A prominent UK cybersecurity stock is under attack from short sellers. Here's what you need to know

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Darktrace, one of the U.K.'s largest cybersecurity companies, was founded in 2013 by a group of former intelligence experts and mathematicians.
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Cybersecurity company Darktrace, one of the U.K.'s most prominent tech names, has found itself under attack from short sellers.

The company, whose tools allow firms to combat cyberthreats with artificial intelligence, was last week targeted in a report by New York-based asset manager Quintessential Capital Management.

QCM, whose stated aim is "exposing fraud and criminal conduct in public companies around the world," claims it has had a 100% success rate in its activist campaigns.

The company told Reuters it holds a short position of 1.3% in Darktrace shares.

London-based hedge fund Marshall Wace also shorted Darktrace, according to data site Breakout Point.

Short selling is a strategy in which investors bet on the price of a stock going down in value. A trader borrows the stock and then sells it on the assumption that it will fall, before buying it back at a discounted price and pocketing the spread.

What is Darktrace?

Darktrace, one of the U.K.'s largest cybersecurity companies, was founded in 2013 by a group of former intelligence experts and mathematicians.

The Cambridge-headquartered company says its technology uses AI to detect and respond to cyberthreats in a business' IT systems.

The company floated on the London Stock Exchange in 2021, and its debut was seen as a key victory in the U.K.'s bid to lure more high-growth tech startups to the London market after its withdrawal from the European Union.

The stock's performance following the listing has been underwhelming. After initially rising to an all-time high of £9.45 ($11.58) in October 2021, Darktrace shares have since plunged dramatically in tandem with a broader slump in global tech stocks.

As of Monday afternoon, Darktrace shares were trading at a price of £2.32, down 37% in the last 12 months.

Darktrace share price performance in the last 12 months.

In August, the firm opened takeover talks with U.S. private equity firm Thoma Bravo. However, Thoma Bravo walked away from the deal a month later after the two sides failed to reach an agreement.

Why is it under attack?

On Tuesday, U.S. hedge fund QCM said it had taken a short position out against Darktrace and published a lengthy report detailing alleged flaws in Darktrace's accounting.

QCM said that, following an investigation into Darktrace's business model and selling practices, it was "deeply skeptical about the validity of Darktrace's financial statements" and believed sales and growth rates may have been overstated.

"We would like to give our strongest possible warning to investors and believe that DT's equity is overvalued and liable to a major correction, or worse," QCM said in the report.

Darktrace was accused by QCM of engaging in "channel stuffing" and "round-tripping" — activities that artificially inflate a company's reported sales — involving individuals with ties to organized crime, money laundering and fraud.

Darktrace didn't directly address those allegations. On Wednesday, the firm's CEO Poppy Gustafsson issued a statement defending the company from what she called "unfounded inferences" made by QCM.

Shares of Adani groups continue to fall in Friday's session
Shares of Adani groups continue to fall in Friday's session
Squawk Box Europe

Separately, QCM suggested Darktrace may have inflated its revenues by booking unearned revenues as actual sales.

The company occasionally books revenue from payments for contracts it receives before delivering its service to clients as deferred revenue, according to the report.

This is not uncommon among subscription-based software companies. However, QCM noted deferred revenue as a percentage of Darktrace's sales had dropped between 2018 and 2022, suggesting the firm "may have increasingly been booking unearned revenue as actual sales."

In response, Darktrace said: "Rarely, customers will pay full contract values in advance but because this is infrequent, non-current deferred revenue balances will decline as these contracts run down unless there is another unusual, large, in-advance payment."

QCM alleged Darktrace may have tried to fill gaps in its receivables left by clients dropping out of sales negotiations through marketing sponsorships with indebted resellers and using shell companies to pose as phantom clients.

"Organisations that transact with the channel will typically co-host marketing events with their partners. Partner marketing events are a normal course of business for almost all software businesses and Darktrace is no different," Darktrace said Wednesday.

"This has been, and remains, a very small part of Darktrace's marketing and the costs of them over the last five years has consistently been substantially below 0.5% of Darktrace's revenue," Darktrace added.

Darktrace was not immediately available for comment when contacted by CNBC.

Separately Wednesday, Darktrace said it would embark on a share buyback worth up to £75 million ($92 million) to be completed no later than Oct. 31, 2023.

The Lynch connection

Lynch founded the enterprise software firm Autonomy, whose sale to Hewlett-Packard was mired in scandal over accusations that Lynch plotted to inflate the value of Autonomy before it was bought by HP for almost $11 billion in 2011.

In 2022, a British judge ruled in favor of HP in a civil fraud case against Lynch. Lynch, an influential figure in the U.K.'s tech scene, faces a possible criminal trial in the U.S. after the U.K. government approved his extradition last year.

He has repeatedly denied the allegations.

Several executives at Darktrace, including Gustafsson and Chief Strategy Officer Nicole Eagan, previously worked for Autonomy.

The QCM report also raised concerns over the connections between Darktrace and Autonomy.

"Darktrace has been led or strongly influenced by many of the very same individuals that participated in the Autonomy debacle," QCM said in its report.

"If our allegations are confirmed, we expect Darktrace to follow the same tragic destiny of its predecessor, Autonomy," QCM said.

Lynch is reportedly no longer involved with Darktrace's management, but remains a significant shareholder.

Lynch is no longer involved with Darktrace's management, but remains its sixth-largest shareholder, according to Refinitiv Eikon data.

Meanwhile, Darktrace is also suffering from uncertainty related to the wider macroeconomic environment. The company lowered its forecast for annual recurring revenue growth for the year ending June 2023 to between 29% and 31.5%, down from an earlier forecast of 31% to 34%, citing weaker customer growth.


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