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How Wall Street's unrealistic expectations created a crisis for Twitter

Vanity Fair New Establishment Summit - Day 2
Twitter CEO Jack Dorsey hasn’t had much luck turning Twitter around.
Photo by Kimberly White/Getty Images for Vanity Fair

The stock market is freaking out over a report that Google is dropping out of the race to buy Twitter. Other rumored bidders, including Apple and Disney, are also expected to pass, according to Vox.com sister site Recode. That could mean that only one company — Salesforce.com — makes a formal bid for the popular social media site later this month.

Jack Dorsey, the Twitter co-founder who returned to the company as CEO last year, is putting Twitter up for sale after spending the last year trying, and failing, to get the company growing again. Twitter’s most recent quarterly results show the number of monthly active users growing a paltry 1 percent over the previous quarter.

The basic problem is that Wall Street investors bought into Twitter’s 2013 initial public offering expecting to get a fast-growing tech company like Facebook or Google. Instead, Twitter’s growth has stalled. So over the past 18 months, Twitter’s stock price has crashed as it’s become increasingly clear that Twitter — though large and reasonably lucrative — is never going to achieve a Facebook-like size of audience or profitability.

But it’s important to be clear that despite Twitter’s stock price troubles, the company is in no danger of going bankrupt. It generates more than $2 billion per year in revenue, which should be more than enough money to run a website. But Wall Street won’t be satisfied if Twitter becomes a medium-size, modestly profitable website. The company’s $17 billion market capitalization is based on an assumption of continued growth.

Selling Twitter gives Dorsey a possible way out of this dilemma. If he can get a decent price, Twitter’s investors will be happy and figuring out how to make Twitter more profitable will be someone else’s problem. The big question is whether anyone wants to take Twitter off his hands.

How a falling stock price created a crisis for Twitter

Like many Silicon Valley technology companies, Twitter has used stock options as a recruitment tool. People who joined Twitter in the early years were granted generous options that in some cases swelled to be worth millions of dollars. As long as Twitter’s value kept rising, these options provided Twitter with a powerful recruiting tool.

But heavy use of options had two big downsides. One was that generally accepted accounting principles require Twitter to treat vesting stock options as an expense to the company. So as Twitter’s stock price rose, the stock-based compensation program became more and more expensive, which meant that — on paper, at least — Twitter was horribly unprofitable.

In one sense, this was just an accounting illusion. The company itself wasn’t losing money, and to some extent this represented early employees earning their rightful rewards for taking a risk on a fledgling company. At the same time, shareholders really were losing value as the value of their shares got diluted.

The second downside is that stock-based rewards don’t work if Twitter’s stock goes down. When a company’s stock is falling, options become worthless. Which means that Twitter has to either pay its employees more cash or lose them to other tech giants hungry for talent.

This creates a danger that a falling stock price becomes self-reinforcing. As the stock price falls, Twitter becomes a less attractive place for its most talented workers. As its best workers leave, its chances of a turnaround get worse and so the stock price falls further.

There’s no reason to think this process will end in Twitter going bankrupt. Twitter has 300 million users; it’s easy to turn a profit with a website that popular. But getting to profitability could require aggressive cost-cutting, which in turn would mean giving up on competing in the same league as Facebook, Microsoft, and Google.

An acquisition could rescue Twitter management from its dilemma

Being acquired gives the company a third option, because a potential acquirer might be able to profit from Twitter in ways that Twitter couldn’t do directly.

Right now, the leading suitor is believed to be Salesforce, which makes a leading platform to help companies manage their relationships with customers. Most companies also use Twitter to communicate with their customers. So there could be some natural benefits if Salesforce acquired Twitter and then offered Salesforce customers better tools to manage their branded Twitter accounts.

Salesforce may also be able to extract valuable business insights from the fire hose of real-time data generated by billions of tweets. And the company has been on the market for a social media company for a while, having lost out to Microsoft in a bidding war for LinkedIn.

But with other rumored suitors already dropping out of the bidding, there’s a danger that no one will bid for Twitter — or that any offers are so low that its shareholders won’t accept them. In that case, Twitter’s leadership will go back to the seemingly impossible task of trying to push up Twitter’s stagnant user numbers.