[Uploaded on flickr on December 29, 2005 by niallkennedy]

With the departure of Bill Gates from the day to day running of Microsoft it marks an end of an era for Microsoft and one of the truly great business icons. However Gates is not remarkable for the technology he produced, but for his ability to transform an industry, understand how to control the means of distribution, and the maintenance of what is now a twenty five year old monopoly. He is remarkable in the same way that Rockefeller was remarkable with Standard Oil and their ability to control access and distribution of the Oil industry.

One cannot argue that Microsoft’s pivotal point was securing the initial operating system contract (DOS) for the IBM Personal Computer (PC1) but the real genius was the licensing agreement and the rights they withheld which ultimately grew the IBM compatible market. This was not the first time they (Paul Allen et al) understood distribution was more important than product. When they first visited MIPS in Albuquerque they understood that getting to market requires the support of a channel and they quickly struck a deal with MIPS to deliver a Basic Language for the Altair 8800.

It was in these early days that Gates had is first taste of piracy which eventually he when on to an obsession in later years. It happened when he was selling paper tape versions of their Basic at the Home Brew Computer Club in Silicon Valley. They had spent a lot of time and money developing the software, but it turned out that the vast majority of their software was not being paid for. He went on to write an open letter to the club:

Is this fair? One thing you don’t do by stealing software is get back at MITS for some problem you may have had. MITS doesn’t make money selling software. The royalty paid to us, the manual, the tape and the overhead make it a break-even operation. One thing you do do is prevent good software from being written. Who can afford to do professional work for nothing? What hobbyist can put 3-man years into programming, finding all bugs, documenting his product and distribute for free? The fact is, no one besides us has invested a lot of money in hobby software. We have written 6800 BASIC, and are writing 8080 APL and 6800 APL, but there is very little incentive to make this software available to hobbyists. Most directly, the thing you do is theft.

This early understanding resulted in the formation of the distribution strategy for later products where they tied personal computer distributors up with exclusive agreements. This became the true success of the business.

Controlling Distribution

Gates understood that if they did not tie the operating system to distribution of the personal computer, then there is no way to control piracy.  This was the initial rational behind the distribution deals they did for DOS and Windows, but these agreements also had another more compelling feature which sealed their dominance in the desktop operating system market. They were able to take control of the distribution channel and effectively hold personal computer manufacturers hostage.

This level of control eventually came to light in the US Department of Justice’s anti trust action against Microsoft. An example of the power they held against Hewlett Packard:

In March 1997, computer maker Hewlett-Packard Co. had what it considered to be a serious complaint against Microsoft Corp.: The software giant was refusing to let Hewlett-Packard change the series of screens that computer buyers see the first time they switch on machines that run Microsoft’s Windows operating system. So Hewlett-Packard fired off a strongly worded letter of protest.

“From a consumer perspective, [the restrictions] are hurting our industry and our customers,” Hewlett-Packard executive John Romano wrote to Microsoft management. “This situation must change.”

At the time an OEM (Original Equipment Manufacturer) Windows license to distribute Windows was essential for a manufacturer to stay in business and Microsoft used it effectively to control their “partners”. This  included the ability to fend off any relationship that the manufacturers wanted to pursue anything that in anyway was competitive (now or in the future) with Microsoft. This included Netscape and AOL (MSN was by this time launched as a dialup service).

These agreements became the basis of the USDOJ lawsuit which resulted in Microsoft agreeing to sanctions and the unraveling of some of the more egregious covenants. This settlement to this day is still being policed by the US DOJ.

The Select Agreement

However one of the most innovative (and restrictive) licensing strategies that Microsoft developed was the Select Agreement for Corporations. They are site license agreements but with some very interesting covenants which were designed to effectively lock in their software into the client. As with the OEM Windows agreements, there was a requirement that every Personal computer was licensed whether or not they actually ran Windows or Microsoft Office. Indeed the licensing arrangement was so complex it required training courses to understand how to sell and implement the agreement. The Select Agreement is a complex locking mechanism that guaranteed pricing and seats for Microsoft and is the true profit engine of Microsoft and Microsoft uses it for good effect:

Bona reports that many of her clients have seen “their software bills continue to climb, while retail pricing remains flat.” She cites an example where a 10,000- to 12,000-desktop corporation went through changes in licensing rules for Microsoft Office. The company witnessed an overall price increase of 220 percent, while the per-unit cost of the software remained stable.

Microsoft is not alone in using licensing terms to generate more revenue from software sales. According to Gartner, as software products mature and have less room for growth in sheer numbers of licenses, vendors must become more ingenious at producing revenue growth. Many companies have used the terms and conditions section of contracts to generate revenue. “The difference is that we see Microsoft activating this option more often than any other vendor in the product space,” says Bona.

Microsoft’s Middle Years

Microsoft’s real innovation is in these agreements they made that created such a profitable business. It was Gates vision firstly in the need for consistent operating system and secondly their ability to control the distribution and licensing of their products. However this unique alignment of the channel that created Microsoft’s dominance has not translated into their other businesses other than the Office Suite. Where Microsoft has not been able to use their dominance of the desktop to leverage their position, in other words use their dominance in the channel to create another dominance, then they have not been able to be successful. A good example of where this has been true is the MSN network. They made some attempts at this in the mid nineties but ultimately the USDOJ anti-trust suit got in the way and they were unable to capitalize effectively on their position.

Microsoft has not had the success in server operating system they had expected. Along with the anti-trust suit came the unification of Unix (read linux) and the open source business model. The internet is largely created using open source software. All of the key components, mail transport, name services, web servers etc are all open source and the numerous APIs are free for anyone to use. This lead to an explosion of innovation on alternative APIs to Microsofts. Now in web development, Microsoft is one of many vendors providing capability and more importantly these tools and services are near free.

Microsoft’s attempt to dominate the database market beginning in the mid nineties with Microsoft SQL Server also has largely fallen flat. Not that MS SQL is not popular and useful but in Microsoft’s eyes they had expected that they would be able to use their licensing tools to lock their corporate customers up. But as of 2005 they had only captured about 15-20% of the market for corporate databases (source DataMonitor) and the market is completely dominanted by Oracle and IBM.

The Future

With the departure of Gates from the day to day running of the business, it removes Microsoft from the ranks of the uber-corp and into the relm of a Fortune 500 company not unlike GE, USAA and First America. All which we don’t know who the CEO is, we just know they make money from the existence of their revenue generating capacity, what ever that may be.

With this change the baton of technology leadership has moved to a new group of leaders such as the Google founders. What this also means is that Microsoft is no longer the company we look to lead the industry and despite their attempts to be relevant in the Internet era their time has passed.

Microsoft will continue to dominant in the desktop operating system market and the office suite market for years to come which will ensure oversized profits but they will continue to struggle in all other markets they will or have pursued. This is because their true success came about through innovation in the distribution and licensing business not technology itself.

Microsoft management’s job is now to maintain it’s WIndows franchise and to find ways to improve there core competency (which was sorely tested with the Vista launch). Any business that cannot leverage their channel is a distraction. This is imporant because unless they are seen to effectively control their Windows franchise, shareholders will discount all the other initiatives.

Microsoft will face a crisis in the next few years which will ultimately result in other businesses such as the game business to be spun out independently. This will allow firstly for developers to get rid of the Microsoft corporate baggage and secondly allow shareholders to evaluate the investment independently of the Microsoft Corporation.

When that happens it will truely be the end of the Gates Era…..