SEC Filing | Eargo, Inc.

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ear-10q_20220331.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2022

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

For the transition period from to

Commission File Number: 001-39616

Eargo, Inc.

(Exact Name of Registrant as Specified in its Charter)

Delaware	27-3879805
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
2665 North First Street, Suite 300 San Jose, California	95134
(Address of principal executive offices)	(Zip Code)

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:

Title of each class

Trading

Symbol(s)

Name of each exchange on which registered

Common Stock, par value $0.0001 per share

EAR

The Nasdaq Stock Market LLC

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 May 19, 2022, the registrant had 39,358,558 shares of common stock, par value $0.0001 outstanding.

Table of Contents

		Page
	SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS	1
PART I.	FINANCIAL INFORMATION	3
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets (Unaudited)	3
	Condensed Consolidated Statements of Operations and Comprehensive Loss (Unaudited)	4
	Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)	5
	Condensed Consolidated Statements of Cash Flows (Unaudited)	6
	Notes to Unaudited Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4.	Controls and Procedures	31
PART II.	OTHER INFORMATION	33
Item 1.	Legal Proceedings	33
Item 1A.	Risk Factors	33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	71
Item 3.	Defaults Upon Senior Securities	72
Item 4.	Mine Safety Disclosures	72
Item 5.	Other Information	72
Item 6.	Exhibits	73

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:

•

the impact on our business of the civil settlement agreement with the U.S. government that resolved the investigation by the U.S. Department of Justice (the “DOJ”) related to insurance reimbursement claims submitted to various federal employee health plans under the Federal Employee Health Benefits (“FEHB”) program, and the extent to which we may be able to validate and establish processes to support the submission of claims for reimbursement to health plans under the FEHB program in the future, if at all, and our ability to obtain, maintain or increase insurance coverage for our hearing aids in the future;

•

the timing or results of claims audits and medical records reviews by third-party payors;

•

the expense, timing and outcome of the purported securities class action litigation alleging that certain of our disclosures about our business, operations and prospects, including reimbursements from third-party payors, violated the federal securities laws and the purported derivative action alleging that our directors breached their fiduciary duties by failing to implement and maintain an effective system of internal controls;

•

our ability to continue to maintain the listing of our securities on The Nasdaq Stock Market LLC (“Nasdaq”), including our ability to execute a plan to regain compliance with the Nasdaq requirements regarding the timely filing of periodic financial reports with the Securities and Exchange Commission (the “SEC”);

•

estimates of our future revenue and expenses, including the extent of any losses we incur from hearing aids delivered to customers where we have not submitted an insurance claim and may not receive payment;

•

estimates of our future capital needs and our ability to raise capital on favorable terms, if at all, including the timing of future capital requirements and the terms or timing of any future financings;

•

our expectations with regard to changes in the regulatory landscape for hearing aid devices, including the anticipated implementation of a pending over-the-counter (“OTC”) hearing aid regulatory framework and potential Medicare coverage for certain hearing aids, as well as any potential actions insurance providers may take following any regulatory changes;

•

our ability to attract and retain customers;

•

our expectations concerning additional orders by existing customers;

•

our expectations regarding the potential market size and size of the potential consumer populations for our products and any future products, including our ability to obtain, maintain or increase insurance coverage of and reimbursement of insurance claims for Eargo hearing aids, which is substantially dependent on, among other things, the outcomes of our efforts to validate and establish processes to support the submission of claims for reimbursement from various federal health plans, any third-party payor audits and pending regulations;

•

our ability to release new hearing aids and the anticipated features of any such hearing aids and our ability to transition our existing customers to new hearing aids, including when older models are discontinued;

•

developments and projections relating to our competitors and our industry, including competing products;

•

our ability to maintain our competitive technological advantages against new entrants in our industry;

•

the pricing of our hearing aids;

•

our expectations regarding the availability, supply, cost and inflationary pressures related to the component parts of our hearing aids;

•

our expectations regarding the ability to make certain claims related to the performance of our hearing aids relative to competitive products;

•

our commercialization and marketing capabilities and expectations;

•

our relationships with, and the capabilities of, our component manufacturers, suppliers and freight carriers;

•

the implementation of our business model and strategic plans for our business, products and technology;

•

the scope of protection we are able to establish and maintain for intellectual property rights covering our products, including the projected terms of patent protection;

•

our ability to effectively manage our business in light of the civil settlement agreement with the U.S. government, third-party payor claims audits and medical records reviews, purported securities class action and derivative litigations, and pending regulations;

•

our ability to retain existing talent and attract new, highly skilled talent;

•

our estimates regarding the COVID-19 pandemic, including but not limited to, its duration and its impact on our business and results of operations; and

•

our future financial performance.

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.

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

Eargo, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

(In thousands, except share and per share amounts)

	March 31,			December 31,
	2022			2021
ASSETS
Current assets:
Cash and cash equivalents	$	89,232		$	110,500
Accounts receivable, net		12,253			12,547
Inventories		5,787			5,712
Prepaid expenses and other current assets		9,528			10,873
Total current assets		116,800			139,632
Operating lease right-of-use assets		6,794			7,165
Property and equipment, net		8,998			9,551
Intangible assets, net		1,526			1,681
Goodwill		873			873
Other assets		544			1,209
Total assets	$	135,535		$	160,111
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	12,029		$	9,053
Accrued expenses		9,086			9,235
Sales returns reserve		13,686			13,827
Settlement liability		34,429			34,372
Long-term debt, current portion		5,000			3,333
Other current liabilities		2,070			1,813
Lease liability, current portion		805			750
Total current liabilities		77,105			72,383
Lease liability, noncurrent portion		6,501			6,640
Long-term debt, noncurrent portion		10,363			11,924
Total liabilities		93,969			90,947
Commitments and contingencies (Note 5)
Stockholders’ equity:
Preferred stock, $0.0001 par value per share; 5,000,000 shares authorized as of March 31, 2022 and December 31, 2021, respectively; zero shares issued and outstanding as of March 31, 2022 and December 31, 2021, respectively		—			—
Common stock; $0.0001 par value; 110,000,000 shares authorized as of March 31, 2022 and December 31, 2021, respectively; 39,344,518 and 39,307,093 shares issued and outstanding as of March 31, 2022 and December 31, 2021, respectively		4			4
Additional paid-in capital		429,019			425,972
Accumulated deficit		(387,457	)		(356,812	)
Total stockholders’ equity		41,566			69,164
Total liabilities and stockholders’ equity	$	135,535		$	160,111

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

Eargo, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

(In thousands, except share and per share amounts)

	Three months ended March 31,
	2022			2021
Revenue, net	$	9,176		$	22,048
Cost of revenue		5,491			6,297
Gross profit		3,685			15,751
Operating expenses:
Research and development		5,847			4,778
Sales and marketing		13,290			16,855
General and administrative		14,934			7,487
Total operating expenses		34,071			29,120
Loss from operations		(30,386	)		(13,369	)
Other income (expense), net:
Interest income		5			11
Interest expense		(264	)		(263	)
Total other income (expense), net		(259	)		(252	)
Loss before income taxes		(30,645	)		(13,621	)
Income tax provision		—			—
Net loss and comprehensive loss	$	(30,645	)	$	(13,621	)
Net loss attributable to common stockholders, basic and diluted	$	(30,645	)	$	(13,621	)
Net loss per share attributable to common stockholders, basic and diluted	$	(0.78	)	$	(0.36	)
Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted		39,323,386			38,283,360

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

Eargo, Inc.

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited)

(In thousands, except share amounts)

	Common stock				Additional paid-in			Accumulated			Total stockholders’
	Shares		Amount		capital			deficit			equity
Balance December 31, 2021		39,307,093	$	4	$	425,972		$	(356,812	)	$	69,164
Stock-based compensation		—		—		3,024			—			3,024
Exercise of stock options		37,425		—		92			—			92
Restricted stock units cash settlement		—		—		(69	)		—			(69	)
Net loss and comprehensive loss		—		—		—			(30,645	)		(30,645	)
Balance March 31, 2022		39,344,518	$	4	$	429,019		$	(387,457	)	$	41,566

	Common stock				Additional paid-in		Accumulated			Total stockholders’
	Shares		Amount		capital		deficit			equity
Balance December 31, 2020		38,246,601	$	4	$	392,965	$	(199,058	)	$	193,911
Stock-based compensation		—		—		5,449		—			5,449
Exercise of stock options		51,467		—		118		—			118
Net loss and comprehensive loss		—		—		—		(13,621	)		(13,621	)
Balance March 31, 2021		38,298,068	$	4	$	398,532	$	(212,679	)	$	185,857

Eargo, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

	Three months ended March 31,
	2022			2021
Operating activities:
Net loss	$	(30,645	)	$	(13,621	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,419			735
Stock-based compensation		2,985			5,131
Non-cash interest expense and amortization of debt discount		105			103
Non-cash operating lease expense		371			295
Bad debt expense		174			62
Loss on disposal of property and equipment		28			—
Changes in operating assets and liabilities:
Accounts receivable		120			(1,608	)
Inventories		(75	)		276
Prepaid expenses and other current assets		1,345			565
Other assets		665			(24	)
Accounts payable		2,962			715
Accrued expenses		107			(1,598	)
Sales returns reserve		(141	)		(1,387	)
Settlement liability		57			—
Other current and noncurrent liabilities		257			1,364
Operating lease liabilities		(84	)		(317	)
Net cash used in operating activities		(20,350	)		(9,309	)
Investing activities:
Purchases of property and equipment		(685	)		(296	)
Capitalized software development costs		(257	)		(1,074	)
Net cash used in investing activities		(942	)		(1,370	)
Financing activities:
Proceeds from stock options exercised		93			118
Restricted stock units settled in cash		(69	)		-
Net cash provided by financing activities		24			118
Net decrease in cash and cash equivalents		(21,268	)		(10,561	)
Cash and cash equivalents at beginning of period		110,500			212,185
Cash and cash equivalents at end of period	$	89,232		$	201,624
Non-cash operating activities:
Lease liability obtained in exchange for right-of-use asset	$	—		$	434
Non-cash investing and financing activities:
Property and equipment and capitalized software costs in accounts payable and accrued liabilities	$	116		$	330
Stock-based compensation included in capitalized software costs	$	39		$	318
Convertible preferred stock issuance costs included in accounts payable	$	600		$	600

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

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 Company’s historically largest third-party payor, 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 at the appropriate time 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 March 31, 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 March 31, 2022 and 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 $13.7 million sales returns reserve recorded as of March 31, 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.

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

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.

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 any 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 March 31, 2022, the Company had cash and cash equivalents of $89.2 million and an accumulated deficit of $387.5 million.

The Company believes that without any 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.

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. 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 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 increase its existing credit facility or access any 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 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

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

assets acquired in a business combination, the useful lives of long-lived assets, accrued product warranty reserve, legal and other 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 three months ended March 31, 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.

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 March 31, 2022, the Company has not experienced any losses on its deposit accounts and money market accounts. As of March 31, 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 March 31, 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 March 31, 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. The increase in gross accounts receivable as of March 31, 2022 was primarily due to the Primary Audit, during which certain claims with a service date after March 1, 2021, have not yet and may never be submitted for reimbursement. 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.

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.

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.

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

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.

3. Fair value measurements

There were no financial assets and liabilities outstanding that were remeasured at fair value on a recurring basis as of March 31, 2022 or 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 fair value of the Company’s outstanding term loan is estimated using the net present value of the payments, discounted at an interest rate that is consistent with a market interest rate. The fair value of the outstanding term loan approximates the carrying amount as the term loan bears a floating rate that approximates the market interest rate.

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

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:

	March 31,		December 31,
	2022		2021
	(in thousands)
Raw materials	$	1,525	$	1,905
Finished goods		4,262		3,807
Total inventories	$	5,787	$	5,712

Prepaid expenses and other current assets

Prepaid expenses and other current assets consist of the following:

	March 31,		December 31,
	2022		2021
	(in thousands)
Advanced payroll deposits	$	3,599	$	3,889
Prepaid insurance fees		2,217		2,945
Prepaid marketing costs		2,221		1,948
Prepaid software subscription		1,080		1,468
Other		411		623
Total prepaid expenses and other current assets	$	9,528	$	10,873

Property and equipment, net

Property and equipment, net, consists of the following:

	March 31,			December 31,
	2022			2021
	(in thousands)
Capitalized software	$	11,579		$	11,569
Tools and lab equipment		4,806			4,712
Furniture and fixtures		906			906
Leasehold improvements		876			861
Computer and equipment		456			401
		18,623			18,449
Less accumulated depreciation and amortization		(9,625	)		(8,898	)
Total property and equipment, net	$	8,998		$	9,551

Depreciation and amortization expense for the three months ended March 31, 2022 and 2021 amounted to $1.3 million and $0.7 million, respectively, which includes amortization of capitalized software costs of $1.0 million and $0.2 million, respectively.

Intangible assets, net

Intangible assets, net consist of the following:

	March 31, 2022
	Gross carrying value		Accumulated amortization		Net carrying value
	(in thousands)
Developed technologies	$	1,700	$	319	$	1,381
Other		290		145		145
Total intangible assets, net	$	1,990	$	464	$	1,526

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

	December 31, 2021
	Gross carrying value		Accumulated amortization		Net carrying value
	(in thousands)
Developed technologies	$	1,700	$	212	$	1,488
Other		290		97		193
Total intangible assets, net	$	1,990	$	309	$	1,681

Amortization expense was $0.2 million for the three months ended March 31, 2022.

The following table summarizes estimated future amortization expense of finite-lived intangible assets, net as of March 31, 2022:

	Amount
	(in thousands)
Remainder of 2022	$	463
2023		425
2024		425
2025		213
Total	$	1,526

Accrued expenses

Accrued expenses consist of the following:

	March 31,		December 31,
	2022		2021
	(in thousands)
Accrued compensation	$	4,428	$	4,845
Accrued warranty reserve		4,240		4,014
Refunds due to customers		418		376
Total accrued expenses	$	9,086	$	9,235

Sales returns reserve

The sales returns reserve consists of the following activity:

	Three months ended March 31,
	2022			2021
	(in thousands)
Sales returns reserve, beginning balance	$	13,827		$	4,326
Reduction of revenue		4,584			6,304
Utilization of sales returns reserve		(4,725	)		(7,691	)
Sales returns reserve, ending balance	$	13,686		$	2,939

Of the $13.7 million sales returns reserve recorded as of March 31, 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

Eargo, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

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:

	Three months ended March 31,
	2022			2021
	(in thousands)
Allowance for credit losses, beginning balance	$	4,838		$	1,868
Charged to expense		174			62
Accounts written off, net of recoveries		(292	)		(298	)
Allowance for credit losses, ending balance	$	4,720		$	1,632

Accrued warranty reserve

The accrued warranty reserve consists of the following activity:

	Three months ended March 31,
	2022			2021
	(in thousands)
Accrued warranty reserve, beginning balance	$	4,014		$	2,390
Charged to cost of revenue		958			950
Utilization of accrued warranty reserve		(732	)		(353	)
Accrued warranty reserve, ending balance	$	4,240		$	2,987

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 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 7.06 years.

For the three months ended March 31, 2022, the Company incurred $0.5 million of operating lease costs. Variable lease payments for operating expenses and costs related to short-term leases were immaterial for the three months ended March 31, 2022 and March 31, 2021.

As of March 31, 2022, undiscounted future minimum lease payments due under the non-cancelable operating leases are as follows:

	Operating leases
	(in thousands)
Remainder of 2022	$	1,103
2023		1,114
2024		1,081
2025		1,331
2026		1,372
Thereafter