Databricks Undervalued? Investor Insights

Databricks' Recent Funding and Valuation

The latest Databricks funding round, involving a $1 billion investment and resulting in a $28 billion valuation, stands out as a significant private investment of the year.

This funding indicated Databricks’ preparation for an Initial Public Offering (IPO). Last year, the company revealed to TechCrunch that its revenue run rate had increased from $200 million to $350 million within a single year. The new capital appears to be the final step in its private fundraising efforts before a potential public launch.

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Analyzing the Round's Pricing

Several questions arose concerning the terms of the funding round, particularly the valuation. With a $28 billion valuation and an Annual Recurring Revenue (ARR) of $425 million, Databricks is currently valued at approximately 66 times its top-line revenue.

This multiple is substantial, potentially among the highest observed in public markets. However, for existing Databricks shareholders, the rapid increase in stock value is undoubtedly positive. They are unlikely to object to the growth of their equity.

But is this price justifiable from an investor’s standpoint? The Exchange spoke with Dharmesh Thakker of Battery Ventures earlier this week to explore this and other related topics. Thakker was listed as a participant in Databricks’ Series D funding round, which introduced Battery Ventures as an investor.

Battery Ventures' Perspective

Surprisingly, Thakker expressed a strong positive outlook on Databricks – a company his firm has supported since a $140 million round in 2017, when the company’s valuation was just under $1 billion.

What was particularly noteworthy was his belief that the current $28 billion valuation might actually be conservative.

This perspective prompted a deeper dive into Thakker’s insights. Quotes from our conversation have been extracted to illustrate his assessment of the market for Databricks, the broader landscape of scaling unicorns, and the potential market size for these companies, all viewed through the framework of risk-adjusted investing.

CEO Ali Ghodsi's Viewpoint

Finally, we will revisit comments made by Databricks CEO Ali Ghodsi when questioned about the valuation by TechCrunch. Let’s proceed!

Databricks' Valuation of $28 Billion Explained

The following details the discussion surrounding Databricks’ valuation with Battery Ventures investor, Dharmesh Thakker.

The Exchange: My conversation with Databricks’ [CEO] Ali [Ghodsi] revealed a substantial valuation – approximately 64x ARR. I questioned the pricing, despite recognizing the company’s strength and understanding its market. I sought insight into whether my assessment was overly cautious.

Dharmesh Thakker: I believe the valuation is justified, and potentially even conservative. This assessment rests on three primary factors.

Firstly, consider the expansive total addressable market for data. Virtually all software and technology decisions are influenced by data, whether through digital transformation or analytics. The potential market size is immense, ranging from $20 billion to $80 billion.

Secondly, Databricks, alongside companies like Snowflake and MongoDB, has ushered in a new era for B2B businesses. These firms demonstrate rapid growth coupled with remarkable efficiency, paving the way for strong operating margins as they scale.

This translates to a capacity to achieve revenues exceeding $1 billion within four to five years – a timeframe previously unheard of. Historically, it took companies five years to reach $100 million and nearly ten to surpass $1 billion. Now, some are attaining $1 billion in revenue within just four to five years of their initial software sale.

These companies also resemble consumer-focused businesses, relying less on costly sales efforts targeting CIOs. Instead, they foster adoption by practitioners who then champion the product internally.

Consequently, sales and marketing expenses as a percentage of revenue decline significantly as these companies grow, falling from around 70% to 40% or 50%. Research and development costs remain relatively stable, and general and administrative expenses are kept low. This results in a business operating within an $80 billion TAM, scaling from $1 billion to $5 billion with operating margins shifting from negative 20% to positive 30% or 40% – a previously unseen phenomenon.

The contrast lies in growth models. Some businesses expand rapidly but incur substantial costs due to extensive sales and customer service requirements. Others, like Databricks, prioritize efficient growth through self-service adoption.

Imagine a $1 billion business growing to $5 billion with 30% to 40% operating margins – that equates to roughly $2 billion in free cash flow. What is the value of such a company? [TechCrunch: An enormous sum.] A multiple of 13 times free cash flow would be an attractive investment.

At this point, I noted a role reversal, as earlier in our discussion, Thakker had emphasized the importance of fair pricing for early-stage startups, while I had argued that the potential for significant success in software justified a higher risk tolerance. He responded:

Dharmesh Thakker: Considering risk adjustment, at Databricks’ current scale, only a select few companies exhibit similar efficiency: Snowflake, Databricks, Zoom, and MongoDB’s Atlas product.

The probability of success increases significantly with scale. Similar to Apple’s trajectory – reaching the first trillion dollars took two decades, but the second trillion arrived in just six weeks. Once a company achieves a certain size, it gains momentum, allowing for sustained growth of 50% or 60% with relative ease.

Expanding from $425 million ARR – a figure I neither confirm nor deny – to $1 billion or $2 billion is considerably less challenging for Databricks than for a typical startup with a one-in-five-hundred chance of success.

Overpaying for an early-stage startup is risky, given the low probability of success. A 20x revenue multiple demands better odds than a 2% success rate. However, with Databricks, the likelihood of success is 50% or higher. The current price is fair, anticipating continued growth and performance. On a risk-adjusted basis, it represents a more favorable investment opportunity.

Evaluating the Underlying Reasoning

I find the core of Thakker’s perspective quite understandable. The primary concern regarding his analysis centers on the potential for a widespread market correction impacting the valuation of software revenue streams. Should such a repricing occur, Databricks might encounter significant challenges in justifying its current valuation to prospective investors.

However, during a conversation with the company’s CEO, he expressed confidence that even in a scenario of market downturn, a single year of continued growth could rectify the situation. My own calculations largely support this assertion, assuming the market decline remains within reasonable bounds.

For Databricks, sustained high growth in the current year is paramount. Achieving this would likely resolve any valuation concerns and position its eventual public offering as an attractive opportunity, demonstrating the reasonableness of its present valuation.