Stock option deep dives : Dan, a software engineer at Reddit

Welcome to the inaugural article of "Stock Option Deep Dives", a series where we take a detailed look at equity and financial situations inspired by real-life tech employees.

Our first deep dive focuses on “Dan,” a fictional software engineer at Reddit, which has been rumored to be planning an IPO in 2024. Through an in-depth analysis of Dan's financial situation and Reddit’s valuation, this case study aims to provide a relatable and informative blueprint for tech professionals navigating the complexity of financial planning with stock options.

TLDR;

• Dan’s net worth is heavily reliant on his Reddit equity
• The downturn in the private markets from 2021 to 2023 has thrown a lot of uncertainty his way.
• He's grappling with a few key questions:
  • What's the current state of my finances?
  • With an IPO potentially on the horizon, what's my game plan?
  • Has my equity lost a lot of value?
  • Is exercising my stock options a smart move?
  • Should I consider selling my shares?
• Figuring out his actual net worth following the 2021-2023 market slump is tricky, raising concerns about his financial future.
• To get a realistic estimate of his Reddit equity's value, there are various methods like public comparable company analysis, fund marks, 409A valuations, along with secondary market data.
• By creating a range of predictions for Reddit's performance, he can make decisions with clear and realistic tradeoffs in mind.

This article uses real company data from Reddit. Dan's financial data is meant to be representative of a Reddit employee. Additional financial data provided by Caplight.

A bit about Dan

Job

• Role: Software Engineer
• Start date: November 1st, 2019

Annual salary

• Gross Income: $275,000
• Annual Bonus: $10,000

Reddit equity package

• Number of Options: 60,000 ISOs.
• Vesting Schedule: 1-year cliff followed by monthly vesting over 36 months.
• Options Vested as of Today: All of them
• Average Strike Price: $7.20 per option

What should Dan do

Dan's financial journey over the past two years has been nothing short of a rollercoaster. Experiencing a nearly 60% drop in net worth in such a short time is a rare event for someone in the corporate world, but one that's all too familiar for startup employees. For them, navigating these turbulent waters should be at the top of their agenda.

To stabilize his financial situation, Dan has to diversify his investments beyond tech stocks, since most of his net worth is concentrated in Reddit stocks. This means diversifying across sectors and countries and perhaps adding fixed-income assets to lower the volatility and risk of his portfolio.

For his Reddit equity, it’s crucial to assess the situation thoroughly. He can assess the way his wealth changes in different exercise, financing, and exit scenarios. Should he finance an exercise, or come out of pocket? Should he wait til the exit and do a cashless exercise and sale? Should he sell a portion now to reduce risk and finance the exercise of his remaining shares? Each option has different tradeoffs that need to be considered in the context of Dan's life and goals.

Our approach

For our analysis of Dan's situation, we first dove into his key assets and his perspective on Reddit. This broke down into three main parts:

• We mapped out a comprehensive view of his financial landscape, gauging his risk tolerance and his capacity for further risk in pursuit of greater gains versus adopting a more cautious approach.
• We then evaluated Reddit's current stock value. In a fluctuating private market, perceptions of stock value can swing wildly — from feeling worthless to overly optimistic. A clear understanding of the likely value is crucial for making informed forecasts and future plans.
• Finally, we explored potential exit scenarios for Reddit. While predicting the future is impossible, it's feasible to create different scenarios, understand the tax consequences of each, and make decisions that optimize outcomes in various situations.

This approach allows Dan to adjust his strategy as new information and circumstances arise.

Analysis 1: Dan’s financial life

At 37, Dan's financial situation extends beyond his salary and stock options at Reddit. In a region known for its high cost of living, he's managed to build a diverse financial portfolio. His journey hasn't been without its challenges. Juggling a demanding tech career in the Bay Area, Dan has had to be smart about where and how he saves and invests his money. His approach involves a mix of regular saving, careful investing, and keeping an eye on the Bay Area's pricey real estate market. Here's a closer look at the various components of Dan's financial landscape, which illustrate the realities faced by many tech professionals in his position.

Dan's balance sheet  (Assets, Liabilities, and net worth)

Dan's financial goals and concerns

Dan's got his eyes set on the FIRE goal: Financial Independence / Retire Early. But in the up-and-down world of tech, he knows it's not all smooth sailing. So, he’s mixing it up – aiming for growth to hit his early retirement dreams, while staying smart about the risks. It's all about finding that sweet spot between making his money work and keeping it safe.

Analysis 2: Understanding Reddit's valuation

There are many different ways to value a company

Getting a grip on Reddit's valuation is more about looking at a range of numbers than pinning down one exact figure. You've got different methods playing into this - like the price venture capitalists think it's worth and the 409A valuation that affects stock option prices. Then, there are the public fund marks, where big investors decide how much their piece of the pie is worth, plus all the action in the secondary market with its bidding and trading. And let's not forget about how similar companies are doing - that adds another piece to the valuation puzzle. All these bits and pieces come together to give us not just one definite price, but a whole spectrum of what Reddit could be worth. It's about piecing together all these clues to come up with a solid guess on the company's value.

Reddit's funding rounds

Reddit's funding rounds, especially the last one from three years ago, can offer a peek into how venture capitalists valued the company at different stages. But here's the thing: With the latest round being three years old, we've got to take that preferred price with a grain of salt. A lot can change in a few years, as shown recently by the effects of record high interest hikes causing significant downloads across the space

Reddit’s 409A valuation and stock options strike price insights

The strike price of options, like the ones Dan has, is set using something called the "409A valuation" also referred to as the Fair Market Valuation. This isn't just any valuation; it's a specific method that the IRS keeps an eye on. It's like getting a snapshot of what Reddit's worth in the eyes of the tax folks, and it's super helpful for figuring out the potential gains for employees who jumped on board at different times in Reddit's journey. As a company matures and approaches an exit, the 409a typically converges towards the valuation expected in public markets, providing useful insight into the potential value at an hypothetical IPO.

Reddit’s public fund marks interpretation

Late-stage investors that have invested in Reddit, like Fidelity, have to regularly mark the value of their stake. These prices reflect how investors are marking the current price per share of Reddit stock, relative to their entry point, based on updated financial information, market comparable and overall sentiment.

Reddit’s secondary market trades review

Reddit shareholders have the option to sell their shares on the secondary market under specific conditions, offering yet another perspective on the company's valuation. However, it's worth noting that the trading volume here is relatively low, and getting solid info can be a bit of a challenge. So, while these trades do give some clues about Reddit's worth, it's wise to take them with a healthy dose of caution.

Reddit’s comparable company analysis

A relatively simple way to analyze Reddit's valuation in real time would be to do a comparable company analysis (CCA).  This involves selecting a group of Reddit's most comparable public company peers, and benchmarking what a relative valuation would look like if Reddit were a publicly traded company. A key benefit of this method is it leverages the collective wisdom of the market, incorporating industry-specific norms and considering the ongoing sentiments of investors. Typically valuations for high-growth SaaS companies, use enterprise value-to-revenue (EV/Revenue) multiples for CCA analysis, multiplied by the companies next-twelve-months-revenue. In the case of Reddit, Snapchat, Meta, and Pinterest are considered as the closest comp group. You can see based on comparables, Reddit's implied  valuation has oscillated significantly in the past 36 months as multiples have been volatile, but a more stable valuation range has begun to emerge.

Implications for Dan and other Reddit employees

For Dan, these valuation insights are not just academic; they are crucial in informing when he might exercise his options or potentially plan for a sale. Despite the volatility, Dan’s strike price is still below all the valuations we looked at, which currently offers him some upside. This wouldn’t be the case if Dan had joined Reddit in early 2022.

Analysis 3: How Reddit’s valuation impacts Dan’s net gains

To map out Dan's potential financial windfall from his Reddit stock options, we delve into a bit of number crunching. First, we factor in the exercise costs of his options and the taxes he'd need to pay at various exit prices. This involves calculating the cost of buying the shares at his strike price and estimating the tax impact based on the selling price. With these numbers in hand, we can then determine Dan's net equity value for different potential exit prices of Reddit.

Reddit exit price range and its impact on Dan’s potential gains

Using Secfi’s tax and equity engine, we are able to run those calculations across a wide range of exit values. Below we plot it from $0 to $80. To help you connect the dots, we also included the values mentioned above.

• At $25 per share (Q3 2023 Bids on secondary markets)
  • Dan potential net gains amount to $525,474
• At $30 per share (Q3 2023 Asks on secondary markets)
  • Dan potential net gains amount to $667,524
• At $35 per share (Q3 2023 Fund Marks)
  • Dan potential net gains amount to $809,574
• At $62 per share (Q3 2021 Preferred price
  • Dan potential net gains amount to $1,576,644

Reddit’s Exit Timeline and Its Impact on Dan’s Net Gains

When it comes to Dan's financial future, the timing of Reddit's potential exit – whether through an IPO or acquisition – plays a huge role. The impact of this timeline on Dan's net gains is mainly due to capital gains tax implications and lock-up periods post-IPO. Let's break it down.

Short-Term Exit (6 months)

• Capital Gains Implications: If Reddit exits in the next 6 months, and Dan decides to exercise and sell his options, he'll face short-term capital gains taxes. These are typically higher, as they're taxed as regular income.
• Exercise Decision: The high tax rate might make Dan consider holding off on exercising his options or selling his shares until he reaches long-term status.

“Long”-Term Exit (12 months)

• Moving to Long-Term Capital Gains: If Reddit exits in 12 months and Dan has held his options for over a year, he moves into the long-term capital gains territory. This means lower tax rates, which could be a good incentive to exercise his options.
• Lock-Up Period Consideration: Post-IPO, Dan will likely face a lock-up period, usually 6 months, where he can’t sell his shares. Planning for financial needs during this time is crucial.

Key Considerations for Reddit Employees Like Dan

Navigating through the financial complexities as a Reddit employee like Dan involves strategic planning, especially when it comes to managing risk and diversifying assets. Let’s break down some of the key strategies.

Diversification: Managing Risk

Dan’s net worth is heavily concentrated in Reddit and tech stocks, which makes him vulnerable to risks related to Reddit and the tech sector in general. Not to mention the fact that his employment is in the tech sector and he lives in the bay area where tech companies dominate the economy.

Diversifying away from technology stocks might be a smart move until his concentrated stake in Reddit has been sold.

The Challenge with Non-Liquid Assets

Reddit stock, being non-liquid, poses a challenge for diversification. Dan can’t simply sell off his shares anytime he wants, especially pre-IPO.

Secondary Sales

A practical way for Dan to reduce his exposure to Reddit and increase liquidity is through secondary market sales. But it's important to remember that these sales often come at a discount  and mean giving up future gains if the stock performs well long-term.

Non-Recourse Financing

Non-recourse financing allows Dan to diversify without fully letting go of his potential upside. By using his Reddit shares as collateral, he can access funds to invest in other areas while retaining a stake in Reddit’s future.

Navigating Wealth Creation Opportunities

The Need for Professional Guidance

For someone in Dan’s position, navigating through what could be life-changing wealth creation opportunities is complex. It requires a balance of understanding market trends, personal financial goals, and the nuances of different financial strategies.

In conclusion, while the potential for significant wealth creation exists for Dan and similar Reddit employees, it comes with its set of challenges.

Professional advice and a well-thought-out strategy are crucial to navigating this landscape successfully.