Freshworks’ Latest Legal Tangle Raises Red Flags Over Growth Claims

As reported earlier today, SaaS giant Freshworks is looking at a potential class action lawsuit in the US over allegedly misleading investors in the run-up to its Nasdaq listing last year.

Litigation firms Scott+Scott, Bronstein, Gewirtz & Grossman, Schall Law, and Kahn Swick & Foti have alerted investors and shareholders in the company about the lawsuit filed by Mohan R Sundaram in the US District Courts, California Northern District Court. Sundaram’s lawsuit is against Freshwork, its directors including investors as well as bankers that had underwritten the IPO.

While our earlier report on the potential class action lawsuit was based on information released by the above litigation firms, Inc42 has since then seen a copy of the original lawsuit filed by Sundaram. It is not yet clear how many shares were owned by Sundaram and what was the quantum of his personal losses (even if notional) for that holding.

In it, the plaintiff has alleged that Freshworks’ registration statement and pre-IPO prospectus (filed in August and September 2021 respectively) “contained materially incorrect or misleading statements and/or omitted material information that was required by law to be disclosed.”

The suit further alleges that Freshworks’ revenue growth and billings had encountered obstacles despite the company claiming to have a healthy net dollar retention rate.

Sundaram further says that after listing, the company’s shares fell sharply. For context, Freshworks’ shares had hit an all-time low of $10.51 per share in the past year and saw a decline of nearly 70% from the offer price. It is currently trading at $12.24 per share.

The lawsuit calls on other shareholders to join the class to seek recovery for the damages suffered as a result of Freshworks’ alleged violations of Sections 11, 12(a)(2), and 15 of the Securities Act, 15 U.S.C. Sections 77k, 77l(a)(2), and 77o of the US Securities Act. These sections have provisions for investors to hold issuers, officers, underwriters, and others liable for damages.

As per the law firms, the deadline to join the class in the suit is January 03, 2023.

What Is Net Dollar Retention?

The crux of the lawsuit is around the very specific metric of net dollar retention or NDR, which is largely only used by SaaS companies as a growth metric.

As per its quarterly filings, Freshworks calculates NDR in this manner: It first determines the “Entering ARR”, or the annual revenue rate of the cohort of customers that started using its services one year prior to the reporting period.

Then the company factors in the “Ending ARR” or the ARR from this same cohort at the end of the reporting period. The Ending ARR is divided by the Entering ARR after factoring in contraction of business for certain customers and the exit of customers from this same cohort.

This gives us the NDR.

 

In its pre-IPO filings, Freshworks had claimed a net dollar retention rate of 118% as of June 30, 2021. This has now fallen to 107% in the September quarter, compared to 111% in Q2 2022 and 117% in Q3 2021.

This adds some credence to Sundaram’s claims in the lawsuit that growth had plateaued.

The decline in Q3 2022 is because of impacts from foreign exchange rates (dollar to euro and GBP) and lower expansion activity in the quarter, Freshworks said. For Q4, Freshworks has projected an even lower net dollar retention of 105% based on current exchange rates.

 

Typically, speaking high net dollar retention is a strong indicator of growth, given that there’s always some churn and attrition. Companies typically look to maximise NDR by upselling or cross-selling to the customers in the cohort being tracked for NDR. This helps balance out some of the lost or shrunk business.

The Question Of Data

While the NDR has definitely fallen in 2022, one thing that has not been revealed in Sundaram’s lawsuit is whether the investor and Freshworks shareholder had access to data that proves any of the allegations.

NDR is a relatively new metric for the software industry and only became fashionable after the entry of SaaS players.

“Earlier software makers would sell for one-time fees or through licences, but SaaS companies began selling software piecemeal and therefore NDR came into the picture. It more accurately represents how well a SaaS company is able to build on low value customers in the long run,” according to the cofounder of a logistics SaaS company who did not wish to be named.

The same source added that the granular data that goes into the net dollar retention calculation is typically only available to preferred shareholders with specific information rights, and is not available to ordinary shareholders.

The average churn is typically a blend of the average attrition rate of enterprise clients, which is typically at 5%-10% and the attrition rate of small and medium businesses, which is typically around 20%-30% for most SaaS companies, the founder told us.

The lawsuit does not mention whether Sundaram had access to the data that pertains to the NDR calculations or indeed other business data that is not in public domain already.

Will Freshworks Face Class-Action Suit? 

Typically speaking, class action lawsuits involve a group of individual plaintiffs who are looking for a singular judgement against a particular entity for their respective but connected cases. In this case, Freshworks’ shareholders are being collectively asked to join the litigation started by Sundaram about alleged misleading statements from the company.

However, it must be noted that the class action lawsuit can only go ahead once the class is certified — i.e after the plaintiff’s litigators get the nod from a minimum threshold of affected individuals.

Freshworks sent a statement to Inc42 after the first version of this article was published. “We don’t comment on pending litigation and intend to defend this and any similar case vigorously,” a company spokesperson said.

Founded in 2010 by Girish Mathrubootham and Shan Krishnasamy, Freshworks offers a suite of softwares for customer service and support, customer engagement, and IT service management. As a private company, Freshworks had global marquee backers such as Sequoia Capital India, Google, Tiger Global and Accel, and it had raised close to $485 Mn between 2010 and its public listing in September 2021.

The company raised $1.03 Bn via the IPO at a market cap of $10.3 Bn. Over the course of its lifetime so far, the stock has fallen from a record high of $53.36 to $13.20 now, wiping off 75% of investor wealth in the process.

Sundaram’s lawsuit was filed on the same day as Freshworks’ Q3 2022 financials. The SaaS major reported a narrower loss of $58.3 Mn in Q3 2022, compared to $140.3 Mn in the year ago period. Revenue grew 33% year-on-year (YoY) to $128.8 Mn in the September quarter.

The company also told shareholders on the call that Q4 2022 will show poorer year-over-year comparisons due to significant early renewal activity in Q4 2021, which will impact some annualised revenue metrics.

This is the latest legal test facing the Girish Mathrubootham-led company. Late last year, Freshworks reached a settlement with Zoho to end a two-year-old legal battle over alleged theft of proprietary data from Zoho.

In March 2020, Zoho had filed a lawsuit alleging that Freshworks had stolen its confidential information and built a business out of it. Incidentally, Freshwork’s Mathrubootham and Krishnasamy worked at Zoho from 2001 to 2010 before founding Freshworks.

While settling the case, Freshworks said a former Freshworks sales employee wrongfully accessed and used Zoho confidential information relating to sales leads on their spouse’s device without their consent or knowledge. It also claimed that the action was not taken at the direction of Freshworks.

Zoho dismissed that lawsuit after the settlement, but now Freshworks might have more questions to answer if at all this class-action lawsuit finds real momentum.

Update Note – November 03 2022

• We have added Freshworks statement to the story. The company shared its response after the initial version was published.