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    EAR   US2700871096

EARGO, INC.

(EAR)
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EARGO, INC. Management's Discussion and Analysis of Financial Condition and Results of Operations. (form 10-Q)

05/13/2022 | 04:28pm EDT
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 of Eargo's results of operations and financial
condition, in conjunction with the consolidated financial statements and notes
for the fiscal year ended December 31, 2020 contained in the Company's Form
10-K
filed on March 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 the Eargo solution to create a hearing
aid that consumers actually want to use. Our innovative product and
go-to-market
approach address the major challenges of traditional hearing aid adoption,
including social stigma, accessibility and cost.

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

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

We believe that our differentiated hearing aids and consumer-oriented approach
have fueled the rapid adoption of our hearing aids and high customer
satisfaction, as evidenced by over 88 thousand Eargo hearing aid systems sold,
net of returns, as of September 30, 2021.

For the nine months ended September 30, 2021, we generated net revenue of
$22.1 million, a decrease of $24.7 million from the nine months ended
September 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 on September 22, 2021 when we learned of the investigation
by the DOJ related to our role in customer reimbursement claim submissions to
various federal employee health plans under the FEHB program. To date, all our
revenue has been generated from customers in the United States.

Our net losses were $112.3 million and $28.1 million for the nine months ended
September 30, 2021 and 2020, respectively. As of September 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, on September 21, 2021, we were informed that we were
the target of a criminal investigation by the U.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. On January 4, 2022, the DOJ confirmed to us that the
investigation had been referred to the Civil Division of the DOJ and the U.S.
Attorney's Office for the Northern District of Texas and the criminal
investigation was no longer active.

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

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The settlement with the U.S. government may not resolve all of the audits of
insurance reimbursement claims by the various third-party payors, and
additionally we remain subject to a prepayment review of claims by the payor who
conducted the Primary Audit. 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 until December 8, 2021, we
continued to process orders for customers with potential insurance benefits
(including FEHB program members) but suspended all claims submission activities
and offered affected customers (
i.e.
, customers using insurance benefits as a method of direct payment for
transactions prior to December 8, 2021) the option to return their hearing aids
or purchase their hearing aids without the use of their insurance benefits in
case their claim is denied or ultimately not submitted by us to their insurance
plan for payment (the "extended right of return").

Beginning on December 8, 2021, we made the decision to stop accepting insurance
benefits as a method of direct payment and it is uncertain when, if ever, we
will resume accepting insurance benefits as a method of direct payment. While we
intend to work with the government and third-party payors 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 ended September 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 through
December 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 on
September 21, 2021 did not meet the criteria for revenue recognition under ASC
606. As such, we did not recognize revenue for shipments to customers with
potential insurance benefits, substantially all of whom were covered under the
FEHB program, subsequent to that date.

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
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 has had a
negative impact on our revenues for the three and nine months ended
September 30, 2021 and resulted in an increase in our sales returns reserve. Of
the $15.6 million sales returns reserve recorded as of September 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 ended September 30, 2021. We recorded an allowance
for doubtful accounts of $4.6 million as of September 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 ended September 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 ended September 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 the Office of Personnel Management (the "OPM") on and establish
processes for supporting the submission of these claims, and we may be unable to
do so.

On January 5, 2022, the U.S. District Court for the Northern District of
California consolidated three purported securities class actions brought against
the Company (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. On
December 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.

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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-employee

directors automatically on the date of our annual meeting of stockholders

          held on November 9, 2021.


• On December 7, 2021, we announced a plan to reduce our employee workforce

to streamline our organization in response to declines in customer orders

          since we announced the 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 our Eargo system, acquire new customers
and convert sales leads. Since our public disclosure of the DOJ investigation on
September 22, 2021, we have experienced and may continue to experience a
material decline in gross systems shipped.

Beginning on December 8, 2021, as a result of the DOJ investigation and claims
audits (as further described in "-DOJ investigation and settlement and claims
audits") we do not currently accept insurance as a direct method of payment, and
all sales from such date are considered by us to be
"cash-pay,"
which includes upfront payment, credit card, third-party financing, and
distributor payment. We have refocused our sales and marketing efforts and
related spend to prioritize conversion of
cash-pay
consumer leads into satisfied customers. While we intend to work with 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.

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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 of September 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 of
September 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 since December 8, 2021.
Following the civil settlement with the U.S. government on April 29, 2022, we
may be unsuccessful in validating and establishing processes to support the
submission of claims for reimbursement from third-party payors participating in
the FEHB program in the future. As a result, we have faced a significant
reduction in revenue and any failure to establish processes to support
reimbursement from third-party payors in the future may significantly and
adversely impact our business and growth prospects and our ability to sell our
products."

Sales returns rate

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

We report revenue net of expected returns, which is an estimate informed in part
by historical return rates. As such, our returns rate impacts our reported net
revenue and gross profit or loss. Sales returns rates, as defined under "-Key
business metrics," increased from 24% for the three months ended June 30, 2021
to 46% for the three months ended September 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 ended September 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 ended September 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 the Eargo 5 in July 2021 and the launch of Eargo 6 in January 2022, we
have now launched six generations of our hearing aids since 2017, with each
iteration having increased functionality and improved sound quality,
amplification, noise reduction, physical fit, comfort, water resistance and
ease-of-use,
as well as reduced costs of goods and better connectivity. We are focused on
continuing to launch new versions of the Eargo hearing aid devices that further
improve these attributes. We believe that the continued introduction of new
products is critical to maintaining existing customers, attracting new
customers, achieving market acceptance of our products and maintaining or
increasing our competitive position in the market.

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

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 on September 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 of
November 9, 2021. In addition, on December 7, 2021, we announced a plan to
reduce our employee workforce to streamline our organization in response to
declines in customer orders since we announced the DOJ investigation. We
substantially completed the employee workforce 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 the U.S.
government, and the claims audits, could continue to adversely affect employee
morale and have a material adverse impact on our ability to recruit, retain and
motivate the high-quality employees critical to our operations, which in turn
could have a material adverse effect on our business, results of operations and
financial condition.

COVID-19
pandemic

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

Although we believe the
COVID-19
pandemic has largely resulted in favorable trends for our business, we have
experienced business disruptions, particularly at our California headquarters,
where a majority of our employees have been working remotely (which we permitted
as an accommodation to our employees despite the fact that we were never
required to close our facilities because we were deemed to have an essential
workforce under the relevant California
COVID-19
measures). Moreover, travel restrictions, factory closures and disruptions in
global supply chains have resulted in industry-wide component supply shortages
(such as in semiconductors), and we may not be able to obtain adequate inventory
on a timely basis or at all. To date, increases in component pricing have
occurred but have not had a material impact on supply continuity. 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 September 30, 2021 but subsequent to learning of

the DOJ investigation. Since our public disclosure of the DOJ

investigation on September 22, 2021, we have experienced and may continue

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 ended

September 30, 2021 does not include the impact of the $5.1 million of

estimated 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 December 31, 2021, we shipped approximately 7,760 and 45,130 gross hearing aid systems, respectively, approximately 20% and 44% of which, respectively, were to customers with potential insurance coverage.


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 of Eargo hearing aid systems, accessories and,
to a lesser extent, sales of extended warranties, with the majority of our
revenue coming from sales of our Eargo hearing aid systems. Following the launch
of Eargo 6 in January 2022, we currently offer four versions of our hearing aid
systems, the Eargo Max, the Eargo Neo HiFi, the Eargo 5, and the Eargo 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.

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As described in more detail in "-DOJ investigation and settlement and claims
audits," we did not recognize revenue for shipments after September 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 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 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
on December 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
for Eargo).

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 of September 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
to September 21, 2021 to customers with potential insurance benefits for which
there was no revenue recognition in the three months ended September 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 on December 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 the SEC, and those of the Nasdaq
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.

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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 July 2020.


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 in July 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 in October 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 in July
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 ended September 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 ended September 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.

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Comparison of the three months ended September 30, 2021 and 2020

                                      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 $ 7,296 $ 2,871 $ 4,425 154.1 %




R&D expenses increased by $4.4 million, or 154.1%, from $2.9 million during the
three months ended September 30, 2020, to $7.3 million during the three months
ended September 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 ended September 30, 2020 to $24.4 million
during the three months ended September 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 $ 16,887 $ 5,163 $ 11,724 227.1 %




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General and administrative expenses increased by $11.7 million, or 227.1%, from
$5.2 million during the three months ended September 30, 2020, to $16.9 million
during the three months ended September 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 September 30, 2021 and 2020

                                        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 ended September 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 ended September 30, 2020, to $22.1 million during the
nine 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 nine 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.

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. 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.

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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 $ 17,222 $ 7,888 $ 9,334 118.3 %




R&D expenses increased by $9.3 million, or 118.3%, from $7.9 million during the
nine months ended September 30, 2020, to $17.2 million during the nine months
ended September 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 ended September 30, 2020 to $63.2 million
during the nine months ended September 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 ended September 30, 2020 to $32.8 million
during the nine months ended September 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.

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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 in March 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 ended September 30, 2020, to $0.8 million during the nine months
ended September 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 ended September 30, 2021, compared to the
same period ended September 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 $18.00 per share, resulting in net proceeds of $148.5 million after deducting underwriting discounts, commissions and offering expenses.


As of September 30, 2021, we had $15.0 million in principal outstanding under
the 2018 Loan, which matures in September 2024 with interest-only payments until
July 2022. Interest on the 2018 Loan accrues at a per annum rate equal to the
Wall Street Journal prime rate plus 1.0%, or 4.25% as of September 30, 2021.

As of September 30, 2021, we had cash and cash equivalents of $156.4 million, which are available to fund operations, and an accumulated deficit of $311.3 million. Cash and cash equivalents as of December 31, 2021 were approximately $110 million.


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 legal

proceedings (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 to

access 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-19

pandemic 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 $ (53,499 ) $ (20,052 ) Net cash used in investing activities (6,570 ) (3,445 ) Net cash provided by financing activities 4,326 80,337


Net increase (decrease) in cash             $ (55,743 )    $  56,840



Operating activities


During the nine months ended September 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.

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The increase in our accounts receivable, net during the nine months ended
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. The increase in our sales returns reserve
during the three months ended September 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 of September 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 ended September 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 ended September 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 September 30, 2020, cash used in investing activities was $3.4 million, which consisted of $2.6 million in capitalized costs related to the development of internal use software and $0.8 million related to the purchase of property and equipment.

Financing activities

During the nine months ended September 30, 2021, cash provided by financing activities was $4.3 million. This was attributable to $2.7 million from employee stock purchase plan purchases and $1.7 million from the exercise of stock options.


During the nine months ended September 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 ended December 31, 2020, except for the following:

• We entered into a new lease agreement in September 2021 for approximately

30,000 square feet of office and laboratory space in San Jose,

California. The initial

93-month

term of this lease commenced in September 2021 and the contractual

obligations during the initial term are approximately $9.4 million in

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 February 2021 related to our operating

lease in Nashville, Tennessee, that reduced our office space to 9,327

square feet and extended the term to March 31, 2023. Payments associated

with this operating lease amendment will result in additional operating

lease obligations of $0.5 million plus operating expenses.

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 the SEC.

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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 with U.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 ended December 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 to December 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 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 (as further described in "-DOJ investigation and settlement
and claims audits"). As of September 30, 2021, and December 31, 2020, we
recorded a sales returns reserve of $15.6 million and $4.3 million,
respectively. The sales returns reserve as of September 30, 2021, and the
results of operations for the three and nine months ended September 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 of
September 30, 2021, and December 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 of
September 30, 2021, and the results of operations for the three and nine months
ended September 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

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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 September 30, 2021, we were an "emerging growth company," as defined in the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies.


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 on June 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 of
December 31, 2021.

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