Eargo, Inc. - Quarter Report: 2022 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2022

OR

For the transition period from                      to                     

Commission File Number: 001-39616

Eargo, Inc.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code: (650) 351-7700

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒    No  ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ☐    No  ☒

As of August 3, 2022, the registrant had 39,385,438 shares of common stock, par value $0.0001 outstanding.

Table of Contents

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Special note regarding forward-looking statements

This Quarterly Report on Form 10-Q contains forward-looking statements about us and our industry that involve substantial risks, uncertainties and assumptions. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our strategy, future financial condition, future operations, projected costs, prospects, plans, objectives of management and expected market growth, are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “aim,” “anticipate,” “assume,” “believe,” “contemplate,” “continue,” “could,” “design,” “due,” “estimate,” “expect,” “forecast,” “goal,” “guidance,” “intend,” “likely,” “may,” “objective,” “plan,” “ongoing,” “positioned,” “possible,” “potential,” “predict,” “project,” “seek,” “shall,” “should,” “target,” “will,” “would” and other similar expressions that are predictions of or indicate future events and future trends, or the negative of these terms or other comparable terminology. These forward-looking statements include, but are not limited to, statements about:

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We have based these forward-looking statements largely on our current expectations, estimates, forecasts and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. In light of the significant uncertainties in these forward-looking statements, you should not rely upon forward-looking statements as predictions of future events. Although we believe that we have a reasonable basis for each forward-looking statement contained in this Quarterly Report on Form 10-Q, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur at all. You should refer to the section titled “Risk Factors” for a discussion of important factors that may cause our actual results to differ materially from those expressed or implied by our forward-looking statements. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. Except as required by law, we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

Eargo, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

(In thousands, except share and per share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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Eargo, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(In thousands, except share and per share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

4

Eargo, Inc.

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited)

(In thousands, except share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

5

Eargo, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

1. Description of business and other matters

Eargo, Inc. (the “Company”) is a medical device company dedicated to improving the quality of life of people with hearing loss. The Company’s innovative product and go-to-market approach address the major challenges of traditional hearing aid adoption, including social stigma, accessibility and cost.

DOJ investigation and settlement and claims audits

On September 21, 2021, the Company was informed that it was the target of a criminal investigation by the U.S. Department of Justice (the “DOJ”) related to insurance reimbursement claims the Company submitted on behalf of its customers covered by various federal employee health plans under the Federal Employee Health Benefits (“FEHB”) program, which is administered by the Office of Personnel Management (the “OPM”). The investigation also pertained to Eargo’s role in customer reimbursement claim submissions to federal employee health plans (collectively, the “DOJ investigation”). Additionally, the third-party payor with whom the Company historically had the largest volume, which is one of the carriers contracted with the OPM under the FEHB program (“largest third-party payor”), conducted an audit of insurance reimbursement claims (“claims”) submitted by the Company (the “Primary Audit”), which included a review of medical records. The Company was informed by the third-party payor conducting the Primary Audit that the DOJ was the principal contact related to the subject matter of the Primary Audit. On January 4, 2022, the DOJ confirmed to the Company that the investigation had been referred to the Civil Division of the DOJ and the U.S. Attorney’s Office for the Northern District of Texas and the criminal investigation was no longer active.

On April 29, 2022, the Company entered into a civil settlement agreement with the U.S. government that resolved the DOJ investigation related to the Company’s role in customer reimbursement claim submissions to various federal employee health plans under the FEHB program. The settlement agreement provided for the Company’s payment of approximately $34.4 million to the U.S. government and resolved allegations that the Company submitted or caused the submission of claims for payment to the FEHB program using unsupported hearing loss-related diagnostic codes.

From the time the Company learned of the DOJ investigation and until December 8, 2021, the Company continued to process orders for customers with potential insurance benefits (including FEHB program members) but suspended all claims submission activities and has offered affected customers (i.e., customers using insurance benefits as a method of direct payment for transactions prior to December 8, 2021) the option to return their hearing aids or purchase their hearing aids without the use of their insurance benefits in case their claim is denied or ultimately not submitted by the Company to their insurance plan for payment (the “extended right of return”).

Beginning on December 8, 2021, the Company made the decision to stop accepting insurance benefits as a method of direct payment and it is uncertain when, if ever, the Company will resume accepting insurance benefits as a method of direct payment. While the Company intends to work with the government and third-party payors with the objective of validating and establishing processes to support any future claims that it may submit for reimbursement, the Company may not be able to arrive at acceptable processes or submit any future claims.

Total life-to-date payments the Company has received through June 30, 2022 from the government in relation to claims submitted under the FEHB program, net of any product returns and associated refunds, were approximately $44 million, which is unchanged from December 31, 2021. As discussed further in Note 5, based on the settlement agreement with the U.S. government, the Company has recorded a settlement liability of $34.4 million as of December 31, 2021. The settlement amount was treated as consideration payable to a customer and was recorded as a reduction of revenue in the third quarter of 2021. On May 2, 2022, the Company paid the settlement amount.

The Company determined that customer transactions using insurance benefits as a method of direct payment occurring subsequent to learning of the DOJ investigation on September 21, 2021 did not meet the criteria for revenue recognition under Accounting Standards Codification (“ASC”) 606. As such, the Company did not recognize revenue for shipments to customers with potential insurance benefits, substantially all of whom were covered under the FEHB program, subsequent to that date.

The Company estimated that a majority of customers with unsubmitted claims will choose to return the hearing aid system if their insurance provider denies their claim or the claim is ultimately not submitted by the Company for payment, resulting in an increase in expected product returns from such transactions that occurred prior to September 21, 2021 that was recorded during the year ended December 31, 2021. Of the $12.7 million sales returns reserve recorded as of June 30, 2022, $11.3 million relates to unsubmitted claims that are included in accounts receivable, net. Returns associated with unsubmitted claims will reduce the sales returns reserve, with a corresponding reduction in the related accounts receivable at the time the product is returned.

Further, the Company also estimated that, in addition to the customers who choose to return their hearing aid systems, a significant number of customers whose claims are denied by insurance providers or not submitted by the Company for payment may not pay for or return the hearing aid system, resulting in bad debt expense that was recorded during the year ended December 31, 2021.

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Notwithstanding the settlement, the Company remains subject to prepayment review of claims by its largest third-party payor before any insurance payments are made. The Company does not intend to submit claims through the FEHB program until it is able to establish processes with applicable third-party payors to support the submission of these claims, and the Company may be unable to do so.

Liquidity and going concern

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) applicable to a going concern, which contemplates the realization of assets and the satisfaction of liabilities during the normal course of business. The Company has incurred losses and negative cash flows from operations since its inception and management expects to incur additional substantial losses in the foreseeable future. As of June 30, 2022, the Company had cash and cash equivalents of $106.6 million and an accumulated deficit of $419.9 million.

In June 2022, the Company entered into a note purchase agreement (“Note Purchase Agreement”) pursuant to which it agreed to issue and sell up to $125.0 million in senior secured convertible notes (the “Notes”) of the Company (the “Note Transaction”), of which $100.0 million were issued as of June 30, 2022 and will mature in June 2023. Further, the Company’s future operating requirements will be substantial and it will need to raise significant additional resources to fund its operations through equity or debt financing, or some variation thereof. The Company is currently exploring fundraising opportunities to meet these capital requirements, including conducting a rights offering (“Rights Offering”) under the terms of the Note Transaction documents. If the Company is unable to raise additional funding to meet its operational needs, it will be forced to limit or cease its operations. The Note Transaction and Rights Offering are discussed further in Note 6.

The Company believes that, without the completion of the Rights Offering or an alternative future financing, its current resources are insufficient to satisfy its obligations as they become due within one year after the date that the financial statements are issued. The negative cash flows and current lack of financial resources of the Company raise substantial doubt as to the Company’s ability to continue as a going concern. Additionally, if the Company is unable to complete the Rights Offering and all of the Notes remain outstanding, it will have insufficient funds to repay the Notes at their maturity without additional capital.

The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might result from the outcome of the uncertainty.

While the extent to which the Company is able to validate and establish processes to support the submission of claims for reimbursement to health plans, including those under the FEHB program, if at all, in the future, and the future impacts of the anticipated implementation of a pending over-the-counter (“OTC”) hearing aid regulatory framework (which may lead insurance providers to take actions limiting the Company’s ability to access insurance coverage and may also generally result in additional compliance or other regulatory requirements for the Company) is difficult to assess or predict at this time, since the announcement of the DOJ investigation, there has been and may continue to be a significant reduction in shipments, revenue and gross margin, which could negatively impact the Company’s liquidity and working capital, including by impacting its ability to access additional capital.

2. Summary of significant accounting policies

Basis of presentation and principles of consolidation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with GAAP and applicable rules and regulations of the Securities and Exchange Commission (the “SEC”) regarding interim financial reporting of Eargo, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

These unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, include all adjustments of a normal recurring nature necessary to present fairly the Company’s consolidated financial position, results of operations and cash flows. The unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021, filed with the SEC on May 13, 2022.

Use of estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the unaudited condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions made in the accompanying unaudited condensed consolidated financial statements include, but are not limited to, the sales returns reserve, the present value of lease liabilities, the fair value of equity securities, the fair value of financial instruments, the allowance for credit losses, the net realizable value of inventory, the fair value of assets acquired in a business combination, the useful lives of long-lived assets, accrued product warranty reserve, legal and other

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contingencies, certain other accruals and recoverability of the Company’s net deferred tax assets and the related valuation allowance. Management periodically evaluates its estimates, which are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from those estimates.

Significant accounting policies

There have been no significant changes to the accounting policies during the six months ended June 30, 2022, as compared to the significant accounting policies described in Note 2 of the Notes to Consolidated Financial Statements in the Company’s audited consolidated financial statements included in the Annual Report on Form 10-K, except for the policy titled “Convertible notes - fair value option” below.

Concentration of credit risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist of demand deposit accounts, money market accounts and accounts receivable, including credit card receivables. The Company maintains its cash and cash equivalents, which may, at times, exceed federally insured limits, with financial institutions of high credit standing. As of June 30, 2022, the Company has not experienced any losses on its deposit accounts and money market accounts. As of June 30, 2022, the Company does not believe there is significant financial risk from nonperformance by the issuers of the Company’s deposit accounts and money market accounts.

Approximately 95% and 93% of the Company’s gross accounts receivable as of June 30, 2022 and December 31, 2021, respectively, were for customers with insurance benefits, substantially all of whom were covered under the FEHB program. Furthermore, approximately 92% and 90% of the Company’s gross accounts receivable as of June 30, 2022 and December 31, 2021, respectively, were related to shipments of Eargo hearing aids to customers insured under a single insurance plan whose claims are processed through the Company’s largest third-party payor, which conducted the Primary Audit. During the Primary Audit, certain claims with a service date after March 1, 2021 were not submitted for reimbursement and, as of June 30, 2022, have not yet and may never be submitted for reimbursement. The gross accounts receivable balance as of June 30, 2022 is primarily attributable to such claims. We remain subject to a prepayment review of claims by the payor who conducted the Primary Audit.

Please see caption “DOJ investigation and settlement and claims audits” in Note 1 for more information regarding the DOJ investigation and claims audits.

Convertible notes - fair value option

As permitted under ASC 825, the Company has elected the fair value option to account for the Notes that were issued in June 2022, discussed further at Note 6. In accordance with ASC 825, the Company recorded the Notes at fair value with changes in fair value recorded as a component of other income (expense), net in the condensed consolidated statements of operations and comprehensive loss with the exception of changes in fair value due to instrument-specific credit risk, which are recorded as a component of other comprehensive income in the condensed consolidated statements of operations and comprehensive loss. Interest expense related to the Notes is included in the changes in fair value. As a result of applying the fair value option, direct costs and fees related to the Notes were expensed as incurred as a component of general and administrative expenses and were not deferred.

Revenue recognition

The Company’s revenue is generated from the sale of products (hearing aid systems and related accessories) and services (extended warranties). These products and services are primarily sold directly to customers through the Eargo website and the Company’s sales representatives.

Under ASC 606, revenue is recognized when promised goods or services are transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services by following a five step process: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation.

Identify the contract with a customer. The Company generally considers completion of an Eargo sales order (which requires customer acceptance of the Company’s click-through terms and conditions for website sales and authorization of payment through credit card or another form of payment for sales made over the phone) as a customer contract provided that collection is considered probable. For payments that are not made upfront by credit card, the Company assesses insurance eligibility or customer creditworthiness based on credit checks, payment history, and/or other circumstances. For orders involving insurance payors, the Company validates customer eligibility and potential reimbursement amounts prior to shipping the product. If the criteria to establish a contract with a customer is not met, revenue is not recognized in accordance with ASC 606.

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Identify the performance obligations in the contract. Product performance obligations include hearing aid systems and related accessories and service performance obligations include extended warranty coverage. The Company also offers customers a one-time replacement of certain components of the hearing aid system for a fee (i.e., “loss and damage policy”), which represents an option with material right. However, as the historical redemption rate under the policy has been low, the option is not accounted for as a separate performance obligation. The Company does not assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer.

The Company has elected to treat shipping and handling activities performed after a customer obtains control of products as a fulfillment activity.

Determine the transaction price and allocation to performance obligations. The transaction price in the Company’s customer contracts consists of both fixed and variable consideration. Fixed consideration includes amounts to be contractually billed to the customer while variable consideration includes the 45-day right of return that applies to all products and the extended right of return offered for certain shipments involving insurance payors prior to December 8, 2021 (at which time the Company ceased accepting insurance benefits as a method of direct payment). Please see caption “DOJ investigation and settlement and claims audits” in Note 1 for more information regarding the extended right of return. To estimate product returns, the Company analyzes various factors, including historical return levels, current economic trends, and insurance coverage. Based on this information, the Company reserves a percentage of product sale revenue and accounts for the estimated impact as a reduction in the transaction price. Consideration paid or payable to a customer that is not for a distinct good or service is accounted for as a reduction of the transaction price and recorded as a reduction in revenue in the period it becomes payable.

Allocate the transaction price to the performance obligations in the contract. For contracts that contain multiple performance obligations, the Company allocates the transaction price to the performance obligations on a relative standalone selling price basis. Standalone selling prices are based on multiple factors including, but not limited to, historical discounting trends for products and services, gross margin objectives, internal costs, competitor pricing strategies, and industry technology lifecycles.

Recognize revenue when or as the Company satisfies a performance obligation. Revenue for products (hearing aid systems and related accessories) is recognized at a point in time, which is generally upon shipment provided all other revenue recognition criteria have been met.

Contract costs

The Company applies the practical expedient to recognize the incremental costs of obtaining a contract as expense when incurred if the amortization period would be one year or less. These incremental costs include processing fees paid to third-party financing vendors, who provide the Company’s customers with the option to finance their purchases. If a customer elects to utilize this service, the Company receives a non-recourse upfront payment for the product sold, less processing fee withheld by the financing vendor. These processing fees are recognized in cost of revenue in the condensed consolidated statements of operations and comprehensive loss as incurred.

Recently adopted accounting pronouncements

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify the accounting for income taxes. This standard removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing standards to improve consistent application. The Company adopted this standard in the fiscal year beginning January 1, 2022. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

In August 2020, the FASB issued ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40), which is intended to simplify the accounting for convertible debt instruments and convertible preferred stock. This standard removes the existing guidance in ASC 470-20 that requires companies to account for cash conversion features and beneficial conversion features in equity separately from the host convertible debt or preferred stock. The Company adopted this standard in the fiscal year beginning January 1, 2022. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

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3. Fair value measurements

The following table summarizes the Company’s financial assets and liabilities that were measured at fair value on a recurring basis by level within the fair value hierarchy:

There were no financial assets and liabilities outstanding that were remeasured at fair value on a recurring basis as of December 31, 2021.

The carrying amounts reflected in the condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to their short-term nature. The Company elected the fair value option to account for the Notes (see Note 6). The fair value of the Notes was determined based on significant inputs not observable in the market, which represents a level 3 measurement within the fair value hierarchy.

4. Balance sheet components

Inventories

Inventories consist primarily of raw materials related to component parts and finished goods. The following is a summary of the Company’s inventories by category:

Prepaid expenses and other current assets

Prepaid expenses and other current assets consist of the following:

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Property and equipment, net

Property and equipment, net, consists of the following:

Depreciation and amortization expense for the three months ended June 30, 2022 and 2021 amounted to $1.1 million and $0.7 million, respectively, which includes amortization of capitalized software costs of $0.9 million and $0.2 million, respectively. Depreciation and amortization expense for the six months ended June 30, 2022 and 2021 amounted to $2.4 million and $1.4 million, respectively, which includes amortization of capitalized software costs of $1.8 million and $0.5 million, respectively.

Intangible assets, net

Intangible assets, net consist of the following:

Amortization expense was $0.2 million and $0.3 million for the three and six months ended June 30, 2022, respectively.

The following table summarizes estimated future amortization expense of finite-lived intangible assets, net as of June 30, 2022:

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Accrued expenses

Accrued expenses consist of the following:

Sales returns reserve

The sales returns reserve consists of the following activity:

Of the $12.7 million sales returns reserve recorded as of June 30, 2022, $11.3 million relates to unsubmitted claims from shipments prior to September 22, 2021 (at which time the Company suspended all claims submissions activities) that are included in accounts receivable, net. Returns associated with unsubmitted claims will reduce the sales returns reserve, with a corresponding reduction in the related accounts receivable at the time the product is returned.

Allowance for credit losses

The allowance for credit losses consists of the following activity:

Accrued warranty reserve

The accrued warranty reserve consists of the following activity:

5. Commitments and contingencies

Operating leases

In September 2021, the Company entered into a lease agreement, as amended, for office and laboratory space located in San Jose, California. The lease commenced in September 2021 and has a 93-month term with two 60-month renewal options, which are not

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reasonably certain of being exercised. The Company also leases office space in Nashville, Tennessee, with a lease term that expires in March 2023. Variable lease payments are primarily comprised of common area maintenance.

The ROU asset and corresponding lease liability for the Company’s operating leases were estimated using a weighted-average incremental borrowing rate of 7.7%. The weighted-average remaining lease term is 6.85 years.

For the three and six months ended June 30, 2022, the Company incurred $0.4 million and $0.9 million of operating lease costs, respectively. Variable lease payments for operating expenses and costs related to short-term leases were immaterial for the three and six months ended June 30, 2022.

As of June 30, 2022, undiscounted future minimum lease payments due under the non-cancelable operating leases are as follows:

Legal and other contingencies

The Company is involved in legal proceedings in the ordinary course of its business and may become involved in additional legal proceedings. Other than those listed below, the Company does not believe that any lawsuits or claims currently pending against it, individually or in the aggregate, are material or will have a material adverse effect on its financial condition, results of operations or cash flows. The Company may enter into settlement discussions, and may enter into settlement agreements, if it believes settlement is in the best interest of the Company and its shareholders. Unless stated otherwise, the matters discussed below, if decided adversely or settled by the Company, individually or in the aggregate, may result in a liability material to the Company’s financial condition, results of operations or cash flows.

The Company is also subject to review from federal and state taxing authorities in order to validate the amounts of income, sales and/or use taxes which have been claimed and remitted. The Company has estimated exposure and established reserves for its estimated sales tax audit liability.

In the normal course of business, the Company may agree to indemnify third parties with whom it enters into contractual relationships, including customers, lessors, and parties to other transactions with the Company, with respect to certain matters. The Company has agreed, under certain conditions, to hold these third parties harmless against specified losses, such as those arising from a breach of representations or covenants, other third-party claims that the Company’s products, when used for their intended purposes, infringe the intellectual property rights of such other third parties, or other claims made against certain parties. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the Company’s limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in any particular claim.

DOJ Investigation and Settlement. On September 21, 2021, the Company was informed that it was the target of a criminal investigation by the DOJ related to insurance reimbursement claims the Company submitted on behalf of its customers covered by various federal employee health plans under the FEHB program. The investigation also pertained to the Company’s role in customer reimbursement claim submissions to federal employee health plans. Additionally, the Company was the subject of an ongoing claims audit by an insurance company that was historically the Company’s largest third-party payor and was informed by such insurance company that the DOJ was the principal contact related to the subject matter of the audit. In addition to such audit, the Company has been subject to a number of other audits of insurance reimbursement claims submitted to additional third-party payors. One of these claims audits does not relate to claims submitted under the FEHB program. On January 4, 2022, the DOJ confirmed to the Company that the investigation had been referred to the Civil Division of the DOJ and the U.S. Attorney’s Office for the Northern District of Texas and the criminal investigation was no longer active.

On April 29, 2022, the Company entered into a civil settlement agreement with the U.S. government that resolved the DOJ investigation, including allegations that the Company violated the False Claims Act by knowingly submitting or causing the submission of false claims for payment under the FEHB program during the period from February 1, 2021 through September 22, 2021. The settlement agreement provided for the payment by the Company of approximately $34.4 million to the U.S. government and resolved allegations that the Company submitted or caused the submission of claims for payment to the FEHB program using

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unsupported hearing loss-related diagnostic codes. As of December 31, 2021, the Company recorded a $34.4 million settlement liability in the condensed consolidated balance sheets in connection with the settlement. The settlement amount was treated as consideration payable to a customer and was recorded as a reduction in revenue in the third quarter of 2021. On May 2, 2022, the Company paid the settlement amount.

The settlement of the investigation may not resolve all of the audits of insurance reimbursement claims by additional third-party payors, and additionally the Company remains subject to a prepayment review of claims by the payor who conducted the Primary Audit. The Company will need to work with applicable third-party payors to establish processes to support any future claims that it may submit for reimbursement, and there are no guarantees that the Company will be able to arrive at any such acceptable processes or submit any future claims. The Company does not intend to submit claims through the FEHB program until it is able to align with such payors on and establish processes for supporting the submission of these claims.

Securities Class Action. Fazio v. Eargo, Inc., Christian Gormsen, & Adam Laponis., No. 21-cv-07848 (N.D. Cal. Oct. 6, 2021); Chung v. Eargo, Inc., Christian Gormsen, & Adam Laponis., No. 21-cv-08597 (N.D. Cal. Nov. 4, 2021); IBEW Local 353 Pension Plan v. Eargo, Inc., Christian Gormsen, Adam Laponis, Josh Makower, Juliet Bakker, Peter Tuxen Bisgaard, Doug Hughes, Geoff Pardo, Nina Richardson, A. Brooke Seawell, David Wu, J.P. Morgan Securities LLC, BofA Securities, Inc., Wells Fargo Securities, LLC, & William Blair & Company, L.L.C., No. 21-cv-08747 (N.D. Cal. Nov. 10, 2021). On October 6, 2021, putative shareholder Joseph Fazio filed a purported securities class action against the Company and certain of its officers (the “Fazio action”). Plaintiff alleges that certain of the Company’s disclosures about its business, operations, and prospects, including reimbursements from third-party payors, violated federal securities laws. Fazio voluntarily dismissed his complaint on December 6, 2021. On November 4, 2021, putative shareholder Alden Chung filed a substantially similar purported class action lawsuit (the “Chung action”). On November 10, 2021, putative shareholder IBEW Local 353 Pension Plan filed a similar purported class action, and also asserted claims under the federal securities laws against current and former members of the Company’s Board of Directors (the “Board of Directors”) and the underwriters of the Company’s October 15, 2020 initial public offering of common stock (the “IBEW action”). These class actions, which seek damages and other relief, were filed in the U.S. District Court for the Northern District of California. The Fazio and Chung actions were brought purportedly on behalf of a class of investors who purchased or otherwise acquired Eargo securities between February 25, 2021 and September 22, 2021. The IBEW Local 353 action was brought purportedly on behalf of a class of investors who purchased or otherwise acquired: (i) Eargo shares in or traceable to the Company’s October 15, 2020 initial public offering of common stock; and/or (ii) shares of Eargo common stock between October 15, 2020 and September 22, 2021. On January 5, 2022, the court consolidated the foregoing class actions (as consolidated, the “Securities Class Action”) under the caption In re Eargo, Inc. Securities Litigation, No. 21-cv-08597-CRB, and appointed IBEW Local 353 Pension Plan and Xiaobin Cai as Lead Plaintiffs and Bernstein Litowitz Berger & Grossmann LLP and Block & Leviton LLP as Lead Counsel. On May 20, 2022, Lead Plaintiffs filed a consolidated amended complaint, which purports to extend the class period through March 2, 2022. Defendants filed a motion to dismiss on July 29, 2022.

The Company intends to vigorously defend the Securities Class Action and cannot reasonably estimate any loss or range of loss that may arise from the litigation. Accordingly, the Company can provide no assurance as to the scope and outcome of this matter and no assurance as to whether its business, financial position, results of operations, or cash flows will not be materially adversely affected.

Derivative Actions. On December 3, 2021, putative shareholder Barbara Wolfson filed a derivative complaint purportedly on Eargo’s behalf against members of the Board of Directors and the Company as nominal defendant, captioned Wolfson v. Christian Gormsen, Joshua Makower, Douglas J. Hughes, Nina Louise Richardson, Katie J. Bayne, Peter Tuxen Bisgaard, A. Brooke Seawell, David Wu, and Eargo, Inc., No. 21-cv-09342 (N.D. Cal. Dec. 3, 2021) (the “Wolfson Action”). Plaintiff asserts, among other things, that the defendants breached their fiduciary duties by allegedly failing to implement and maintain an effective system of internal controls related to the Company’s financial reporting, public disclosures and compliance with laws, rules and regulations governing the business. Plaintiff purports to assert derivative claims on the Company’s behalf for alleged violations of Section 14(a) of the Securities Exchange Act of 1934, as amended, breach of fiduciary duty, waste of corporate assets, and aiding and abetting. On March 1, 2022, the court entered the parties’ stipulation staying the Wolfson Action until the pending motion to dismiss in the Securities Class Action is decided. On June 9, 2022, putative shareholder Brodie Woodward filed a derivative complaint purportedly on Eargo’s behalf against the same defendants as in the Wolfson Action, as well as Juliet Tammenoms Bakker, Adam Laponis, and Geoff Pardo, captioned Woodward v. Gormsen, et al., No. 22-cv-03419 (N.D. Cal. June 9, 2022) (together with the Wolfson Action, the “Derivative Actions”). Plaintiff Woodward asserts substantively similar allegations and causes of action as those asserted in the Wolfson Action. On August 4, 2022, the court granted the parties’ stipulation to consolidate the Derivative Actions and to stay the consolidated action until the resolution of the pending motion to dismiss in the Securities Class Action.

The defendants intend to vigorously defend the Derivative Actions and cannot reasonably estimate any loss or range of loss that may arise from the litigations. Accordingly, the Company can provide no assurance as to the scope and outcome of these matters and no assurance as to whether its business, financial position, results of operations, or cash flows will not be materially adversely affected.

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6. Debt obligations

2018 Loan Agreement

In June 2018, the Company entered into a Loan and Security Agreement (as subsequently amended, the “2018 Loan Agreement”) with Silicon Valley Bank, as amended in January 2019, May 2020 and September 2020. The Company’s existing subsidiaries were, and any additional future domestic subsidiaries of the Company were required to be, co-borrowers jointly and severally liable under the 2018 Loan Agreement.

On June 28, 2022, in connection with the Note Transaction, the Company repaid the outstanding balance of $15.0 million, as well as a prepayment fee of $0.3 million and a final payment fee of $0.9 million, and terminated the 2018 Loan Agreement. In connection with the repayment of the 2018 Loan Agreement, the Company recognized a loss on extinguishment of $0.8 million.

During the six months ended June 30, 2022 and 2021, the Company recognized interest expense related to the 2018 Loan Agreement of $0.5 million and $0.5 million, respectively, which is inclusive of amortization of debt discount.

2022 Convertible Notes

On June 24, 2022, the Company entered into the Note Purchase Agreement with an affiliate of Patient Square Capital (together with any subsequent holders of notes under the Note Purchase Agreement, the “Noteholders”) and Drivetrain Agency Services, LLC, as administrative agent and collateral agent. Pursuant to the Note Purchase Agreement, the Company agreed to issue and sell up to $125.0 million of Notes. On June 28, 2022, the Company closed the initial issuance of $100.0 million of Notes (the “First Tranche Closing”). The Company incurred $5.7 million in transaction costs related to the Note Transaction, which were recorded to general and administrative expenses.

The Notes mature and will be due in cash at the Repayment Value (as defined below) on the one-year anniversary of the First Tranche Closing, subject to earlier conversion, redemption or repurchase in accordance with their terms (the “Maturity Date”). The Notes are senior, secured obligations bearing interest at a rate of 12.00% per annum, payable quarterly in arrears on the first calendar day of each calendar quarter. Other than on the Maturity Date or any optional redemption date, accrued interest shall be paid in-kind by adding such interest to the outstanding principal of the Notes. The Company may, at its option, repay all (but not a portion) of the Notes outstanding upon three business days’ prior written notice at a price equal to the Repayment Value, and the Note Purchase Agreement does not prohibit the Company from refinancing the Notes with a new equity or debt financing. The “Repayment Value” of any Note on any applicable date means an amount payable such that the annualized return on the initial principal amount, which excludes accrued interest, of the Notes is no less than 12.00%, or, if greater, an amount equal to 150% of the initial principal amount of such Note. Upon an event of default, which includes a failure to complete the Rights Offering by December 24, 2022, the violation of certain covenants, and a change in control, the Company can be required to repay the Notes at the Repayment Value. Immediately upon the occurrence and during the continuance of an event of default, the Notes shall bear interest at a rate per annum which is 12.00% above the rate that is otherwise applicable thereto.    

Rights offering

The Company has agreed to complete a Rights Offering, subject to stockholder approval, for an aggregate of 375 million shares of common stock to the Company’s stockholders at an offering price of $0.50 per share of common stock. If a Rights Offering is completed within 150 days following the First Tranche Closing, then the Notes will automatically convert into (i) a number of shares of common stock equal to 375 million less the number of shares purchased in the Rights Offering by the Company’s stockholders, and (ii) cash in an amount equal to (x) the Repayment Value of Notes outstanding less (y) the Rights Offering Shortfall Amount. The “Rights Offering Shortfall Amount” represents an amount equal to (a) 375 million less the number of shares purchased by the Company’s stockholders in the Rights Offering, multiplied by (b) $0.50. If existing stockholders purchase less than 75 million shares in the Rights Offering, then the Noteholders have agreed to purchase up to an additional $25.0 million of Notes (the “Second Tranche”).

If a Rights Offering is completed between 150 days and 180 days following the First Tranche Closing, then the Second Tranche will be issued in full and the Notes will automatically convert into (i) a number of shares of common stock equal to 375 million less the number of shares purchased in the Rights Offering by the Company’s stockholders, and (ii) cash in an amount equal to the number of shares purchased by the Company’s stockholders multiplied by $0.50.

Fair value

The Company elected as of the issuance date to account for the Notes at fair value, which it believes better reflects the underlying economics of the Notes and their embedded features. Fair value was determined to be $100 million upon issuance, which is the principal amount of the Notes upon the First Tranche Closing. The Company determined that the fair value of the Notes did not materially change between the First Tranche Closing and June 30, 2022. The fair value of the Notes is estimated as a combination of the Company’s equity and an option on the Company’s equity valued using the Black-Scholes option pricing model.

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The following table provides a summary of the change in the estimated fair value of the Notes:

Covenants and collateral

The Notes are collateralized by substantially all the assets of the Company, including intellectual property. The Note Purchase Agreement contains various affirmative and restrictive covenants, including with respect to the Company’s ability to enter into fundamental transactions, incur additional indebtedness, grant liens, pay any dividend or make any distributions to its holders, make investments, merge or consolidate with any other person or engage in transactions with the Company’s affiliates, as well as requiring the Company to maintain a minimum of $40.0 million of cash and cash equivalents. The Company was in compliance with all of the covenants as of June 30, 2022.

7. Stock-based compensation

Total stock-based compensation is as follows:

Stock-based compensation recorded to research and development expenses during the three and six months ended June 30, 2022 reflect a decrease in cumulative compensation cost recorded for performance-based restricted stock units (“RSU”) as a result of a change in the estimated probability of vesting conditions being met as of June 30, 2022, as discussed further below.

Stock-based compensation costs capitalized as part of capitalized software costs was $0.3 million and $0.6 million during the three and six months ended June 30, 2021, respectively. No stock-based compensation costs have been capitalized during the six months ended June 30, 2022.  

Equity incentive plans

As of June 30, 2022, 4,920,572 shares of common stock are issuable upon the exercise of outstanding awards under the 2010 Equity Incentive Plan. As of June 30, 2022, the Company had reserved 9,130,881 shares of common stock for issuance under the 2020 Equity Incentive Plan (the “2020 Plan”), of which 6,711,814 are available for issuance in connection with grants of future awards.

As a result of the uncertainty created by the DOJ investigation and the ongoing claims audits, on November 9, 2021, the Company temporarily restricted its employees from selling Company common stock, ceased granting restricted stock units (“RSU”) that settle solely in Company common stock, suspended its ESPP and paused the settlement of outstanding RSUs, each effective as of November 9, 2021. RSUs that vested on November 15, 2021 were settled in cash during the first quarter of 2022. RSUs that vested on February 15, 2022 and May 15, 2022, respectively, were settled in shares during the second quarter of 2022. All equity awards that are currently outstanding continue to vest in accordance with their existing vesting schedules.

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Stock options

Stock option activity for the six months ended June 30, 2022 is set forth below:

There were no stock options granted during the six months ended June 30, 2022. The weighted-average grant-date fair value of options granted during the six months ended June 30, 2021 was $27.53 per share.

The aggregate intrinsic values of options outstanding and vested and exercisable were calculated as the difference between the exercise price of the options and the fair value of the Company’s common stock.

As of June 30, 2022, total unrecognized stock-based compensation related to outstanding unvested stock options was $9.6 million, which the Company expects to recognize over a remaining weighted-average period of approximately 2.0 years.

Restricted stock units

RSUs granted under the 2020 Plan are share awards that generally entitle the holder to receive freely tradable shares of the Company’s common stock upon vesting. The RSUs cannot be transferred and the awards are subject to forfeiture if the holder’s service to the Company terminates prior to the release of the vesting restrictions.

RSU activity for the six months ended June 30, 2022 is set forth below:

As of June 30, 2022, total unrecognized stock-based compensation related to unvested RSUs was $18.3 million, which the Company expects to recognize over a remaining weighted-average period of approximately 3.5 years.

Performance-based restricted stock units

In June 2021, the Company granted 80,000 RSUs with performance-based vesting conditions that primarily related to the achievement of certain minimum sales of Eargo hearing aid systems and that must be met by December 31, 2022 for the awards to vest. The vesting conditions associated with 75% of the awards were deemed not probable as of June 30, 2022. The Company previously estimated that all vesting conditions were probable of being satisfied as of March 31, 2022 and therefore recorded a reduction in cumulative compensation cost of $1.1 million during the three months ended June 30, 2022 as if the new estimate has been applied since the service inception date of the awards. The grant date fair value of the awards was $3.0 million. None of these awards have vested or were forfeited as of June 30, 2022.

Employee stock purchase plan

As of June 30, 2022, the Company reserved 1,502,310 shares of common stock for issuance under the ESPP, of which 1,327,567 are available for future issuance. The ESPP provides for consecutive, overlapping 24-month offering periods, which are generally divided into four purchase periods of approximately six months. The offering periods are scheduled to start on the first trading day on or after

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May 16 and November 16 of each year. Contributions under the ESPP are generally limited to a maximum of 15% of an employee’s eligible compensation.

Each offering period consists of four six-month purchase periods. On each purchase date, which falls on the last date of each purchase period, ESPP participants will purchase shares of common stock at a price per share equal to 85% of the lesser of (1) the fair market value per share of the common stock at the start of the offering period or (2) the fair market value of the common stock on the purchase date.

The ESPP was suspended on November 9, 2021, and there were no offering periods in effect during the six months ended June 30, 2022.

8. Net loss per share attributable to common stockholders

The following outstanding potentially dilutive common stock equivalents have been excluded from the computation of diluted net loss per share for the periods presented due to their anti-dilutive effect:

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

You should read the following discussion and analysis of our financial condition and results of operations together with our unaudited condensed consolidated financial statements and the related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q, and for a full understanding of Eargo’s results of operations and financial condition, in conjunction with the consolidated financial statements and notes for the fiscal year ended December 31, 2021 contained in the Company’s Form 10-K filed on May 13, 2022. The following discussion and analysis of our financial condition and results of operations contains forward-looking statements about us and our industry that involve substantial risks, uncertainties and assumptions. All statements other than statements of historical facts contained in this item, including statements regarding factors affecting our business, trends and uncertainties, are forward-looking statements. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Quarterly Report on Form 10-Q, our actual results could differ materially from the results described in or implied by these forward-looking statements. You should carefully read the “Risk Factors” to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements.

Overview

We are a medical device company dedicated to improving the quality of life of people with hearing loss. We developed the Eargo solution to create a hearing aid that consumers actually want to use. Our innovative product and go-to-market approach address the major challenges of traditional hearing aid adoption, including social stigma, accessibility and cost.

We believe our Eargo hearing aids are the first ever virtually invisible, rechargeable, completely-in-canal, United States Food and Drug Administration (“FDA”) regulated, exempt Class I or Class II devices indicated to compensate for mild to moderate hearing loss. Our rapid pace of innovation is enabled by our deep industry and technical expertise across mechanical engineering, product design, audio processing, clinical and hearing science, consumer electronics and embedded software design, and is supported by our strategic intellectual property portfolio.

We market and sell our hearing aids direct to consumers with a personalized, consumer-centric approach. Our commercial organization consists of a talented marketing team with deep experience in consumer-focused brand and performance marketing, a team of inside sales consultants, and a dedicated customer support team that includes audiologists and hearing professionals. We generate revenue from orders processed primarily through our website and over the phone by our sales consultants.

We believe that our differentiated hearing aids and consumer-oriented approach have fueled the rapid adoption of our hearing aids and high customer satisfaction, as evidenced by over 99 thousand Eargo hearing aid systems sold, net of returns, as of June 30, 2022.

For the six months ended June 30, 2022, we generated net revenue of $16.4 million, a decrease of $28.5 million from the six months ended June 30, 2021. The revenue decline was primarily due to a decrease in the volume of Eargo hearing aid systems shipped that was primarily due to our selling our products on a “cash-pay” basis only during the six months ended June 30, 2022 as compared to our having accepted both cash pay and insurance as a method of direct payment during the six months ended June 30, 2021. We previously accepted insurance as a method of direct payment, but suspended all claims submission activities on September 22, 2021 when we learned of the investigation by the DOJ related to our role in customer reimbursement claim submissions to various federal employee health plans under the FEHB program, as discussed in more detail below under “—DOJ investigation and settlement and claims audits.” We have sold our products on a “cash-pay” basis only since December 8, 2021. To date, all our revenue has been generated from customers in the United States.

Our net losses were $63.1 million and $32.9 million for the six months ended June 30, 2022 and 2021, respectively. As of June 30, 2022, we had an accumulated deficit of $419.9 million. We expect to continue to incur losses for the foreseeable future.

Given our need for additional capital to fund our operations, our Board, management team and financial advisors have devoted significant time and effort into exploring our strategic alternatives, including potential financing transactions to generate requisite capital to support our short- and long-term business strategies and a potential sale of the Company. We have concurrently undertaken significant measures to reduce operating expenses and preserve capital, including the elimination of certain programs and reductions in employee workforce. After reviewing all available alternatives, on June 24, 2022, we entered into a Note Purchase Agreement (the “Note Purchase Agreement”) with an affiliate of Patient Square Capital (together with any subsequent holders of notes under the Note Purchase Agreement, the “Noteholders”) and Drivetrain Agency Services, LLC, as administrative agent and collateral agent, pursuant to which we agreed to issue and sell up to $125 million in senior secured convertible notes (the “Notes”) convertible into shares (“Conversion Shares”) of our common stock. On June 28, 2022, we closed the initial issuance of $100 million of Notes (the “First Tranche Closing”). We used approximately $16.2 million of the net proceeds to repay all existing third-party indebtedness and related pay-off expenses.

As of June 30, 2022, we had cash and cash equivalents of $106.6 million, including the net proceeds received from the First Tranche Closing, which are available to fund operations. Under the terms of the Note Purchase Agreement and related documents, we are required to use the proceeds for working capital purposes and to fund the Company’s general business requirements. The Note Purchase Agreement provides for our undertaking of a rights offering (the “Rights Offering”) by no later than December 24, 2022.

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Based on the results of the Rights Offering and conversion of the Notes, our stockholders may experience substantial dilution of their holdings and the Noteholders may obtain a substantial or controlling interest in us. In order for us to complete the Rights Offering and issue the Conversion Shares, we will require stockholder approval, which we intend to seek at our 2022 annual meeting of stockholders that we intend to hold on October 12, 2022 (the “Annual Meeting”). If we are unable to complete the Rights Offering by December 24, 2022, including as a result of a failure to obtain stockholder approval for the Share Increase Amendment Proposal or the Nasdaq Proposal (both as defined herein), the Notes will remain outstanding and we will be in default under the Note Purchase Agreement. In such event, we will face immediate repayment obligations to our Noteholders. Unless we are able to arrange alternative financing or a sale of the Company, we expect that we would not have sufficient funds to satisfy such repayment obligations, which would allow the Noteholders to foreclose on the collateral, which consists of substantially all of our assets, including our intellectual property. For additional information regarding the Notes and the Rights Offering, see the section titled “– Convertible Note Financing” below.

DOJ investigation and settlement and claims audits

As previously disclosed, on September 21, 2021, we were informed that we were the target of a criminal investigation by the DOJ related to insurance reimbursement claims we submitted on behalf of our customers covered by various federal employee health plans under the Federal Employee Health Benefits (“FEHB”) program, which is administered by the Office of Personnel Management (“OPM”). The investigation also pertained to our role in customer reimbursement claim submissions to federal employee health plans (collectively, the “DOJ investigation”). Also as previously disclosed, the third-party payor with whom historically we had the largest volume, which is one of the carriers contracted with the OPM under the FEHB program (“largest third-party payor”), conducted an audit of insurance reimbursement claims (“claims”) submitted by us (the “Primary Audit”), which included a review of medical records. We were informed by the third-party payor conducting the Primary Audit that the DOJ was the principal contact related to the subject matter of the Primary Audit. In addition to the Primary Audit, we have been subject to a number of other audits of insurance reimbursement claims submitted to additional third-party payors (collectively with the Primary Audit, the “claims audits”). One of these claims audits does not relate to claims submitted under the FEHB program. On January 4, 2022, the DOJ confirmed to us that the investigation had been referred to the Civil Division of the DOJ and the U.S. Attorney’s Office for the Northern District of Texas and the criminal investigation was no longer active.

On April 29, 2022, we entered into a civil settlement agreement with the U.S. government that resolved the previously disclosed DOJ investigation related to our role in customer reimbursement claim submissions to various federal employee health plans under the FEHB program. We cooperated fully with the DOJ investigation. We deny the allegations in the settlement agreement, and the settlement is not an admission of liability by us. The allegations did not pertain to the quality or performance of our product. The settlement agreement provided for our payment of approximately $34.4 million to the U.S. government and resolved allegations that we submitted or caused the submission of claims for payment to the FEHB program using unsupported hearing loss-related diagnostic codes. On May 2, 2022, we paid the settlement amount.

The settlement with the U.S. government may not resolve all of the audits of insurance reimbursement claims by the various third-party payors, and additionally we remain subject to a prepayment review of claims by the payor who conducted the Primary Audit.

From the time we learned of the DOJ investigation and until December 8, 2021, we continued to process orders for customers with potential insurance benefits (including FEHB program members) but suspended all claims submission activities and offered affected customers (i.e., customers using insurance benefits as a method of direct payment for transactions prior to December 8, 2021) the option to return their hearing aids or purchase their hearing aids without the use of their insurance benefits in case their claim is denied or ultimately not submitted by us to their insurance plan for payment (the “extended right of return”).

Beginning on December 8, 2021, we made the decision to stop accepting insurance benefits as a method of direct payment and it is uncertain when, if ever, we will resume accepting insurance benefits as a method of direct payment. While we intend to work with the government and third-party payors with the objective of validating and establishing processes to support any future claims that we may submit for reimbursement, we may not be able to arrive at acceptable processes or submit any future claims.

Total life-to-date payments we have received through June 30, 2022 from the government in relation to claims submitted under the FEHB program, net of any product returns and associated refunds, were approximately $44 million, which is unchanged from December 31, 2021. As discussed further in Note 5 to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, based on the settlement agreement with the U.S. government, we recorded a settlement liability of $34.4 million in the condensed consolidated balance sheets as of December 31, 2021, respectively. The settlement amount was recorded as a reduction of revenue in the third quarter of 2021.

We determined that customer transactions using insurance benefits as a method of direct payment occurring subsequent to learning of the DOJ investigation on September 21, 2021 did not meet the criteria for revenue recognition under ASC 606. As such, we did not recognize revenue for shipments to customers with potential insurance benefits, substantially all of whom were covered under the FEHB program, subsequent to that date.

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We estimated that a majority of customers with unsubmitted claims will choose to return the hearing aid system if their insurance provider denies their claim or the claim is ultimately not submitted by us for payment, resulting in an increase in expected product returns from such transactions that occurred prior to September 21, 2021 that was recorded during the year ended December 31, 2021. Of the $12.7 million sales returns reserve recorded as of June 30, 2022, $11.3 million relates to unsubmitted claims that are included in accounts receivable, net. Returns associated with unsubmitted claims will reduce the sales returns reserve, with a corresponding reduction in the related accounts receivable at the time the product is returned.

Further, we also estimated that, in addition to the customers who choose to return their hearing aid systems, a significant number of customers whose claims are denied by insurance providers or not submitted by us for payment may not pay for or return the hearing aid system, resulting in bad debt expense that was recorded during the year ended December 31, 2021.

Notwithstanding the settlement, we remain subject to prepayment review by our largest third-party payor, which administers an FEHB plan, of any claims we submit. We do not intend to submit claims through the FEHB program until we are able to establish processes with applicable third-party payors and FEHB carriers to support the submission of these claims, and we may be unable to do so. We cannot provide any assurance as to the timing or costs associated with establishing such processes, if we can do so at all, or the impact that such processes may have on our business and results of operations. At the same time, we are also taking steps to further strengthen and enhance our compliance program. Although we are working to establish dialogues with third-party payors, we expect any negotiations with payors to last for an extended period of time, and we do not plan to provide an update until if and when we have reached an understanding with payors.

Based on our correspondence to date with the OPM and the third-party payor with whom historically we had the largest volume, we expect that any such processes will require additional testing by a licensed healthcare provider to establish medical necessity, with supporting clinical documentation. We are evaluating alternatives for testing, including but not limited to accepting clinical documentation and prescriptions from third-party healthcare professionals, contracting with third parties or existing networks, and/or establishing a management services organization, separate from our existing corporate structure, that manages professional entities that employ licensed healthcare providers. These alternatives involve significant time and related activities, including, but not limited to, development of internal processes, training, and compliance and quality control programs, coordination with external healthcare providers and professional services organizations, and evaluation of and compliance with state-by-state regulatory requirements. We cannot provide any assurance as to the timing or costs associated with these alternatives, whether we will be successful in implementing any of them, or the impact that such changes may have on our business and operations. If we are unable to implement at least one of these alternatives for testing, we expect that we will not be able to obtain insurance coverage of our products going forward.

Effective November 1, 2022, we will not have contracts with any FEHB carriers, third-party payors, or other insurance providers, meaning that our products will be considered out-of-network for such payors and insurance providers. Based on our research and correspondence to date with the FEHB carrier with whom we historically had the largest volume, we do not anticipate the reimbursement amounts, patient co-payment amounts, or the claims submission process, including medical necessity requirements and documentation requirements, would change based on whether we are in-network or out-of-network for that FEHB carrier or other FEHB plans.  To illustrate, the hearing aid benefit in this FEHB plan is a set amount that covers the hearing aid itself and related fees and supplies, regardless of the plan option and regardless of whether the hearing aid is provided by a preferred, participating, or non-participating provider (i.e., regardless of if it is in-network or out-of-network), which is not always the case for other benefit categories. However, depending on the FEHB carrier or third-party payor, payment may be made directly to the patient rather than to the Company if the Company is out-of-network.

Further, the pending over-the-counter (“OTC”) hearing aid regulatory framework, if finalized as currently proposed, may lead such payors to take additional actions further limiting our ability to access insurance coverage, which may have a material adverse effect on our financial condition, results of operations or cash flows.

On January 5, 2022, the U.S. District Court for the Northern District of California consolidated three purported securities class actions brought against the Company (as consolidated, the “Securities Class Action”). On May 20, 2022, the lead plaintiffs filed a consolidated amended complaint, which generally alleges that certain of the Company’s disclosures about its business, operations and prospects, including reimbursements from third-party payors, violated federal securities laws. Defendants filed a motion to dismiss the consolidated amended complaint on July 29, 2022. On August 4, 2022, the U.S. District Court for the Northern District of California consolidated two verified shareholder derivative complaints brought against certain of our executive officers and current and former members of our board of directors (as consolidated, the “Derivative Action”). The court stayed the consolidated Derivative Action until the resolution of the pending motion to dismiss the Securities Class Action. See Note 5 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information.

As a result of the uncertainty created by the DOJ investigation and the claims audits, we took certain actions including, but not limited to:

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Convertible note financing

Note Purchase Agreement

On June 24, 2022, after reviewing all available alternatives to secure the funding needed to support the Company’s ongoing operations and pursuit of its business strategies, and a potential sale of the Company, we entered into the Note Purchase Agreement with Noteholders and Drivetrain Agency Services, LLC, as administrative agent and collateral agent. Pursuant to the Note Purchase Agreement, we agreed to issue and sell up to $125 million in Notes (the “Note Transaction”). Our Board concluded that the Note Transaction represented the best opportunity available to us to secure necessary capital and was in the best interests of stockholders. In making such determination, the Board considered, among other things, our significant cash burn for an extended period of time, including cash burn due to the settlement of the DOJ investigation, the lack of an alternative firm proposal for a financing transaction, our anticipated continued losses and deteriorating financial position in the near term, the substantial doubt as to our ability to continue as a going concern, our need for additional financing both to continue operations and focus on our business strategies, and the terms of the transaction with the Noteholders, including the availability of the Rights Offering to allow existing stockholders to mitigate the significant potential dilution to stockholders resulting from the Note Transaction and our continued ability to pursue a sale or merger transaction under the terms of the Note Transaction.

On June 28, 2022, we closed the initial issuance of $100 million of Notes, providing the Company with critical capital. We incurred $5.7 million in transaction costs related to the Note Transaction, which were recorded to general and administrative expenses. We used approximately $16.2 million of the net proceeds to repay all existing third-party indebtedness, including all amounts due under our existing term loan (the “2018 Loan Agreement”), and related pay-off expenses.

Rights Offering

In connection with the Note Transaction, we have agreed to consummate the Rights Offering for an aggregate of 375 million shares of common stock to stockholders as of a record date to be determined at an offering price of $0.50 per share of common stock. The Rights Offering is subject to our stockholders approving (i) an amendment to our certificate of incorporation to increase the number of authorized shares of common stock under the Company’s certificate of incorporation to an amount necessary to consummate the Rights Offering (the “Share Increase Amendment Proposal”) and (ii) for purposes of complying with Nasdaq Listing Rule 5635, the issuance of the full potential amount of Conversion Shares upon conversion of the Notes (the “Nasdaq Proposal”). If we are unable to complete the Rights Offering by December 24, 2022, the Notes will remain outstanding and we will be in default under the Note Purchase Agreement. We intend to commence the Rights Offering shortly after the Annual Meeting and expect it to be completed prior to November 25, 2022 (the 150^th day following the First Tranche Closing), and in any event by December 24, 2022.

Conversion

If the Rights Offering is consummated by November 25, 2022, then the Notes will automatically convert into (i) a number of shares of common stock equal to 375 million less the number of shares actually subscribed for and purchased with the Rights Offering, and (ii) cash in an amount equal to (x) the Repayment Value of Notes outstanding less (y) the Rights Offering Shortfall Amount. The “Rights Offering Shortfall Amount” represents an amount equal to the product of (a) 375 million less the number of shares of common stock subscribed for and actually purchased in the Rights Offering, multiplied by (b) $0.50.

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If the Rights Offering is consummated after November 25, 2022 but on or prior to December 24, 2022, then the Second Tranche Notes will be issued (subject to certain conditions) and (a) the total gross proceeds of the Rights Offering will be immediately used to repay in cash a portion of the Notes at the Repayment Value, with the principal amount of the Notes redeemed being equal to the total gross proceeds of the Rights Offering divided by 1.50, and (b) the remaining amount of the Notes that are not redeemed will immediately convert into a number of shares equal to 375 million less the number of shares actually subscribed for and purchased in the Rights Offering. The Second Tranche Notes may not be issued if the Rights Offering is not consummated by December 24, 2022.

Use of proceeds

We are permitted to use the proceeds from the sale of the Notes as working capital, to fund our general business requirements and to pay off existing indebtedness.

Interest, redemption, maturity and events of default

The Notes are senior, secured obligations of the Company, bearing interest at a rate of 12.00% per annum, payable quarterly in arrears on the first calendar day of each calendar quarter commencing on July 1, 2022. Immediately upon the occurrence and during the continuance of an event of default, the interest rate will be increased by an additional 12.00%. Other than on June 28, 2023 (the “Maturity Date”) or any optional redemption date, accrued interest shall be paid in-kind.

We may, at our option, repay all (but not a portion) of the Notes outstanding upon three business days’ prior written notice at a price equal to the Repayment Value of the Notes outstanding. The Repayment Value of any Note on any applicable date means an amount payable such that the annualized return on the initial principal amount of the Notes is no less than 12.00%, or, if greater, an amount equal to 150% of the initial principal amount of such Note.

The Notes will mature and be due in cash at the Repayment Value on the Maturity Date, subject to earlier conversion, redemption or repurchase in accordance with their terms.

The Note Purchase Agreement contains certain “events of default,” which, if triggered, would result in an increase in the amount of interest due on the Notes and may result in the acceleration of the maturity of the Notes (including the Repayment Value), among other things. Events of default under the Note Purchase Agreement include, among other things:

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Restrictions on certain activities

The Note Purchase Agreement contains various covenants that limit our ability to engage in specified types of transactions without the Noteholders’ prior consent. These covenants limit our ability to, among other things:

Nothing in the Note Purchase Agreement prohibits us from refinancing the Notes (at their Repayment Value) with a new equity or debt financing, or from selling the Company (and repaying the Notes at the Repayment Value in connection with such sale). We expect that in the event we enter into a sale transaction, then we would not proceed with the Rights Offering.

Collateral

Pursuant to the Note Purchase Agreement, we granted a first-priority security interest on substantially all of our assets, including intellectual property. Any subsidiary we form or acquire is also required to become party to the Note Purchase Agreement, subject to the same requirements. Upon the occurrence of an event of default, the Administrative Agent, on behalf of the Noteholders, is entitled to, among other things, foreclose on the collateral.

Stockholder approval

In connection with the Note Transaction, we agreed to hold a meeting of stockholders within 120 days of the First Tranche Closing (i.e., by October 28, 2022) to obtain stockholder approval of the Share Increase Amendment Proposal and the Nasdaq Proposal. We intend to seek stockholder approval of these matters at the Annual Meeting.

Factors affecting our business

Our business priorities include: (i) potentially regaining insurance coverage of Eargo hearing aids for government employees under the FEHB program; (ii) refining and expanding our retail strategy; (iii) optimizing our cash pay business; and (iv) continuing to invest in innovation. We believe that our future performance will depend on many factors, including those described below and in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.

Efficient acquisition of new customers

We have spent significant amounts on sales and marketing designed to build a strong brand, achieve broad awareness of our Eargo system, acquire new customers and convert sales leads. Since our public disclosure of the DOJ investigation on September 22, 2021 and our related decision to stop accepting insurance benefits as a method of direct payment, we have experienced and may continue to experience a material decline in gross systems shipped.

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Beginning on December 8, 2021, as a result of the DOJ investigation and claims audits (as further described in “—DOJ investigation and settlement and claims audits”) we do not currently accept insurance as a direct method of payment, and all sales from such date are considered by us to be “cash-pay,” which includes upfront payment, credit card, third-party financing, and distributor payment. We have refocused our sales and marketing efforts and related spend to prioritize conversion of cash-pay consumer leads into satisfied customers. While we intend to work with third-party payors with the objective of validating and establishing the process to support any future claims that we may submit for reimbursement, we may not be able to arrive at an acceptable process or submit any future claims. The shift to a model that excludes insurance as a direct method of payment will likely result in a sustained increased cost of customer acquisition and require significant sales and marketing investments, based on the historically lower conversion rate for cash-pay customers as compared to customers with potential insurance benefits. Further, the exclusion of insurance as a direct payment method may also necessitate identifying commercial partnerships, omni-channel, including retail, or other opportunities, as well as the potential implementation of cost-savings measures, in order to drive cost-efficient cash-pay customer acquisition and offset the significantly higher return rates as well as the related negative impact on revenue and gross margin historically applicable to cash-pay customers

Changes to the regulatory landscape

Hearing aids are considered medical devices subject to regulation by the FDA. We currently market our products pursuant to the FDA regulatory framework for air-conduction hearing aids, which are classified as Class I or Class II devices exempt from premarket review procedures. In addition, while applicable FDA regulations establish certain “conditions for sale” of all hearing aids, including that prospective hearing aid users must have a medical evaluation by a licensed physician within the six months prior to hearing aid dispensation or sign a waiver of medical evaluation, the FDA has stated that it does not intend to enforce these medical evaluation and waiver requirements prior to the dispensing of Class I air-conduction and Class II wireless air-conduction hearing aids to individuals 18 years of age and older. Accordingly, while we are required to comply with other FDA requirements, including specific hearing aid labelling requirements and provision of a User Instructional Brochure, our products have not been reviewed by the FDA and we are not currently requiring a medical evaluation by a licensed physician to dispense.

The regulatory landscape for hearing aid devices has been subject to recent changes that may alter or increase our requirements for regulatory compliance. The FDA Reauthorization Act of 2017 (“FDARA”) set forth a process to create a new category of OTC hearing aids that are intended to be available without supervision, prescription, or other order, involvement or intervention of a licensed practitioner. The language in FDARA is not self-implementing, and on October 20, 2021, the FDA published the Proposed Rule to establish new regulatory categories for OTC and prescription hearing aids.

The Proposed Rule also includes revised requirements for labelling, conditions for sale, performance standards and other provisions applicable to either OTC or prescription hearing aids, or both. Under the Proposed Rule, devices that require 510(k) clearance to come into compliance with the new requirements would need to be cleared by the effective date of the Final Rule to continue marketing. For all other currently marketed devices, the proposed compliance date is 180 days after the effective date of the Final Rule (240 days after the publication of the Final Rule).

We market the Eargo system devices as Class I air-conduction hearing aids or Class II wireless air-conduction hearing aids, both of which are exempt from 510(k) premarket review. Our hearing aids may be marketed under the current FDA framework during the FDA’s rulemaking proceeding. However, we cannot know to what extent the Final Rule may differ from the Proposed Rule. Once the FDA issues a Final Rule, we will need to expend time and resources evaluating the Final Rule and ensuring that our devices and processes come into compliance with the new requirements in order to market our products in line with our primary direct-to-consumer business and omni-channel models in the future. It is possible that a finalized regulatory framework for OTC hearing aids may lead to additional commercial partnership, omni-channel, including retail, or other opportunities, although there are no assurances that it will do so. The Final Rule and the responses thereto by leading insurance providers could also materially impact our efforts to resume submitting claims for customers with potential insurance benefits or have other unforeseen impacts on our business and results of operations.

Please see the Risk Factor titled, “Changes in the regulatory landscape for hearing aid devices could materially impact our direct-to-consumer business model and lead to increased regulatory requirements, and we may be required to seek additional clearance or approval for our products” for more information.

Omni-channel marketing and distribution activities through commercial partnerships

Eargo’s self-administered hearing screeners are intended to be part of our retail customer experience and are expected to be located in physical retail settings so customers can obtain general information regarding their hearing and see Eargo hearing aids in person. We also have a select number of commercial partnerships to, among other things, facilitate the retail experience, and we intend to continue to pursue additional opportunities for in-person customer engagement. For example, we have entered into an agreement with an authorized vendor to facilitate access to our hearing screeners at certain Verizon store locations. While customers can learn about Eargo hearing aids and obtain general information about their hearing through our current hearing screeners, they cannot purchase or

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order Eargo hearing aids in retail settings. We believe that if the Proposed Rule by the FDA regarding an OTC regulation of hearing aids is finalized in substantially the same form as proposed, the Final Rule will facilitate negotiation and execution of additional retail opportunities in the future, including the potential ability to purchase or order our products directly at retail locations.

Third-party payors

A significant portion of our revenue has historically been dependent on payments from third-party payors; for example, in the year ended December 31, 2021, 44% of total gross systems shipped were to customers with potential insurance coverage. Historically, we submitted claims on behalf of our customers to a concentrated number of third-party payors under certain benefit plans, and substantially all such claims related to the FEHB program.

As described in Note 2 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, approximately 95% and 93% of our gross accounts receivable as of June 30, 2022 and December 31, 2021, respectively, were for customers with potential insurance benefits, substantially all of whom were covered under the FEHB program. Furthermore, approximately 92% and 90% of our gross accounts receivable as of June 30, 2022 and December 31, 2021, respectively, were related to shipments of Eargo hearing aids to customers insured under a single insurance plan whose claims are processed through our largest third-party payor, which conducted the Primary Audit. We remain subject to a prepayment review of claims by the payor who conducted the Primary Audit. In addition to the Primary Audit, we are currently subject to a number of other ongoing audits of insurance reimbursement claims. One of these claims audits does not relate to claims submitted under the FEHB program. During the claims audits, the third-party payors (including our largest third-party payor) conducting such claims audits have generally suspended payments for, and in some cases denied, claims we submitted on behalf of customers, other than one third-party payor that has continued to process claims for payment throughout its ongoing audit.

We recorded a sales returns reserve of $12.7 million and $13.8 million as of June 30, 2022 and December 31, 2021, respectively, largely related to our estimate that a majority of customers with unsubmitted claims will choose to return the hearing aid system if their insurance provider denies their claim or the claim is ultimately not submitted by us for payment. We recorded an allowance for credit losses of $4.7 million and $4.8 million as of June 30, 2022 and December 31, 2021, respectively, primarily related to insurance claims receivable due from third-party payors and end-users as we estimate that, in addition to the customers who choose to return their hearing aid systems, a significant number of customers with an extended right of return and claims that have not yet and may never be submitted by us for payment may not pay for or return the hearing aid system.

While we intend to work with third-party payors with the objective of validating and establishing processes to support any future claims that we may submit for reimbursement, we may not be able to arrive at acceptable processes or submit any future claims. At the same time, we are also taking steps to further strengthen and enhance our compliance program. Although we are working to establish dialogues with third-party payors, we expect any negotiations with payors to last for an extended period of time, and we do not plan to provide an update until if and when we have reached an understanding with payors.

Based on our correspondence to date with the OPM and the third-party payor with whom historically we had the largest volume, we expect that any such processes to support claims for reimbursement will require additional testing by a licensed healthcare provider to establish medical necessity, with supporting clinical documentation. We are evaluating alternatives for testing, including but not limited to accepting clinical documentation and prescriptions from third-party healthcare professionals, contracting with third parties or existing networks, and/or establishing a management services organization separate from our existing corporate structure that manages professional entities that employ licensed healthcare providers. These alternatives involve significant time and related activities, including, but not limited to, development of internal processes, training, and compliance and quality control programs, coordination with external healthcare providers and professional services organizations, and evaluation of and compliance with state-by-state regulatory requirements. We cannot provide any assurance as to the timing or costs associated with these alternatives, whether we will be successful in implementing any of them, or the impact that such changes may have on our business and operations. In addition, it is possible that such testing would be required to be conducted in-person, representing a significant change from our past processes and customer experience that may adversely impact the attractiveness of our offerings to customers, and we may not be able to efficiently or effectively integrate such tests into our operating model.

Effective November 1, 2022, we will not have contracts with any FEHB carriers, third-party payors, or other insurance providers, meaning that our products will be considered out-of-network for such payors and insurance providers. Based on our research and correspondence to date with the FEHB carrier with whom we historically had the largest volume, we do not anticipate the reimbursement amounts, patient co-payment amounts, or the claims submission process, including medical necessity requirements and documentation requirements, would change based on whether we are in-network or out-of-network for that FEHB carrier or other FEHB plans.  To illustrate, the hearing aid benefit in this FEHB plan is a set amount that covers the hearing aid itself and related fees and supplies, regardless of the plan option and regardless of whether the hearing aid is provided by a preferred, participating, or non-participating provider (i.e., regardless of if it is in-network or out-of-network), which is not always the case for other benefit categories. However, depending on the FEHB carrier or third-party payor, payment may be made directly to the patient rather than to the Company if the Company is out-of-network.

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In light of the DOJ investigation, claims audits and pending OTC hearing aids regulatory framework, we may need to make significant changes to our business and operating model, including a potential long-term shift to a model that excludes insurance as a direct method of payment, which would likely result in a sustained increased cost of customer acquisition and require identification of commercial partnership, omni-channel, including retail, or other opportunities, to drive cost efficient acquisition of cash-pay customers.

See “—DOJ investigation and settlement and claims audits” for more information. Please see the Risk Factors titled, “We are subject to risks from legal proceedings, investigations, and inquiries, including a number of recent legal proceedings and investigations, which have had and could continue to have a material adverse effect on our reputation, business, financial condition, cash flows and results of operations, and could result in additional claims and material liabilities,” and “We face considerable uncertainty in our business prospects, as a significant portion of our revenue has historically been dependent upon reimbursement from third-party payors participating in the FEHB program but we have operated on a “cash pay” only basis since December 8, 2021. Following the civil settlement with the U.S. government on April 29, 2022, we may be unsuccessful in validating and establishing processes to support the submission of claims for reimbursement from third-party payors participating in the FEHB program in the future. As a result, we have faced a significant reduction in revenue and any failure to establish processes to support reimbursement from third-party payors in the future may significantly and adversely impact our business and growth prospects and our ability to sell our products.”

Sales returns rate

Our return policy generally allows our customers to return hearing aids for any reason within the first 45 days of delivery for a full refund, subject to a handling fee in certain states, and can be extended under certain circumstances, including the extended right of return offered for shipments involving insurance payors. Historically, the most commonly cited reason for returning our hearing aids is unsatisfactory fit, which we believe is a byproduct of our direct-to-consumer model and online distribution that results in nearly all of our customers ordering our product without trying it first. In addition to unsatisfactory fit, the next most cited reason for returns is that our hearing aids do not provide sufficient audio amplification.

We report revenue net of expected returns, which is an estimate informed in part by historical return rates. As such, our returns rate impacts our reported net revenue and gross profit or loss. Sales returns rates, as defined under “—Key business metrics,” were 32% for the year ended December 31, 2021 and 34% for the six months ended June 30, 2022.

New product introductions

Our technical capabilities and commitment to innovation have allowed us to deliver product enhancements on a rapid development timeline and support a compelling new product roadmap that we believe will continue to differentiate our competitive position over the next several years. With the full commercial launch of the Eargo 5 in July 2021 and the launch of Eargo 6 in January 2022, we have now launched six generations of our hearing aids since 2017, with each iteration having increased functionality and improved sound quality, amplification, noise reduction, physical fit, comfort, water resistance and ease-of-use, as well as reduced costs of goods and better connectivity. We are focused on continuing to launch new versions of the Eargo hearing aid devices that further improve these attributes. We believe that the continued introduction of new products is critical to maintaining existing customers, attracting new customers, achieving market acceptance of our products and maintaining or increasing our competitive position in the market.

We expect to continue refining and improving Eargo hearing aids, and we have the intention of an approximate annual cadence of new product launches. To this end, we are working on the development of a cost-conscious offering as well as the next Eargo hearing aid model with improved functionality. Accordingly, we expect to continue to invest in research and development to support new product introductions. In connection with our product innovation and iteration, we also need to successfully manage our product transitions to avoid delays in customer purchases, excess or obsolete inventory and increased returns as customers wait for our new products to become available. Our development priorities are focused, in part, on expanding refurbishment capability for returned hearing aids. Our refurbishment capabilities include full refurbishment, conversion, and components, and allow us to refurbish and resell or reuse certain returned devices.

Recruitment and retention of personnel

Our success depends in part upon our continued ability to recruit, retain and motivate high-quality employees, including management, administrative, our clinical and scientific personnel and our direct sales force (among others), and competition for qualified personnel can be intense due to the limited number of individuals possessing the requisite training, skill and experience we require. As a result of uncertainty created by the DOJ investigation and the claims audits, we suspended our practice of granting equity awards (except for new restricted stock unit grants that we have the option to settle in cash at the time of vesting), suspended our employee stock purchase plan and deferred the settlement of outstanding restricted stock units, in each case effective as of November 9, 2021.

In addition, on December 7, 2021, we announced a plan to reduce our employee workforce to streamline our organization in response to declines in customer orders since we announced the DOJ investigation. We substantially completed the employee workforce

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reduction during the fourth quarter of 2021, resulting in a reduction of approximately 27% of our employee workforce, or approximately 90 people. On May 24, 2022, we announced a plan to reduce our employee workforce as part of our cost-cutting measures to reduce operating expenses and preserve capital. We substantially completed the employee workforce reduction during the second quarter of 2022, resulting in a reduction of approximately 17% of our employee workforce, or 44 people

The suspension of equity awards and reductions in workforce, in addition to any negative perceptions of employment with us as a result of the DOJ investigation, the settlement with the U.S. government, and the claims audits, could continue to adversely affect employee morale and have a material adverse impact on our ability to recruit, retain and motivate the high-quality employees critical to our operations, which in turn could have a material adverse effect on our business, results of operations and financial condition.

COVID-19 pandemic

We believe the COVID-19 pandemic has accelerated the pace of consumer awareness of our vertically integrated telecare model and has facilitated customer adoption of the same. Shelter-in-place restrictions and increased reluctance of consumers to conduct in-person activities, particularly among older individuals that comprise a majority of the population needing hearing aids has resulted in increased knowledge of our business and sales. We cannot be sure this trend will continue.

Although we believe the COVID-19 pandemic has largely resulted in favorable trends for our business, we have experienced business disruptions, particularly at our California headquarters, where a majority of our employees have been working remotely (which we permitted as an accommodation to our employees despite the fact that we were never required to close our facilities because we were deemed to have an essential workforce under the relevant California COVID-19 measures). Moreover, travel restrictions, factory closures and disruptions in global supply chains have resulted in industry-wide component supply shortages (such as in semiconductors), and we may not be able to obtain adequate inventory on a timely basis or at all. To date, increases in component pricing have occurred but have not had a material impact on supply continuity or gross margin. We have taken steps to monitor our supply chain and actions to address limited supply and increasing lead times, including outreach to critical suppliers and spot market purchases. While we have not been impacted by any significant disruptions to our supply chain that have impacted our ability to service customers or access to necessary raw materials and component parts for the manufacture of our products to date, disruptions have occurred across a number of industries and we cannot provide any assurance that future disruptions will not emerge as a result of the ongoing supply chain issues, inflation, the COVID-19 pandemic or other extrinsic factors. Future disruptions in our supply chain, including the sourcing of certain components and raw materials, such as semiconductor and memory chips, as well as increased logistics costs, could impact our sales and gross margins.

Key business metrics

To analyze our business performance, determine financial forecasts and help develop long-term strategic plans, we review the following key business metrics, each of which is an important measure that represents the state of our business:

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The following table details the number of gross systems shipped and sales returns rates for the periods presented below: