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Can Freshworks Brace Itself For The US Lawsuit Impact?

Indian SaaS start-up Freshworks, an inspiration for Indian founders, is eyeballing trouble as a possible class action lawsuit could wipe off a big chunk of its financials besides tarnishing its image beyond repair. We look at the likely outcomes for the homegrown software giant

Can Freshworks Brace Itself For The US Lawsuit Impact?
Girish Mathrubootham, founder and chief executive officer of Freshworks
POSTED ON November 12, 2022 11:02 PM

"Today is a dream come true for me - from humble beginnings in #Trichy to ringing the bell at @Nasdaq for the FreshWorks IPO. Thank you to our employees, customers, partners, and investors for believing in this dream," tweeted Girish Mathrubootham, founder and chief executive officer (CEO) of Freshworks after India's first software-as-a-service (SaaS) tech start-up got listed on Nasdaq last year.

The Chennai-origin company literally flung open the doors for other start-ups to take Indian software to global enterprises. However, a year later, it faces one of its worst nightmares—a potential class action lawsuit in the US over misleading investors before getting listed. 

Two American firms—New York's Scott+Scott Attorneys at Law LLP and Los Angeles-based The Schall Law Firm—have alleged that Freshworks' revenue growth and billings had encountered obstacles despite the company claiming to have a healthy net dollar retention (NDR). 

NDR is a key metric used by SaaS companies to determine how well they can retain and maximise the revenue from existing customers. Freshworks' NDR fell to 107 per cent in Q3 2022, compared to 111 per cent in Q2 2022 and 117 per cent in Q3 2021.

The India-born, US-headquartered SaaS giant went public last year, offering 28.5 million shares at $36 per share to raise over $1 billion at a valuation of about $10 billion. The shares, which began trading at around $46 per share on its Nasdaq debut on on September 22, 2021, have since been on a downfall. On November 9, the shares ended trading at $12.80—a drop of over 74 per cent since the company got listed.

The Aftermath

The allegations, if proven, can land a double whammy on Freshworks. On the one hand, it could face substantial losses if the court orders it to pay damages to numerous plaintiffs who are part of the class action suit. This, in turn, could lead to further microscopic scrutiny and thus, reputational injury. 

"Apart from shareholder action, the company as well as its directors/officers run the risk of being exposed to prosecution by the Securities Exchange Commission, USA, the regulatory agency tasked with prevention of fraud in the purchase or sale of securities," said Naresh Thacker, partner at Economic Laws Practice.

Lawsuit legal
Freshworks could face substantial losses if the court orders it to pay damages to numerous plaintiffs who are part of the class action suit

Some experts believe that going forward, when the allegations are investigated further, Freshworks will have to develop a better plan to safeguard itself. 

"From the concerned firm's press release, it appears that the allegation is about false and misleading disclosure by Freshworks about the difficulties in its business. I suspect this allegation will be further distilled and made more specific as the case progresses and it will be up to Freshworks to demonstrate that the risks and the headwinds were adequately highlighted," claimed Vishal Yaduvanshi, Partner at IndusLaw. 

In general, shareholder activism in the US, resulting in IPO-related lawsuits, has been a cost of doing business in the country's public markets. As the number of IPOs grows, so does the number of lawsuits. This is especially in depressed market conditions where the stock does not perform as well as expected. 

Listings in 2021 were also at much higher valuations, which means investors lose more money if the market sentiment turns negative and the stock does not perform.

"While many such lawsuits are either dismissed or settled, some are remanded or even go to trial. This results in liabilities (in form of damages) against the issuer, its senior officers or even the underwriters, depending on the facts of the case. Regardless of the outcome of the litigation, the stock price of the concerned company is likely to be adversely affected as a result of the action," cautioned Yaduvanshi.

It needs to be, however, noted that the class action lawsuit can only go ahead once the class is certified—i.e. after the plaintiff's litigators get participation from a minimum number of affected individuals.

On reaching out, the Freshworks spokesperson said, "We don't comment on pending litigation and intend to defend this and any similar case vigorously."

Warning Bell for Others?

The US Securities Act permits claims based on material misstatements or omissions in an offer document (referred to as a registration statement). However, liability can arise only for false or misleading statements when the registration statement becomes effective. 

Further, due diligence and disclosures are cornerstones of any defence against alleged misstatement. Hence, experts advise issuers to accurately depict the pessimistic scenarios that may affect the company's business. That, in many ways, can act like insurance against a future lawsuit alleging misrepresentation or omission.

Freshworks IPO
Last September, Freshworks became India's first software-as-a-service (SaaS) start-up to get listed on Nasdaq

"From a long-term market perspective in the current conditions, this class action lawsuit against Freshworks could be a warning sign to other Indian tech start-ups founders and they will be more cautious to list in the US or anywhere else outside India," said Salman Waris, founder and managing partner of TechLegis Advocates & Solicitors. "Normally, in such class action suit, the shareholders can collectively litigate against the company for causing 'economic injury' due to the violation of certain securities laws, and shareholders can get monetary compensation if successful." 

Regarding the legal scenario in India, shareholders closer home can also initiate class action lawsuits (introduced by the Companies Act 2013) against the company/ its directors (who bear personal liability). Moreover, it can file it against its auditors for any false and misleading statement in the audit report or fraudulent, unlawful or wrongful conduct. 

Naresh Thacker, partner at Economic Laws Practice
Naresh Thacker, partner at Economic Laws Practice

Lawsuits can also be filed against any expert for misleading statements made to the company or for any fraudulent, unlawful conduct on his part. Also, the Securities and Exchange Board of India (SEBI) has broad powers for initiating suo motu action for any false/ misleading statement / representation by a company during the IPO and (i) initiate criminal prosecution with imprisonment for a term up to 10 years or fine up to Rs 25 crore or both as well as initiate debarment proceedings barring the company and its directors from accessing the securities market.

Legal Past

This is not the first time Freshworks has locked horns with the lawmakers. In December 2021, the company settled with close rival Zoho, to end a two-year-old legal battle over the alleged theft of proprietary data from Zoho.

In March 2020, Zoho filed a lawsuit alleging Freshworks had stolen its confidential information and built a business out of it. In a lawsuit filed in the US District Court Northern District of California on March 17, Zoho accused Freshworks of building its business by stealing and misusing its financial information that was not public. It also accused the company of poaching Zoho's employees. Incidentally, Freshworks founders Mathrubootham and Shan Krishnasamy earlier worked at Zoho from 2001 to 2010.

While settling the case, Freshworks said one of its former sales employees wrongfully accessed and used Zoho's 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. However, if a new class-action lawsuit finds real momentum, Freshworks may find itself in a tight spot to answer several questions. 

Zoho, incidentally, just turned around $1 billion in revenue, with its India business growing 77 per cent y-o-y.  

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

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