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

You should read the following discussion and analysis of our financial condition
and results of operations together with our consolidated financial statements
and the related notes included in Part II, Item 8 of this Annual Report on Form
10-K.

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 Annual Report on Form 10-K, 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. Our innovative products 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-the-canal, FDA-regulated 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 primarily in a direct-to-consumer format
with a personalized, consumer-centric approach. Our commercial organization
consists of a marketing team with deep experience in consumer-focused brand and
performance marketing, a team of inside sales consultants, and a dedicated
customer support team.

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 109,000 Eargo hearing aid systems shipped,
net of returns, as of December 31, 2022. To date, all our revenue has been
generated from customers in the United States.

For the year ended December 31, 2022, we generated net revenue of $37.2 million,
an increase of $5.1 million from the year ended December 31, 2021. Our gross
systems shipped during the year ended December 31, 2022 were 24,247, compared to
45,136 during 2021. The decrease in shipment volume was largely driven by our
decision to temporarily stop accepting insurance benefits as a method of direct
payment between December 8, 2021 and September 15, 2022. During the year ended
December 31, 2021, we recorded adjustments that materially reduced net revenue
as discussed in detail below under "-DOJ investigation and settlement and claims
audits."

Our net losses were $157.5 million, $157.8 million and $39.9 million for the
years ended December 31, 2022, 2021 and 2020, respectively. As of December 31,
2022 and 2021, we had an accumulated deficit of $514.3 million and $356.8
million, respectively. We expect to continue to incur losses for the foreseeable
future. As of December 31, 2022, we had cash and cash equivalents of $101.2
million, which are available to fund operations. As of December 31, 2022, we had
no debt outstanding.

DOJ investigation and settlement and claims audits

As previously disclosed, on September 21, 2021, we were informed that we were
the target of a criminal investigation by the DOJ related to insurance claims we
submitted for reimbursement on behalf of our customers covered by various
federal employee health plans under the Federal Employee Health Benefits
("FEHB") program, which is administered by the Office of Personnel Management
(the "OPM"). The investigation also pertained to our role in claim submissions
to federal employee health plans (collectively, the "DOJ investigation"). Total
payments the Company received from the government in relation to claims
submitted under the FEHB program, as subject to the DOJ investigation, net of
any product returns and associated refunds, were approximately $44.0 million.
Also as previously disclosed, the third-party payor with whom historically we
had the largest volume, which is one of the carriers contracted with the OPM
under the FEHB program ("largest third-party payor"), conducted an audit of
insurance claims for reimbursement ("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 claims audits by
additional third-party payors (collectively with the Primary Audit, the "claims
audits"). One of these claims audits did 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 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

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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. As discussed further in
Note 6 to the Consolidated Financial Statements included in this Annual Report
on Form 10-K, based on the settlement agreement with the U.S. government, we
recorded a settlement liability of $34.4 million in the consolidated balance
sheets as of December 31, 2021. The settlement amount was recorded as a
reduction of revenue in the third quarter of 2021. On May 2, 2022, we paid the
settlement amount.

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

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

From December 8, 2021 until September 15, 2022, we did not accept insurance benefits as a method of direct payment.

We determined that customer transactions using insurance benefits as a method of
direct payment occurring between September 21, 2021 (when we learned of the DOJ
investigation) and December 8, 2021 (when we temporarily stopped accepting
insurance benefits as a method of direct payment) did not meet the criteria for
revenue recognition and, as a result, we did not recognize revenue for shipments
within that timeframe to customers with potential insurance benefits,
substantially all of whom were covered under the FEHB program.

We previously estimated that a majority of customers with unsubmitted claims
would choose to return the hearing aid system if their insurance provider denied
their claim or the claim was ultimately not submitted by us for payment,
resulting in an increase in expected product returns from sales transactions
that occurred prior to September 21, 2021 and recorded during the year ended
December 31, 2021. Returns associated with unsubmitted claims reduce the sales
returns reserve, with a corresponding reduction in the related accounts
receivable at the time the product is returned.

We also estimated that, in addition to the customers who chose to return their
hearing aid systems, a significant number of customers whose claims were denied
by payors or not submitted by us for payment would not pay for or return the
hearing aid system, resulting in bad debt expense that was recorded during the
year ended December 31, 2021.

During the year ended December 31, 2022, we made the determination not to seek
payment for approximately $16.1 million from customers with unsubmitted and
unpaid claims. We accounted for this decision as a pricing concession (the
"Pricing Concession") and, during the year ended December 31, 2022 recorded a
$16.1 million reduction to our insurance-related accounts receivable balance
along with related reduction to net revenue of $11.6 million and an allowance
for credit losses balance of $4.5 million for such unsubmitted and unpaid
claims. Further, we simultaneously recorded a decrease in our insurance-related
sales return reserve of $11.3 million, with a corresponding increase of $11.3
million to net revenue for the year ended December 31, 2022 related to
unsubmitted and unpaid claims. These changes resulted in a decrease in net
revenue of $0.3 million for the year ended December 31, 2022.

On January 5, 2022, the U.S. District Court for the Northern District of
California consolidated three purported securities class actions brought against
the Company (as consolidated, the "Securities Class Action"). On May 20, 2022,
the lead plaintiffs in the Securities Class Action filed a consolidated amended
complaint, which generally alleges that certain of the Company's disclosures
about its business, operations and prospects, including reimbursement from
third-party payors, violated federal securities laws. Defendants filed a motion
to dismiss the consolidated amended complaint on July 29, 2022. The Court
granted the defendants' motion to dismiss on February 14, 2023, and the
plaintiffs have until March 16, 2023, to file a second amended complaint.

On August 4, 2022, the U.S. District Court for the Northern District of
California consolidated two verified shareholder derivative complaints brought
against certain of our executive officers and current and former members of our
board of directors (as consolidated, the "Derivative Action"). The court stayed
the consolidated Derivative Action until the resolution of the motion to dismiss
the Securities Class Action. See Note 6 of the Notes to Consolidated Financial
Statements included in this Annual Report on Form 10-K 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:

•

We temporarily restricted our employees from selling Company common stock,
ceased granting stock option awards and restricted stock unit ("RSUs") that
settle solely in Company common stock, suspended our 2020 Employee Stock
Purchase Plan ("ESPP") and temporarily paused the settlement of outstanding
RSUs, in each case effective as of November 9, 2021 (collectively, the "employee
equity actions"). RSUs that vested on November 15, 2021 were settled for $0.1
million in cash during the first quarter of 2022. All RSUs that vested during
the year ended December 31, 2022 were settled in shares during the reporting
period. All outstanding equity awards continued and continue to vest in
accordance with their existing vesting schedules.

•

Our Board of Directors temporarily 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. In August 2022, our
non-employee directors were granted options having an aggregate grant date fair
value of $26.80 per share that vested in substantially equal monthly
installments between November 9, 2021 and the date of the 2022 annual meeting of
stockholders, and vested options remain outstanding and exercisable until the
later of December 31, 2024 or 3 months following a termination of service.

•

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.

•

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

Patient Square Capital Investment

On June 24, 2022, after reviewing all available alternatives to secure the
funding needed to support our ongoing operations and pursuit of our business
strategies, and a potential sale of the Company, we entered into an agreement
(the "Note Purchase Agreement") with PSC Echo, LP (the "PSC Stockholder"), an
affiliate of Patient Square Capital ("Patient Square"), and Drivetrain Agency
Services, LLC, as administrative agent and collateral agent. Pursuant to the
Note Purchase Agreement, we issued approximately $105.5 million in two tranches
of senior secured convertible notes (the "Notes") and agreed to conduct a rights
offering for an aggregate of 18.75 million shares of common stock to
stockholders as of a record date determined by our Board, at an offering price
of $10.0 per share of common stock (the "Rights Offering"). Pursuant to the
Rights Offering, which closed on November 23, 2022, we sold an aggregate of
approximately 2.9 million shares to our existing stockholders, from which we
received net proceeds of $27.6 million, and, in accordance with the terms of the
Note Purchase Agreement, the Notes converted into 15,821,299 shares of our
common stock (the "Conversion Shares"), in each case, on a post-reverse stock
split basis, representing approximately 76.3% of our outstanding common stock as
of the date of conversion.

In connection with the Note Purchase Agreement, we had also entered into an
Investors' Rights Agreement with the PSC Stockholder, pursuant to which, among
other things, the PSC Stockholder has the right to nominate a number of
directors to our Board that is proportionate to the PSC Stockholder's ownership
of the Company, rounded up to the nearest whole number (and which shall in no
event be less than one). As a result, following the closing of the Rights
Offering and the conversion of the Notes, the PSC Stockholder has the right to
nominate six directors to our Board. The PSC Stockholder exercised its right to
nominate three directors to the Board, Trit Garg, M.D., Karr Narula and Justin
Sabet-Peyman, in December 2022.

As of March 20, 2023, the PSC Stockholder held 15,821,299 shares, representing
approximately 76.3% of our outstanding common stock. As a result of Patient
Square's ownership position, we are considered a "controlled company" within the
meaning of the marketplace rules (the "Listing Rules") of the Nasdaq Stock
Market ("Nasdaq") and Patient Square may be able to determine all matters
requiring stockholder approval.

Reverse Stock Split

On October 12, 2022, at our 2022 annual meeting of stockholders, our
stockholders approved an amendment to our Amended and Restated Certificate of
Incorporation to effect a reverse stock split of our common stock, at a ratio in
the range of 1-for-5 to 1-for-50, with such ratio to be determined by the Board.
On January 11, 2023, we announced that the Board had approved a 1-for-20 reverse
stock split (the "Reverse Stock Split"), and on January 17, 2023, the Reverse
Stock Split was effected. Our common stock began trading on a split-adjusted
basis on January 18, 2023. All share and per share information presented in this
Annual Report on Form 10-K has been retrospectively adjusted to reflect the
Reverse Stock Split.

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Factors affecting our business

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

Our direct-to-consumer and omni-channel business model

We sell our hearing aids primarily on a direct-to-consumer basis, engaging
consumers through a mix of digital and traditional marketing as well as select
commercial partnership, omni-channel (including retail) and other opportunities
that are designed to appeal to prospective customers on a personal level and
build our brand.

Via our direct-to-consumer model, customers are able to complete purchases over
the phone with an Eargo sales consultant or directly on our website. The Eargo
purchasing experience is designed to be simple and to improve the accessibility
of hearing aids.

Following the United States Food and Drug Administration ("FDA") final rule
regarding the creation of a new category of over-the-counter ("OTC") hearing
aids (the "OTC Final Rule"), we have focused efforts on transitioning to the new
OTC framework and exploring select additional commercial partnerships,
omni-channel (including retail) and other opportunities. For example, we have a
commercial arrangement with Victra, one of America's largest wireless retailers,
to facilitate access to our hearing screeners and demonstrate our devices at
approximately 1,500 Victra store locations across the country; customers are
also able to purchase or order Eargo hearing aids at such store locations. We
believe that the OTC Final Rule may facilitate the opportunity to execute
additional commercial partnerships, expanding our customers' ability to learn
about our hearing aids, obtain general information about their hearing through
our current hearing screeners, and experience our devices in person prior to
purchasing or ordering directly at retail locations.

Moreover, following the effective date of the OTC Final Rule, we have partnered
with certain resellers and other distributors, including benefits managers, to
offer Eargo hearing aids for sale through their online storefronts or portals.
Under these partnerships, we sell Eargo hearing aids to resellers at wholesale
prices, who in turn offer our products to end-customers through their respective
online storefronts or portals. Generally, we fulfill and ship orders placed
through these online storefronts or portals directly to end-customers, and we
generally do not submit insurance claims on behalf of customers who purchase
from one of these authorized resellers, including Victra. We believe these
partnerships will help expand consumer access to our hearing aids and allow us
to target high-intent customers more efficiently. We continue to look for
additional partners to help expand our customer base.

Once a customer purchases Eargo hearing aids, whether directly through us or
through one of our partners, distributors, or authorized resellers, they are
assigned to one of our hearing professionals, who provides complimentary,
convenient support by phone, chat or e-mail. Our hearing professionals and
customer care team are also available to provide unlimited support for as long
as the customer owns an Eargo device. Additionally, we provide short, online
training videos and other resources that customers can access online. The
combination of these services allows us to deliver remote customer support in an
efficient and streamlined manner.

We believe our business model and consumer-centric focus offer certain
advantages relative to traditional sales channels (which are characterized by a
business-to-business model in which hearing aid manufacturers rely on a
fragmented network of independent audiology clinics to sell their devices to
consumers), including in particular the convenience and accessibility of our
remote customer support as well as our consumer-centric focus. We offer free
online education, convenient consultation and remote customer support, the
ability to easily purchase the Eargo system, and fast delivery.

Changes to the regulatory landscape

Hearing aids are considered medical devices subject to regulation by the FDA. On
August 17, 2022, the FDA published the OTC Final Rule, which established new
regulatory categories for OTC and prescription hearing aids. The OTC Final Rule
implements relevant provisions of the FDA Reauthorization Act of 2017 ("FDARA"),
which set forth requirements for the FDA 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. Prior to
the effective date of the OTC Final Rule, no OTC category of hearing aids
existed. Following publication of a proposed rule in October 2021, the FDA
issued its OTC Final Rule with requirements for labelling, conditions of sale,
performance standards, design requirements and other provisions under which
manufacturers may elect to market hearing aids as either OTC or prescription
devices, or both. In addition, under FDARA, the OTC hearing aid controls
promulgated in the OTC Final Rule preempt any state or local requirement
specifically related to hearing products that would restrict or interfere with
commercial activity involving OTC hearing aids. The OTC Final Rule became
effective on October 17, 2022, although certain previously marketed devices have
until April 14, 2023 to come into compliance with the OTC Final Rule.

We have marketed in the past, and continue to market, certain Eargo system
devices as Class I air-conduction or Class II wireless air-conduction hearing
aids under existing regulations at 21 CFR 874.330 and 874.3305, respectively,
both of which are exempt from 510(k) premarket review. In June 2022, we
submitted a 510(k) premarket notification seeking FDA clearance of expanded
labelling

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for our Eargo 5 and Eargo 6 hearing aids under the "self-fitting" regulation at
21 CFR 874.3323. In December 2022, we received FDA 510(k) clearance for Eargo 5
and Eargo 6 as Class II self-fitting air-conduction hearing aids. Additionally,
in January 2023, we launched the Eargo 7 as our third over-the-counter, 510(k)
cleared self-fitting device. We plan to market our devices as OTC hearing aids
and intend to comply with all applicable OTC regulatory requirements as of the
compliance date for currently marketed devices on April 14, 2023, or sooner. We
may also seek to market certain devices as prescription hearing aids, which
would require compliance with separate physical and electronic labeling
requirements under the OTC Final Rule.

In connection with the OTC Final Rule, we have expended, and will continue to
expend, significant time and resources evaluating the OTC Final Rule and
ensuring that our devices and processes comply with the new requirements in
order to market our products in line with our primary direct-to-consumer
business and omni-channel models. It is possible that the OTC Final Rule may
lead to additional commercial partnership, omni-channel, including retail, or
other opportunities, although there are no assurances that it will do so. The
OTC 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 Factors titled, "Changes in the regulatory landscape for
hearing aid devices could materially impact our direct-to-consumer business
model and lead to increased regulatory requirements, and we may be required to
seek additional clearance or approval for our products" and "Our hearing aids
are subject to extensive government regulation at the federal and state level,
and our failure to comply with applicable requirements could harm our business"
for more information.

Insurance-related business

A significant portion of our revenue has historically been dependent on payments
from third-party payors; for example, in the year ended December 31, 2021, 44%
of total gross systems shipped were to customers with potential insurance
coverage. Historically, we submitted claims on behalf of our customers to a
concentrated number of third-party payors under certain benefit plans, and
substantially all such claims related to the FEHB program. See "-DOJ
investigation and settlement and claims audits" for a discussion of the DOJ
investigation and settlement as well as claims audits prior to the resumption of
our insurance claims submissions practices in September 2022.

Between December 8, 2021 and September 15, 2022, we did not accept insurance
benefits as a direct method of payment to the Company, a practice we refer to as
"direct plan access." In "direct plan access," we submit an insurance claim on
behalf of an Eargo customer to their insurance plan, or support an Eargo
customer in their own claim submission, and the customer's insurance benefits
are utilized for the purchase, in whole or in part. Common forms of utilization
can include, but are not limited to, co-pay, payment by a third-party payor to
either Eargo or the customer, reimbursement by a third-party payor to the
customer, or application toward a customer's deductible.

Because we do not currently have contracts with any FEHB carriers, third-party
payors, or other insurance providers, our products are considered out-of-network
with such payors and insurance providers. We do not believe that the
reimbursement amounts, patient co-payment amounts, or the claims submission
process, including medical necessity and other documentation requirements,
depend on whether we are in-network or out-of-network with that FEHB carrier or
other FEHB plans. To illustrate, the hearing aid benefit in an FEHB plan is a
set amount that covers the hearing aid itself and related fees and supplies,
regardless of the plan option and regardless of whether the hearing aid is
provided by a preferred, participating, or non-participating provider (i.e.,
regardless of whether it is in-network or out-of-network), which is not always
the case for other benefit categories. However, depending on the FEHB carrier or
third-party payor, payment may be made directly to the patient rather than to us
if Eargo is out-of-network.

Beginning on September 15, 2022, we resumed our direct plan access
insurance-based business, accepting insurance benefits as a method of direct
payment in certain limited circumstances, when the customer has undergone
additional testing by an independent, licensed healthcare provider to establish
medical necessity, with supporting clinical documentation. We are evaluating
additional alternatives for testing or establishing medical necessity,
including, but not limited to, contracting with third parties or existing
networks of licensed healthcare providers, and/or establishing a management
services organization, separate from our existing corporate structure, that
manages professional entities that employ licensed healthcare providers. These
alternatives involve significant time and related activities, including, but not
limited to, development of additional internal processes, training, and
compliance and quality control programs, coordination with external healthcare
providers and professional services organizations, and evaluation of and
compliance with state-by-state regulatory requirements. We cannot provide any
assurance as to the efficacy of the processes that we have established or the
extent to which such processes will need to be changed, or additional processes
established, or the associated timing or costs, whether we will be successful in
implementing any of them, or the impact that such processes and changes may have
on our business and operations. If we are unable to successfully implement at
least one of these alternatives for testing, or to otherwise establish
additional acceptable processes to support claims that we may submit for
reimbursement, we expect that we may not be able to submit future claims in
sufficient volume to meaningfully restore or expand the amount of our
insurance-based business related to direct plan access. In addition, it is
possible that such testing would be required to be conducted in-person,
representing a significant change from our past processes and customer
experience that may adversely impact the attractiveness of our offerings to
customers, and we may not be able to efficiently or effectively integrate such
tests into our operating model. Further, the OTC Final

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Rule may lead payors to take additional actions, such as excluding OTC hearing
aids from coverage, further limiting our ability to access insurance coverage,
or there may be a delay in accessing insurance coverage as payors seek to
address the OTC Final Rule in their offered benefits, if at all, any of which
may have a material adverse effect on our financial condition, results of
operations or cash flows.

We are also seeking to establish relationships with benefits managers or managed
care providers. Employer self-funded plans or other health plans may at times
offer supplemental benefits, which may include hearing aid benefits or general
"over-the-counter" benefits; they may in those cases contract with benefits
managers or managed care providers in the administration of such supplemental
benefits. In this role, among other things, benefits managers are responsible
for selecting benefits vendors, i.e., vendors whose products or services are
eligible to be covered by the supplemental benefit. The vendors themselves, or
Eargo in this role, are not responsible for claims submissions but instead
fulfill the product order from the customer through the benefits manager.

We cannot provide any assurances that we will be able to maintain or increase
our participation in arrangements with third-party payors, insurance carriers,
benefits managers, or managed care providers or that we will be adequately
reimbursed or otherwise paid by such parties for the products we sell, which may
have a material adverse effect on our financial condition, results of operations
or cash flows.

In light of the DOJ investigation, claims audits and the OTC Final Rule, we have
made and may continue to need to make significant changes to our business and
operating model, including a potential long-term shift to a model without a
meaningful insurance-related business, 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 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 primarily "cash-pay" basis since December 8,
2021. 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."

Efficient acquisition of new customers

We have spent significant amounts on sales and marketing designed to build a
strong brand, achieve broad awareness of our Eargo system, acquire new customers
and convert sales leads. Since our public disclosure of the DOJ investigation on
September 22, 2021 and our related decision to temporarily stop accepting
insurance benefits as a method of direct payment between December 8, 2021 and
September 15, 2022, we have experienced and may continue to experience a
material decline in sales and gross systems shipped.

From December 8, 2021 until September 15, 2022, as a result of the DOJ
investigation and claims audits (as further described in "-DOJ investigation and
settlement and claims audits"), we did not accept insurance as a direct method
of payment to the Company (referred to as "direct plan access"). Instead, all
sales within such timeframe were to customers we refer to as "cash-pay" or
"self-pay" customers, which includes upfront payment, credit card, third-party
financing, and third-party distributor, authorized reseller or partner payments.
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 continue to work with third-party payors with the objective of
validating and establishing additional processes to support any future claims
that we may submit for reimbursement, we may not be able to arrive at additional
acceptable processes or submit future claims in sufficient volume to
meaningfully restore or expand our insurance-based business. The shift to a
primarily "cash-pay" model, with minimal volume from our customers using
insurance benefits as a direct method of payment to Eargo, 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 direct plan access insurance customers. We
anticipate that our expansion into retail locations may allow for a more
streamlined sales process; however, it may not ultimately reduce our cost of
customer acquisition due to new sales and marketing initiatives related to such
expansion. We are currently unable to predict whether our expansion into retail
locations will affect the return rate for our cash-pay customers, and the impact
any such change may have on our cost of customer acquisition. Further, the low
volume of direct plan access insurance customers using 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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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, for example, the previously extended right of return offered for
shipments made prior to 2022 involving insurance payors. Historically, the most
commonly cited reason for returning our hearing aids is unsatisfactory fit,
which we believe is a by-product of our direct-to-consumer model and online
distribution that results in nearly all of our customers ordering our product
without trying it first. In addition to unsatisfactory fit, the next most cited
reason for returns is that our hearing aids do not provide sufficient audio
amplification.

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

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 7 in February 2023, we have now launched seven generations
of our hearing aids since 2017, with each iteration having increased
functionality and improved sound quality, amplification, noise reduction,
physical fit, comfort, water resistance and ease-of-use, as well as reduced
costs of goods and better connectivity. We are focused on continuing to launch
new versions of the Eargo hearing aid devices that further improve these
attributes. We believe that the continued introduction of new products is
critical to maintaining existing customers, attracting new customers, achieving
market acceptance of our products and maintaining or increasing our competitive
position in the market.

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

Recruitment and retention of personnel

Our success depends in part upon our continued ability to recruit, retain and
motivate high-quality employees, including management, administrative, our
clinical and scientific personnel and our direct sales force (among others), and
competition for qualified personnel can be intense due to the limited number of
individuals possessing the requisite training, skill and experience we require.
As a result of uncertainty created by the DOJ investigation and the claims
audits, we temporarily suspended our practice of granting equity awards,
suspended our employee stock purchase plan and deferred the settlement of
outstanding restricted stock units, in each case effective as of November 9,
2021. We resumed granting RSUs on March 18, 2022 and resumed granting stock
option awards on August 23, 2022. However, as of February 1, 2023, we have again
suspended our practice of granting RSUs.

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

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

Macroeconomic environment

Our business, results of operation and financial condition are dependent on
macroeconomic conditions. We face domestic as well as global macroeconomic
challenges, particularly in light of the effects of the COVID-19 pandemic,
inflationary trends, uncertainty or volatility in the market (including recent
and potential disruption in the banking system and financial markets) and
geopolitical events (such as the conflict in Ukraine and tensions across the
Taiwan Strait).

We believe the COVID-19 pandemic accelerated the pace of consumer awareness of
our vertically integrated remote customer support model and facilitated customer
adoption of the same. Shelter-in-place restrictions and increased reluctance of
consumers to conduct

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in-person activities, particularly among older individuals that comprise a
majority of the population needing hearing aids, resulted in increased knowledge
of our business and sales and a potential acceleration of consumer acceptance of
our primarily direct-to-consumer business model. However, we cannot be sure
whether this trend in consumer behavior will persist or if consumers will
instead return to pre-pandemic patterns. In addition, the benefits of such
trends in consumer behavior, to the extent they persist, may be outweighed by
other macroeconomic factors, including, but not limited to, inflationary
pressures, financial market volatility, and slower growth or recession, which
can adversely impact consumer confidence and result in lower discretionary
consumer spending. If these macroeconomic pressures continue or increase, we may
experience an adverse impact on demand for our products. Additionally, our
business is also subject to disruptions in the banking system and financial
markets and other uncertainties or volatility in the markets. For example, on
March 10, 2023, the Federal Deposit Insurance Corporation (the "FDIC") took
control and was appointed receiver of Silicon Valley Bank ("SVB"). Although the
FDIC ultimately announced that it would pay all deposits, including deposits
that exceeded FDIC-insured amounts, we and other SVB customers initially were
not able to access our accounts and faced significant uncertainty about whether
and when we would be able to fully access amounts held through SVB, which would
have had several follow-on consequences with respect to our ability to meet our
near-term payment obligations. If other banks and financial institutions enter
receivership or become insolvent in the future in response to financial
conditions affecting the banking system and financial markets, our ability to
access our existing cash, cash equivalents and investments may be threatened and
could have a material adverse effect on our business and financial condition. In
addition, even if we lack exposure to the uncertainty or volatility of one or
more financial institutions, the impact of financial institution volatility on
our partners, customers or suppliers may also impact our business and financial
condition.

We rely on a number of international suppliers and manufacturers, including our
primary manufacturer, Pegatron Corporation, who is headquartered in Taiwan,
which exposes us to foreign operational and political risks such as changes in
trade policies and export regulations between the United States and other
countries or geopolitical conflict. Additionally, although we believe the
COVID-19 pandemic has largely resulted in favorable consumer trends for our
business, travel restrictions, factory closures and disruptions in global supply
chains have resulted in industry-wide component supply shortages (such as in
semiconductors), and we may not be able to obtain adequate inventory on a timely
basis or at all. To date, increases in component pricing have occurred but have
not had a material impact on supply continuity or gross margin. We have taken
steps to monitor our supply chain and actions to address limited supply and
increasing lead times, including outreach to critical suppliers and spot market
purchases. While we have not experienced any significant disruptions to our
supply chain that have impacted our ability to service customers or our 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,
geopolitical events or other extrinsic factors. Future disruptions in our supply
chain, including the sourcing of certain components and raw materials, such as
semiconductor and memory chips, as well as increased logistics costs, could
impact our revenue and gross margins.

For a further discussion of trends, uncertainties and other factors that could
impact our operating results, see the section titled "Risk Factors" in Item 1A
of Part I in this Annual Report on Form 10-K.

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:

•

Gross systems shipped. We define our gross systems shipped as the number of
hearing aid systems shipped during the period. Since our public disclosure of
the DOJ investigation on September 22, 2021 and our related decision to
temporarily stop accepting insurance benefits as a method of direct payment
between December 8, 2021 and September 15, 2022, we have experienced and may
continue to experience a material decline in gross systems shipped. Beginning on
September 15, 2022, we resumed accepting insurance benefits as a method of
direct payment in certain limited circumstances and for which revenue is and has
been recognized. Continued negative publicity, including in relation to the DOJ
investigation and settlement, 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.

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

                                                         Three months ended
              Mar 31,      Jun 30,      Sep 30,       Dec 31,       Mar 31,       Jun 30,       Sep 30,       Dec 31,
                2021         2021         2021         2021          2022          2022          2022          2022
Gross
systems
shipped         11,704       12,548       13,117         7,767         5,773         4,455         5,156         8,863
Sales
returns
rate              23.2 %       24.1 %       46.4 %        34.0 %        33.9 %        33.3 %        32.3 %        34.9 %


During the twelve months ended December 31, 2022 and 2021, Eargo shipped 24,247
and 45,136 gross hearing aid systems, respectively, of which less than 1% and
44%, respectively, were to customers with potential insurance coverage. We made
the decision to temporarily stop accepting insurance benefits as a method of
direct payment between December 8, 2021 and September 15, 2022. Beginning
September 2022, we resumed accepting insurance benefits as a method of direct
payment in certain limited circumstances and for which revenue is and has been
recognized. Additionally, during the fourth quarter of 2022, we shipped Eargo
hearing devices to Victra, our retail partner, for in-person customer sales at
its approximately 1,500 store locations across the United States, for which we
recognize revenue upon shipment to our retail partner.

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 the 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 and gross margin may
remain depressed as compared to prior periods for so long as there is minimal
volume from our customers using insurance benefits as a direct method of payment
to Eargo; however, we are currently unable to predict whether the expansion of
our omni-channel strategy (including retail and other partners) will affect our
return rate for cash-pay customers, and the impact any such change may have on
our revenue, gross profit and gross margin.

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 primarily from the sale of Eargo hearing aid systems. We
market a variety of models of hearing aids, 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 expected returns, which is an estimate informed in part by
historical return rates.

Since learning of the DOJ investigation, we temporarily suspended all insurance
claims submissions and, from December 8, 2021 until September 15, 2022, did not
accept insurance as a direct method of payment. Instead, we focused our efforts
on cash-pay customers, which includes upfront payment, credit card payments,
third-party financed payments and distributor payments. Historically, cash-pay
customers have had significantly higher return rates than customers with
potential insurance benefits, and therefore the potential long-term shift to
primarily cash-pay sales may adversely impact revenue, net. Beginning on
September 15, 2022, we resumed accepting insurance benefits as a method of
direct payment in certain limited circumstances.

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 and any
potential actions insurance providers may take following the implementation of
the FDA's new OTC hearing aid regulatory framework that may limit our ability to
access insurance coverage.

We expect our gross margin to remain depressed for so long as there is minimal
volume from our customers using insurance benefits as a direct method of payment
to Eargo, unless we can successfully target and convert new customers with a
similarly low rate of return.

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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.

Sales and marketing expenses

Our sales and marketing expenses have generally been 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
direct sales force consisting of 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 the 2021 and 2022
reductions in force.

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, transaction fees,
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.

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. In connection with the fair value option, we elected to present interest expense related to the Notes in the changes in fair value.

Change in fair value of convertible notes

We elected on issuance to account for the Notes at fair value until their
settlement. The change in fair value of the convertible notes is recognized in
the consolidated statements of operations, with the exception of changes in fair
value due to instrument-specific credit risk, which are recorded as a component
of other comprehensive income, if present.

Loss on extinguishment of debt

The loss on extinguishment of debt arose from the early repayment of long-term debt under our 2018 Loan Agreement in June 2022.

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.

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Results of operations

Comparison of the years ended December 31, 2022 and 2021

We made the decision to temporarily stop accepting insurance benefits as a
method of direct payment between December 8, 2021 and September 15, 2022 as a
result of the DOJ investigation and claims audits (as further described in "-DOJ
investigation and settlement and claims audits"). Beginning in late 2021, as a
result of the impact of the DOJ investigation on the Company's business and
financial condition, we shifted our strategy 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 2022 and 2021 fiscal
years reflect a trend of decreasing expenditures due to the implementation of
capital and liquidity preservation measures.

                                                   Year ended
                                                  December 31,                    Change
(dollars in thousands)                         2022           2021         Amount           %
Revenue, net                                $   37,248     $   32,122     $   5,126          16.0 %
Cost of revenue                                 22,988         27,956        (4,968 )       (17.8 )
Gross profit (loss)                             14,260          4,166        10,094         242.3
Operating expenses:
Research and development                        18,813         25,232        (6,419 )       (25.4 )
Sales and marketing                             52,947         85,759       (32,812 )       (38.3 )
General and administrative                      54,259         49,882         4,377           8.8
Total operating expenses                       126,019        160,873       (34,854 )       (21.7 )
Loss from operations                          (111,759 )     (156,707 )      44,948         (28.7 )
Other income (expense), net:
Interest income                                  1,196             21         1,175             *
Interest expense                                  (549 )       (1,068 )         519         (48.6 )
Change in fair value of convertible notes      (45,503 )            -       (45,503 )           *
Loss on extinguishment of debt                    (772 )            -          (772 )           *
Total other income (expense), net              (45,628 )       (1,047 )     (44,581 )           *
Loss before income taxes                      (157,387 )     (157,754 )         367          (0.2 )
Income tax provision                               100              -           100             *
Net loss and comprehensive loss             $ (157,487 )   $ (157,754 )   $     267          (0.2 )%


* Not Meaningful

Revenue, net

                              Year ended
                             December 31,                Change
(dollars in thousands)     2022         2021       Amount        %
Revenue, net             $ 37,248     $ 32,122     $ 5,126       16.0 %


Gross systems shipped during 2022 were 24,247, compared to 45,136 in 2021, of
which less than 1% and 44%, respectively, were to customers with potential
insurance coverage. The decrease in shipment volume was largely driven by our
decision to temporarily stop accepting insurance benefits as a method of direct
payment in the fourth quarter of 2021. Beginning September 2022, we resumed
accepting insurance benefits as a method of direct payment in certain limited
circumstances and for which revenue is and has been recognized. Additionally,
during the fourth quarter of 2022, we shipped Eargo hearing devices to Victra,
our retail partner, for in-person customer sales at its approximately 1,500
store locations across the United States, for which we recognize revenue upon
shipment to our retail partner.

Revenue, which is reported net of consideration payable to customers and
expected returns, increased by $5.1 million, or 16.0%, from $32.1 million during
the year ended December 31, 2021 to $37.2 million during the year ended December
31, 2022.

In September 2022, we made the determination not to seek payment for
approximately $16.1 million from customers with unsubmitted and unpaid claims,
or the Pricing Concession. This decision resulted in a reduction in net revenue
of $0.3 million for the year ended December 31, 2022 after the remeasurement of
the corresponding sales return reserve and the utilization of the related
allowance for expected credit losses.

During the year ended December 31, 2021, the $34.4 million settlement amount
associated with the DOJ investigation was recorded as a reduction in revenue.
Additionally, we previously estimated that a majority of customers with
unsubmitted claims as of December 31, 2021 would choose to return the hearing
aid system if their insurance provider denied their claim or the claim was
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

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returns reserve on approximately 2,230 Eargo hearing aid systems shipped during the year ended December 31, 2021 and subsequent to learning of the DOJ investigation, as these transactions did not meet the criteria for revenue recognition.

Cost of revenue, gross profit, and gross margin

                              Year ended
                             December 31,                 Change
(dollars in thousands)     2022         2021        Amount         %
Cost of revenue          $ 22,988     $ 27,956     $ (4,968 )     (17.8 )%
Gross profit               14,260        4,166       10,094       242.3 %
Gross margin                 38.3 %       13.0 %


Cost of revenue decreased by $5.0 million, or 17.8%, from $28.0 million during
2021 to $23.0 million during 2022. The change was primarily due to the decrease
in the volume of Eargo hearing aid systems shipped, partially offset by charges
related to certain slow moving inventory items.

Gross margin increased to 38.3% during 2022, compared to 13.0% during 2021. The
increase in gross margins is primarily due to revenue-related adjustments made
in 2021, including the $34.4 million settlement amount associated with the DOJ
investigation, the expected increase in product returns from customers with
unsubmitted claims, as well as the approximately 2,230 Eargo hearing aid systems
shipped during the year ended December 31, 2021, for which no revenue was
recognized as the transactions did not meet criteria for revenue recognition.

Estimated sales returns are recorded as a reduction in revenue. The $18.2
million of estimated sales returns recorded during 2022 significantly decreased
from the $37.7 million of estimated sales returns recorded during 2021. The
reduction is attributable primarily to $13.3 million recorded during the year
ended December 31, 2021 for estimated sales returns related to the expected
increase in product returns from shipments to customers with potential insurance
benefits and the reduction in the number of our gross systems shipped during the
year ended December 31, 2022.

Research and development (R&D)

                                Year ended
                               December 31,                 Change

(dollars in thousands) 2022 2021 Amount % Research and development $ 18,813 $ 25,232 $ (6,419 ) (25.4 )%

R&D expenses decreased by $6.4 million, or 25.4%, from $25.2 million during 2021
to $18.8 million during 2022. The change was primarily due to the impact of
decreased headcount, a net decrease of $5.5 million in personnel and
personnel-related costs due in part to a decrease in stock-based compensation,
primarily related to the suspension of our ESPP in November 2021 and a reduction
in cumulative compensation costs of $1.8 million recognized during the year
ended December 31, 2022 related to the non-achievement of certain performance
targets for restricted stock units. Additionally, during the year ended December
31, 2022, there was a net decrease of $1.1 million in third-party costs
subsequent to the commercial launches of Eargo 5 in July 2021 and Eargo 6 in
January 2022.

Sales and marketing

                              Year ended
                             December 31,                 Change
(dollars in thousands)     2022         2021        Amount          %
Sales and marketing      $ 52,947     $ 85,759     $ (32,812 )     (38.3 )%


Sales and marketing expenses decreased by $32.8 million, or 38.3%, from $85.8
million during 2021 to $52.9 million during 2022. The change was primarily due
to decreases in direct marketing, advertising and promotional expenses of $19.5
million due to a reduction in media spend following our decision to temporarily
stop accepting insurance benefits as a method of direct payment on December 8,
2021, and decreases in personnel and personnel-related costs of $13.3 million
due to decreased headcount and suspension of our ESPP in November 2021.

General and administrative

                                  Year ended
                                 December 31,               Change
(dollars in thousands)         2022         2021       Amount        %
General and administrative   $ 54,259     $ 49,882     $ 4,377       8.8 %


General and administrative expenses increased by $4.4 million, or 8.8%, from
$49.9 million during 2021 to $54.3 million during 2022. This change was
primarily due to an increase of $6.6 million in general corporate costs
primarily related to legal, accounting, consulting and other professional fees
driven by activities related to the DOJ investigation and compliance matters and
increase in

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insurance overhead costs as a result of operating as a public company, and $5.7
million in third-party costs related to the issuance of the Notes. The increase
was partially offset by a net decrease in bad debt expense during the year ended
December 31, 2022. During the year ended December 31, 2021 our bad debt expense
was higher by $8.9 million, based on our estimate that 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.

Interest income

                             Year ended
                            December 31,           Change

(dollars in thousands) 2022 2021 Amount % Interest income $ 1,196 $ 21 $ 1,175 *

Interest income increased by $1.2 million, from $0.1 million during 2021 to $1.2
million during 2022. The increase in interest income was primarily attributable
to the increased interest rates on cash balances during 2022.

Interest expense

                             Year ended
                            December 31,                Change
(dollars in thousands)    2022        2021        Amount         %
Interest expense         $ (549 )   $ (1,068 )   $    519       (48.6 )%


Interest expense decreased by $0.5 million, or 48.6%, from $1.1 million during
2021 to $0.6 million during 2022. The decrease in interest expense was primarily
attributable to the repayment of long-term debt under our 2018 Loan Agreement in
June 2022 and our accounting policy election to account for the Notes at fair
value and include interest expense related to the Notes in the changes in fair
value.

Change in fair value of convertible notes

                                                Year ended
                                               December 31,             Change
(dollars in thousands)                        2022        2021       Amount       %

Change in fair value of convertible notes $ (45,503 ) $ - $ (45,503 ) *

The change in fair value of convertible notes payable of $45.5 million for the
year ended December 31, 2022 represents the difference between the fair value of
the Notes at issuance and the fair value of the Conversion Shares on the dates
of settlement. Prior to the closing of the Rights Offering, the fair value of
the Notes was estimated as a combination of our equity, an option on our equity
valued using the Black-Scholes option pricing model, and a short position in a
bond valued under the discounted cash flow model. The conversion date fair value
of the Notes was estimated based on the closing price of the Company's common
stock adjusted for the impact of certain legal restrictions on the Conversion
Shares.

Loss on extinguishment of debt

                                     Year ended
                                    December 31,            Change
(dollars in thousands)             2022        2021      Amount      %

Loss on extinguishment of debt $ (772 ) $ - $ (772 ) *

Loss on extinguishment of debt of $0.8 million for the year ended December 31, 2022 arose from the early repayment of long-term debt under our 2018 Loan Agreement in June 2022.

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Comparison of the years ended December 31, 2021 and 2020

                                           Year ended
                                          December 31,                   Change
(dollars in thousands)                 2021          2020          Amount          %
Revenue, net                        $   32,122     $  69,154     $  (37,032 )     (53.6 )%
Cost of revenue                         27,956        21,873          6,083        27.8
Gross profit                             4,166        47,281        (43,115 )     (91.2 )
Operating expenses:
Research and development                25,232        12,045         13,187       109.5
Sales and marketing                     85,759        49,525         36,234        73.2
General and administrative              49,882        20,582         29,300       142.4
Total operating expenses               160,873        82,152         78,721        95.8
Loss from operations                  (156,707 )     (34,871 )     (121,836 )     349.4
Other income (expense), net:
Interest income                             21            37            (16 )     (43.2 )
Interest expense                        (1,068 )      (1,920 )          852       (44.4 )
Other income (expense), net                  -        (1,474 )        1,474 

*

Loss on extinguishment of debt               -        (1,627 )        1,627 

*

Total other income (expense), net (1,047 ) (4,984 ) 3,937

      (79.0 )
Loss before income taxes              (157,754 )     (39,855 )     (117,899 )     295.8
Income tax provision                         -             -              -           -
Net loss and comprehensive loss     $ (157,754 )   $ (39,855 )   $ (117,899 )     295.8 %


* Not Meaningful

Revenue, net

                              Year ended
                             December 31,                 Change
(dollars in thousands)     2021         2020        Amount          %
Revenue, net             $ 32,122     $ 69,154     $ (37,032 )     (53.6 )%


Gross systems shipped during 2021 were 45,136, compared to 38,243 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 $37.0 million, or 53.6%, from $69.2 million
during the year ended December 31, 2020 to $32.1 million during the year ended
December 31, 2021.

The $34.4 million settlement amount associated with the DOJ investigation was
recorded as a reduction in revenue during the year ended December 31, 2021.
Additionally, we estimated that a majority of customers with unsubmitted claims
will choose to return the hearing aid system if their insurance provider denies
their claim or the claim is ultimately not submitted by us for payment,
resulting in an increase in expected product returns from such transactions that
occurred prior to September 21, 2021. 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 2,230 Eargo hearing aid systems shipped during third and fourth
quarters of 2021 subsequent to learning of the DOJ investigation, as these
transactions did not meet the criteria for revenue recognition. We recognized
revenue on approximately 42,910 Eargo hearing aid systems shipped to customers
during 2021, a 12.2% increase compared to the 38,243 Eargo hearing aid systems
for which revenue was recognized during 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 from customers with potential insurance
benefits and with unsubmitted claims as of December 31, 2021, and by the hearing
aid systems shipped for which we did not recognize revenue.

Cost of revenue, gross profit, and gross margin

                              Year ended
                             December 31,                 Change
(dollars in thousands)     2021         2020        Amount          %
Cost of revenue          $ 27,956     $ 21,873     $   6,083        27.8 %
Gross profit                4,166       47,281       (43,115 )     (91.2 )%
Gross margin                 13.0 %       68.4 %




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Cost of revenue increased by $6.1 million, or 27.8%, from $21.9 million during
2020 to $28.0 million during 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.

Gross margin decreased to 13.0% during 2021, compared to 68.4% during 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 2,230 Eargo
hearing aid systems shipped during the third and fourth quarters of 2021 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 $37.7
million of estimated sales returns recorded during 2021 is an increase of $15.0
million from the $22.7 million of estimated sales returns recorded during 2020.
This change is primarily due to $13.3 million of estimated sales returns
recorded during the third quarter of 2021 related to the expected increase in
product returns from shipments to customers with potential insurance benefits.

Research and development (R&D)

                                Year ended
                               December 31,                 Change

(dollars in thousands) 2021 2020 Amount % Research and development $ 25,232 $ 12,045 $ 13,187 109.5 %

R&D expenses increased by $13.2 million, or 109.5%, from $12.0 million during
2020 to $25.2 million during 2021. The change was primarily due to a net
increase of $10.6 million in personnel and personnel-related costs, which
includes the impact of increased headcount and an increase in stock-based
compensation of $6.1 million, and a net increase of $1.8 million in third-party
costs related to current and future product development initiatives.

Sales and marketing

                              Year ended
                             December 31,                Change
(dollars in thousands)     2021         2020        Amount        %
Sales and marketing      $ 85,759     $ 49,525     $ 36,234       73.2 %


Sales and marketing expenses increased by $36.2 million, or 73.2%, from $49.5
million during 2020 to $85.8 million during 2021. The change was primarily due
to increases in direct marketing, advertising and promotional expenses of $18.9
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 $17.3 million, which includes the impact of increased
headcount (a trend that was reversed in the fourth quarter of 2021 as further
described in the introductory paragraph to this "-Results of operations" and
"-DOJ investigation and settlement and claims audits"), higher commissions from
increased sales and an increase in stock-based compensation of $9.6 million.

General and administrative

                                  Year ended
                                 December 31,                 Change
(dollars in thousands)         2021         2020        Amount         %
General and administrative   $ 49,882     $ 20,582     $ 29,300       142.4 %


General and administrative expenses increased by $29.3 million, or 142.4%, from
$20.6 million during 2020 to $49.9 million during 2021. This change was
primarily due to an increase in general corporate costs of $14.3 million, an
increase in personnel and personnel-related costs of $9.7 million, and a net
increase in bad debt expense of $7.3 million.

The change in general corporate costs includes $8.4 million in legal and other
professional fees as a result of the DOJ investigation as well as increased
costs as a result of operating as a public company. 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 $6.3
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.

Interest expense

                              Year ended
                             December 31,                 Change
(dollars in thousands)     2021         2020        Amount         %
Interest expense         $ (1,068 )   $ (1,920 )   $    852       (44.4 )%




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Interest expense decreased by $0.9 million, or 44.4%, from $1.9 million during
2020 to $1.1 million during 2021. The decrease in interest expense was primarily
attributable to lower long-term debt balance outstanding and lower related
interest rate during 2021 as compared 2020.

Other income (expense), net

                                  Year ended
                                 December 31,           Change

(dollars in thousands) 2021 2020 Amount % Other income (expense), net $ - $ (1,474 ) $ 1,474 *

Other income (expense), net during 2020 consisted primarily of 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. There was no similar expense in the comparable period of 2021.

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.

On June 28, 2022 (the "First Tranche Closing"), we completed the initial issuance of $100.0 million aggregate principal amount of Notes (the "First Tranche Notes"). The Notes were secured by a first-priority lien on substantially all our assets, including our intellectual property. We used approximately $16.2 million of the net proceeds from the First Tranche Notes issuance to repay all existing third-party indebtedness and related pay-off expenses.

Pursuant to the Note Purchase Agreement, the PSC Stockholder agreed to purchase
up to an additional $25.0 million of Notes if the Company completed the Rights
Offering within 150 days after the First Tranche Closing and the existing
stockholders of Eargo subscribed to purchase less than 3,750,000 shares of newly
issued common stock in such Rights Offering.

The Rights Offering expired on November 17, 2022 and existing stockholders of
Eargo subscribed for an aggregate of approximately 2.9 million shares of common
stock. On November 23, 2022, the Rights Offering was consummated, and we
received net proceeds of approximately $27.6 million from existing stockholders.
In accordance with the terms of the Note Purchase Agreement, on November 25,
2022, the PSC Stockholder purchased an additional approximately $5.5 million of
aggregate principal amount of Notes (the "Second Tranche Notes").

On November 23, 2022, the First Tranche Notes converted into an aggregate of
15,000,000 shares of our common stock, and on November 25, 2022 the Second
Tranche Notes converted into an aggregate of 821,299 shares of our common stock,
in each case pursuant to the Note Purchase Agreement. Following such conversion,
the PSC Stockholder beneficially owned approximately 76.3% of the outstanding
common stock. As of December 31, 2022, we had no debt outstanding.

As of December 31, 2022, we had cash and cash equivalents of $101.2 million,
which are available to fund our operations. Cash and cash equivalents include
amounts deposited in financial institutions regulated by the FDIC. The FDIC
insures cash deposits of up to $250,000. We regularly maintain cash balances in
deposit accounts in excess of the FDIC insured limits. Additionally, our cash
equivalents are held in accordance with cash sweep arrangements with financial
institutions, which amounts are invested in money market accounts that are
neither included on the balance sheets of such financial institutions nor
insured by the FDIC. According to our cash sweep arrangements, we believe we
should be recognized by the FDIC as the owner of such assets in the event of
such financial institution's failure, such as the March 10, 2023 closure of SVB.
While we have regained access to our funds at SVB and are evaluating our banking
relationships, future disruptions of financial institutions where we bank or
disruptions of the financial services industry in general could adversely affect
our ability to access our cash and cash equivalents. If we are unable to access
our cash and cash equivalents as needed, our financial position and ability to
operate our business could be adversely affected. In addition, even if we lack
exposure to the uncertainty or volatility of one or more financial institutions,
the impact of financial institution volatility on our partners, customers or
suppliers may also impact our business and financial condition.

Our net losses were $157.5 million, $157.8 million and $39.9 million for the
years ended December 31, 2022, 2021 and 2020, respectively. We had an
accumulated deficit of $514.3 million as of December 31, 2022. 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.

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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. Uncertainty in the market
generally due to increasing interest rates and inflation may make it challenging
to raise additional capital, and such 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 expected future capital requirements and ability to raise additional capital
will depend on many forward-looking factors, including but not limited to the
following:

•

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 third-party claims audits, as well as other
legal proceedings (including the shareholder class action and derivative actions
discussed in Note 6 to the Consolidated Financial Statements included in this
Annual Report on Form 10-K), and their duration and impact on our business
generally;

•

the availability of insurance coverage for our hearing aid devices, and any
costs associated with reimbursement and compliance, including following the
implementation of the OTC Final Rule (which may lead insurance providers to take
actions limiting our ability to access insurance coverage), and any resulting
changes to our business model, including a potential long-term shift to a model
that generally 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;

•

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 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 I. While the extent to which we
are able to validate and establish additional processes to support the
submission of claims for reimbursement to health plans, including those under
the FEHB program, and the future impacts of the implementation of the FDA's new
OTC hearing aid regulatory framework (which may lead insurance providers to take
actions limiting our ability to access insurance coverage) are difficult to
assess or predict at this time, since the announcement of the DOJ investigation
and our related decision to temporarily stop accepting insurance benefits as a
method of direct payment between December 8, 2021 and September 15, 2022, 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.



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Cash flows

The following table summarizes our cash flows for the periods indicated:

                                               Twelve months ended December 

31,

(in thousands)                                    2022                   

2021

Net cash used in operating activities $ (117,304 ) $ (98,456 ) Net cash used in investing activities

                 (3,087 )               (7,587 )
Net cash provided by financing activities            111,129                

4,358

Net decrease in cash and cash equivalents $ (9,262 ) $ (101,685 )

Operating activities

In 2022, cash used in operating activities was $117.3 million, attributable to a
net loss of $157.5 million, partially offset by non-cash charges of $69.4
million and a net change in our net operating assets and liabilities of $29.2
million. Non-cash charges primarily consisted of $45.5 million related to the
change in fair value of convertible notes, $10.0 million in stock-based
compensation, $5.7 million in debt issuance costs from convertible notes, $5.5
million in depreciation and amortization expense, $1.1 million in non-cash
operating lease expense, $0.8 million in loss on extinguishment of debt, and
$0.7 million in bad debt expense. The change in our net operating assets and
liabilities was primarily due to the payment of $34.4 million settlement
liability associated with the DOJ investigation, a $9.9 million decrease in
sales returns reserve and a $2.8 million decrease in accounts payable. These
changes were partially offset by a $9.9 million decrease in accounts receivable,
a $4.3 million decrease in prepaid expenses and other current and noncurrent
assets, a $3.7 million increase in accrued expenses and a $0.7 million decrease
in inventories.

In 2021, cash used in operating activities was $98.5 million, attributable to a
net loss of $157.8 million, partially offset by non-cash charges of $43.2
million and a net change in our net operating assets and liabilities of $16.1
million. Non-cash charges primarily consisted of $27.7 million in stock-based
compensation that includes the amounts recorded upon the suspension of the ESPP
in the fourth quarter of 2021, $9.6 million in bad debt expense, $4.2 million in
depreciation and amortization expense, and $1.1 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 $9.5 million increase in sales returns reserve, and a $3.1
million increase in accounts payable. These changes were partially offset by a
$18.4 million increase in accounts receivable, a $7.4 million increase in
prepaid expenses and other current and noncurrent assets and a $3.0 million
increase in inventories.

Investing activities

In 2022, cash used in investing activities was $3.1 million, which consisted of
$2.8 million related to the purchase of property and equipment and $0.3 million
in payments for costs related to the development of internal use software
capitalized during 2021.

In 2021, cash used in investing activities was $7.6 million, which consisted of
$3.8 million in capitalized costs related to the development of internal use
software, $2.9 million in cash paid for acquisition of a business, and $0.9
million related to the purchase of property and equipment.

Financing activities

In 2022, cash provided by financing activities was $111.1 million. This was
primarily attributable to $99.7 million in net proceeds from issuance of the
Notes and $27.6 million in net proceeds from issuance of our common stock upon
the Rights Offering closing, offset by $16.2 million relating to the repayment
of long-term debt under the 2018 Loan Agreement.

In 2021, cash provided by financing activities was $4.4 million. This was primarily attributable to $2.7 million from employee stock purchase plan purchases and $1.7 million from the exercise of stock options.

Critical accounting estimates

Management's discussion and analysis of our financial condition and results of
operations is based on our consolidated financial statements, which have been
prepared in accordance with U.S. generally accepted accounting principles. Our
significant accounting policies and methods used in the preparation of our
consolidated financial statements are described in Note 2 of the Notes to
Consolidated Financial Statements included in Part II, Item 8 of this Annual
Report on Form 10-K.

The preparation of the 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.

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Revenue recognition-sales returns reserve

Revenue is recorded net of expected returns, which are estimated based on analysis of various factors including historical returns, current economic trends, and changes in customer demand.

As of December 31, 2022 and 2021, we recorded a sales returns reserve of $3.9
million and $13.8 million, respectively, in the consolidated balance sheets. We
recorded $18.2 million of estimated sales returns as a reduction in revenue
during 2022 based on our estimated returns of products sold during the year,
which includes $13.3 million recorded during the third quarter of 2021 primarily
based on 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 (as further
described in "-DOJ investigation and settlement and claims audits"). See also
the caption "Sales returns reserve" under Note 4 of the Notes to the
Consolidated Financial Statements included in this Annual Report on Form 10-K.
The estimated sales returns recorded during the third quarter of 2021 included
$5.1 million related to transactions that occurred during the first and second
quarters of 2021. 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-estimated credit losses

Accounts receivable is recorded net of an allowance for expected credit losses, which is based on our historical collection experience, current and future economic market conditions and a review of the current aging status and financial condition of our customers.

As of December 31, 2022 and 2021, we recorded an allowance for credit losses of
$0.2 million and $4.8 million, respectively, in the consolidated balance sheets.
We recorded $0.7 million and $9.6 million in bad debt expense during the years
ended December 31, 2022 and 2021, respectively. Bad debt expense recorded in
2021 was primarily based on our 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. Of the $9.6 million recorded to bad debt expense during the year ended
December 31, 2021, $5.8 million relates to submitted claims that have been
denied or have not been paid and were written off during 2021. During the year
ended December 31, 2022, we released $4.5 million from the allowance for credit
losses balance as part of the Pricing Concession. See the captions "DOJ
investigation and settlement and claims audits" and "Allowance for credit
losses" in the Notes 1 and 4 to our Consolidated Financial Statements included
in this Annual Report on Form 10-K.

As similarly described in "Revenue recognition-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.

Stock-based compensation-valuation of equity awards

The valuation model used for calculating the estimated fair value of stock
options and purchase rights granted under the employee stock purchase plan is
the Black-Scholes option-pricing model. The Black-Scholes model requires us to
make assumptions and judgments about the variables used in the calculations,
including the expected term (weighted-average period of time that the
stock-based awards are expected to be outstanding), the expected volatility of
our common stock, the related risk-free interest rate and the expected dividend.
We have elected to recognize forfeitures of stock options as they occur.

The Black-Scholes option-pricing model requires the use of highly subjective assumptions which determine the fair value of stock-based awards. These assumptions include:

•

Fair value of common stock. For grants prior to our IPO in October 2020, the
fair value of our common stock underlying share-based awards was estimated on
each grant date by our board of directors. In order to determine the fair value
of our common stock underlying option grants, our board of directors considered,
among other things, valuations of our common stock prepared by an unrelated
third-party valuation firm in accordance with the guidance provided by the
American Institute of Certified Public Accountants Practice Guide, Valuation of
Privately-Held-Company Equity Securities Issued as Compensation. For all grants
subsequent to our IPO in October 2020, the fair value of common

                                       75
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stock was determined by using the closing price per share of common stock as reported on the Nasdaq Global Select Market.

•

Expected term. The expected term represents the period that share-based awards
are expected to be outstanding. The expected term for option grants is
determined using the simplified method. The simplified method deems the term to
be the average of the time-to-vesting and the contractual life of the
share-based awards.

•

Expected volatility. Since we had been privately held and did not have any
trading history for our common stock and subsequent to our IPO have limited
trading history for our common stock, the expected volatility was estimated
based on the average volatility for comparable publicly traded companies over a
period equal to the expected term of the stock option grants. The comparable
companies were chosen based on their similar size, stage in the life cycle or
area of specialty.

•

Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of option.

•

Expected dividend. We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero.

Recent accounting pronouncements

See Note 2 to our consolidated financial statements appearing under Part II,
Item 8 for more information about recent accounting pronouncements, the timing
of their adoption, and our assessment.

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