them. However, these distributions have not been consistent, as sometimes the distributions have been less than or in excess of the shareholder’s estimated U.S. federal and California income tax liabilities resulting from their ownership of our stock. In addition, these estimates have been based on individual income tax rates, which may differ from the rates imposed on the income of C Corporations. Once our status as an S Corporation terminates, no income will be “passed through” to any shareholders, but, as noted above, we will commence paying U.S. federal income tax and a higher California income tax. The amounts that we have historically distributed to our shareholders may not be indicative of the amount of U.S. federal and California income tax that we will be required to pay after we commence to be taxed as a C Corporation. Depending on our effective tax rate and our future dividend rate, our future cash flows and financial condition could be positively or adversely affected compared to our historical cash flows and financial condition.

Furthermore, deferred tax assets and liabilities will be recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of our existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation will be recognized in net income in the quarter such change takes place. The difference between the financial statement carrying amounts of assets and liabilities and their respective tax bases would have been recorded as a net deferred tax asset of $5.3 million, or an increase of $4.7 million, and a corresponding $4.7 million increase to shareholders’ equity if it had been recorded on our balance sheet as of December 31, 2020.

Public Company Costs

Following the completion of this offering, we expect to incur additional costs associated with operating as a public company. We expect that these costs will include additional personnel, legal, consulting, regulatory, insurance, accounting, investor relations and other expenses that we did not incur as a private company.

The Sarbanes-Oxley Act, as well as rules adopted by the SEC, the FDIC, the DFPI and national securities exchanges, requires public companies to implement specified corporate governance practices that are currently inapplicable to us as a private company. These additional rules and regulations will increase our legal, regulatory and financial compliance costs and will make some activities more time-consuming and costly.

Key Factors Affecting Our Business

 

COVID-19

The COVID-19 pandemic and the impact of actions to mitigate the spread of the virus affected our business, financial condition and results of operations in the year ended December 31, 2020. During the year, we maintained our focus on relationship-based banking and made the health and safety of our customers and employees our first priority. To help protect our customers and their finances during the pandemic, we were able to re-open all of our branches, taking into account guidelines from public health officials, while encouraging our customers to conduct business with us via phone, online banking and mobile apps.

Our financial results for the year ended December 31, 2020 were also impacted by the COVID-19 pandemic. On March 27, 2020, the CARES Act was enacted, providing wide ranging economic relief for individuals and businesses impacted by COVID-19, including the PPP, a loan program administered by the SBA. The Consolidated Appropriations Act, 2021, enacted on December 27, 2020, extended some of these relief provisions in certain respects. Under the PPP if a loan is fully forgiven, the SBA will repay the lending bank in full. If a loan is partially forgiven or not forgiven at all, a lender must look to the borrower for repayment of unforgiven principal and interest. If the borrower defaults, in part or in full, the loan is guaranteed by the SBA.

Our responsiveness and certainty of execution resulted in our ability to quickly provide PPP loans to 1,124 customers nationwide, approximately 35% of which were new customers. Because of our relationship-based

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banking approach, the influx of new customers contributed to a corresponding increase in deposits in the year ended December 31, 2020. We expect these trends to continue as we extend additional loans under the PPP in 2021. Our balance of PPP loans at December 31, 2020 was $148.0 million, or 9.8% of total loans.

Additionally, the uncertainty and economic downturn caused by the COVID-19 pandemic affected our overall existing loan portfolio. In 2020, our methodology for evaluating allowance for loan losses was affected by the COVID-19 pandemic resulting in higher reserve levels primarily related to our commercial secured portfolio. We also recognized COVID-19 deferments and related modifications on our loan portfolio more generally. The CARES Act, as amended by the Consolidated Appropriations Act, 2021, specified that COVID-19 related loan modifications executed between March 1, 2020 and the earlier of (i) 60 days after the date of termination of the national emergency declared by the President and (ii) January 1, 2022, on loans that were current as of December 31, 2019 are not TDRs. Additionally, under guidance from the federal banking agencies, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief are not TDRs under ASC Subtopic 310-40, “Troubled Debt Restructuring by Creditors.” These modifications include short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant. We elected to apply these temporary accounting provisions to payment relief loans beginning in March 2020. As of December 31, 2020, 35 loans totaling $41.4 million, or 2.7% of the loan portfolio, were in a COVID-19 deferral period and 304 loans totaling $108.0 million had been in a COVID-19 deferment at some point during 2020 but were not in such deferment as of December 31, 2020. We accrue and recognize interest income on loans under payment relief based on the original contractual interest rates. When payments resume at the end of the relief period, the payments will generally be applied to accrued interest due until accrued interest is fully paid.

Interest Rates

Net interest income is the most significant contributor to our net income and is the difference between the interest and fees earned on interest-earning assets and the interest expense incurred in connection with interest-bearing liabilities. Net interest income is primarily a function of the average balances and yields of these interest-earning assets and interest-bearing liabilities. These factors are influenced by internal considerations such as product mix and risk appetite as well as external influences such as economic conditions, competition for loans and deposits and market interest rates.

The cost of our deposits and short-term borrowings is primarily based on short-term interest rates, which are largely driven by the Federal Reserve’s actions and market competition. The yields generated by our loans and securities are typically affected by short-term and long-term interest rates, which are driven by market competition and market rates often impacted by the Federal Reserve’s actions. The level of net interest income is influenced by movements in such interest rates and the pace at which such movements occur.

We anticipate that interest rates will remain low over the next few years. Based on our asset sensitivity, a steepened yield curve could have an adverse impact on our net interest income. Conversely, a continued flat yield curve would be expected to benefit our net interest income.

Operating Efficiency

In 2018 we began investing heavily in our infrastructure and personnel, primarily our management and core processing systems. As we have begun to leverage these investments, our efficiency has improved compared to that year. We believe that we are well-positioned for future growth without needing significant additional investment in the near team.

Credit Quality

We have well established loan policies and underwriting practices that have resulted in very low levels of charge-offs and nonperforming assets. We strive to originate quality loans that will maintain the credit quality of

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our loan portfolio. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition.

Competition

The industry and businesses in which we operate are highly competitive. We may see increased competition in different areas including interest rates, underwriting standards and product offerings and structure. While we seek to maintain an appropriate return on our investments, we anticipate that we will experience continued pressure on our net interest margins as we operate in this competitive environment.

Economic Conditions

Our business and financial performance are affected by economic conditions generally in the United States and more directly in the market of Northern California where we primarily operate. The significant economic factors that are most relevant to our business and our financial performance include, but are not limited to, real estate values, interest rates and unemployment rates.

Regulatory Trends

We operate in a highly regulated environment and nearly all of our operations are subject to extensive regulation and supervision. Regulators appointed by the Biden Administration, Congress, the State of California and the DFPI may revise the laws and regulations applicable to us, may impose new laws and regulations, increase the level of scrutiny of our business in the supervisory process, and pursue additional enforcement actions against financial institutions. Future legislative and regulatory changes such as these may increase our costs and have an adverse effect on our business, financial condition and results of operations. The legislative and regulatory trends that will affect us in the future are impossible to predict with any certainty.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and with general practices within the financial services industry. Application of these principles requires management to make complex and subjective estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under current circumstances. These assumptions form the basis for our judgments about the carrying values of assets and liabilities that are not readily available from independent, objective sources. We evaluate our estimates on an ongoing basis. Use of alternative assumptions may have resulted in significantly different estimates. Actual results may differ from these estimates.

Our most significant accounting policies are described in Note 1 to our Financial Statements for the years ended December 31, 2020 and 2019, which are contained elsewhere in this prospectus. We have identified the following accounting policies and estimates that, due to the difficult, subjective or complex judgments and assumptions inherent in those policies and estimates and the potential sensitivity of our consolidated financial statements to those judgments and assumptions, are critical to an understanding of our consolidated financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of our financial statements are reasonable and appropriate.

Pursuant to the JOBS Act, as an emerging growth company, we can elect to opt out of the extended transition period for adopting any new or revised accounting standards. We have elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we may adopt the standard on the application date for private companies.

We have elected to take advantage of the scaled disclosures and other relief under the JOBS Act, and we may take advantage of some or all of the reduced regulatory and reporting requirements that will be available to us under the JOBS Act, so long as we qualify as an emerging growth company.

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Loans and Allowance for Loan Losses

The allowance for loan losses represents the estimated probable incurred loan losses in our loan portfolio. The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries of previously charged off amounts, if any, are credited to the allowance for loan losses.

The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability 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.

Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal or when a loan becomes contractually past due by 90 days or more with respect to interest or principal. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

We consider an originated loan to be impaired when it is probable that the collection of all amounts due, according to the contractual terms is unlikely. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the facts and circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Interest income is recognized on impaired loans in the same manner as nonaccrual loans.

We consider a loan to be a TDR when we have granted a concession and the borrower is experiencing financial difficulty. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy. A TDR loan generally is kept on nonaccrual status until, among other criteria, the borrower has paid for six consecutive months with no payment defaults, at which time the TDR may be placed back on accrual status.

The CARES Act, as amended by the Consolidated Appropriations Act, 2021, specified that COVID-19 related loan modifications executed between March 1, 2020 and the earlier of (i) 60 days after the date of termination of the national emergency declared by the President and (ii) January 1, 2022, on loans that were current as of December 31, 2019 are not TDRs. Additionally, under guidance from the federal banking agencies, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief are not TDRs under ASC Subtopic 310-40, “Troubled Debt Restructuring by Creditors.” These modifications include short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant.

Fair Value Measurement

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base the fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

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We have established and documented a process for determining fair value. We maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Whenever there is no readily available market data, management uses its best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of management’s judgment.

As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial consolidated statements.

Securities Impairment

At each consolidated financial statement date, management assesses each investment to determine if impaired investments are temporarily impaired or if the impairment is other than temporary. Various factors are considered in the assessment, including the nature of the investment, the cause of the impairment, the severity and duration of the impairment, credit ratings and other credit related factors such as third party guarantees and volatility of the security’s fair value. This assessment also includes a determination as to whether we intend to sell the security, or if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit losses. If we intend to sell a security or if it is more likely than not that we will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the entire difference between the security’s amortized cost basis and its fair value.

Stock-Based Compensation

Compensation cost is recognized for stock options and restricted stock awards issued to executives and directors, based on the fair value of these awards at the date of grant. The fair value of restricted stock awards is determined by considering projections of discounted cash flows available to shareholders (paid in the form of dividends) as well as comparable values for publicly traded banks of similar size and complexity. A Black-Scholes model is utilized to estimate the grant date fair value of stock options, while the estimated fair value of our common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Primary Factors Used to Evaluate Our Business

 

Results of Operations

In addition to net income, the primary factors we use to evaluate and manage our results of operations include net interest income, noninterest income and noninterest expense.

Net Interest Income

Net interest income is the most significant contributor to our net income. Net interest income represents interest income from interest earning assets, such as loans and investments, less interest expense on interest-bearing liabilities, such as deposits, FHLB advances, subordinated notes and other borrowings, which are used to fund those assets. In evaluating our net interest income, we measure and monitor yields on our interest-earning assets and interest-bearing liabilities as well as trends in our net interest margin. Net interest margin is a ratio calculated as net interest income divided by total interest-earning assets for the same period. We manage our earning assets and funding sources in order to maximize this margin while limiting credit risk and interest rate sensitivity to our established risk appetite levels. Changes in market interest rates and competition in our market typically have the largest impact on periodic changes in our net interest margin.

Noninterest Income

Noninterest income is a secondary contributor to our net income. Noninterest income consists primarily of net gains on the sale of loans, FHLB dividends, and other fee income including loan-related fees and fees related to customer deposits.

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Noninterest Expense

Noninterest expense includes salaries and employee benefits, occupancy and equipment costs, Federal deposit insurance expense, data processing and software fees, professional services fees, advertising and promotional expense, loan-related costs and other general and administrative expenses. In evaluating our level of noninterest expense we closely monitor our efficiency ratio. The efficiency ratio is calculated by dividing noninterest expense to net interest income plus noninterest income. We constantly seek to identify ways to streamline our business and operate more efficiently, which has enabled us to reduce our noninterest expense in both absolute terms and as a percentage of our revenue while continuing to achieve growth in total loans and assets.

Over the past several years, we have invested significant resources in personnel and infrastructure. Noninterest expense is declining and we expect our efficiency ratio will improve due, in part, to our past investment in infrastructure. We believe that we are currently well positioned to continue our growth trajectory without meaningful additions to our cost structure.

Financial Condition

The primary factors we use to evaluate and manage our financial condition include asset quality, capital and liquidity.

Asset Quality

We manage the quality of our loans based upon trends at the overall loan portfolio level as well as within specific product type. We measure and monitor key factors that include the level and trend of classified, delinquent, nonaccrual and nonperforming assets, collateral coverage and credit scores and debt service coverage, where applicable. The metrics directly impact our evaluation of the adequacy of our allowance for loan losses. The quality of our investment portfolio is measured by composition of investment type and is almost entirely comprised of guaranteed U.S. government agency securities and obligations of states and political subdivisions.

Capital

We manage our capital by tracking our level and quality of capital with consideration given to our overall financial condition, our asset quality, our level of allowance for loan losses, our geographic and industry concentrations, and other risk factors in our balance sheet, including interest rate sensitivity. Bank holding companies and banks are subject to various regulatory capital requirements administered by federal bank and state regulatory agencies. We operate under the Small Bank Holding Company Policy Statement, and accordingly are exempt from the Federal Reserve’s generally applicable risk-based-capital ratio and leverage ratio requirements. The Bank is subject to minimum risk-based and leverage capital requirements under federal regulations implementing the Basel III framework, and to regulatory thresholds that must be met for an insured depository institution to be classified as “well-capitalized” under the prompt corrective action framework. Our capital ratios and the capital ratios of the Bank at December 31, 2020 exceeded all applicable minimum capital requirements and the regulatory standards for the Bank to be “well-capitalized.” See the section entitled “Business—Supervision and Regulation” for more information regarding the regulatory capital adequacy requirements applicable to us.

Liquidity

We manage liquidity based upon factors that include the level of diversification of our funding sources, the composition of our deposit types, the availability of unused funding sources, off-balance sheet obligations, the amount of cash and liquid securities we hold and the availability of assets to be readily converted into cash without undue loss. The FDIC evaluates the liquidity of the Bank on a stand-alone basis pursuant to applicable guidance and policies. See the section entitled “Liquidity Management and Capital Adequacy—Liquidity Management” for additional detail on the liquidity requirements applicable to the Bank.

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Operating Highlights

The year ended December 31, 2020 reflects trends of growth in income, assets and deposits that we planned to achieve through our investments over the past several years. These operations resulted in the following highlights:

  · Strong balance sheet growth:
  · We grew our assets by $473.9 million during the year ended December 31, 2020, an increase of 32.0% from December 31, 2019.
  · Loans increased $321.1 million during the year ended December 31, 2020, an increase of 27.1% from December 31, 2019.
  · Total deposits grew by $472.3 million during the year ended December 31, 2020, an increase of 36.0% from December 31, 2019.
  · Strong income growth:
  · We grew our net income by $6.6 million, an increase of 22.6%, during the year ended December 31, 2020, while improving our efficiency ratio from 38.63% to 37.92% during the same period.
  · Strong credit quality:
  · Nonperforming assets were 0.02% of total assets as of December 31, 2020 and net charge-offs were 0.12% of total average loans during the year ended December 31, 2020.

Results of operations—Years ended December 31, 2020 and December 31, 2019

 

Overview

For the year ended December 31, 2020, our net income was $35.9 million as compared to $29.3 million for the year ended December 31, 2019. The increase of $6.6 million, or 22.6%, was attributed primarily to a $12.2 million increase in net interest income and a $3.9 million increase in noninterest income, offset by a $3.5 million increase in the provision for loan losses and a $5.7 million increase in noninterest expenses.

Net Interest Income

Net interest income increased by $12.2 million, or 22.9%, to $65.2 million for the year ended December 31, 2020 from $53.0 million for the year ended December 31, 2019. Our net interest margin of 3.68% for the year ended December 31, 2020 declined from our net interest margin of 3.98% for the year ended December 31, 2019, primarily due to the decline in the yield on earnings assets which declined from 4.86% to 4.20%, offset by the decline in the cost of interest-bearing liabilities from 1.26% to 0.78%.

Average balance sheet, interest and yield/rate analysis. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yield earned and rates paid for the years ended December 31, 2020 and 2019. The average balances are daily averages and include both performing and nonperforming loans.

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Average Balance Sheet, and Net Interest Analysis.

   For the Years Ended December 31, 
   2020   2019 
(Dollars in thousands)  Average
Balance
   Interest
Inc/Exp
   Average
Yield/Rate
   Average
Balance
   Interest
Inc/Exp
   Average
Yield/Rate
 
Interest-Earning Assets                              
Loans(1)  $1,439,380   $71,405    4.96%  $1,070,972   $58,349    5.45%
Securities, AFS(2)   86,487    1,359    1.57%   77,788    1,630    2.10%
Securities, HTM(2)   8,671    428    4.94%   9,271    458    4.94%
Interest-bearing deposits in other banks   237,815    1,198    0.50%   173,256    4,241    2.45%
Total interest-earning assets   1,772,353    74,390    4.20%   1,331,287    64,678    4.86%
                               
Noninterest-earning assets(3)   72,628              32,882           
                               
Total assets  $1,844,981             $1,364,169           
                               
                               
Interest-Bearing Liabilities                              
Deposits:                              
Transaction accounts  $141,293    374    0.26%  $130,472    476    0.36%
Money market and savings   906,599    5,844    0.64%   666,259    7,316    1.10%
Time   102,890    1,189    1.16%   99,650    2,220    2.23%
Total interest-bearing deposits   1,150,782    7,407    0.64%   896,381    10,012    1.12%
                               
Sub debt   28,364    1,773    6.25%   25,032    1,601    6.40%
Borrowings           0.00%   1,066    22    2.06%
                               
Total interest-bearing liabilities   1,179,146    9,180    0.78%   922,479    11,635    1.26%
                               
Noninterest-bearing liabilities                              
Noninterest-bearing deposits   546,048              342,959           
Other noninterest-bearing liabilities   4,496              5,418           
Total noninterest-bearing liabilities   550,544              348,377           
                               
Equity   115,291              93,313           
                               
   $1,844,981             $1,364,169           
                               
Net interest spread(4)             3.42%             3.60%
                               
Net interest income/margin(5)       $65,210    3.68%       $53,043    3.98%
(1) Loan balance includes both loans held for investment and loans held for sale. Nonaccrual loans are included in total loan balances. No adjustment has been made for these loans in the yield calculations. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs.
(2) Securities available-for-sale, or AFS, and held-to-maturity, or HTM, include obligations of states and political subdivisions of $27.6 million and $17.1 million as of December 31, 2020 and 2019, respectively. Yields are not calculated on a tax-equivalent basis.
(3) Noninterest-earning assets includes the allowance for loan losses.
(4) Net interest spread is the average yield on total interest-earning assets minus the average rate on total interest-bearing liabilities.
(5) Net interest margin is net interest income divided by total interest-earning assets.
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Interest rates and operating interest differential. Increases and decreases in interest income and interest expense result from change in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned from our interest-earning assets and interest incurred on our interest-bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the current period’s average rate. The effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume. The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

Analysis of Changes in Interest Income and Expenses

 

   For the Years Ended December 31,   For the Years Ended December 31, 
   2020 vs 2019   2019 vs 2018 
   Variance Due To   Variance Due To 
(Dollars in thousands)  Volume   Yield/Rate   Total   Volume   Yield/Rate   Total 
Interest-Earning Assets                              
Loans  $18,672   $(5,616)  $13,056   $11,464   $1,500   $12,964 
Securities, available for sale   170    (441)   (271)   146    (21)   125 
Securities, held to maturity   (30)       (30)   (23)       (23)
Cash and cash equivalents   1,184    (4,227)   (3,043)   18    624    642 
Total Interest-earning assets   19,996    (10,284)   9,712    11,605    2,103    13,708 
                               
Interest-Bearing Liabilities                              
Deposits                              
Transaction accounts   36    (138)   (102)   56        56 
Money market and savings accounts   2,157    (3,629)   (1,472)   1,269    2,090    3,359 
Time deposits   70    (1,101)   (1,031)   222    680    902 
Total interest-bearing deposits   2,263    (4,868)   (2,605)   1,547    2,770    4,317 
                               
Subordinated notes   210    (38)   172    38    5    43 
Borrowings   (11)   (11)   (22)   22        22 
Total interest-bearing liabilities   2,462    (4,917)   (2,455)   1,607    2,775    4,382 
                               
Net interest income/margin  $17,534   $(5,367)  $12,167   $9,998   $(672)  $9,326 

Total interest income increased by $9.7 million, or 15.0%, for the year ended December 31, 2020 as compared to the same period of 2019. For the year ended December 31, 2020, interest income from loans increased by $13.1 million as the average daily balance of loans increased by $368.4 million, or 34.4%, compared to the same period of 2019. This interest income increase from greater average loan balances was partially offset by a 49 basis points decrease in loan yield for the year ended December 31, 2020 as compared to the same period of 2019. Excluding PPP loans, the average loan balances increased by $207.3 million and the yield declined by 40 basis points for the year ended December 31, 2020 compared to the same period of 2019.

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Total interest expense decreased $2.4 million to $9.2 million for the year ended December 31, 2020 from $11.6 million for the year ended December 31, 2019. Interest expense on customer deposits decreased $2.6 million to $7.4 million for the year ended December 31, 2020 from $10.0 million for the same period of 2019. This decrease is due to the cost of interest-bearing deposits declining to 0.64% for the year ended December 31, 2020, from 1.12% for the same period ended 2019, reflecting the decline in overall interest rates during the period.

Provision for Loan Losses

The provision for loan losses is based on management’s assessment of the adequacy of our allowance for loan losses. Factors impacting the provision include inherent risk characteristics in our loan portfolio, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of the change in collateral values, and the funding probability on unfunded lending commitments. The provision for loan losses is charged against earnings in order to maintain our allowance for loan losses, which reflects management’s best estimate of probable losses inherent in our loan portfolio at the balance sheet date.

We recorded a provision for loan losses totaling $9.0 million for the year ended December 31, 2020 as compared to a provision for loan losses of $5.5 million for the year ended December 31, 2019, a $3.5 million increase due to the increase in reserves on the commercial secured portfolio due to higher uncertainty related to the COVID-19 pandemic and related economic effects.

Noninterest Income

Noninterest income increased by $3.9 million to $9.3 million for the year ended December 31, 2020 from $5.4 million for the year ended December 31, 2019.

The following table presents the major components of our noninterest income for the years ended December 31, 2020 and 2019:

   For the Years Ended December 31, 
(Dollars in thousands)  2020   2019   $ Increase
(Decrease)
   % Increase
(Decrease)
 
Service charges on deposit accounts  $367   $453   $(86)   (19.0)%
Net gains (losses) on sales of securities AFS   1,438    (66)   1,504    2,278.8 %
Gain on sale of loans   4,145    3,818    327    8.6 %
Loan-related fees   2,309    287    2,022    704.5 %
FHLB stock dividends   321    327    (6)   (1.8)%
Earnings on bank-owned life insurance   220    227    (7)   (3.1)%
Other   502    347    155    44.7 %
   $9,302   $5,393   $3,909    72.5 %
                     

Net gains (losses) on sales of securities. Gains on the sale of securities increased by $1.5 million to $1.4 million for the year ended December 31, 2020 from a loss of $66,000 for the same period ended December 31, 2019. The increase was primarily due to sales, largely of municipal securities, to take advantage of the interest rate environment. During the years ended December 31, 2020 and 2019, we had $46.4 million and $15.0 million in proceeds from the sale of securities, respectively.

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Gain on sale of loans. Gain on sale of loans increased by $327,000 to $4.1 million for the year ended December 31, 2020 from $3.8 million for the same period of 2019. The aggregate principal balance of SBA 7(a) guaranteed portions sold during the year ended December 31, 2020 was $71.3 million compared to $70.6 million in 2019. The weighted average premium received was 11.82% during the year ended December 31, 2020 compared to 10.94% in 2019.

Loan-related fees. Loan-related fees increased by $2.0 million to $2.3 million for the year ended December 31, 2020 from $287,000 for the year ended December 31, 2019. Of this increase, $1.6 million relates to swap referral fees. Such fees are recognized when borrowers seeking fixed rate loans are referred to a counterparty who places the swap for the borrower. Another $521,000 of the increase relates to fees received from the City of Sacramento for administering their Small Business and Creative Economy and Emergency Loan Programs.

Noninterest Expense

Noninterest expense increased by $5.7 million to $28.3 million for the year ended December 31, 2020 from $22.6 million for the year ended December 31, 2019.

The following table presents the major components of our noninterest expense for the years ended December 31, 2020 and 2019:

   For the Years Ended December 31, 
(Dollars in thousands)  2020   2019   $ Increase
(Decrease)
   % Increase
(Decrease)
 
Salaries and employee benefits  $16,084   $12,723   $3,361    26.4 %
Occupancy and equipment   1,715    1,575    140    8.9 %
Data processing and software   1,982    1,323    659    49.8 %
Federal deposit insurance   1,137    370    767    207.3 %
Professional services   1,960    1,414    546    38.6 %
Advertising and promotional   1,102    1,306    (204)   (15.6)%
Loan-related expenses   732    439    293    66.7 %
Other operating expenses   3,545    3,425    120    3.5 %
   $28,257   $22,575   $5,682    25.2 %

Salaries and employee benefits. Salaries and employee benefits increased by $3.4 million to $16.1 million for the year ended December 31, 2020 from $12.7 million for the same period ended 2019. The increase was primarily due to the increase in full-time equivalent employees from 107 to 141, a 31.8% increase, and increased commissions related to our loan and deposit growth as of December 31, 2019 compared to December 31, 2020.

Data processing and software. Data processing and software fees increased by $659,000 to $2.0 million for the year ended December 31, 2020 from $1.3 million for the same period ended 2019. The increase was primarily due to: (i) higher transaction volumes related to the increased number of loan and deposit accounts and (ii) higher software costs for a new online banking product that was implemented in late 2019 and various software products for loan documentation and workflow.

Federal deposit insurance. Federal deposit insurance expense increased by $767,000 to $1.1 million for the year ended December 31, 2020 from $370,000 for the same period ended 2019. The increase was primarily due to our higher assessment base.

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Professional services. Professional services fees increased by $546,000 to $2.0 million for the year ended December 31, 2020 from $1.4 million for the same period ended 2019. The increase was primarily due to higher audit, consulting and legal costs.

Loan-related. Loan-related costs increased by $293,000 to $732,000 for the year ended December 31, 2020 from $439,000 for the same period ended 2019. The increase was primarily due to higher collections legal fees, credit report costs and amortization of SBA servicing asset.

State Income Tax

State income tax expense was $1.3 million and $1.1 million for the years ended December 31, 2020 and 2019 with an effective tax rate of 3.5%. During the periods discussed, we have elected to be taxed as an S Corporation. Under these provisions, we did not pay corporate U.S. federal income tax on our taxable income. Instead, our taxable income was “passed through” to our shareholders. See the sections entitled “—S Corporation Status” above for a discussion of our status as an S Corporation and “—Pro Forma Income Tax Expense and Net Income” below for a discussion on what our income tax expense and net income would have been had we been taxed as a C Corporation.

Pro Forma Income Tax Expense and Net Income

Because of our status as an S Corporation, we had no U.S. federal income tax expense for the years ended December 31, 2020 and 2019. Had we been taxed as a C Corporation and paid U.S. federal income tax for the years ended December 31, 2020 and December 31, 2019, our combined statutory income tax rate would have been 29.56% in each period. These pro forma statutory rates reflect a U.S. federal income tax rate of 21.0% and a California income tax rate of 8.56%, after adjustment for the federal tax benefit, on corporate income and the fact that a portion of our net income in each of these periods was derived from nontaxable income and other nondeductible expenses. Our net income for the years ended December 31, 2020 and 2019 was $35.9 million and $29.3 million, respectively. Had we been subject to U.S. federal income tax during these periods, on a pro forma basis, our provision for combined federal and state income tax would have been $11.0 million and $9.0 million, respectively, for the years ended December 31, 2020 and December 31, 2019. As a result of the foregoing factors, our pro forma net income (after U.S. federal and California state income tax) for the years ended December 31, 2020 and December 31, 2019 would have been $26.2 million and $21.4 million, respectively.

Discussion and Analysis of Financial Condition

The following table summarizes selected components of our balance sheet as of December 31, 2020 and 2019.

         
   As of December 31, 
(Dollars in thousands)  2020   2019 
Total assets  $1,953,765   $1,479,859 
Total loans  $1,507,979   $1,186,840 
Total investments  $122,928   $86,160 
Total deposits  $1,784,001   $1,311,750 
Total subordinated notes  $28,320   $28,253 
Total equity  $133,775   $108,877 
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Total Assets

Total assets as of December 31, 2020 were $2.0 billion compared to $1.5 billion at December 31, 2019, an increase of $473.9 million or 32.0%. The increase was primarily driven by an increase in gross loans held for investment and for sale of $321.1 million. Our loan growth was funded primarily through deposits, which increased by $472.3 million, or 36.0%, to $1.8 billion as of December 31, 2020 from $1.3 billion as of December 31, 2019.

Loan Portfolio

Our loan portfolio is our largest class of earning assets and typically provides higher yields than other types of earning assets. Associated with the higher yields is an inherent amount of credit risk which we attempt to mitigate with strong underwriting. As of December 31, 2020 and 2019, our total loans held for investment and for sale amounted to $1.5 billion and $1.2 billion, respectively. The following table presents the balance and associated percentage of each major product type within our portfolio as of the dates indicated.

 

  As of December 31, 
   2020   2019 
(Dollars in thousands)   Amount   % of
Loans
   Amount   % of
Loans
 
Loans held for investment:                    
Real Estate -                    
Commercial  $1,002,497    66.3%  $817,365    68.8%
Commercial land and development   10,600    0.7%   16,328    1.4%
Commercial construction   91,760    6.1%   98,989    8.3%
Residential construction   11,914    0.8%   17,423    1.5%
Residential   30,431    2.0%   33,572    2.8%
Farmland   50,164    3.3%   72,090    6.1%
Commercial -                    
Secured   138,676    9.2%   106,981    9.0%
Unsecured   17,526    1.2%   9,549    0.8%
Paycheck Protection Program   147,965    9.8%       0.0%
Consumer and other   4,921    0.3%   8,945    0.8%
Total loans held for investment   1,506,454    99.7%   1,181,242    99.5%
                     
Loans held for sale:                    
Commercial   4,820    0.3%   6,527    0.5%
                     
Total loans before deferred fees   1,511,274    100.0%   1,187,769    100.0%
                     
Net deferred loan fees   (3,295)        (929)     
                     
Total loans  $1,507,979        $1,186,840      
                     

Commercial real estate, or CRE, loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, manufactured home communities, self-storage, hospitality, faith-based properties, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers.

 

Commercial land and construction loans consist of loans made to fund commercial construction and land acquisition and development. The real estate purchased with these loans is generally located in or near our market.

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Commercial loans consist of financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial loans can be secured or unsecured but are generally secured with the assets of the company and/or the personal guarantee of the business owners.

Residential real estate and construction real estate loans consist of loans secured by single-family and multifamily residential properties, which are both owner-occupied and investor-owned.

 

The following tables present the CRE loan balance, associated percentage of CRE concentrations by collateral type, estimated collateral values and related loan to value, or LTV, ranges as of the dates indicated. Revolving lines of credit with zero balance and 0.0% LTV are excluded from this table. Collateral values are determined at origination using third party real estate appraisals or evaluations. Updated appraisals are obtained for loans that are downgraded to watch or substandard. Loans over $1.0 million are reviewed annually, at which time an internal assessment of collateral values is completed.

                     
(Dollars in thousands)  Loan
Balance
   % of
Commercial
Real Estate
   Collateral
Value
   Minimum
LTV
   Maximum
LTV
 
December 31, 2020                         
Manufactured home community  $244,156    24.4%  $421,048    12.1%   73.6%
Office   115,913    11.6%   237,837    4.0%   75.0%
Retail   104,878    10.5%   208,632    4.5%   76.1%
Faith based   92,885    9.3%   242,148    3.2%   73.2%
Mini storage   69,973    6.9%   120,010    21.2%   70.0%
Industrial   69,153    6.9%   174,140    1.9%   75.5%
Multifamily   66,113    6.6%   171,411    0.3%   75.0%
Mixed use   62,531    6.2%   119,333    2.9%   75.0%
All other types*   176,895    17.6%   413,381    6.9%   84.9%
     Total  $1,002,497    100.0%  $2,107,940    0.3%   84.9%

(Dollars in thousands)  Loan
Balance
   % of
Commercial
Real Estate
   Collateral
Value
   Minimum
LTV
   Maximum
LTV
 
December 31, 2019                         
Manufactured home community  $145,216    17.8%  $261,303    17.2%   74.9%
Office   121,582    14.9%   258,618    2.7%   75.0%
Retail   78,003    9.5%   144,737    4.7%   73.4%
Faith based   88,672    10.8%   206,483    5.7%   74.5%
Mini storage   64,050    7.9%   135,884    0.6%   70.0%
Industrial   64,776    7.9%   163,834    0.3%   75.0%
Multifamily   49,979    6.1%   124,446    6.9%   73.8%
Mixed use   65,478    8.0%   116,039    3.8%   71.6%
All other types*   139,609    17.1%   334,802    5.1%   98.7%
     Total  $817,365    100.0%  $1,746,146    0.3%   98.7%

 

* Types of collateral in the “all other types” category are those that individually make up less than 5.0% CRE concentration and include hospitality, auto dealerships, car washes, assisted living communities, country clubs, gas stations/convenience stores, medical offices, special purpose property, mortuaries, restaurants and schools.

 

Over the past few years, we have experienced significant growth in our loan portfolio, although the relative composition of the portfolio has not changed significantly (when PPP loans are excluded). Our primary focus remains commercial real estate lending, which constitutes over 73.1% of our portfolio at December 31, 2020 (81.0% excluding PPP loans). Commercial secured lending (consisting primarily of SBA 7(a) loans under

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$350,000) represents 9.2% of our portfolio at December 31, 2020 (10.2% excluding PPP loans). We sell the guaranteed portion of all SBA 7(a) loans in the secondary market and will continue to do so as long as market conditions continue to be favorable.

 

We recognize that our CRE concentration is significant within our balance sheet. CRE loan balances as a percentage of risk-based capital were 624% and 619% as of December 31, 2020 and December 31, 2019, respectively. We have established internal concentration limits in the loan portfolio for CRE loans by sector (i.e., manufactured home communities, self-storage, hospitality, etc.). All loan sectors are within our established limits as of December 31, 2020. Additionally, our loans are geographically concentrated with borrowers and collateral properties in California. At December 31, 2020, 83.9% of our real estate loans were collateralized by properties in California.

The following table presents the balance, associated percentage of real estate loan concentrations and total count of real estate loans collateralized by properties outside of California as of the dates indicated.

 

(Dollars in thousands)  Loan
Balance
   % of Loans
Collateralized
by non-CA
Property
   % of All Real
Estate Loans
   # of Loans 
December 31, 2020                    
Manufactured home community, term  $118,230    61.4%   9.9%   69 
Owner-occupied nonfarm nonresidential, term   27,707    14.4%   2.3%   10 
Nonowner-occupied nonfarm nonresidential, term   24,508    12.7%   2.0%   8 
All other real estate loans*   22,188    11.5%   1.9%   13 
     Total  $192,633    100.0%   16.1%   100 

                 
(Dollars in thousands)  Loan
Balance
   % of Loans
Collateralized
by non-CA
Property
   % of All Real
Estate Loans
   # of Loans 
December 31, 2019                    
Manufactured home community, term  $58,280    46.9%   5.5%   36 
Owner-occupied nonfarm nonresidential, term   26,667    21.5%   2.5%   8 
Nonowner-occupied nonfarm nonresidential, term   19,269    15.5%   1.8%   7 
All other real estate loans*   19,916    16.1%   1.9%   14 
     Total  $124,132    100.0%   11.7%   65 
                     

*Types of loans in the “all other real estate loans” category are those that individually make up less than 5.0% real estate loan concentration and include nonresidential construction term, 1-4 family residential first lien term, other multifamily residential term and lines of credit, 1-4 family residential construction term and lines of credit, farmland construction and land development term and manufactured home community lines of credit.

 

At December 31, 2020, 16.1% of our real estate loans were collateralized by properties outside California, of which approximately 61.4% of the loans are manufactured home community term loans. The collateral located outside of California is primarily located in Oregon, Arizona, and Florida. The percentage of real estate loans with collateral in these states is 20.1%, 13.7%, and 10.8%, respectively. Non-real estate loans with collateral outside of California include commercial and industrial, agricultural production, and consumer loans totaling approximately $304.5 million (or approximately 98.5% of non-real estate loans) as of December 31, 2020.

We believe that our past success is attributable to focusing on products and markets where we have significant expertise. Given our concentrations, we have established strong risk management practices including risk-based lending standards, self-established product and geographical limits, annual evaluations of income property loans and semi-annual top down and bottom up stress testing. We expect to continue growing our loan portfolio. We do not expect our product or geographic concentrations to materially change.

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The following table sets forth the contractual maturities of our loan portfolio as of December 31, 2020:

(Dollars in thousands)  Due in 1
year or
less
   Due after 1
year through
5 years
   Due after 5
years through
15 years
   Due after
15 years
   Total 
Loans:                         
Real estate -                         
Commercial  $46,579   $100,882   $821,130   $33,906   $1,002,497 
Commercial land and development   7,248    2,672    680        10,600 
Commercial construction   12,358    15,883    63,519        91,760 
Residential construction   5,754    6,160            11,914 
Residential   1,462    4,905    22,205    1,859    30,431 
Farmland   410    13,060    36,694        50,164 
Commercial -                         
Secured   44,230    36,055    63,211        143,496 
Unsecured   1,580    1,692    14,254        17,526 
Paycheck Protection Program       147,965            147,965 
Consumer and other   51    3,835    1,035        4,921 
Total loans  $119,672   $333,109   $1,022,728   $35,765   $1,511,274 

 

The following table sets forth the sensitivity to interest rate changes to our loan portfolio as of December 31, 2020:

 

(Dollars in thousands)  Fixed
Interest
Rates
   Floating or
Adjustable
Rates
   Total 
Loans:               
Real estate -               
Commercial  $134,029   $868,468   $1,002,497 
Commercial land   743    9,857    10,600 
Commercial construction   15,527    76,233    91,760 
Residential construction       11,914    11,914 
Residential   2,737    27,694    30,431 
Farmland   4,464    45,700    50,164 
Commercial -               
Secured   28,241    115,255    143,496 
Unsecured   14,882    2,644    17,526 
Paycheck Protection Program   147,965        147,965 
Consumer and other   4,921        4,921 
Total loans  $353,509   $1,157,765   $1,511,274 
                

Asset Quality

Our primary objective is to maintain a high level of asset quality in our loan portfolio. We believe our underwriting practices and policies, established by experienced professionals, appropriately govern the risk profile for our loan portfolio. These policies are continually evaluated and updated as necessary. All loans are assessed and assigned a risk classification at origination based on underlying characteristics of the transaction such as collateral cash flow, collateral coverage and borrower strength. We believe that we have a comprehensive methodology to proactively monitor our credit quality after the origination process. Particular emphasis is placed on our commercial portfolio where risk assessments are reevaluated as a result of reviewing commercial property operating statements and borrower financials. On an ongoing basis, we also monitor payment performance, delinquencies and tax and property insurance

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compliance. We design our practices to facilitate the early detection and remediation of problems within our loan portfolio. Assigned risk classifications are an integral part of management assessing the adequacy of our allowance for loan losses. We periodically employ the use of an outside independent consulting firm to evaluate our underwriting and risk assessment process. Like other financial institutions, we are subject to the risk that our loan portfolio will be exposed to increasing pressures from deteriorating borrower credit due to general economic conditions.

Nonperforming assets. Our nonperforming assets consist of nonperforming loans and foreclosed real estate, if any. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal or when a loan becomes contractually past due by 90 days or more with respect to interest or principal. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

Troubled debt restructurings. We consider a loan to be a TDR when we have granted a concession and the borrower is experiencing financial difficulty. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy. A TDR loan generally is kept on nonaccrual status until, among other criteria, the borrower has paid for six consecutive months with no payment defaults, at which time the TDR may be placed back on accrual status.

 

COVID-19 deferments. The CARES Act, as amended by the Consolidated Appropriations Act, 2021, specified that COVID-19 related loan modifications executed between March 1, 2020 and the earlier of (i) 60 days after the date of termination of the national emergency declared by the President and (ii) January 1, 2022, on loans that were current as of December 31, 2019 are not TDRs. Additionally, under guidance from the federal banking agencies, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief are not TDRs under ASC Subtopic 310-40, “Troubled Debt Restructuring by Creditors.” These modifications include short-term (e.g., up to six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant. We elected to apply these temporary accounting provisions to payment relief loans beginning in March 2020. As of December 31, 2020, 35 loans totaling $41.4 million, or 2.7% of the loan portfolio, were in a COVID-19 deferral period and 304 loans totaling $108.0 million had been in a COVID-19 deferment at some point during 2020 but were not in such deferment as of December 31, 2020. We accrue and recognize interest income on loans under payment relief based on the original contractual interest rates. When payments resume at the end of the relief period, the payments will generally be applied to accrued interest due until accrued interest is fully paid.

SBA 7(a) payments made under the CARES Act. Section 1112 of the CARES Act required the SBA to make payments on new and existing 7(a) loans for six months. The Consolidated Appropriations Act, 2021, amended this section of the CARES Act to extend the payment on 7(a) loans in existence on March 27, 2020, beginning on February 1, 2021 for an additional three or eight months, depending on the borrower’s industry code, and to require the SBA to make six months of payments on new 7(a) loans approved between February 1, 2021, and September 30, 2021. These payments are not deferments but rather full payments of principal and interest that the borrower will not be responsible for in the future. During the year ended December 31, 2020, the SBA made payments under this program on 1,060 of our SBA 7(a) loans. Total payments were $4.3 million, consisting of $2.4 million of principal and $1.9 million of interest. As of December 31, 2020, the principal outstanding on loans that received one or more of these payments under the CARES Act was $51.2 million, representing substantially all of our SBA 7(a) loans as of December 31, 2020.

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The following table provides details of our nonperforming and restructured assets as of the dates presented and certain other related information:

   As of December 31, 
(Dollars in thousands)  2020   2019 
Nonaccrual loans          
Real estate -          
Commercial  $137   $ 
Commercial land        
Commercial construction        
Residential construction        
Residential   183     
Farmland        
Commercial -          
Secured   132    772 
Unsecured        
Paycheck Protection Program        
Consumer and other        
    452    772 
           
Loans past due 90 days or more and still accruing          
Real estate -          
Commercial        
Commercial land        
Commercial construction        
Residential construction        
Residential        
Farmland        
Commercial -          
Secured        
Unsecured        
Paycheck Protection Program        
Consumer and other        
         
Total nonperforming loans   452    772 
           
Real estate owned          
Total nonperforming assets  $452   $772 
COVID-19 deferments  $41,439   $ 
           
Troubled debt restructurings (performing – not included above)  $   $ 
           
Allowance for loan losses to period end nonperforming loans   4,909.07%   1,931.99%
Nonperforming loans to period end loans   0.03%   0.07%
Nonperforming assets to total assets   0.02%   0.05%
Nonperforming loans plus performing TDRs to total loans   0.03%   0.07%
COVID-19 deferments to period end loans   2.75%   0.00%
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The ratio of nonperforming loans to period end loans declined from 0.07% as of December 31, 2019 to 0.03% as of December 31, 2020. The decline related to our commercial secured portfolio resulting from improvements in our SBA 7(a) underwriting criteria and processes combined with CARES Act assistance provided to SBA 7(a) and other borrowers.

 

The ratio of the allowance for loan losses to nonperforming loans increased from 1,931.99% as of December 31, 2019 to 4,909.07% as of December 31, 2020. The increase was primarily due to higher reserves related to our commercial secured portfolio which increased $5.1 million, a 117% increase, from December 31, 2019 to December 31, 2020 while commercial secured nonaccrual loans declined $640,000, or 82.9%, from $772,000 as of December 31, 2019 to $132,000 as of December 31, 2020. Reserves on the commercial secured portfolio were increased due to increased uncertainty related to the COVID-19 pandemic and related economic effects.

 

Potential problem loans. We utilize a risk grading system for our loans to aid us in evaluating the overall credit quality of our real estate loan portfolio and assessing the adequacy of our allowance for loan losses. All loans are categorized into a risk category at the time of origination. Commercial real estate loans over $1.0 million are reevaluated at least annually for proper classification in conjunction with our review of property and borrower financial information, while all loans are re-evaluated for proper risk grading as new information such as payment patterns, collateral condition and other relevant information comes to our attention. We use the following risk ratings.

Loans Rated Pass or Better: These are loans to borrowers with satisfactory or better financial support, repayment capacity, and credit strength. Borrowers in this category demonstrate fundamentally sound financial positions, repayment capacity, credit history, and management expertise. Loans in this category must have an identifiable and stable source of repayment and meet the Bank’s policy regarding debt service coverage ratios. These borrowers are capable of sustaining normal economic, market, or operational setbacks without significant financial impacts. Financial ratios and trends are acceptable. Negative external industry factors are generally not present. The loan may be secured, unsecured, or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain.

Loans Rated Watch: These are loans which have deficient loan quality and potentially significant issues, but losses do not appear to be imminent, and temporary in nature. The significant issues are typically: (i) a history of losses or events that threaten the borrower’s viability, (ii) a property with significant depreciation and/or marketability concerns, or (iii) poor or deteriorating credit, occasional late payments, limited reserves but loan is generally kept current. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date.

 

Loans Rated Substandard: These are loans which are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged (if any). Loans so classified exhibit a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Loans are characterized by the distinct possibility that the Bank may sustain some loss if the deficiencies are not corrected. The substandard loan category includes loans that management has determined not to be impaired, as well as loans that are impaired.

Loans Rated Doubtful: These are loans in which the collection or liquidation of the entire debt is highly questionable or improbable. Typically, the possibility of loss is extremely high. The losses on these loans are deferred until all pending factors have been addressed.

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The banking industry defines loans graded Substandard or Doubtful as “classified” loans. The following table shows our levels of classified loans as of the periods indicated:

(Dollars in thousands)  Watch   Substandard   Doubtful   Total 
December 31, 2020                    
Real estate loans:                    
Commercial  $16,836   $35,543   $   $52,379 
Commercial land and development                
Commercial construction   5,900            5,900 
Residential construction                
Residential       183        183 
Farmland                
Commercial:                    
Secured   1,552    132        1,684 
Unsecured                
Consumer and other                
   $24,288   $35,858   $   $60,146 
 
                    
(Dollars in thousands)  Watch   Substandard   Doubtful   Total 
December 31, 2019                    
Real estate loans:                    
Commercial  $9,033   $859   $    $9,892 
Commercial land and development                
Commercial construction                
Residential construction                
Residential                
Farmland                
Commercial:                    
Secured   1,892    772        2,664 
Unsecured                
Consumer and other       50        50 
   $10,925   $1,681   $   $12,606 

Allowance for loan losses: The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries of previously charged off amounts, if any, are credited to the allowance for loan losses.

The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability 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.

 

In 2020, our methodology for evaluating allowance for loan losses was affected by the COVID-19 pandemic resulting in higher reserve levels primarily related to our commercial secured portfolio. Reserves on the commercial secured portfolio were increased due to higher uncertainty related to the COVID-19 pandemic and related economic effects.

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While the entire allowance for loan losses is available to absorb losses from any and all loans, the following table represents management’s allocation of our allowance for loan losses by loan category, and the percentage of allowance for loan losses in each category, for periods indicated.

   As of December 31, 
  2020   2019 
(Dollars in thousands)  Dollars   % of Total   Dollars   % of Total 
Collectively allocated for impairment:</