Twitter License Plates
Image source: Twitter.

Many investors point to Twitter's (NYSE:TWTR) sluggish user growth over the last few quarters as a reason Twitter is trading below the values of competing companies like Facebook (NASDAQ:FB). Indeed, without more users, Twitter simply won't have nearly as big of an audience as other platforms like Instagram or smaller but rapidly growing networks like Snapchat. That reduces the ad inventory Twitter can sell without inundating existing users with still more ads in their timelines.

But the flip side of the coin is just as worrisome. Twitter needs more advertisers. At just 100,000 active advertisers, it only has 4% of the total number of advertisers on Facebook. Surprisingly, Twitter hasn't done a terrible job attracting businesses to its platform, with 65.8% of U.S. businesses active on Twitter, according to a report from eMarketer. That number is 84.7% for Facebook and 32.3% for Instagram. The real problem is converting those businesses into paid advertisers.

Disparate conversion rates
Facebook touts that there are 45 million small and medium-sized businesses on its platform. Of those 45 million, 2.5 million are actively paying for advertisements on its platform. That's a conversion rate of 5.6%.

Twitter is lucky if its conversion rate is even half that. The company doesn't have any public metrics on how many businesses are on its platform, but it has told investors that it has 100,000 active advertisers. Extrapolating from eMarketer's data on U.S. businesses and Twitter's and Facebook's demographic data (Twitter has a higher percentage of users in the U.S.), Twitter probably has between 4 million and 9 million businesses on its platform. At the midpoint of those numbers, Twitter would be converting businesses at a rate of just 1.5%.

This minuscule conversion rate is a big opportunity for Twitter and its investors. Twitter only recently expanded its self-service ads to nearly every market it served, previously limiting it to 33 markets. But the most valuable markets, like the United States, Canada, and Western Europe, have had self-service ads for about two years.

Figuring out how to transition businesses from merely having a presence on Twitter to becoming advertisers will be a key part of Twitter's future success. Facebook has shown what's possible, and it could lead to a tripling in demand for Twitter advertisements. That would have a correlated impact on Twitter's average ad prices, which have mostly trended downwards over the last few years.

Keep filling the funnel
As important as increasing its conversion rate, Twitter needs to keep filling its funnel -- i.e., adding more businesses to its platform.

As it currently stands, eMarketer isn't expecting Twitter to add nearly as many new businesses over the next two years as it did in the previous two. While the percentage of U.S. businesses on Twitter increased from an estimated 60% to 65.8% from 2013 to 2015, that number is only expected to rise to 67.2% in 2017. In fact, eMarketer expects Instagram to have a larger business presence than Twitter in 2017 despite just 32.3% of U.S. businesses currently using the photo-sharing app.

Part of the problem is that Twitter's user base simply isn't as large as Instagram's or Facebook's. Solving its user growth problem will go a long way to attracting more businesses.

Beyond that, Twitter needs to provide businesses with a reason to have a presence on its product. Facebook allows businesses to establish a web presence very easily through Pages, which are accessible to everyone regardless of whether they use Facebook or not. Using Twitter for the same thing is redundant.

Twitter's strength is in allowing businesses to interact with customers. Businesses are able to easily monitor topics and mentions of their company and address issues and provide customer support. Management needs to determine a way to monetize that (and other) use case(s) for businesses before Facebook does. The bigger company is already working on a few solutions.

If Twitter can figure out how to continue increasing the number of businesses on its platform and how to funnel them into becoming paid advertisers, it could surprise investors with continued outsized revenue growth. However, there aren't many reasons to believe Twitter is capable of converting at rates as high as its competition.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.