EARGO, INC. 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 thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, and for a full understanding ofEargo's results of operations and financial condition, in conjunction with the consolidated financial statements and notes for the fiscal year endedDecember 31, 2020 contained in the Company's Form 10-K filed onMarch 16, 2021 . 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 theEargo 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 ourEargo 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 88 thousandEargo hearing aid systems sold, net of returns, as ofSeptember 30, 2021 . For the nine months endedSeptember 30, 2021 , we generated net revenue of$22.1 million , a decrease of$24.7 million from the nine months endedSeptember 30, 2020 . The revenue decline relates to matters discussed in detail below under "-DOJ investigation and settlement and claims audits." We previously accepted insurance as a method of direct payment, but suspended all claims submission activities onSeptember 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. To date, all our revenue has been generated from customers inthe United States . Our net losses were$112.3 million and$28.1 million for the nine months endedSeptember 30, 2021 and 2020, respectively. As ofSeptember 30, 2021 , we had an accumulated deficit of$311.3 million . We expect to continue to incur losses for the foreseeable future.
DOJ investigation and settlement and claims audits
As previously disclosed, onSeptember 21, 2021 , we were informed that we were the target of a criminal investigation by theU.S. Department of Justice (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. 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, our 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. OnJanuary 4, 2022 , the DOJ confirmed to us that the investigation had been referred to theCivil Division of the DOJ and theU.S. Attorney's Office for the Northern District of Texas and the criminal investigation was no longer active. OnApril 29, 2022 , we entered into a civil settlement agreement with theU.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 theU.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. 25
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The settlement with theU.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. We will need to work with the government (including the OPM) and third-party payors to potentially validate and establish processes to support any future claims that we may submit for reimbursement, and there are no guarantees that we will be able to arrive at any such acceptable processes or submit any future claims. We do not intend to submit any claims through the FEHB program until we are able to align with the OPM on and establish processes for supporting the submission of these claims. From the time we learned of the DOJ investigation and untilDecember 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 toDecember 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 onDecember 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 at the appropriate time 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. During the three months endedSeptember 30, 2021 , we shipped 13,117 gross hearing aid systems, approximately 48% of which were to customers with potential insurance coverage. Total life-to-date payments we have received throughDecember 31, 2021 from the government in relation to claims submitted under the FEHB program, net of any product returns and associated refunds, were approximately$44 million . As discussed further in Note 6 to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, the settlement amount of$34.4 million associated with the DOJ investigation was recorded as a reduction in 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 onSeptember 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. We 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, resulting in an increase in expected product returns from such transactions that occurred prior toSeptember 21, 2021 . As a result, we recorded$13.3 million of estimated sales returns as a reduction in revenue in the third quarter of 2021 related to shipments to customers with potential insurance benefits. This has had a negative impact on our revenues for the three and nine months endedSeptember 30, 2021 and resulted in an increase in our sales returns reserve. Of the$15.6 million sales returns reserve recorded as ofSeptember 30, 2021 ,$12.5 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 estimate 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. As a result, we recorded$8.7 million of bad debt expense during the third quarter of 2021 related to insurance claims receivable balances, which has had a negative impact on our operating results for the three and nine months endedSeptember 30, 2021 . We recorded an allowance for doubtful accounts of$4.6 million as ofSeptember 30, 2021 , net of accounts written off, which includes the impact of a change in our accounting estimate of$6.1 million related to insurance claims receivable balances from transactions that occurred during the first and second quarters of 2021 (see the caption "Allowance for doubtful accounts" under Note 4 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information). Of the$9.3 million recorded to bad debt expense during the nine months endedSeptember 30 , 202,$5.8 million relates to submitted claims that have been denied or have not been paid and was written off during the three and nine months endedSeptember 30, 2021 . Notwithstanding the settlement, we remain subject to prepayment review of claims by our largest third-party payor before any insurance payments are made. We do not intend to submit any claims through the FEHB program until we are able to align with theOffice of Personnel Management (the "OPM") on and establish processes for supporting the submission of these claims, and we may be unable to do so. OnJanuary 5, 2022 , theU.S. District Court for the Northern District of California consolidated three purported securities class actions brought against the Company (the "Securities Class Action"). While the lead plaintiffs have not yet filed a consolidated amended complaint, the complaints of the individual lawsuits filed prior to the consolidation generally alleged that certain of the Company's disclosures about its business, operations and prospects, including reimbursements from third-party payors, violated federal securities laws. OnDecember 3, 2021 , a putative stockholder filed a derivative complaint purportedly on the Company's behalf against members of the Company's Board of Directors and the Company as nominal defendant (the "Derivative Action"), alleging (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. See Note 6 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information. 26
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As a result of the uncertainty created by the DOJ investigation and the claims audits, we took certain actions including, but not limited to (see Note 11 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information):
• 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 2020 Employee Stock Purchase Plan
("ESPP") and deferred the settlement of outstanding restricted stock
units ("RSUs"), in each case effective as of November 9, 2021
(collectively, the "employee equity actions").
• Our Board of Directors suspended the
non-employee
director compensation program with respect to the option awards that
would otherwise have been awarded to
non-employeedirectors automatically on the date of our annual meeting of stockholders
held on November 9, 2021 .
• On
to streamline our organization in response to declines in customer orders
since we announced the investigation of the Company by the DOJ. We
substantially completed the employee workforce reduction during the
fourth quarter of 2021, resulting in a reduction of approximately 27% of
our employee workforce, or approximately 90 people.
As a result of the DOJ investigation and the various claims audits, we were not
able to timely file this Quarterly Report on Form
10-Q
for the three months ended September 30, 2021 (our "Q3
10-Q").
On November 16, 2021 , we filed a Form
12b-25
notifying the SEC that we would be unable to timely file our
Q3 10-Q.
On November 18, 2021 , we were notified by the Nasdaq Stock Market LLC ("Nasdaq")
that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) for continued
listing as a result of the delay in filing our
Q3 10-Q
with the SEC . In accordance with Nasdaq Listing Rules, we submitted a plan to
regain compliance. Nasdaq granted us an exception of up to 180 calendar days
from the
Q3 10-Q
original filing due date, or until May 16, 2022 , to regain compliance. On
March 2, 2022 , we filed a Form
12b-25
notifying the SEC that we would be unable to timely file our Annual Report on
Form
10-K
for the year ended December 31, 2021 . On March 4, 2022 , we were notified again
by Nasdaq that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) for
continued listing as a result of the delay in filing our Annual Report on Form
10-K.
As a result, we submitted to Nasdaq an update to our original plan to regain
compliance. Nasdaq's notification dated March 4, 2022 indicated that any
additional exception to allow us to regain compliance with all untimely filings
will be limited to a maximum of 180 calendar days from the due date of our Q3
10-Q,
or May 16, 2022 .
On May 11, 2022 , we filed a Form 12b-25 notifying the SEC that we would be
unable to timely file our Quarterly Report on
Form 10-Q
for the three months ended March 31, 2022 (our "Q1 2022 10-Q"). On May 12, 2022 ,
we received a letter from Nasdaq notifying us that because we remain delinquent
in filing our Q3 10-Q and Annual Report on Form 10-K, and, in addition, because
we are delinquent in filing our Q1 2022 10-Q, we had not regained compliance and
will not meet the terms of the exception. The letter indicated that our
securities would be subject to delisting on May 23, 2022 as a result of our
non-compliance, unless on or before May 19, 2022 we request a hearing before the
Nasdaq Hearings Panel and request an extended stay of suspension or delisting.
We intend to timely request a hearing before the Nasdaq Hearings Panel , at which
hearing we will present our plan to regain compliance and request the continued
listing of our securities on Nasdaq pending our return to compliance. Such
request would automatically stay any suspension or delisting action by Nasdaq
for a period of 15 days from the date of our request. The stay could be extended
at the option of the Nasdaq Hearings Panel upon our request and support of such
extension, and we intend to ask the Nasdaq Hearings Panel for a further stay
concurrent with our request for a hearing and pending the ultimate conclusion of
the hearing process.
Factors affecting our business
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 ourEargo system, acquire new customers and convert sales leads. Since our public disclosure of the DOJ investigation onSeptember 22, 2021 , we have experienced and may continue to experience a material decline in gross systems shipped. Beginning onDecember 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 the government and third-party payors at the appropriate time 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. 27
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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
labeling requirements and provision of a User Instructional Brochure, our
products have not been reviewed by the FDA and are not dispensed by licensed
physicians.
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 labeling, 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 render our
direct-to-consumer
business model contrary to applicable regulatory requirements, and we may be
required to seek additional clearance or approval for our products" for more
information.
Third-party payors
A significant portion of our revenue has historically been dependent on payments
from third-party payors; for example, in the quarter ended September 30, 2021 ,
48% 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 92% and 74% of our gross accounts receivable as of September 30,
2021 and December 31, 2020 , respectively, were for customers with potential
insurance benefits, substantially all of whom were covered under the FEHB
program. Furthermore, approximately 85% and 45% of our gross accounts receivable
as of September 30, 2021 and December 31, 2020 , 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. The increase in gross accounts receivable as of
September 30, 2021 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 by us for reimbursement. We remain subject to a prepayment review of
claims by the payor who conducted the Primary Audit. Additionally, we are
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.
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We recorded a sales returns reserve of$15.6 million as ofSeptember 30, 2021 , 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 doubtful accounts of$4.6 million as ofSeptember 30, 2021 , 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 reimbursement may not pay for or return the hearing aid system. While we intend 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 we may submit for reimbursement, we may not be able to arrive at acceptable processes or submit any future claims. For example, we do not currently conduct in-person hearing tests, as they run counter to our primary direct-to-consumer business and omni-channel models. If such processes were to require in-person hearing tests, we may not be able to efficiently or effectively integrate such tests into our operating model. In light of the DOJ investigations, 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 sinceDecember 8, 2021 . Following the civil settlement with theU.S. government onApril 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," increased from 24% for the three months endedJune 30, 2021 to 46% for the three months endedSeptember 30, 2021 . This change is primarily driven by our expectation that a majority of customers with unsubmitted claims related to products shipped during the three months endedSeptember 30, 2021 will choose to return the hearing aid system if their insurer denies their claim or the claim is ultimately not submitted by us for payment. The sales returns rate of 46% for the three months endedSeptember 30, 2021 does not include the impact of the$5.1 million of estimated sales returns recorded as a reduction in revenue in the period related to transactions that occurred during the first and second quarters of 2021. See "-DOJ investigation and settlement and claims audits" and the caption "Sales returns reserve" under Note 4 of the Notes to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. 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 theEargo 5 inJuly 2021 and the launch ofEargo 6 inJanuary 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 theEargo 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. 29
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We expect to continue refining and improvingEargo 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 nextEargo 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.
Seasonality
Prior to the effects of COVID-19, we experienced seasonality in our business, with higher sales volumes in quarters when we commercially launch new products and in the fourth calendar quarter as a result of holiday promotional activity. However, since our public disclosure of the DOJ investigation onSeptember 22, 2021 , we have experienced and may continue to experience a material decline in gross systems shipped.
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 ofNovember 9, 2021 . In addition, onDecember 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 reduction during the fourth quarter of 2021, resulting in a reduction of approximately 27% of our employee workforce, or approximately 90 people. Both the suspension of equity awards and reduction in workforce, in addition to any negative perceptions of employment with us as a result of the DOJ investigation, the settlement with theU.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 ourCalifornia 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 relevantCalifornia 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. 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 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. To date, increases in our product 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. 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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• Gross systems shipped.
We define our gross systems shipped as the number of hearing aid systems
shipped during the period. However, we have not recorded revenue and
related sales returns reserve for approximately 670 shipments of Eargo hearing aid systems to customers with potential insurance benefits during
the three months ended
the DOJ investigation. Since our public disclosure of the DOJ
investigation on
to experience a material decline in gross systems shipped. Continued
negative publicity, including in relation to the DOJ investigation, the
claims audits, and other legal proceedings could further harm our
reputation and lead to a further decline in gross systems shipped. See
"-DOJ investigation and settlement and claims audits" and "-Factors
affecting our business."
• Sales returns rates.Sales returns rates are determined by management at the end of each
reporting period to estimate the percentage of products for which we have
recorded revenue during that period that are expected to be returned.
This determination is informed in part by historical actual return rates.
Sales returns rates do not represent actual returns during a period as
customers may return the product for a period of time that can extend
beyond the period end, which can result in a hearing aid being returned
after the period in which the revenue from its sale was recognized. If
actual returns differ from the sales returns rate determined at period
end or new factors arise, indicating a rate of return that is different
from the original estimated sales returns rate, revenue is adjusted in
subsequent periods to reflect the actual returns made. Such an adjustment
to revenue is not included in the sales returns rates disclosed in the
table below. The sales returns rate of 46% for the three months endedestimated sales returns recorded as a reduction in revenue in the third
quarter of 2021 with respect to unsubmitted claims from transactions that
occurred during the first and second quarters of 2021. See "-DOJ
investigation and settlement and claims audits" and "-Factors affecting
our business" and "-Critical accounting policies and estimates-Revenue
recognition-sales returns rate."
The following table details the number of gross systems shipped and sales returns rates for the periods presented below:
Three months ended
March 31, June 30, September 30, December 31, March 31, June 30, September 30,
2020 2020 2020 2020 2021 2021 2021
Gross systems shipped 7,030 9,040 10,077 12,096 11,704 12,548 13,117
Sales returns rate 28.2 % 27.1 % 25.2 % 24.3 % 23.2 % 24.1 % 46.4 %
During the three and twelve months ended
We believe these key business metrics provide useful information to help investors understand and evaluate our business performance. Gross systems shipped is a key measure of sales volume, which drives potential revenue, while sales returns rates are an indicator of expected reductions to revenue and an indicator of change in customer mix and factors affecting the returns rates by customer type. However, as discussed elsewhere in this report, our sales volume, sales returns rate and revenue during the current period were not consistent with prior periods as a result of the DOJ investigation and settlement and claims audits. See "-DOJ investigation and settlement and claims audits." Due to the historically higher return rate for cash-pay customers as compared to insurance customers, we expect that revenue, gross profit or loss, and gross margin may remain depressed as compared to prior periods for so long as we are unable to accept insurance benefits as a direct method of payment.
Components of our results of operations
See the discussion under "-DOJ investigation and settlement and claims audits," which describes a variety of circumstances currently affecting our business and results of operations, and which require that we continually evaluate and adapt our business model and expenditures as new information becomes available.
Revenue, net
We generate revenue from the sale ofEargo hearing aid systems, accessories and, to a lesser extent, sales of extended warranties, with the majority of our revenue coming from sales of ourEargo hearing aid systems. Following the launch ofEargo 6 inJanuary 2022 , we currently offer four versions of our hearing aid systems, the Eargo Max, the Eargo Neo HiFi, theEargo 5, and theEargo 6, each at different price points, and we periodically offer discounts and promotions, including holiday promotions. For product sales, control is transferred upon shipment to the customer. We report revenue net of consideration payable to customers and expected returns, which is an estimate informed in part by historical return rates. 31
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As described in more detail in "-DOJ investigation and settlement and claims audits," we did not recognize revenue for shipments afterSeptember 21, 2021 for customers with potential insurance benefits, substantially all of whom were covered under the FEHB program. The$34.4 million settlement amount associated with the DOJ investigation was recorded as a reduction of revenue in the third quarter of 2021. Further, we estimate that a majority of customers with unsubmitted claims as ofSeptember 30, 2021 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 a higher sales returns rate in the current period than in prior periods and an increase in expected returns with respect to unsubmitted claims from such transactions occurring during the first and second quarters of 2021. Since learning of the DOJ investigation, we have suspended all insurance claims submissions and, beginning onDecember 8, 2021 , do not currently accept insurance as a direct method of payment. Instead, we are currently focused on "cash-pay" customers, which includes upfront payment, credit card, third-party financing and distributor payment. Historically, cash-pay customers have had significantly higher return rates than customers with potential insurance benefits, and therefore the current shift to cash-pay only sales may adversely impact revenue, net.
Cost of revenue and gross margin
Cost of revenue consists of expenses associated with the cost of finished goods, freight, personnel costs, consumables, product warranty costs, transaction fees, reserves for excess and obsolete inventory, depreciation and amortization, and related overhead. Our gross margin has been and will continue to be affected by a variety of factors, including sales volumes, product mix, channel mix, pricing strategies, sales returns rates, costs of finished goods, product warranty claim rates and refurbishment strategies, and our ability to service insurance customers in the future and any potential actions insurance providers may take following the anticipated implementation of a pending OTC hearing aid regulatory framework that may limit our ability to access insurance coverage (which OTC framework may also generally result in additional compliance or other regulatory requirements forEargo ). Our gross margin has been negatively impacted by the$34.4 million settlement amount associated with the DOJ investigation. Our gross margin was also negatively impacted by an expected increase in sales returns from insurance customers with unsubmitted claims as ofSeptember 30, 2021 , which customers have historically had a significantly lower rate of return than cash-pay customers. Additionally, we incurred costs associated with shipments subsequent toSeptember 21, 2021 to customers with potential insurance benefits for which there was no revenue recognition in the three months endedSeptember 30, 2021 (see "-DOJ investigation and settlement and claims audits"). We expect our gross margin to remain depressed for so long as we are unable to accept insurance benefits as a direct method of payment unless we can successfully target and convert new customers with a similarly low rate of return.
Research and development expenses
Research and development ("R&D") expenses, consist primarily of engineering and
product development costs to develop and support our products, regulatory
expenses,
non-recurring
engineering and other costs associated with products and technologies that are
in development, as well as related overhead costs. These expenses include
personnel-related costs, including salaries and stock-based compensation,
supplies, consulting fees, prototyping, testing, materials, travel expenses,
depreciation and allocated facility overhead costs. Additionally, R&D expenses
include internal and external costs associated with our regulatory compliance
and quality assurance functions, and related overhead costs. The uncertainty
regarding the anticipated implementation of a pending OTC hearing aid regulatory
framework will require that we evaluate our R&D expenses as new information
becomes available.
Sales and marketing expenses
Our sales and marketing expenses are the largest component of our operating expenses and consist primarily of personnel-related costs, including salaries and stock-based compensation, direct and channel marketing, advertising and promotional expenses, consulting fees, public relations costs and allocated facility overhead costs. Sales and marketing personnel include our inside sales consultants, hearing professionals, marketing professionals and related support personnel. We expect our sales and marketing expenses to fluctuate over time as a percentage of revenue. In response to the factors discussed in "-DOJ investigation and settlement and claims audits," we have reduced sales and marketing resources that were previously focused on insurance customers to prioritize the conversion of cash-pay consumers into satisfied customers, including as part of the reduction in force announced onDecember 8, 2021 .
General and administrative expenses
Our general and administrative expenses consist primarily of compensation for executive, finance, legal, information technology and administrative personnel, including stock-based compensation. Other significant expenses include professional fees for legal and accounting services, consulting fees, recruiting fees, information technology costs, corporate insurance, bad debt expense, general corporate expenses and allocated facility overhead costs. Excluding the costs associated with the DOJ investigation, we expect our general and administrative expenses will increase in absolute dollars in future periods as a result of operating as a public company, including expenses related to compliance with the rules and regulations of theSEC , and those of theNasdaq Stock Market , additional insurance costs, investor relations activities and other administrative and professional services, as well as professional service and legal fees and expenses related to shareholder litigation that has been filed and that may be filed in the future. 32
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Interest income
Interest income consists of interest earned on cash and cash equivalents.
Interest expense
Interest expense consists of interest related to borrowings under our debt
obligations and our convertible promissory notes prior to their redemption in
Other income (expense), net Other income (expense), net consists primarily of adjustments to the fair value of embedded derivatives associated with certain redemption features of our convertible promissory notes prior to their redemption inJuly 2020 and adjustments to the fair value of our convertible preferred stock warrant liabilities prior to their reclassification to additional paid-in capital upon the closing of our IPO inOctober 2020 .
Loss on extinguishment of debt
The loss on extinguishment of debt arose on the redemption of our convertible promissory notes into shares of our Series E convertible preferred stock inJuly 2020 . Income tax provision We use the asset and liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. Due to our historical operating performance and our recorded cumulative net losses in prior fiscal periods, our net deferred tax assets have been fully offset by a valuation allowance. Financial statement effects of uncertain tax positions are recognized when it is more-likely-than-not, based on the technical merits of the position, that it will be sustained upon examination. Interest and penalties related to unrecognized tax benefits are included within the provision for income tax.
Results of operations
During the nine months endedSeptember 30, 2021 , we made significant investments in R&D, sales and marketing and general and administrative functions of the business. However, as discussed further in the description of these functions above, as a result of the DOJ investigation and claims audits (as further described in "-DOJ investigations and settlement and claims audits"), we shifted to limit our costs, conducted a reduction in force and took other precautionary measures to preserve capital and liquidity. As a result, the following comparison of the three and nine months endedSeptember 30, 2021 and 2020, reflect a trend of increasing expenditures to drive growth in our business, and it should be noted that in response to the uncertainties arising in connection with the DOJ investigation and settlement and claims audits, the trend of rising expenditures began to moderate during the latter portion of our fourth quarter due to the implementation of capital and liquidity preservation measures. 33
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Comparison of the three months ended
Three months ended
September 30, Change
(dollars in thousands) 2021 2020 Amount %
Revenue, net $ (22,869 ) $ 18,186 $ (41,055 ) (225.8 )%
Cost of revenue 7,552 5,434 2,118 39.0
Gross profit (loss) (30,421 ) 12,752 (43,173 ) (338.6 )
Operating expenses:
Research and development 7,296 2,871 4,425 154.1
Sales and marketing 24,444 12,354 12,090 97.9
General and administrative 16,887 5,163 11,724 227.1
Total operating expenses 48,627 20,388 28,239 138.5
Loss from operations (79,048 ) (7,636 ) (71,412 ) 935.2
Other income (expense), net:
Interest income 2 3 (1 ) (33.3 )
Interest expense (269 ) (279 ) 10 (3.6 )
Other income (expense), net - (187 ) 187 (100.0 )
Loss on extinguishment of debt - (1,627 ) 1,627 (100.0 )
Total other income (expense), net (267 ) (2,090 ) 1,823
(87.2 )
Loss before income taxes (79,315 ) (9,726 ) (69,589 ) 715.5
Income tax provision - - - -
Net loss and comprehensive loss $ (79,315 ) $ (9,726 ) $ (69,589 ) 715.5 %
Revenue, net
Three months ended
September 30, Change
(dollars in thousands) 2021 2020 Amount %
Revenue, net $ (22,869 ) $ 18,186 $ (41,055 ) (225.8 )%
As discussed under "-Key business metrics," our gross systems shipped during the
three months ended September 30, 2021 , were 13,117, compared to 10,077 during
the comparable period in 2020. The increase in shipment volume was largely
driven by a continued expansion in national marketing efforts and customer
adoption of our telecare model. However, revenue, which is reported net of
consideration payable to customers and expected returns, decreased by
$41.1 million , or 225.8%, from $18.2 million during the three months ended
September 30, 2020 ,
to $(22.9) million during the three months ended September 30, 2021 .
The $34.4 million settlement amount associated with the DOJ investigation was
recorded as a reduction in revenue during the three months ended September 30,
2021 . Additionally, we estimate that a majority of customers with unsubmitted
claims as of September 30, 2021 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 . As a
result, we recorded $13.3 million of estimated sales returns as a reduction in
revenue in the third quarter of 2021 related to shipments to customers with
potential insurance benefits. This $13.3 million of estimated sales returns
includes a change in our accounting estimate of the expected sales returns of
$5.1 million from transactions that occurred during the first and second
quarters of 2021.
Further, we did not recognize revenue and related sales returns reserve on
approximately 670 Eargo hearing aid systems shipped during the three months
ended September 30, 2021 and subsequent to learning of the DOJ investigation, as
these transactions did not meet the criteria for revenue recognition under ASC
606. We recognized revenue on approximately 12,450 Eargo hearing aid systems
shipped to customers during the three months ended September 30, 2021 , a 23.5%
increase compared to the 10,077 Eargo hearing aid systems for which revenue was
recognized during the comparable period ended September 30, 2020 . The impact on
revenue from an increase in the volume of shipments was offset by the $34.4
million settlement amount, the increase in expected returns, which includes an
increase in expected returns from transactions occurring during the first and
second quarters of 2021, and by the hearing aid systems shipped for which we did
not recognize revenue.
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Cost of revenue, gross profit or loss, and gross margin
Three months ended
September 30, Change
(dollars in thousands) 2021 2020 Amount %
Cost of revenue $ 7,552 $ 5,434 $ 2,118 39.0 %
Gross profit (loss) (30,421 ) 12,752 (43,173 ) (338.6 )%
Gross margin * 70.1 %
* Not meaningful
Cost of revenue increased by $2.1 million , or 39.0%, from $5.4 million during
the three months ended September 30, 2020 , to $7.6 million during the three
months ended September 30, 2021 . The change was primarily due to the increase in
the volume of Eargo hearing aid systems shipped, product mix shift towards Eargo
5, which has a higher average product cost, and higher depreciation and software
amortization related to the Eargo 5 commercial launch in July 2021 .
We recorded gross loss of $30.4 million during the three months ended
September 30, 2021 , compared to gross profit of $12.8 million and gross margin
of 70.1% during the three months ended September 30, 2020 . This change is
primarily due to the $34.4 million settlement amount associated with the DOJ
investigation, the expected increase in product returns from customers with
unsubmitted claims, the approximately 670 Eargo hearing aid systems shipped
during the three months ended September 30, 2021 to our customers with potential
insurance benefits for which we did not recognize related revenue, and a product
mix shift towards Eargo 5, which has a higher cost of goods per product sold.
Estimated sales returns are recorded as a reduction in revenue. The $19.0
million of estimated sales returns recorded during the three months ended
September 30, 2021 is an increase of $12.9 million from the $6.1 million of
estimated sales returns recorded in the comparable period. This change is
primarily due to the $13.3 million of estimated sales returns recorded during
the three months ended September 30, 2021 related to the expected increase in
product returns from shipments to customers with potential insurance benefits.
We continued to process orders for customers with potential insurance benefits
from September 21, 2021 , the date we learned of the DOJ investigation, through
December 8, 2021 . We expect our gross margin to remain depressed for so long as
we are unable to accept insurance benefits as a direct method of payment unless
we can successfully target and convert new customers with a similarly low rate
of return. See "-DOJ investigation and settlement and claims audits" for more
information.
Research and development (R&D)
Three months
ended
September 30 , Change
(dollars in thousands) 2021 2020 Amount %
Research and development
R&D expenses increased by$4.4 million , or 154.1%, from$2.9 million during the three months endedSeptember 30, 2020 , to$7.3 million during the three months endedSeptember 30, 2021 . The change was primarily due to a net increase of$3.2 million in personnel and personnel-related costs which includes the impact of increased headcount and an increase in stock-based compensation of$1.3 million , and a net increase of$0.7 million in third-party costs related to current and future product development initiatives. Sales and marketing Three months ended September 30, Change (dollars in thousands) 2021 2020 Amount % Sales and marketing$ 24,444 $ 12,354 $ 12,090 97.9 % Sales and marketing expenses increased by$12.1 million , or 97.9%, from$12.4 million during the three months endedSeptember 30, 2020 to$24.4 million during the three months endedSeptember 30, 2021 . The change was primarily due to increases in direct and channel marketing, advertising and promotional expenses of$8.3 million , partially driven by increased rates due to decreased cable TV viewership in our core demographic, and an increase in personnel and personnel-related costs of$3.8 million , which includes the impact of increased headcount, higher commissions from increased sales and an increase in stock-based compensation of$1.5 million .
General and administrative
Three months ended
September 30 , Change
(dollars in thousands) 2021 2020 Amount %
General and administrative
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General and administrative expenses increased by$11.7 million , or 227.1%, from$5.2 million during the three months endedSeptember 30, 2020 , to$16.9 million during the three months endedSeptember 30, 2021 . This change was primarily due to a net increase in bad debt expense of$7.3 million , an increase in personnel and personnel-related costs of$2.6 million and an increase in general corporate costs of$1.8 million . The$7.3 million net increase in bad debt expense is primarily based on our estimate 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. The change in personnel and personnel-related costs includes compensation-related costs as a result of increased headcount as well as an increase in stock-based compensation of$1.2 million . The change in general corporate costs reflects increased costs as a result of operating as a public company.
Comparison of the nine months ended
Nine months ended
September 30, Change
(dollars in thousands) 2021 2020 Amount %
Revenue, net $ 22,062 $ 46,776 $ (24,714 ) (52.8 )%
Cost of revenue 20,311 15,295 5,016 32.8
Gross profit 1,751 31,481 (29,730 ) (94.4 )
Operating expenses:
Research and development 17,222 7,888 9,334 118.3
Sales and marketing 63,202 34,041 29,161 85.7
General and administrative 32,806 14,498 18,308 126.3
Total operating expenses 113,230 56,427 56,803 100.7
Loss from operations (111,479 ) (24,946 ) (86,533 ) 346.9
Other income (expense), net:
Interest income 19 26 (7 ) (26.9 )
Interest expense (798 ) (1,422 ) 624 (43.9 )
Other income (expense), net - (87 ) 87 (100.0 )
Loss on extinguishment of debt - (1,627 ) 1,627 (100.0 )
Total other income (expense), net (779 ) (3,110 ) 2,331 (75.0 ) Loss before income taxes (112,258 ) (28,056 ) (84,202 ) 300.1 Income tax provision - - - - Net loss and comprehensive loss$ (112,258 ) $ (28,056 ) $ (84,202 ) 300.1 % Revenue, net Nine months ended September 30, Change (dollars in thousands) 2021 2020 Amount % Revenue, net$ 22,062 $ 46,776 $ (24,714 ) (52.8 )% Our gross systems shipped during the nine months endedSeptember 30, 2021 , were approximately 36,700, compared to 26,147 during the comparable period in 2020. The increase in shipment volume was largely driven by a continued expansion in national marketing efforts and customer adoption of our telecare model. However, revenue, which is reported net of consideration payable to customers and expected returns, decreased by$24.7 million , or 52.8%, from$46.8 million during the nine months endedSeptember 30, 2020 , to$22.1 million during the nine months endedSeptember 30, 2021 . The$34.4 million settlement amount associated with the DOJ investigation was recorded as a reduction in revenue during the nine months endedSeptember 30, 2021 . Additionally, we estimate that a majority of customers with unsubmitted claims as ofSeptember 30, 2021 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 toSeptember 21, 2021 . As a result, we recorded$13.3 million of estimated sales returns as a reduction in revenue in the third quarter of 2021 related to shipments to customers with potential insurance benefits. Further, we did not recognize revenue and related sales returns reserve on approximately 670Eargo hearing aid systems shipped during the three months endedSeptember 30, 2021 and subsequent to learning of the DOJ investigation, as these transactions did not meet the criteria for revenue recognition under ASC 606. The impact on revenue from an increase in the volume of shipments was offset by the$34.4 million settlement amount, the increase in expected returns, and by the hearing aid systems shipped for which we did not recognize revenue. 36
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Cost of revenue, gross profit, and gross margin
Nine months ended
September 30, Change
(dollars in thousands) 2021 2020 Amount %
Cost of revenue $ 20,311 $ 15,295 $ 5,016 32.8 %
Gross profit 1,751 31,481 (29,730 ) (94.4 )%
Gross margin 7.9 % 67.3 %
Cost of revenue increased by $5.0 million , or 32.8%, from $15.3 million during
the nine months ended September 30, 2020 , to $20.3 million during the nine
months ended September 30, 2021 . The change was primarily due to the increase in
the volume of Eargo hearing aid systems shipped.
Gross margin decreased to 7.9% during the nine months ended September 30, 2021 ,
compared to 67.3% during the nine months ended September 30, 2020 . The decrease
in gross margins is primarily due to the $34.4 million settlement amount
associated with the DOJ investigation, the expected increase in product returns
from customers with unsubmitted claims, the approximately 670 Eargo hearing aid
systems shipped during the three months ended September 30, 2021 to our
customers with potential insurance benefits for which we did not recognize
related revenue, and a product mix shift towards Eargo 5, which has a higher
cost of goods per product sold.
Estimated sales returns are recorded as a reduction in revenue. The $32.6
million of estimated sales returns recorded during the nine months ended
September 30, 2021 is an increase of $16.7 million from the $15.9 million of
estimated sales returns recorded in the comparable period. This change is
primarily due to the $13.3 million of estimated sales returns recorded during
the three months ended September 30, 2021 related to the expected increase in
product returns from shipments to customers with potential insurance benefits.
We continued to process orders for customers with potential insurance benefits
from September 21, 2021 , the date we learned of the DOJ investigation, through
December 8, 2021 . We expect our gross margin to remain depressed for so long as
we are unable to accept insurance benefits as a direct method of payment unless
we can successfully target and convert new customers with a similarly low rate
of return. See "-DOJ investigation and settlement and claims audits" for more
information.
Research and development (R&D)
Nine months ended
September 30 , Change
(dollars in thousands) 2021 2020 Amount %
Research and development
R&D expenses increased by$9.3 million , or 118.3%, from$7.9 million during the nine months endedSeptember 30, 2020 , to$17.2 million during the nine months endedSeptember 30, 2021 . The change was primarily due to a net increase of$6.5 million in personnel and personnel-related costs, which includes the impact of increased headcount and an increase in stock-based compensation of$3.2 million , and a net increase of$1.8 million in third-party costs related to current and future product development initiatives. Sales and marketing Nine months ended September 30, Change (dollars in thousands) 2021 2020 Amount % Sales and marketing$ 63,202 $ 34,041 $ 29,161 85.7 % Sales and marketing expenses increased by$29.2 million , or 85.7%, from$34.0 million during the nine months endedSeptember 30, 2020 to$63.2 million during the nine months endedSeptember 30, 2021 . The change was primarily due to increases in personnel and personnel-related costs of$11.2 million , which includes the impact of increased headcount, higher commissions from increased sales and an increase in stock-based compensation of$5.0 million , and increases in direct and channel marketing, advertising and promotional expenses of$18.0 million , partially driven by increased rates due to decreased cable TV viewership in our core demographic. General and administrative Nine months ended September 30, Change (dollars in thousands) 2021 2020 Amount % General and administrative$ 32,806 $ 14,498 $ 18,308 126.3 % General and administrative expenses increased by$18.3 million , or 126.3%, from$14.5 million during the nine months endedSeptember 30, 2020 to$32.8 million during the nine months endedSeptember 30, 2021 . This change was primarily due to an increase in personnel and personnel-related costs of$8.1 million , a net increase in bad debt expense of$7.2 million and an increase in general corporate costs of$4.9 million . The increase was partially offset by a decrease in terminated IPO costs of$1.6 million . 37
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The change in bad debt expense is primarily based on our estimate 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. The change in personnel and personnel-related costs includes compensation-related costs as a result of increased headcount as well as an increase in stock-based compensation of$4.9 million . The change in general corporate costs reflects increased costs as a result of operating as a public company. Terminated IPO costs consist of deferred offering costs expensed upon termination of our previously planned IPO inMarch 2020 . The offering was terminated primarily because of the uncertainty in the public markets during the initial onset of the COVID-19 pandemic. Interest expense Nine months ended September 30, Change (dollars in thousands) 2021 2020 Amount % Interest expense$ (798 ) $ (1,422 ) $ 624 (43.9 )% Interest expense decreased by$0.6 million , or 43.9%, from$1.4 million during the nine months endedSeptember 30, 2020 , to$0.8 million during the nine months endedSeptember 30, 2021 . The decrease in interest expense was primarily attributable to lower long-term debt balance outstanding and lower related interest rate during the nine months endedSeptember 30, 2021 , compared to the same period endedSeptember 30, 2020 .
Liquidity and capital resources
Sources of liquidity and operating capital requirements
Since our inception, we have incurred net losses and negative cash flows from operations. We have funded our operations primarily from the net proceeds received from the sale of our equity securities, indebtedness and revenue from the sale of our products.
In connection with our IPO, we sold an aggregate of 9,029,629 shares of our
common stock at a price of
As ofSeptember 30, 2021 , we had$15.0 million in principal outstanding under the 2018 Loan, which matures inSeptember 2024 with interest-only payments untilJuly 2022 . Interest on the 2018 Loan accrues at a per annum rate equal to theWall Street Journal prime rate plus 1.0%, or 4.25% as ofSeptember 30, 2021 .
As of
We expect to incur additional substantial losses in the foreseeable future. We believe that without any future financing, our current resources are insufficient to satisfy our obligations as they become due within one year after the date that the financial statements are issued. Our negative cash flows and current lack of financial resources raise substantial doubt as to our ability to continue as a going concern. We anticipate our future operating requirements will be substantial and that we will need to raise significant additional resources to fund our operations through equity or debt financing, or some combination thereof. We are currently exploring fundraising opportunities to meet these capital requirements. If we are unable to raise additional funding to meet our operational needs, we will be forced to limit or cease our operations. In addition to our current capital needs, we regularly consider fundraising opportunities and may decide, from time to time, to raise capital based on various factors, including market conditions and our plans of operation. We may seek funds through borrowings or through additional rounds of financing, including private or public equity or debt offerings. Additional capital may not be available to us on acceptable terms on a timely basis, or at all. If adequate funds are not available, or if the terms of potential funding sources are unfavorable, our business and our ability to develop our technology and our products would be harmed. Furthermore, any new equity or convertible debt securities we issue may result in the dilution of our stockholders, and any debt financing may include covenants that restrict our business.
Our longer term future capital requirements and ability to raise additional capital will depend on many forward-looking factors and are not limited to the following:
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• investor confidence in our ability to continue as a going concern;
• the timing, receipt and amount of sales from our current and future
products;
• the costs involved in resolving the third-party claims audits and
potential recoupment of previous claims paid, as well as other legalproceedings (including the shareholder class action and derivative suits
discussed in Note 6 to the Unaudited Condensed Consolidated Financial
Statements included in this Quarterly Report on Form
10-Q),
and their duration and impact on our business generally (particularly
with respect to our ability in future periods to accept insurance as a
direct method of payment);
• the availability of insurance coverage for our hearing aid devices, and
any costs associated with reimbursement and compliance, including the
anticipated implementation of a pending OTC regulatory framework (which
may lead insurance providers to take actions limiting our ability toaccess insurance coverage and may also generally result in additional
compliance or other regulatory requirements for us), and any resulting
changes to our business model, including a potential long-term shift to a
model that excludes insurance benefits as a method of direct payment to
Eargo , which would likely result in a sustained increased cost of customer acquisition;
• the cost and timing of expanding our sales, marketing and distribution
capabilities and our continued success in reducing our customer
acquisition costs;
• any expenses, as well as the impact to our business and operating model,
as a result of changes in the regulatory landscape for hearing aid
devices;
• the cost of manufacturing, either ourselves or through third-party
manufacturers, our products;
• the terms, timing and success of any other licensing, partnership,
omni-channel, including retail, or other arrangements that we may
establish;
• any product liability or other lawsuits related to our current or future
products;
• the expenses needed to attract, hire and retain skilled personnel;
• the extent of our spending to support research and development
activities; and the expansion of our product offerings;
• the costs associated with being a public company;
• the duration and severity of the
COVID-19pandemic and its impact on our business and financial markets generally;
• the costs involved in preparing, filing, prosecuting, maintaining,
defending and enforcing our intellectual property portfolio; and
• the extent to which we acquire or invest in businesses.
Our liquidity is subject to various risks, including the risks identified in the
section titled "Risk Factors" in Item 1A of Part II. While the extent to which
we are 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 OTC hearing aid regulatory framework (which may lead
insurance providers to take actions limiting our ability to access insurance
coverage and may also generally result in additional compliance or other
regulatory requirements for Eargo ) are 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 in the future negatively impact our liquidity and working capital,
including by impacting our ability to access any additional capital.
Cash flows
The following table summarizes our cash flows for the periods indicated:
Nine months ended
September 30,
(in thousands) 2021 2020
Net cash used in operating activities
Net increase (decrease) in cash$ (55,743 ) $ 56,840
Operating activities
During the nine months endedSeptember 30, 2021 , cash used in operating activities was$53.5 million , attributable to a net loss of$112.3 million , partially offset by non-cash charges of$29.1 million and a net change in our net operating assets and liabilities of$29.7 million . Non-cash charges primarily consisted of$15.9 million in stock-based compensation,$9.3 million in bad debt expense,$2.8 million in depreciation and amortization expense, and$0.6 million in non-cash operating lease expense. The change in our net operating assets and liabilities was primarily due to the$34.4 million settlement liability associated with the DOJ investigation, a$11.3 million increase in sales returns reserve, a$5.2 million increase in accounts payable, a$1.7 million decrease in prepaid expenses and other current assets, a$1.6 million increase in other current liabilities, and a$0.6 million increase in accrued expenses. These changes were partially offset by a$20.5 million increase in accounts receivable, a$3.5 million increase in inventories, and a$0.7 million decrease in operating lease liabilities. 39
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The increase in our accounts receivable, net during the nine months endedSeptember 30, 2021 , was primarily due to the Primary Audit, during which certain claims with a service date afterMarch 1, 2021 have not yet and may never be submitted by us for reimbursement. The increase in our sales returns reserve during the three months endedSeptember 30, 2021 , was primarily due 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. Of the$15.6 million sales returns reserve recorded as ofSeptember 30, 2021 ,$12.5 million relates to unsubmitted claims that are included in accounts receivable, net. Returns associated with unsubmitted claims will reduce the sales returns reserve along with a corresponding reduction in the related accounts receivable at the time the product is returned. During the nine months endedSeptember 30, 2020 , cash used in operating activities was$20.1 million , attributable to a net loss of$28.1 million and a net change in our net operating assets and liabilities of$2.0 million , partially offset by non-cash charges of$10.0 million . Non-cash charges primarily consisted of$2.4 million in stock-based compensation,$2.1 million in bad debt expense,$1.6 million in loss on extinguishment of debt,$1.8 million in depreciation and amortization,$1.2 million in non-cash interest expense and amortization of debt discount and$0.8 million in non-cash operating lease expense. The change in our net operating assets and liabilities was primarily due to a$2.7 million increase in accounts receivable, a$0.9 million decrease in lease liabilities, a$0.6 million decrease in the sale returns reserve, a$0.4 million increase in inventories to support the growth in sales, a$0.2 million decrease in deferred revenue and a$0.1 million decrease in other liabilities. These changes were partially offset by a$1.0 million decrease in other assets, a$0.8 million increase in accrued expenses, a$0.6 million increase in accounts payable, a$0.4 million increase in other current liabilities, and a$0.2 million decrease in prepaid expenses and other current assets.
Our operating cash flows have been and will continue to be materially affected by the DOJ investigation and claims audits. See "-DOJ investigation and settlement and claims audits" for more information.
Investing activities
During the nine months endedSeptember 30, 2021 , cash used in investing activities was$6.6 million , which consisted of$2.4 million in cash paid for acquisition of a business,$3.4 million in capitalized costs related to the development of internal use software and$0.7 million related to the purchase of property and equipment.
During the nine months ended
Financing activities
During the nine months ended
During the nine months endedSeptember 30, 2020 , cash provided by financing activities was$80.3 million , attributable to$67.9 million in net proceeds from the issuance of our Series E convertible preferred stock,$19.6 million in borrowings under our term loan and paycheck protection program ("PPP") loan,$10.1 million in proceeds from the issuance of convertible notes, and$0.4 million from the exercise of stock options, partially offset by$17.3 million in debt repayments, which includes repayment of our PPP loan.
Contractual obligations and commitments
There have been no changes to our contractual obligations and commitments included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 , except for the following:
• We entered into a new lease agreement in
30,000 square feet of office and laboratory space in
93-month
term of this lease commenced in
obligations during the initial term are approximately
aggregate. We have the option to extend this lease for two additional
60-month
periods after the initial term.
• We entered into an amendment in
lease in
square feet and extended the term to
with this operating lease amendment will result in additional operating
lease obligations of
Off-balance
sheet arrangements
During the period presented, we did not have any off-balance sheet arrangements as defined in the rules and regulations of theSEC . 40
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Critical accounting policies and estimates
Management's discussion and analysis of our financial condition and results of operations is based on our unaudited condensed consolidated financial statements, which have been prepared in accordance withU.S. generally accepted accounting principles. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and assumptions regarding the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. The estimates, assumptions and judgments described below involve a substantial level of estimation uncertainty and as a result have had or are reasonably likely to have a material impact on our consolidated financial statements, results of operations and financial condition. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. There have been no significant changes in our critical accounting policies and estimates as compared to the critical accounting policies and estimates disclosed in the section titled "Management's Discussion and Analysis of Financial Condition and Operations" included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 , except as discussed below:
Revenue recognition - sales returns reserve
Each product is sold with a 45-day right of return and we have offered insurance customers with unsubmitted claims (transactions prior toDecember 8, 2021 , at which date we ceased accepting insurance benefits as a method of direct payment) 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. We account for the estimated impact of any returns as a reduction of transaction price. To estimate product sales that will be returned ( i.e. , variable consideration), we analyze various factors including historical returns, current economic trends, and changes in customer demand. Based on this information, we reserve a percentage of each dollar of product sales that provide the customer with the right of return. The transaction price includes an estimate of variable consideration up to the amount for which it is probable that a significant reversal in the amount of cumulative revenue recorded will not occur once the uncertainties surrounding the variable consideration are resolved. We estimate that a majority of customers with unsubmitted claims as ofSeptember 30, 2021 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 (as further described in "-DOJ investigation and settlement and claims audits"). As ofSeptember 30, 2021 , andDecember 31, 2020 , we recorded a sales returns reserve of$15.6 million and$4.3 million , respectively. The sales returns reserve as ofSeptember 30, 2021 , and the results of operations for the three and nine months endedSeptember 30, 2021 , include the$5.1 million change in accounting estimate related to transactions with customers with potential insurance benefits that occurred during the first and second quarters of 2021. See the caption "Sales returns reserve" under Note 4 of the Notes to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. These estimates are inherently subject to estimation uncertainty because they assume the potential actions that a substantial number of our insurance pay customers may take as a result of the unavailability of insurance benefits as a direct payment method, which increases the probability of higher returns. If actual returns differ from our estimates or new factors arise indicating a rate of return that is different from our original estimate, an adjustment to revenue in a subsequent period will be recorded, which could have a material impact on our results of operations.
Accounts receivable - allowance for doubtful accounts
Accounts receivable represents amounts from third-party institutions for credit card and debit card transactions and trade accounts receivable. Trade accounts receivable are primarily insurance claims receivable amounts due from third-party payors and end-users. Accounts receivable are recorded at invoiced amounts, net of allowances for doubtful accounts. The allowance for doubtful accounts is based on an assessment of the collectability of accounts. Management regularly reviews the adequacy of the allowance for doubtful accounts by considering the age of each outstanding invoice, each customer's expected ability to pay, and the collection history with each customer, when applicable, to determine whether a specific allowance is appropriate. 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 whose claims are denied by insurance providers or are not submitted by us for payment may not pay for or return the hearing aid system. As ofSeptember 30, 2021 , andDecember 31, 2020 , we recorded an allowance for doubtful accounts of$4.6 million and$1.9 million , respectively, in the condensed consolidated balance sheets. The allowance for doubtful accounts as ofSeptember 30, 2021 , and the results of operations for the three and nine months endedSeptember 30, 2021 , include the impact of the$6.1 million change in accounting estimate related to insurance claims receivable balances from transactions that occurred during the first and second quarters of 2021. See the caption "Allowance for doubtful accounts" under Note 4 of the Notes to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. As similarly described in "-sales returns reserve" above, estimates with respect to the actions of our customers, in this case relating to non-payment, are subject to estimation uncertainty, particularly because any attempt to predict the behavior of individual customers can be affected by a variety of external factors. If actual credit losses differ from our estimates or new factors arise indicating credit losses that are different from our original estimate, it could have a material impact on our future operating expenses and results of operations 41
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Loss contingencies
We are subject to various loss contingencies arising in the ordinary course of business. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. If some amount within a range of probable loss appears to be a better estimate than any other amount within the range, we accrue that amount. Alternatively, when no amount within a range of probable loss appears to be a better estimate than any other amount, we accrue the lowest amount in the range. If we determine that a loss is reasonably possible and the range of the loss is estimable, then we disclose the range of the possible loss if the upper end of the range is material. If we cannot estimate the range of loss, we will disclose the reason why we cannot estimate the range of loss and if there is a reasonable possibility that the amount of loss may be material. We regularly evaluate current information available to it to determine whether an accrual is required, an accrual should be adjusted and if a range of possible loss should be disclosed. Estimated accruals for contingencies are made based on the best information reasonably available, which can be highly subjective and result in estimation uncertainty. Our accruals for contingencies may fluctuate from period to period as a result of new information becoming available, which can occur sporadically and without forewarning. See also our significant legal proceedings as discussed in Note 6 to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
Recent accounting pronouncements
See Note 2 of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information about recent accounting pronouncements, the timing of their adoption, and our assessment. JOBS Act Accounting Election
As of
We elected to use this extended transition period to enable us to comply with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our consolidated financial statements and our interim condensed consolidated financial statements may not be comparable to companies that comply with new or revised accounting pronouncements. The aggregate worldwide market value of our voting common stock held by non-affiliates (or public float) exceeded$700 million onJune 30, 2021 , and we were deemed to be a "large accelerated filer" under Rule 12b-2 of the Exchange Act as of the end of the 2021 fiscal year. As a large accelerated filer, we ceased to qualify as an emerging growth company as ofDecember 31, 2021 .
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