UVA-OM--1387

Jun. 116, 2011

INN
NOVATION
N STRATE
EGY AT MIICROSOFT
T: CLOUDS
S ON THE H
HORIZON

Michael
M Steeep, chief of operations for the Miccrosoft Innoovation Team m, arrived aat the
Executivve Briefing Center (EBC) at Micro osoft’s Redm mond, Washhington, heaadquarters. After
glancing at his watchh, Steep realized he was a few minuutes early forr his meetingg with execuutives
from the Applied Caarbon Corpo oration (ACC C), and he hhad enough time to graab a quick cuup of
coffee. ACC
A was a large
l enviro
onmental tecchnology connglomerate, and Steep w was schedulled to
meet witth the chief innovation
i officer,
o the chief
c technollogy officer, and other ssenior execuutives
from AC CC who weree out for a tw wo-day visitt to Microsooft. This wass the tenth eexecutive briiefing
Steep hadd delivered over
o the past few month hs. The goal of these brieefings was too give key gglobal
accounts an overview w of how Miicrosoft engaaged in innovvation, whatt type of inittiatives Micrrosoft
was working on, and the value that these initiatives
i coould deliverr to clients. These execcutive
briefings had becom me routine beecause innov vation seemeed to be the topic of intterest for moost of
Microsofft’s global accounts—th
a hey wanted to know hoow Microsoft could hellp them leverage
technologgy to deliverr new sourcees of growth.

As
A he waited d for the exeecutives from m ACC, Ste ep reflectedd on his expeeriences oveer the
past yearr—including g the first dayy he had join
ned the Innoovation Team m and his firrst encounterr with
founder Bill
B Gates an nd Ray Ozziie, chief softtware architeect. Steep haad been invitted to sit in oon an
operationns review with
w Gates, Ozzie, O and several otheer senior exxecutives (seee Exhibit 1 for
executivee biographiees)—one of many such reviews coonducted oveer the coursse of a year. The
subject of
o this review w was Micro osoft’s new approach too Internet search technollogy. The reeview
started with
w product managers
m an
nd engineerss detailing thhe core technnology. Gatees remained silent
for the first
fi 90 minu utes of discu ussions. Then, out of thee blue, he tuurned to onee of the soft ftware
engineerss and asked about the allgorithm thaat was to be used for thee new searchh technologyy. As
the engin neer tried to
t answer his h question ns, Gates beecame moree and more engaged inn the
conversaation. He gott up from hiss seat and staarted to skettch algorithmms and formuulas on the bboard
alongsidee the young engineer. No one in the room seemeed to undersstand where Gates was taaking
the discu
ussion. Finallly, Gates taalked about a search alggorithm that would increease the speeed of
the searcch. The simp ple model prroposed by Gates reducced the timee used on thhe massive sserver
banks, which
w were trremendous energy
e sinks.. Eventually,, he tied the innovation tto a monetizzation
model thhat would saave corporations million ns of dollarss in energy ccosts. Steep knew the yyoung

This case was written by b Raul O. Ch hao, Assistantt Professor at the Darden S School of Busiiness, and Styylianos
Kavadias, Associate Proffessor at the Georgia
G Institutte of Technoloogy. It was wriitten as a basiss for class disccussion
n to illustrate effective
rather than e or in
neffective hand dling of an adm ministrative sittuation. Copyrright  2011 bby the
University of Virginia Daarden School Foundation,
F Ch VA. All rights reserved. To oorder copies, seend an
harlottesville, V
e-mail to sales@dardenbusinesspublish hing.com. No part
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 -2- UVA-OM-1387

engineer would take the message back to his product group and there would be immediate
change. Steep’s first operations review was burned in his memory; he was impressed by Gates’s
ability to tie technological innovation to value creation as well as his ability to drive change
effectively across the entire company.

The ACC executives entered the room. Steep greeted his guests and began to give them
an overview of how innovation happened at Microsoft. He told the executives that, in addition to
the work done in product groups and Microsoft Research labs, his Innovation Team had three
major processes aimed at generating grassroots innovation at Microsoft. Midway through the
briefing, the executives wanted to know if grassroots innovation really worked at Microsoft.
They had heard plenty of buzz about grassroots innovation,1 but they were skeptical of the real
impact such processes could have when put to use in a large corporation. The timing of the
discussion could not have been more relevant. In a few weeks, Ozzie and the Innovation Team
would have to make a decision on whether to continue funding the grassroots innovation
processes at Microsoft, and the jury was still out as to their impact.

Innovation at Microsoft: Top-Down or Bottom-Up?

Steep explained to the ACC team that, historically, radical innovation at Microsoft—truly
game-changing, big-impact innovation around products and services—occurred in a decidedly
top-down fashion, a sort of “one-man show” that depended on the vision and drive of a senior
leader such as Gates. (See Exhibit 2 for key historical events.) The most glaring examples of this
were the “Internet Tidal Wave Memo” and the “Services Wave Memo” Gates wrote. (Exhibit 3
and Exhibit 4 contain excerpts of both memos.) They called for dramatic change in the products,
services, and technologies Microsoft offered. Gates was famous for his deep understanding of
technology and business, and he implemented his ideas through a hands-on approach to
management. Although radical innovation was mostly top-down, extensions to existing products
and services occurred in the product groups. Over the previous five years, new products and
services accounted for over a third of Microsoft’s revenue, and almost all these additions
followed the traditional licensing model approach.

Grassroots innovation was a new effort to tap into the diverse ideas of all Microsoft
employees and turn those ideas into profitable new businesses. If one thing was certain, it was
that Microsoft’s employees had a vast amount of technological expertise, which could be tapped
to drive innovation. Steep was the business lead for the Innovation Team, which was responsible
for generating grassroots innovation within Microsoft. The Innovation Team headed up four
processes: ThinkWeek, Quest, IdeAgency, and the Innovation Outreach Program (IOP). Some of
these processes had been in place just before Steep took over the team; others he had launched
himself.

1
Grassroots innovation was the topic du jour when discussions turned to new ways to innovate. The buzz began
with open-source software, and companies such as InnoCentive had become famous for hosting worldwide
“innovation tournaments” on a wide array of topics.
 -3- UVA-OM-1387

ThinkWeek was a process in which technical papers were submitted once a year directly
to Gates. He would then isolate himself for a week to review the papers and make comments as
needed. Quest was a similar process, which involved Microsoft’s most senior and accomplished
technical fellows. Both efforts tapped into the expertise of senior technical staff, leaving out the
thousands of other Microsoft employees. In an attempt to complement these processes, the
Innovation Team had launched a new effort called IdeAgency, which aimed to fully realize the
potential of grassroots innovation by all Microsoft employees.

As part of the IdeAgency initiative, Steep pioneered the IdeaExchange tool, a web portal
that allowed every employee at Microsoft to submit ideas in response to technology challenges
set by senior executives. After a thorough screening by the Innovation Team and the challenge
sponsor, selected projects were given management and incubation support within the IdeAgency
(Exhibit 5). The approach was simple: An executive sponsor, usually a product group leader,
identified a problem that needed a solution and initiated a challenge by posting it on the
IdeaExchange portal; all Microsoft employees were encouraged to respond to the challenge with
their ideas, which would be captured and stored on IdeaExchange.

In a learning-by-doing fashion, the Innovation Team soon discovered the difficulty of

relying simply on a tool to generate solutions. Employees were willing to submit ideas, but the
ideas alone did not seem original enough to provide the promise of real leadership in technology
for new markets. As a response, the team decided to complement the IdeaExchange tool along
with a “high engagement” process of facilitation. The top idea people who submitted the most
promising solutions were invited to a facilitation session; well over 300 people participated in the
first session. The entire Innovation Team assisted with the session by forming groups that would
present their ideas to the executive sponsor. If the executive sponsor chose the idea, budget and
resources would be allocated to develop a prototype. At the end of eight weeks, the executive
sponsor could decide to transfer the idea to his product group or drop the idea altogether. After
one year of operation, the IdeAgency had conducted eight challenges. Over 1,200 ideas were
produced, and three prototypes were transferred to the product groups.

While ThinkWeek, Quest, and IdeAgency were events that took place internally, Steep
realized that Microsoft needed a process that directly involved customers to increase the
relevance and potential value of the ideas. He initiated the IOP, which brought together the chief
innovation officers from 10 of Microsoft’s largest accounts—all in noncompeting industry
segments—for a two-day innovation brainstorming conference. The exercise consisted of these
officers looking out over a five-year time horizon without being bogged down by the short-term
pressure of the financial markets. The objective was to outline a long-term perspective with
challenging new technologies and novel business models that could be applied to the industry.
Steep thought this portfolio of processes (i.e., ThinkWeek, Quest, IdeAgency, and IOP) could
deliver the innovation that Microsoft needed because it capitalized on two critical flows of
information: top-down guidance and bottom-up expertise. The innovation processes within the
Innovation Team complemented the work being done in product groups and Microsoft Research
labs (Exhibit 6).
 -4- UVA-OM-1387

The Information Technology Industry: Clouds on the Horizon

The grassroots innovation initiatives were a direct response to the changes taking place in
the industry. Microsoft faced intense competition from all sides, including Apple, Amazon,
Google, Linux, and many others. It was not clear that its licensing model could deliver the
growth needed going forward. Acquisition was not an automatic solution; Microsoft was not the
only company with cash to burn, and bidding wars were sure to break out for the most promising
technology start-ups. Ozzie, Steep, and other members of the Innovation Team were convinced
that Microsoft would have to grow businesses from the inside to be sure of retaining its position
as a market leader.

Microsoft generated most of its revenue from consumer and enterprise licenses for its
software products. In 2008, operating income was $22.5 billion on revenue of $60.4 billion, a
compound annual growth rate of approximately 15%. Gross margins from software licensing
were estimated at 75% to 80%. The company’s share price increased exponentially between
1985 and 2000, splitting eight times during that period. After the burst of the dot-com bubble,
shares were relatively flat, and the company began paying steady dividends in 2004 (Exhibit 7).

Despite some recent difficulties, most notably the development and launch of the
Windows Vista operating system, Microsoft was still a dominant player in the software business.
That said, new technologies threatened the importance of the Windows operating system as a
ubiquitous platform. Emerging business models that had evolved since the advent of the Internet
nipped at Microsoft’s heels, undermining the traditional licensing model that had been so
successful for so long.

Microsoft’s business model relied heavily on the product groups within each business
division. These decentralized groups were responsible for taking a product from idea to a box on
a shelf. Although each product group tailored its software development process to its core
technology and markets, all the product groups followed a more-or-less traditional milestone
review process aligned with an overarching technology road map (Exhibit 8). The product
groups worked closely with the Sales, Marketing, and Services division to deliver on customer
needs. Enterprise agreements (EAs) allowed product groups to include new applications on large
public- and private-sector accounts. An installed base of close to 400 million users and close to
600,000 independent vendors implied that the product groups could generate impressive revenue
by adding to or incrementally improving existing software products. For example, an application
added to the EA may cost only $10 per license, but because of the enormous installed base, that
application could generate hundreds of millions of dollars in revenue with a high profit margin.

Despite the success of the licensing model, many Microsoft insiders, business analysts,
and technology experts suspected that change might be inevitable. Most important, the business
model of developing and marketing shrink-wrapped software and generating revenue through
user licenses had come under fire. The most-often-mentioned business models that threatened
licensing were software as a service (SaaS), online advertising, online transaction management,
 -5- UVA-OM-1387

and utility computing.2 Many of these business models fell under the general umbrella of cloud
computing.3

Microsoft faced intense competition from Apple, Yahoo!, Oracle, IBM, Nintendo,
Amazon, and Google, among others. Each of these companies used revenue models distinct from
Microsoft’s predominant licensing model (Exhibit 9), and they competed across all of
Microsoft’s business lines. These competitors had achieved some significant wins:

 In 2000, Apple launched MobileMe, a web-based personal cloud space that subscribers
could access from any computer in the world, similar to a personal website with
convenient online services. In summer 2007, Apple launched the iPhone and has had
huge success with iTunes, its online transaction-based music store. In 2008, Apple had
operating income of $6.3 billion on revenues of $32.5 billion.
 Yahoo! successfully implemented an online advertising business model. In 2008,
Microsoft launched an unsuccessful bid to acquire Yahoo!. In that same year, Yahoo!
earned operating income of $4.1 billion on revenue of $7.2 billion.
 Amazon successfully implemented an online services and transaction business model. In
2002, the company launched Amazon Web Services (AWS), a remote computing service
aimed at developers. In 2007, Amazon launched the Kindle e-reader and negotiated
exclusive rights to distribute a number of best-selling titles. In 2008, Amazon earned
operating profit of $840 million on revenue of $19.1 billion.
 Google was the leader in online information search and management, with revenue of
$21.8 billion, operating income of $6.6 billion, and a market share of more than 70%.
Since its inception, the company had developed a slew of desktop, mobile, web, and
hardware products and services that impinged on Microsoft’s traditional businesses. In
2005, Google acquired Android, a software platform for mobile devices. In 2008, Google
made the Android operating system available as open source and achieved early
success—the T-Mobile G1 smartphone ran on Android. In June 2009, Google announced
it would develop an open-source operating system to compete directly with Microsoft’s
core business line.

Financial projections and industry estimates around SaaS business models were quite
varied. The Gartner Group estimated that the 2007 SaaS market was $5 billion with an expected
40% compound annual growth rate through 2012. Some analysts claimed that SaaS business
models delivered a 30% to 40% gross margin. Despite data that indicated SaaS may not be as
attractive to Microsoft as it was to smaller software development firms, Microsoft’s ecosystem
was in the process of transforming itself. A significant number of independent software vendors
were developing SaaS applications, more than 50% of start-ups in the software industry were
2
Utility computing was the packaging of computing resources, such as computation and storage, as a metered
service similar to a traditional public utility (e.g., electricity, water, natural gas, or telephone networks).
3
Cloud computing was a style of computing in which technology resources (infrastructure, platform, and
software) were provided as a service over the Internet.
 -6- UVA-OM-1387

based on a SaaS business model, and 75% of Microsoft partners viewed SaaS as a significant
opportunity for the future.

Grassroots Innovation under the Microscope

As Steep wrapped up the EBC briefing with ACC, he thought more deeply about the
difficulty managing innovation at Microsoft. Microsoft Research labs around the world worked
under the direction of Craig Mundie, a recognized technology expert, to deliver long-range
technological developments. In Steep’s mind, the key was to maintain the current income stream
through licensing to provide the cash needed to develop newer software and services models. So
it made sense that product groups were focused on the short term, while Microsoft Research was
focused on the distant future. But Steep recognized that Microsoft needed a way to deliver some
significant growth in the coming three to five years. He believed the most promising way to do
so was to mine the employee base or customer base for new growth ideas. After all, that was the
reason Microsoft had started the grassroots innovation processes. Still, so many different
processes were running concurrently with so much capital tied to them. Many employees and
analysts wondered if Microsoft was delivering on its promise.

Serious discussion about the value generated by grassroots innovation was already
occurring within the Innovation Team. Ozzie believed that both ThinkWeek and Quest were
completely dependent on Gates. His involvement offered legitimacy, but he would no longer be
at the helm. Ozzie said, “[ThinkWeek] was…a very Bill unique thing…I don’t think that’s
something that we want to reproduce.”4 In any case, both processes were focused on very high-
level, long-term technology breakthroughs. Gates’s departure and the leadership transition issue
were always on Steep’s mind. Steep believed that key senior executives at Microsoft had very
different views about how to lead. CEO Steven Ballmer was not a technology expert, but he was
extremely adept at managing the day-to-day business. He was competitive and wanted to win.
Ozzie, on the other hand, was a technology expert. He understood the future of the SaaS business
model and had been instrumental in launching the new cloud-computing approach with Azure.
Craig Mundie was a long-term technology thinker with a 10-year vision—he had done a great
job heading up Microsoft Research. Similarly, Bob Muglia had done a terrific job heading up the
Server and Tools business—those technologies were critical to any services model. With Gates
no longer at the helm, it was not clear which of these approaches would be best, or whether there
was another model out there that would be a better fit for Microsoft’s future.

IdeAgency was a wonderful initiative—on paper. The process had delivered a number of
successes during the first year of operation. But there were several major drawbacks, not the
least of which was the problem of scaling across all of Microsoft’s divisions. Members of the
Innovation Team invested immense amounts of time facilitating the process. Just a year earlier,

4
Remarks by Ray Ozzie at the Churchill Club, San Jose, California, June 4, 2009. The transcript is available at
http://www.microsoft.com/presspass/exec/ozzie/06-04-09ChurchillClub.mspx (accessed April 25, 2011).
 -7- UVA-OM-1387

IdeAgency and IdeaExchange had seemed like the way to go; now they were being questioned. It
seemed as if Microsoft as a whole made it difficult for a “tool-and-touch” process to succeed.

Steep personally believed his team was running into too many hurdles trying to engender
fruitful collaboration in a resistant environment. Despite continuous improvements to increase
participation in the IdeAgency challenges, the team seemed to run up against a recurrent
obstacle—it simply took too much effort to get anything going across the product groups. Many
employees refused to work on projects beyond their defined objectives and commitments out of
fear of receiving poor evaluations.

Organization Structure and Design

Microsoft comprised three business divisions: Platform Products and Services, Microsoft
Business, and Entertainment and Devices (Exhibit 10). These three divisions were deep silos of
activity that rarely communicated or collaborated. Microsoft Research and the Innovation Team
were part of the Innovation Organization, which was distinct from the business divisions. Sales
operations and the Enterprise Partner Group fell under Sales, Marketing, and Services.

The three business divisions, seven business groups, and 27 product groups within them
were highly autonomous. Each division, business group, and product group was squarely focused
on its individual profit and loss. Steep had come to the conclusion that the business groups had
no time or incentive for the investment of resources beyond assigned core product lines. At the
same time, those product groups were under tremendous pressure to deliver organic growth of
$3 billion to $5 billion per year over the next three to five years.

For some time, Steep had witnessed the difficulty that managers in the business groups
and product groups had in translating the vision outlined by senior executives into operational
products, services, and results. Although senior executives made extraordinary statements in the
press or at technology conferences, business managers did not necessarily understand how or
why they should deliver on those promises. Many Microsoft insiders believed that senior
executives were overextending themselves.

Culture and beliefs

Microsoft was often referred to as a developer-centric company because most employees

possessed a prodigious amount of technical expertise. Every employee, including the most senior
executive, had a small office with a closed-door policy so employees could concentrate on their
individual projects without distraction.

The culture at Microsoft was primarily a result of Gates’s and, more recently, Ballmer’s
behavior and management style, which was driven by three core beliefs. First was individual
excellence—Microsoft believed it had the best and brightest employees in the world. Second was
a reliance on extremely competitive behavior. Finally, Microsoft employees were expected to
 -8- UVA-OM-1387

never accept second best. “Ducks fly high, but eagles fly higher,” so everyone should try to be an
eagle. “Go big or go home” was a mantra often heard at Microsoft meetings.

These beliefs and principles led to extreme intra- and interfirm competition intensity. In
fact, employees and groups were often cast into competing positions with the expectation that the
best ideas and people would ultimately survive. Stories of managers being called to task by Gates
or Ballmer were quite common. Nothing highlighted this more than the “BillG Review”—a
personal meeting with Gates and his lieutenants in which major decisions (and employees) were
dissected and reviewed—a grilling that could make or break a career at Microsoft. An
individual’s performance at a BillG Review was often measured by the number of times Gates
shook his head and yelled profanities.5 For Gates, such intense confrontation was something
positive and desirable because everyone at Microsoft was expected to be superior, so there was
no need to coddle employees.

Commitments and evaluations

At Microsoft, individual and group incentives were primarily influenced by the

“commitments” tied to each employee’s output. Commitments were detailed objectives stated in
the form of a contract between an employee and his or her supervisor. At the beginning of the
year, commitments were set in stone and could not be changed. Employees who did not deliver
on their commitments would face severe penalty in their performance evaluations. Given the
penalty associated with not achieving them, most employees tried to ensure that their
commitments remained within their spheres of influence. The result was that commitments
would typically be focused within the business group or product group, as opposed to laterally or
with a 360-degree vision. Each employee’s commitments were carefully monitored through an
online system. In fact, employees stood a good chance being penalized if they undertook
activities unrelated to their commitments. There was no such thing as “15 percent time” at
Microsoft.6

At the business group and division levels, commitments translated to strict financial
goals. Business group executives and division leaders were fanatically focused on ensuring that
their units achieved target financial results. If a business group or division did not deliver on its
commitments, the unit was subject to a midyear review process that incorporated something
called the “Correction of Errors.” During the Correction of Errors, which took place in an open
forum, similar to a company retreat, senior executives and top-line reports spent two days
dissecting units that did not achieve their sales targets.

For many years, Microsoft used a stack ranking employee evaluation system in which
managers ranked their employees from “number one” to “dead last” in terms of performance.
The rankings were then used to score employees using a forced curve on a one-to-five scale.

5
Fred Vogelstein, “Rebuilding Microsoft,” Wired, October 2006.
6
The term “15 percent time” was often associated with the 3M Corporation because 3M encouraged employees
to spend up to 15% of their time on projects of their own choosing.
 -9- UVA-OM-1387

Eventually, the company became too large to do this effectively, so Microsoft began grouping
employees into buckets: limited (10%), achieving (65%), and exceeding (25%).

Compensation

Microsoft took pride in paying less than market value for talent. The company wanted to
hire great people who were not working for the money; it believed employees should be
motivated by the potential impact of their work. Between 1980 and 2005, Microsoft was able to
offer all employees stock options. During that period, employees were virtually guaranteed to
become millionaires because of the exponential increase in the company’s stock price. The
growth of Microsoft created four billionaires and over 10,000 millionaires.7 In 2005, the
company stopped granting stock options and began giving employees stock grants.

Forecast for the Future: Sunny or Cloudy?

As Steep left the EBC, he thought about everything that was at stake for Microsoft.
Ozzie, Steep, and the Innovation Team were responsible for delivering innovative business
models to fuel organic growth at Microsoft, but it was not clear how to do this. Steep thought to
himself:

Where do we go from here? Ninety thousand employees and countless large and
small businesses all over the world depend on Microsoft. Our way of doing things
has resulted in great success over the past 30 years…But is it sustainable?

7
Julie Bick, “The Microsoft Millionaires Come of Age,” New York Times, May 29, 2005.
 -10- UVA-OM-1387

Exhibit 1
INNOVATION STRATEGY AT MICROSOFT: CLOUDS ON THE HORIZON
Executive Biographies

Michael Steep is chief of operations and the business lead for the Microsoft Innovation Team. Prior to joining the
Innovation Team, Steep managed field engagement and operations for Microsoft’s technical enterprise sales force
focused on Microsoft’s offerings in Software-As-A-Service. Steep also started up and managed the Telco partner
channel for Microsoft’s Unified Communications group responsible for Live Meeting and Office Communicator. He
has over 30 years of experience in the technology industry, having held executive roles as chief operating officer of
a NASDAQ company acquired by Kodak; corporate vice president international for Lexmark; general manager of
Apple Computer’s Imaging System division; and managing director of Worldwide Channels for Xerox. He has an
undergraduate degree from the University of Pennsylvania and an MBA from the University of Virginia, Darden
Graduate School of Business Administration.

Ray Ozzie is responsible for oversight of Microsoft’s technical strategy and product architecture. Ozzie is also
directing development of the company’s next-generation software services platform—“Windows in the Cloud.”
Previously, Ozzie was chief technical officer from April 2005 to June 2006. He assumed that role in April 2005 after
Microsoft acquired Groove Networks, a collaboration software company he formed in 1997. Prior to Groove, Ozzie
was a founder and president of Iris Associates, where he created and led the development of Lotus Notes. Before
Iris, he was involved in early distributed operating systems development at Data General Corp. Ozzie earned a
bachelor’s degree in computer science from the University of Illinois Urbana-Champaign.

Steven A. Ballmer is chief executive officer of Microsoft Corporation. Ballmer joined Microsoft in 1980 and was
the first business manager hired by Bill Gates. Ballmer and the company’s business and technical leaders are
focused on continuing Microsoft’s innovation and leadership across the company’s core businesses. Variously
described as ebullient, focused, funny, passionate, sincere, hard-charging, and dynamic, Ballmer has infused
Microsoft with his own brand of energetic leadership, vision, and spirit over the years. Ballmer was born in March
1956, and grew up near Detroit, Michigan, where his father worked as a manager at Ford Motor Co. He graduated
from Harvard University with a bachelor’s degree in mathematics and economics. After college, he worked for two
years at Procter & Gamble Co. as an assistant product manager and, before joining Microsoft, attended Stanford
University Graduate School of Business.

Craig Mundie is chief research and strategy officer of Microsoft Corp., reporting to CEO Steve Ballmer. In this
role, he oversees Microsoft Research, one of the world’s largest computer-science research organizations, and is
responsible for Microsoft’s long-term technology strategy. Mundie also directs the company’s fast-growing health-
care-solutions business, along with a number of technology incubations. He routinely works with government and
business leaders around the world on technology policy, regulation and standards. Mundie holds a bachelor’s degree
in electrical engineering and a master’s degree in information theory and computer science from the Georgia
Institute of Technology.

Bob Muglia is president of the Server and Tools Business (STB) at Microsoft. As the STB business leader, Muglia
is responsible for developing and marketing Microsoft’s infrastructure and developer software. This integrated set of
products provides the foundation for IT operations, security, application development and integration. Muglia holds
a bachelor’s degree in computer science from the University of Michigan.

Source: “Microsoft Executives,” http://www.microsoft.com/presspass/exec/a-d.aspx (accessed April 26, 2011).

 -11- UVA-OM-1387

Exhibit 2
INNOVATION STRATEGY AT MICROSOFT: CLOUDS ON THE HORIZON
Key Historical Events

1975–1985
Bill Gates and Paul Allen founded Microsoft to develop software for the Altair 8800 (a microcomputer
developed by Micro Instrumentation and Telemetry Systems). Steve Ballmer joined the company on June
11, 1980. On August 12, 1981, IBM awarded a contract to Microsoft to provide a version of DOS, to be
used in the upcoming IBM Personal Computer. By aggressively marketing MS-DOS to manufacturers of
IBM-PC clones, Microsoft rose from a small player to become one of the major software vendors in the
home computer industry.

1985–1995
On November 20, 1985, Microsoft released its first retail version of Microsoft Windows, a graphical
extension for its MS-DOS operating system. On March 13, 1986, the company went public, with an initial
offering price of $21.00. Over the next two decades, the rise of the stock price has made four billionaires
and more than 10,000 millionaires from within its ranks. By the end of 1995, the Windows operating
system held a market share of approximately 90% and has maintained this share through 2009.

1995–2005
In May 1995, following Bill Gates’s internal “Internet Tidal Wave” memo, Microsoft began to expand its
product line into computer networking and the World Wide Web. In August 1995, Microsoft released
Windows 95, a graphical user interface similar to the Macintosh user interface. The company released its
web browser, Internet Explorer, in subsequent Windows versions. Microsoft also launched a major online
service, MSN (Microsoft Network), and a joint venture with NBC called MSNBC. In October 1997, the
Department of Justice filed an antitrust motion against Microsoft, claiming that the company had engaged
in predatory pricing by giving away Internet Explorer with its Windows operating system. Microsoft
encountered additional turmoil in March 2004 when antitrust legal action was brought against it by the
European Union for abusing its current dominance with the Windows operating system

2005–present
In October 2005, 10 years after writing the “Internet Tidal Wave” memo, Bill Gates authored a “Services
Wave” memo stating that Microsoft should incorporate a service model along with its software offering.
This is the genesis of Microsoft’s software-plus-service model. In June 2008, Bill Gates retired from day-
to-day activities in the company, following a two-year transition period from his role as chief software
architect. Ray Ozzie took over that role.

Source: “Facts About Microsoft,” http://www.microsoft.com/presspass/inside_ms.mspx (accessed April 26, 2011).

 -12- UVA-OM-1387

Exhibit 3
INNOVATION STRATEGY AT MICROSOFT: CLOUDS ON THE HORIZON
Excerpts from Internet Tidal Wave Memo

From: Bill Gates

Sent: May 25, 1995
To: Executive Staff and Direct Reports
Subject: The Internet Tidal Wave

Our vision for the last 20 years can be summarized in a succinct way. We saw that exponential improvements in
computer capabilities would make great software quite valuable. Our response was to build an organization to
deliver the best software products. In the next 20 years the improvement in computer power will be outpaced by the
exponential improvements in communications networks.

The Internet is at the forefront of all of this and developments on the Internet over the next several years will set the
course of our industry for a long time to come. Perhaps you have already seen memos from me or others here about
the importance of the Internet. I have gone through several stages of increasing my views of its importance. Now I
assign the Internet the highest level of importance. In this memo I want to make clear that our focus on the Internet
is crucial to every part of our business.

The Internet is the most important single development to come along since the IBM PC was introduced in 1981. It is
even more important than the arrival of the graphical user interface (GUI). The PC analogy is apt for many reasons.
The PC wasn’t perfect. Aspects of the PC were arbitrary or even poor. However a phenomena [sic] grew up around
the IBM PC that made it a key element of everything that would happen for the next 15 years. Companies that tried
to fight the PC standard often had good reasons for doing so but they failed because the phenomena overcame any
weaknesses that resisters identified. I think that virtually every PC will be used to connect to the Internet and that the
Internet will help keep PC purchasing very healthy for many years to come.

We enter this new era with some considerable strengths. Among them are our people and the broad acceptance of
Windows and Office. There will be a lot of uncertainty as we first embrace the Internet and then extend it. Since the
Internet is changing so rapidly we will have to revise our strategies from time to time and have better inter-group
communication than ever before.

The next few years are going to be very exciting as we tackle these challenges are opportunities. The Internet is a
tidal wave. It changes the rules. It is an incredible opportunity as well as incredible challenge I am looking forward
to your input on how we can improve our strategy to continue our track record of incredible success.

Source: Bill Gates, “The Internet Tidal Wave,” May 26, 1995, http://www.usdoj.gov/atr/cases/exhibits/20.pdf
(accessed April 26, 2011).
 -13- UVA-OM-1387

Exhibit 4
INNOVATION STRATEGY AT MICROSOFT: CLOUDS ON THE HORIZON
Excerpts from Services Wave Memo

From: Bill Gates

Sent: Sunday, October 30, 2005 9:56 PM
To: Executive Staff and Direct Reports; Distinguished Engineers
Subject: Internet Software Services

Microsoft has always had to anticipate changes in the software business and seize the opportunity to lead. Today, the
opportunity is to utilize the Internet to make software far more powerful by incorporating a services model, which
will simplify the work that IT departments and developers have to do while providing new capabilities.

The broad and rich foundation of the Internet will unleash a “services wave” of applications and experiences
available instantly over the Internet to millions of users. Advertising has emerged as a powerful new means by
which to directly and indirectly fund the creation and delivery of software and services along with subscriptions and
license fees. Services designed to scale to tens or hundreds of millions will dramatically change the nature and cost
of solutions deliverable to enterprises or small businesses.

We will build our strategies around Internet services and we will provide a broad set of service APIs and use them in
all of our key applications. This coming “services wave” will be very disruptive. We have competitors who will
seize on these approaches and challenge us—still, the opportunity for us to lead is very clear. More than any other
company, we have the vision, assets, experience, and aspirations to deliver experiences and solutions across the
entire range of digital workstyle & digital lifestyle scenarios, and to do so at scale, reaching users, developers and
businesses across all markets.

But in order to execute on this opportunity, as we’ve done before, we must act quickly and decisively. This next
generation of the Internet is being shaped by its “grassroots” adoption and popularization model, and the cost-
effective “seamless experiences” delivered through the intentional fusion of services, software and sometimes
hardware. We must reflect upon what and for whom we are building, how best to deliver new functionality given the
internet services model, what kind of a platform in this new context might enable partners to build great profitable
businesses, and how our applications might be reshaped to create service-enabled experiences uniquely compelling
to both users and businesses alike.

Steve and I recently expanded Ray Ozzie’s role as CTO to include leading our services strategy across all three
divisions. We did this because we believe our services challenges and opportunities will impact most everything we
do. Ray has long demonstrated his passion for software, and through his work at Groove he also came to realize the
transformative potential for combining software and services.

The next sea change is upon us. We must recognize this change as an opportunity to take our offerings to the next
level.

Source: CNET News.com staff writer, “Gates Memo: Brace for ‘Services Wave,’” November 9, 2005,
http://news.cnet.com/Gates-memo-Brace-for-services-wave/2100-1016_3-5942191.html?tag=mncol;txtd (accessed
April 26, 2011).
 -14- UVA
A-OM-1387

Exhibit 5
INNOV
VATION STRA
ATEGY AT MICROSOFT:
M C
CLOUDS ON T
THE HORIZO
ON
The Id
deAgency Process

So
ource: Created by case
c writer.
 -15- UVA
A-OM-1387

Exhibit 6
INNOV
VATION STRA
ATEGY AT MICROSOFT:
M C
CLOUDS ON T
THE HORIZO
ON
Innovation Mechanisms
M at Microsoft
M

Sourrce: Created by casse writer based on publicly

p available information.
 -16- UVA-OM--1387

Exhibit
E 7
INN
NOVATION
N STRATE
EGY AT MIICROSOFT
T: CLOUDS
S ON THE H
HORIZON
Select Financial Inform
mation

Consolidateed Income Staatement

(in milllions of dollarrs, except perr-share amounnts)

Year Ended June 30 2008 2007 2006

Revenue 60,420 51,122 44,282
Operating expenses:
e
Cost of revenue
r 11,598 10,693 7,650
Researchh and developpment 8,164 7,121 6,584
Sales an
nd marketing 13,039 11,455 9,818
General and administtrative 5,127 3,329 3,758
Total operating
o exp
penses 337,928 32,598 27,810
Operating inncome 222,492 18,524 16,472
Investment income and other
o 1,322 1,577 1,790
Income beffore income taaxes 223,814 20,101 18,262
Provision fo
or income tax
xes 6,133 6,036 5,663
Net incomee 17,681 14,065 12,599

Closing Price
P (1990–22009)

Data sou
urce: Microsofft annual reportts.
 -17- UVA-OM-1387

Exhibit 8
INNOVATION STRATEGY AT MICROSOFT: CLOUDS ON THE HORIZON
Product Group Software Development Process

Release to
Product Cycle Planning Development Testing
Manufacturing
Program  Drive vision  Manage product  Make feature  Coordinate release
Manager  Feature design status, spec, and tradeoffs and delivery of
 Write functional team  Finalize master
specifications communications publishing and  Begin publishing
 Create master  Keep team focused production and production
schedule  Plan publishing and processes for processes for web
production web products products
processes for web
products
Software Design  Conduct  Write, reuse, and  Debug and  Build release
Engineer feasibility review debug code stabilize code elements and
of proposed  Create beta master products
features releases
 Create
development team
plan and schedule

Source: “Microsoft Product Development Process,” http://www.microsoft.com/college/fyp_prodcycle.aspx

(accessed July 1, 2009).
 -18- UVA-OM--1387

Exhibit
E 9
INN
NOVATION
N STRATE
EGY AT MIICROSOFT
T: CLOUDS
S ON THE H
HORIZON
2008
8 Revenue Breakdown byy Competitoor

Data sourrce: Company 10-K reports.

 -19- UVA
A-OM-1387

Exhibit 10
INNOV
VATION STRA
ATEGY AT MICROSOFT:
M C
CLOUDS ON T
THE HORIZO
ON
Microsoft Organization
O Strructure

Source: Created by
y case writer.