Inside Freshworks’ IPO filing

Freshworks, a customer engagement software company with roots in both California in the United States and Tamil Nadu in India, is going public. Its S-1 filing paints the picture of a company scaling rapidly, with improving profitability as it matures. However, to understand the company’s numbers, we’ll have to peel away certain costs for a clear picture.

The Exchange spoke with Freshworks CEO Girish Mathrubootham a few weeks ago about his company, a conversation that in hindsight we timed rather well. We’ll lean on notes from the call as we parse Mathrubootham’s IPO filing.

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Quite a lot of venture capital is riding on Freshworks’ IPO going well. The company raised hundreds of millions of dollars while private, per Crunchbase data, including a $150 million Series H in late 2019 that valued the company at around $3.5 billion. Its investor list includes Accel, Tiger, Sequoia and Capital G.

This morning, let’s dig into the company’s historical growth, track Freshworks’ changing profitability profile and check to see if its revenue quality is improving over time.

Quick notes on product

Before we dive into the numbers, let’s discuss Freshworks’ historical product work.

The company started life with a single piece of software called Freshdesk. Freshdesk was born after the company’s CEO struggled with poor customer service when trying to return a broken television.

Per Mathrubootham, he felt like there were more avenues than ever for customers to reach companies, and that the business market was evolving in a way that gave customers more clout in how brands were perceived. So, Freshdesk brought together a host of customer contact methods, including social media, which at the time was a more nascent market category.

Freshworks later noticed that some of its customers were using its customer service software to offer IT support to their own employees. From that observation, the company built Freshservice, a version of its original product, but tuned for internal use. The company later built out sales tools and, more recently, a unified database for customer data. The latter allows companies using Freshworks software to have a single record for each customer across marketing and sales interactions, which it intends to extend to support communications as well.

All that’s to say that Freshworks has a product that it can sell to small companies that may need a single piece of its larger product mix, and lots more software that it can upsell to those customers. And it has a product suite it can sell to larger companies as well.

So how has the company performed in the market? Let’s find out.

The big numbers

For the folks who like to read along, here’s the Freshworks income statement from its S-1 filing:

We can quickly see that Freshworks posted quick growth from 2019 to 2020, expanding its top line by 45% to $249.7 million. Over the same period, its gross margin expanded modestly from 78.8% to 79.0%. We’re not too worried about Freshworks’ historical gross margin improvement being slight, given the high base value it set in 2019.

More recently, Freshworks grew its revenues from $110.5 million in the first half of 2020 to $168.9 million in the first two quarters of 2021, growth of 53%. That means Freshworks is seeing accelerating revenue growth, a great sign for the health of its business; most companies see their growth rates decline as they scale, as larger denominators make growth in percentage terms more difficult.

Now let’s check on Freshworks’ historical profitability. The company’s net loss rose in 2020 compared to 2019, but not to levels that were unpalatable. Investors both private and public are willing in the current market for companies to expand their losses modestly provided that growth remains strong and a company’s losses as a percentage of revenue don’t deteriorate materially.

Freshworks’ net loss as a percentage of its revenue grew from around 18% in 2019 to just under 23% in 2020. Since then, however, the metric has improved. The company’s H1 2021 loss declined massively to just $9.8 million, or just under 6% of revenue, from $57.2 million in H1 2020.

There are other costs that we are not reckoning with that Freshworks details in its S-1 filing, including everyone’s favorite line item: “Accretion of redeemable convertible preferred stock.” However, for companies showing accelerating growth, non-cash costs that come from the changing value of shares aren’t too important for our understanding of their economics, so we’re discounting it for now.

But if we’re not worrying about costs relating to convertible preferred stock, why are we being strict when discussing Freshworks’ profitability by focusing on its net losses instead of adjusted profitability metrics? Because the company’s adjusted profitability metrics represent only modest improvements on its GAAP metrics. That’s a compliment, mind.

For example, Freshworks’ non-GAAP (adjusted) net loss in H1 2021 was $7.7 million, a mere $2.1 million better than its fully loaded result. More simply, Freshworks isn’t a company where we need to cut it lots of slack, as we might with an adjusted EBITDA number. It is going public ready for Big Kid metrics.

That bodes well for the company.

Quarterly results

When digging into software companies, it’s always a good idea to observe quarterly growth rates to see how consistent net revenue additions have proved over time.

From the first quarter of 2020 through the second of 2021, here are Freshworks’ revenue results on a quarterly basis:

• $54.0 million
• $56.5 million
• $66.2 million
• $73.0 million
• $80.6 million
• $88.3 million

In those numbers, we can see rising per-quarter revenue adds over time, from $2.65 million in the second quarter of 2020, to $6.8 million in Q4 2020, to $7.7 million in Q2 2021.

But the news is not all good. Freshworks’ net income reached positive territory in Q3 2020 with a result of $1.4 million. Since then, the company has posted three consecutive net losses, deficits that have risen consistently to $7.4 million in its most recent three-month period. So, while Freshworks does have a nice historical profitability profile, there is some degradation to its net margins to be found in its most recent results. Still, the company posted positive free cash flow in 2020 and H1 2021, so investors likely won’t be too perturbed by its recent net losses.

Now let’s get back to talking about product.

What’s driving growth?

We discussed Freshworks’ product expansion at the top not merely to frame its revenue growth, but to understand how its top line is expanding.

What we want to understand is how the company’s expanding product suite has impacted its net dollar retention. Or, in English, whether the company is able to sell more of its products to its customers over time, driven in part by an expanding product set.

To see how that is playing out, let’s observe the company’s historical net dollar retention results since the start of 2019:

• 2019: 115%
• 2020: 111%
• Q1 2020: 113%
• Q2 2020: 107%
• Q1 2021: 112%
• Q2 2021: 118%

The data indicates that Freshworks is able to sell more of its products to its customers over time, a signal that its product work is helping it grow existing customer accounts. The results of its net dollar retention figure improving over time is material. Per its S-1 filing, Freshworks’ 53% revenue growth rate in the first half of 2021 was 38% driven by new customers (20% of its 53% growth rate), while 62% (33% of its 53% growth rate) was “was attributable to revenue from existing customers as of June 30, 2020.”

What’s it worth?

So far we’ve seen a healthy SaaS business with improving profitability and a history of cash generation. That’s valuable. The question, of course, is just how valuable.

Recall that Freshworks was worth $3.55 billion in 2019. The company’s $88.3 million in Q2 revenue gives it an annualized run rate of $353.4 million. At its final private valuation, the company is worth just about 10x its revenue run rate. That’s modest, so Freshworks should be able to easily clear its final private valuation when it does list.

Freshworks is growing a little bit faster than the top quartile of public SaaS companies, which command revenue multiples of around 28x, per the Bessemer Cloud Index. At that multiple, doing some very loose math, Freshworks would be worth $9.9 billion. The software market has seen its valuations improve since 2019, so it’s easy to see.

Now we’re not saying that Freshworks will be able to command a $10 billion valuation when it does price its IPO. But we can see from that back-of-the-envelope number that the company should be able to easily surpass its final private valuation when it does list. For its investors — especially those who put capital in early — its exit should prove more than lucrative.

More when it sets an initial price range.