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Microsoft Catches a Wave, and the First Shot in the Software Patent Wars

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On this day in economic and business history ...

Microsoft (NASDAQ: MSFT  ) CEO Bill Gates has a great track record of anticipating computing trends. He founded Microsoft to provide a programming language for the primitive Altair 8800, a direct predecessor to the PC. The launch of the PC put Microsoft and its DOS operating system at the crossroads of the greatest technological proliferation since the 1920s, but it might never have been possible without a combination of great timing and incredible luck. However, by 1995, Gates began to realize that Microsoft would miss the boat on the next major computing revolution, and that possibility might pose the greatest threat to his company's long-term survival.

On May 26, 1995, Gates sent his top lieutenants a long memo that would become known as "The Internet Tidal Wave." In this memo, he laid out what was happening and why it was so important that Microsoft not miss the wave. Here are a few of the more pertinent excerpts:

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. ...

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 (NYSE: IBM  ) PC was introduced in 1981. It is even more important than the arrival of the graphical user interface (GUI). ...

Most important is that the Internet has bootstrapped itself as a place to publish content. It has enough users that it is benefiting from the positive feedback loop of the more users it gets, the more content it gets, and the more content it gets, the more users it gets. ...

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. ...

The On-line services business and the Internet have merged. What I mean by this is that every On-line service has to simply be a place on the Internet with extra value added. ... The amount of free information available today on the Internet is quite amazing. Although there is room to use brand names and quality to differentiate from free content, this will not be easy and it puts a lot of pressure to figure out how to get advertiser funding. Even the CD-ROM business will be dramatically affected by the Internet. Encyclopedia Brittanica is offering their content on a subscription basis. ...

Once a format gets established it is extremely difficult for another format to come along and even become equally popular. ...

A new competitor "born" on the Internet is Netscape. Their browser is dominant, with 70% usage share, allowing them to determine which network extensions will catch on. They are pursuing a multi-platform strategy where they move the key API into the client to commoditize the underlying operating system. They have attracted a number of public network operators to use their platform to offer information and directory services. We have to match and beat their offerings including working with MCI, newspapers, and others who are considering their products.

This memo reached the public during Microsoft's antitrust case, which had been instigated by (among other Microsoft competitors) Netscape. Though nothing in the memo implies underhanded tactics were to be wielded against the browser upstart, it still cast Gates and Microsoft in a negative light in the press.

Microsoft did manage to gain significant early browser share as a result of its intensified (and occasionally underhanded) Internet focus, and the company now earns roughly a quarter of its revenue from Internet-related products and services (primarily in the server market). However, Microsoft has yet to move beyond Windows and Office, the two key products that Gates feared might become obsolete if they failed to gain a significant role in enabling Internet use. Its direct forays into online dominance -- MSN and the Bing search engine -- have produced disappointing results.

Coding new protections
A different sort of tidal wave began rising on May 26, 1981. That day, the U.S. Patent and Trademark Office awarded programmer and attorney Satiya Pal Asija the first software patent in the United States. Asija had originally programmed a natural-language interface called Swift-Answer all the way back in 1969, when IBM mainframes were still the norm and the minicomputer era was only starting to gain steam. At the time, software was ruled unpatentable, but Asija took this as a challenge to be overcome, in this case via legal training. He attended law school, specializing in (what else?) patent law, and filed his patent shortly after attaining the bar in 1974.

The reversal of a Supreme Court decision against software patents began a monumental shift in the relationship between software companies and their software just at the moment that consumer computing was about to explode in popularity. By this point, Swift-Answer was essentially obsolete (the computers it was written for were largely obsolete, too), but the floodgates had been opened, and there would be no stopping the software patent flood, nor the later flood of that most reviled of enterprise, the patent troll. The USPTO issued approximately 40,000 software patents two decades after Asija's patent, and many of these patents now represent extremely lucrative sources of revenue for their filers. Unfortunately for innovators, much of that lucrative potential is tapped in the courtroom -- more than 5,000 software-patent infringement lawsuits are now filed in American courts each year.

Today, IBM and Microsoft have the two largest software-heavy patent hoards in the United States. IBM was granted 6,500 patents, and Microsoft 2,600, in 2012. Interestingly, many of the top U.S. patent-holding companies aren't U.S. companies -- only three of the top 10 companies by 2012 patent grants (General Electric is the third) are based in the United States, and the rest are all Asian consumer-electronics companies. However, all four of the Dow Jones Industrial Average's (DJINDICES: ^DJI  ) computing-focused companies rank among the top patent holders (if slightly further down on the list). In addition to IBM and Microsoft, Hewlett-Packard (NYSE: HPQ  ) and Intel (NASDAQ: INTC  ) are also beneficiaries of software patents, despite their hardware focus. The former company gained 1,400 patents in 2012, and the latter gained 1,300. These computing companies are patent heavyweights compared with the pharmaceutical industry -- the largest patent trove granted in that industry would barely equal half that earned by HP or Intel.

It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In a new premium report on Microsoft, a Motley Fool analyst explains that while the opportunity is huge, so are the challenges. The report includes regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.

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Alex Planes

Alex Planes specializes in the deep analysis of tech, energy, and retail companies, with a particular focus on the ways new or proposed technologies can (and will) shape the future. He is also a dedicated student of financial and business history, often drawing on major events from the past to help readers better understand what's happening today and what might happen tomorrow.

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