The Agreement That Catapulted Microsoft Over IBM

Bill Gates was only 23 years old when he and Paul Allen formed Microsoft.

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Why you should care

Because sometimes business domination begins with a single well-negotiated contract.

Too Big Not to Fail: An OZY Series on Pitfalls Facing Corporate Titans. Too Big Not to Fail: An OZY Series on Pitfalls Facing Corporate Titans.

When Thomas Watson Jr. took over his father’s company in 1956, he began the process of modernizing and revitalizing International Business Machines, or IBM. Invoking Søren Kierkegaard’s parable about tame ducks who — rather than fly south — remain up north growing fat on the food that’s given them, Watson wanted to build a company filled with “wild ducks,” those willing to break formation or “think different,” as another computer manufacturer once put it. Despite its wild ducks ethos, IBM was still a slow-moving corporate behemoth, one that waited too long to enter the personal computer business in the late 1970s. It was a delay that provided a fateful opening for two true wild ducks, Microsoft’s Bill Gates and Paul Allen, to fly down south in 1980 and pull off a contractual coup that would change the course of tech history … and help oust IBM as the world’s dominant computer company.

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Thomas Watson Sr., the president of IBM, was essentially the first celebrity CEO.

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As Kevin Maney chronicles in The Maverick and His Machine, Thomas Watson Sr. was essentially the first celebrity CEO — not only the highest-paid man in America but also a visionary who believed that his mission-driven IBM could be a great place to work and make an impact on the world. As it grew its share of the computer market, IBM cultivated an equally strong corporate culture, including countless employee perks, a monthly magazine, even a company songbook. IBM’s sales reps were not permitted to drink, and they were required to wear suits and ties.

IBM’s legal caution would prove to be Microsoft’s business windfall.

And then two men who hardly ever wore suits turned up in them for a meeting with IBM in August 1980. Gates and Allen had started Microsoft just three years earlier, but the Bellevue, Washington, software company had already sold more than a half-million copies of its Basic software program, which had drawn the attention of the largest computer-maker in the world. IBM had traditionally developed new products in-house, but by 1980 it was late to the PC market and wanted to move as fast as possible, which meant outsourcing some key work. Among other things, IBM needed software to enable the operation of various programs for its first PC. And so IBM approached Microsoft and other software-makers about their top-secret “Project Chess” (also with the initials PC), requiring each to sign a nondisclosure agreement before IBM would even sit down with them. 

 

As Paul Allen shares in Idea Man: A Memoir by the Cofounder of Microsoft, a key competitor of Microsoft’s had refused to sign the NDA that IBM gave them — and while their lawyers were bogged down negotiating, Allen and Gates made their move, signing IBM’s NDA and promising them (even though they were not sure quite how to deliver) that Microsoft could create a disk operating system (DOS) that would meet their needs. “[T]hanks to a fluke,” Allen writes, “we’d been handed the opportunity to create the pivotal product of the era.”

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Microsoft’s Paul Allen and Bill Gates met with IBM in 1980.

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On Nov. 6, 1980, the contract that would change the future of computing was signed: IBM would pay Microsoft $430,000 for what would be called MS-DOS. But the key provision in that agreement was the one that allowed Microsoft to license the operating system to other computer manufacturers besides IBM — a nonexclusive arrangement that IBM agreed to in part because it was caught up in decades of antitrust investigations and litigation. IBM’s legal caution, however, would prove to be Microsoft’s business windfall, opening the door for the company to become the dominant tech company of the era.

Hundreds of thousands of IBM computers were sold with MS-DOS, but more than that, Microsoft became the maker of the crucial connection that was needed between the software and hardware used to operate computers. Company revenue skyrocketed from $16 million in 1981 to $140 million in 1985 as other computer-makers like Tandy and Commodore also chose to partner with them.

And as Microsoft’s fortunes rose, IBM’s declined. The company known as Big Blue, which had once been the largest in America, and 3,000 times the size of Microsoft, lost control of the PC platform it had helped build as software became more important than hardware. By the early 1990s, the company was losing billions of dollars a year and struggling to stay afloat, with Microsoft surpassing IBM in market value in January 1993. While parts of IBM, including its research labs, had done a great job at championing wild ducks and crazy ideas, over time, says Maney, “the company no doubt became loaded with tame ducks.”

IBM had also let its wild ducks be corralled by overly cautious lawyers — a lesson Microsoft would learn from, throwing legal caution to the wind at times. That would occasionally land the company in hot water, including with the famous antitrust suit brought by the U.S. Justice Department in the late 1990s. Microsoft tried to rebel against IBM’s bulky, top-down corporate style in other ways as well. “We hated IBM,” Peter Neupert, a former Microsoft executive, told Wired in 2000. “The people who were rewarded most at Microsoft were cowboys and misfits — the guys IBM would never hire.”

And so goes the history of modern computing — from hardware to software, from wild ducks to cowboys and misfits, transitions powered in large part by a single highly consequential contract provision.

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