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Professor Jonas Heese, Zeya Yang (MBA 2019), and Mike Young (MBA 2019) prepared this case. This case was developed primarily from published
sources. Funding for the development of this case was provided by Harvard Business School and not by the company. “Olivia Nash” and “BlueShark
Capital Management” are fictional. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as
endorsements, sources of primary data, or illustrations of effective or ineffective management. The author acknowledges the assistance of Ned
Segal, Twitter.

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J O N A S H E E S E

Z E Y A Y A N G

M I K E Y O U N G

Stock-Based Compensation at Twitter

Olivia Nash, an analyst at leading hedge fund BlueShark Capital Management, sat back and popped
open a fresh can of Kiwi LaCroix as she looked out the pristine glass window in her office. Olivia was
part of BlueShark’s technology sector coverage team, having been with the firm since completing her
MBA five years ago. She had just finished listening to the hour-long earnings call for Twitter’s Q4 2017
results.

Was Twitter doing well? That depended on which numbers she chose to believe. According to
Generally Accepted Accounting Principles (GAAP), Twitter had recorded a $108M net loss for 2017.
But on the earnings call, CEO Jack Dorsey and CFO Ned Segal had emphasized a slightly different and
much better-looking metric: non-GAAP net income of $329M. This adjusted version of net income was
a measure Twitter had defined itself when it first went public in 2013. The biggest difference between
the two was that Twitter’s non-GAAP net income stripped out stock-based compensation expense.

The use of non-GAAP earnings was not unusual among Twitter’s peers, and most Wall Street
analysts had for years judged performance based almost exclusively on the companies’ self-defined
metrics. Still, Olivia couldn’t help but wonder: Was stock-based compensation a true expense? Why
did analysts and even regulators condone non-GAAP metrics? And, most importantly, how did the
reporting of these metrics impact Twitter’s profitability and the way the company was managed?

Company Background
just setting up my twttr

— Jack Dorsey, March 21, 2006 (first tweet)

Spun out of the failed podcasting startup Odeo in 2006, Twitter was founded by Jack Dorsey, Evan
Williams, Noah Glass, and Biz Stone to help people stay connected through short, 140-character status
updates called “tweets.” After setting up an account, a user could create a tweet by sending a short
message service (SMS) text message to Twitter’s phone number, 40404. Anyone who had opted to
“follow” that user would then receive a text message with the tweet (the initial 140-character limit

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corresponded to the maximum allowable length of an SMS message). Users could also go to Twitter’s
website to view a chronological feed of their own tweets and the tweets of the users they followed.

As the product gained traction, new use cases emerged. People came to Twitter not only to see what
their friends were up to but also to follow celebrities, read breaking news, and engage in real-time
debates about world events. By democratizing access to information and giving a platform to anyone
with a phone or computer, Twitter became an important tool for news and public discourse. As
cofounder Williams explained, “The insight we eventually came to was Twitter was really more of an
information network than it is a social network.” 1 Venture capital investors thought this utility was
valuable: in 2009, despite having no revenue earned to date, the company raised money at a $1.2B
valuation. 2

Dick Costolo took over as CEO in 2010 and focused on building a sustainable business in
preparation for taking the company public. Twitter created an advertising-based revenue model in
which businesses could pay to place “promoted tweets” in the timelines of targeted users. Under
Costolo’s leadership, the company grew from 30 to 2,000 employees, from ~20 million to ~200 million
monthly active users, and from $0 to $665 million in annual revenue by the time of its initial public
offering (IPO) on November 7, 2013.3 Twitter shares ended their first day up 73% to $44.90, valuing the
company at more than $24 billion. 4

Over the next several years, the company struggled to match lofty expectations for growth in its
revenue, earnings, and user base, while other social networks like Facebook, Instagram, and Snap
(“Snapchat”) continued growing and taking share. In July 2015, Costolo stepped down as CEO and
Dorsey reassumed his previous role. The stock hit an all-time low of $13.90 in May 2016, down almost
70% from its first day of trading. 5 Anthony Noto, who first joined as the company’s CFO in July 2014
and later transitioned to the COO role, left the company in February 2018. Twitter’s next CFO, Ned
Segal, joined the company in August 2017. (See Exhibits 1, 2, 3, and 4 for Twitter financial data, and
Exhibit 5 for Twitter’s historical stock price chart.)

Stock-Based Compensation

What Is SBC?

Stock-based compensation (SBC) was a non-cash form of payment that granted employees an
ownership stake in the company. The most common forms of SBC were employee stock options and
restricted stock units (RSUs).

Stock options gave employees the right to purchase shares of the company’s stock at a
predetermined price, known as the exercise price. For example, 400 options might be granted to an
employee to purchase 400 shares of common stock at an exercise price of $10 at a later date. If the share
price exceeded $10 on the date when the employee was permitted to exercise the option, the employee
would profit. If the stock price was $15, the employee could pay the company $4,000 to exercise the
options, for 400 shares worth $6,000 total. Once the options were exercised, the employee could choose
to hold the stock, or sell it to cash in on the profit.

RSUs (restricted stock units) were “phantom stock” that were exchanged into common stock at the
time of vesting. For simplicity, many employees found it useful to think of an RSU as an option with
an exercise price of $0; the RSUs simply converted into common shares at no cost. This could lead to
significant differences in the value of the SBC: while a grant of traditional stock options might be worth
$0 if the company’s stock price did not exceed the exercise price at the time of vesting, an employee

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Stock-Based Compensation at Twitter 119-032

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with RSUs would always receive some value from her grant so long as the company’s stock price did
not fall to $0. Historically, RSUs tended to be used only by public companies, but in the 2010s, as pre-
IPO companies began to stay private longer, later-stage private companies such as Twitter, Airbnb,
and Dropbox adopted the use of RSUs while still private.6

Regardless of the form, SBC was subject to vesting requirements, a period over which ownership of
the granted package would be transferred to the employee according to a schedule. The most common
structure was a linear four-year vesting period with a one-year “cliff” and quarterly vesting thereafter.
For instance, an employee who was granted 400 options upon joining a company would vest 100
options (1/4 of the total grant) after working at the company for a year, and then 25 options (1/16 of
the total grant) each quarter thereafter (see Exhibit 6 for an illustrative vesting schedule).

If an employee left the company, she forfeited the unvested portion of the grant. Historically,
companies had to estimate the percentage of options that would eventually be forfeited. However, a
change came into effect in the accounting for stock options in fiscal year 2017. The Accounting
Standards Update (ASU) 2016-09, “Compensation — Stock Compensation (Topic 718): Improvements
to Employee Share-Based Payment Accounting,” allowed companies to account for forfeitures as they
occurred, rather than estimate expected forfeitures. Many companies, including Twitter, chose to
account for forfeitures as they occurred. 7

Why Use Stock-Based Compensation?

Stock-based compensation was widely believed to be an effective mechanism to recruit, motivate,
reward, and retain employees.8 An Anderson Consulting study from the 1990s found that 90% of
surveyed CEOs cited “attraction and retention of talent” as their primary reason for granting stock
options to their employees. 9

SBC was a useful recruiting tool because it allowed employees to participate in a lucrative outcome
in the case of an upside scenario. This was especially true for early-stage companies, where the upside
potential and granted ownership stake could be much larger than what would be possible at a more
mature company. Pre-IPO private companies could also use large stock grants to attract and recruit
senior executives from more established companies, who were crucial in helping companies scale
beyond the startup stage and ultimately prepare to go public.

Vesting schedules were an effective mechanism to retain employees. The one-year “cliff” was a
significant deterrent to any employee leaving before spending at least a year with the company, as
doing so would result in having no vested stock. Beyond that, if an employee had confidence that their
equity would be worth a meaningful amount in the long term, she would be motivated to stay at the
company until her entire grant had vested.

Stock grants did not need to be limited to new employees. Companies could also use SBC to
motivate, reward, and retain current employees through “refresh” grants.10 Incremental to the initial
stock package, a company could grant additional stock to employees as part of a performance
evaluation to reward strong performers.

Another key reason for using SBC was its non-cash nature. Early-stage companies that generated
little or no cash flow, who could not afford to compensate their employees commensurately at market
salaries on a cash-only basis, found stock-based compensation a useful tool for keeping cash burn
lower.

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SBC started gaining popularity in the late 1980s among both emerging technology companies and
established Fortune 500 companies, as competition for highly educated talent intensified. 11 By 2017,
34% of public companies implemented some form of employee stock purchase plan according to FW
Cook, with prevalence highest among tech companies, 70% of which implemented such a plan (see
Exhibit 7 for SBC by industry and company size).

However, not all were in favor of the growing use of SBC. Critics expressed concern that high levels
of SBC could distort managerial decision-making. Because it tied compensation closely to a company’s
stock price, some argued that SBC incentivized executives to make the company look better during the
periods when they received equity grants, even though doing so might not be in the company’s best
long-term interests. Academic studies showed that CEOs with larger equity packages tended to take
bigger risks, and that their companies were more likely to engage in illegal earnings manipulation. 12
Other studies claimed that higher levels of SBC were not in fact correlated with better company
performance.13

Regulation of SBC

Because stock-based compensation did not involve a cash outflow, there had been questions about
the expense treatment of employee stock option grants since the late 1980s. Historically, the Federal
Accounting Standards Board (FASB) did not require companies to record the fair value of SBC as an
expense, instead permitting the use of the intrinsic value method. In 1993, the FASB proposed new
accounting rules for stock options, recommending that companies value stock options using the fair
value method and expensing these accounts in their income statements. Corporate America reacted
with overwhelming disapproval, resulting in a less ambitious change and the release of Statement of
Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” in
October 1995. Under SFAS 123, companies were “encouraged” to take an earnings charge based on an
estimated fair value for the stock grants they issued, although they were given the option to disclose
this value in a footnote instead and continue using the intrinsic value method. 14 By 2000, all but a
handful of the companies most actively issuing SBC opted to use the footnote approach rather than
report the fair value of these options in their earnings. 15 (See Appendix A for a further explanation of
accounting rules for intrinsic value and fair value methods.)

In the early 2000s, major accounting scandals at large companies like Enron and Worldcom led to a
renewed focus on financial reporting regulations. SBC was one area that came under particular
scrutiny, as the bursting of the dot-com tech bubble had exposed the high cost of equity grants. In the
2002 Sarbanes-Oxley Act, SBC was specifically highlighted as a concern in Section 404, which required
issuers to disclose the scope and adequacy of their procedures and internal control structure for
financial reporting. 16 In December 2004, the FASB issued SFAS 123R, “Share-Based Payment,” to
replace the previous SFAS 123 standard, which finally required that stock options be valued using the
fair value method and thus recorded as an expense as of the grant date.

SBC as an Expense?

In the years leading up to the FASB’s modification to SFAS 123, there was intense debate among
standard-setters, politicians, investors, corporations, and academics about whether to require the
expensing of stock options. 17 The eventual 2004 announcement of SFAS 123R was met with corporate
uproar and heavy congressional lobbying to reverse the FASB’s decision.18

Those in favor of SFAS 123R argued that expensing SBC presented a more accurate representation
of a company’s profitability. They claimed that SBC reflected a cost of acquiring employee labor, and
that expensing SBC conveyed this information to outsiders consistently with other labor costs, such as

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salaries and cash bonuses.19 Many investors argued that because the granting of employee stock
options allowed companies to pay their employees lower cash salaries, not including this expense
artificially inflated profits. 20 A study in 2001 found that for a sample of large growth firms, mandatory
expensing of SBC would have made the median firm’s earnings per share 14% lower.21

From a corporate governance perspective, proponents of expensing argued that the absence of SBC
from income statements exacerbated ineffective corporate governance and allowed C-level executives
to extract excessive compensation. 22 Requiring the expensing of SBC would bring more transparency
in C-level executive compensation.

Arguments against expensing focused on the uncertainty of the value of SBC. Because it was not
paid in cash and because employees might not be able to realize the value of the grants for several
years, they argued, the true value could not be known. Even though there were common fair value
valuation methods, such as Black-Scholes, SBC contracts were constructed in a way that led employee
behaviors to deviate from the assumptions underlying such pricing models, with features such as
vesting provisions, long expiration periods, non-transferability, and accelerated maturity when the
holder terminates employment. 23 Accounting standard-setters were often reluctant to endorse figures
in the financial statements that could not be measured reliably.24 In the most extreme argument,
because options were often underwater at the time of being granted, accounting purists argued that
options held no tangible value at the time of issue.25

Even if fair values were clearly assigned to equity grants, the compensation expense recorded over
the duration of the vesting schedule was calculated according to the fair value at the time of the grant,
and not using an updated fair value at the time of the vesting. This meant that as the stock price rose
or fell, the compensation expense recorded in a period would not necessarily match the value of those
shares at market prices at that time, but rather the value at the time they were initially granted. If the
stock price fell dramatically, the company would be recording an expense that was arguably
overstated, and if the stock price appreciated significantly, the compensation expense would arguably
be understated. Segal emphasized that “from my experience, this is an important nuance of SBC, which
is not well understood.” 26

Furthermore, prominent business leaders argued that the economic costs of SBC were already
reflected in their dilutive effects on “earnings per share” (EPS), as the exercise of options by employees
increased the number of shares outstanding, thereby diluting existing shareholders’ equity by reducing
their previous ownership.27 This dilution materialized in EPS by increasing the denominator figure in
the EPS calculation, lowering EPS. If a fully diluted EPS metric already captured the dilution cost, they
argued, expensing SBC would double-count their cost by also penalizing the numerator figure (see
Exhibit 8 for an illustrative calculation). More tactically, they worried that expensing SBC would
convey weaker financial results to investors, which could raise the firms’ cost of financing and stifle
corporate investment and innovation. 28

Despite the FASB’s clear ruling, the debate continued into 2018. Companies reacted to the
accounting change in a number of ways. One common reaction was to provide pro-forma, non-GAAP
statements for investors that showed profitability metrics that excluded the expensing of options. 29

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Twitter’s Use of Stock-Based Compensation
Twitter, like many of its venture capital-backed contemporaries, relied heavily on SBC as a tool to

recruit and retain employees.a The company granted SBC to employees across all functions,
categorized under cost of revenue, research and development, sales and marketing, and general and
administrative (Exhibit 3 includes a breakdown of SBC expense by function).b Twitter furthermore
used SBC to retain employees that joined the company through acquisitions. The company’s growth
coincided with a period of rapidly intensifying competition for engineering talent in Silicon Valley, and
SBC provided a way for startups to present employees with compensation packages potentially worth
far more than what they could afford to pay in cash. As Twitter noted in its S-1c and all subsequent
quarterly reports:

We depend on highly skilled personnel to grow and operate our business, and if we
are unable to hire, retain and motivate our personnel, we may not be able to grow
effectively. . . . Competition for highly skilled personnel is intense, particularly in the San
Francisco Bay Area. We may need to invest significant amounts of cash and equity to
attract and retain new employees.30

Segal echoed the sentiment, explaining: “Twitter attracts and retains employees in part by
compensating competitively. We view equity as an important component of compensation. When you
choose to work at Twitter, you are betting on equity in Twitter. Our philosophy is that employees
behave differently when they feel like owners.” 31

Even among similar companies, one could make the case that Twitter granted an unusually large
amount of equity. By the time of its IPO in 2013, it had granted equity awards estimated to be worth
almost $1 billion.32 By 2015, the company’s SBC expense as a percentage of revenue was almost twice
as high as that of any of its closest comparables (see Exhibit 9 for SBC as a percentage of revenue for
selected internet companies). In fiscal years 2017, 2016, and 2015, Twitter’s SBC expense as a percentage
of revenue was 18%, 24%, and 31%, respectively.

In addition to the SBC expense reflected on the income statement, Twitter, like many other
technology companies, capitalized the cost of engineering for underlying technology to run its
business, including relevant employee compensation, of which SBC was one component. In fiscal years
2017, 2016 and 2015, Twitter capitalized costs totaling $113.9 million, $139.0 million, and $92.8 million,
respectively, out of which $51.8 million, $73.9 million, and $50.3 million were SBC expenses,
respectively. 33 These capitalized costs were included in property and equipment, net (PP&E). The
estimated useful life of such capitalized expenses, evaluated on a project-by-project basis, could be up
to four years. In fiscal years 2017, 2016 and 2015, the amortization of capitalized costs included in the
cost of revenue totaled approximately $96.5 million, $74.6 million, and $37.8 million, respectively.34

a In August 2018, Twitter had over 400 open job postings on its website (https://careers.twitter.com/en.html)

b Per Twitter’s 10-K, “cost of revenue” included infrastructure costs; other direct costs including content costs, amortization
expense of technology acquired through acquisitions, and amortization of capitalized labor costs for internally developed
software; allocated facilities costs; and traffic acquisition costs. “Research and development” consisted primarily of personnel-
related costs for engineers and other employees engaged in the research and development of products and services. “Sales and
marketing” consisted primarily of personnel-related costs for employees engaged in sales, sales support, business development
and media, marketing, corporate communications, and customer service functions. “General and administrative” consisted
primarily of personnel-related costs for executive, finance, legal, information technology, human resources, and other
administrative employees.

c A form that companies going public must file to register with the U.S. Securities and Exchange Commission.

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Although there was no one clear reason, a confluence of factors contributed to the magnitude of
Twitter’s SBC expense. From a product reliability standpoint, the real-time nature of the product meant
that site outages, which happened regularly in the company’s early years at times of peak usage, were
especially problematic. The company therefore put extra emphasis on hiring the best engineering talent
to fix and prevent such issues.35 At the executive level, internal turmoil among the founders and
company leadership led to unusually high levels of executive turnover. The company had three
different CEOs in its first four years, and so many Heads of Product were fired or resigned that the role
was often compared to the Defense Against the Dark Arts professorship from the Harry Potter book
series (a position in which no professor lasted more than one year).36 Each new executive required a
new large equity grant (although some of the departing executive’s SBC expense might be reversed if
the grant had not fully vested). Additionally, because the company was slow to monetize and revenue
growth was slower than anticipated, the grants may have been larger relative to future revenue than
was expected at the time they were issued.

Finally, many employee grants ended up being worth less than expected due to the company’s
floundering stock price. Twitter issued additional grants in an attempt to make up the difference,
leading to additional SBC expense. At one point in 2016, the company was offering refresh stock grants
companywide to make up for the losses and prevent a mass talent exodus to better-performing
competitors. 37 This put Twitter at risk of falling into a “downward spiral”: if a company’s stock price
went down, so did its compensation level relative to competitors, leaving the company vulnerable to
high employee turnover. In addition, the company’s GAAP financials would be further depressed
because the expensing of SBC relied on the fair value of the grant at the time of the issuance instead of
the time of the vesting, even if a lower stock price meant the grants were worth less at the time of
vesting. A company in such a scenario, if it were not managing this risk well, could then be compelled
to grant even more SBC to stem turnover, costing the business more and depressing its stock price
further.

Shareholders frequently reached out to Twitter expressing concern over the additional stock grants.
At that time Twitter presented three arguments in favor of doling out the extra grants:

(1) The cost of these additional grants was less than it appeared on the company’s income
statement, because according to GAAP rules, SBC had to be expensed based on the stock price
at which it was granted. Since Twitter’s stock price had decreased, the earlier grants ended up
being worth less than the associated GAAP-approved expense suggested.

(2) The cost of the grants was lower than the alternative cost of potentially higher employee
turnover at a critical moment in the company’s life.

(3) Because employees’ equity grants were worth less than was expected at the time they were
initially granted, these employees did not have the ownership stake or level of compensation
that the company had originally intended for them to have. Twitter believed that employees
should have enough equity in the company to reflect their contributions, and wanted to issue
additional shares to ensure they continued to be appropriately invested in the business.38

Twitter’s Use of “Adjusted Earnings”
Although beholden to GAAP reporting rules, Twitter’s management felt that including SBC as an

expense was not the only way investors would want to see the business’s financials. To address this,
the company included certain non-GAAP financial measures in its earnings reports. These non-GAAP
metrics included “adjusted EBITDA” (earnings before interest, tax, depreciation and amortization) and

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“non-GAAP net income,” both of which removed stock-based compensation expense from profit
calculations, among other adjustments.

The company noted in its first quarterly earnings press release as a public company:

Twitter believes that adjusted EBITDA, non-GAAP net income (loss) and non-GAAP
EPS help identify underlying trends in its business that could otherwise be masked by the
effect of the expenses that we exclude . . . Twitter also believes that adjusted EBITDA, non-
GAAP net income (loss) and non-GAAP EPS provide useful information about its
operating results, enhance the overall understanding of the Company’s past performance
and future prospects and allow for greater transparency with respect to key metrics used
by the Company’s management in its financial and operational decision-making. Twitter
uses these measures to establish budgets and operational goals for managing its business
and evaluating its performance. The Company is presenting these non-GAAP financial
measures to assist investors in seeing the Company’s operating results through the eyes
of management, and because it believes that these measures provide an additional tool
for investors to use in comparing Twitter’s core business operating results over multiple
periods with other companies in its industry. 39

Segal added, “We want investors to have the tools to make good decisions about our equity and we
give them all the data they need. We were aware that investors would look at non-GAAP metrics, and
would often adjust for SBC. Because investors have historically looked at non-GAAP metrics, we
provide and give …

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