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COVER STORY PODCASTWhen Microsoft Corp. () hired computer scientist Kai-Fu Lee away from hardware maker Silicon Graphics Inc. () in 1998, the move underscored how thoroughly the software giant dominated the computer industry. Not only did it monopolize PC operating systems and hold an edge in Web browsers, but it was also vacuuming up the world's brightest technologists. Lee's expertise was in speech recognition, considered one of the next big leaps in computing. With people like him flocking to Microsoft's labs, it seemed that the digital world's reigning champion had a lock on the future.
Things didn't turn out that way. In July, Lee bolted from Microsoft for Web search king Google Inc. (), and once again his personal journey is emblematic of a shift in computing's balance of power. These days it's Google, not Microsoft, that seems to have the most momentum. Microsoft sued to stop Lee from working for the upstart, citing his noncompete agreement. But on Sept. 13 a state judge in Seattle ruled that Lee could work for Google, with some restrictions, pending a January trial. Microsoft said it was happy the judge limited the type of work Lee could do. Yet when court adjourned, Lee smiled broadly and threw both arms in the air. "I feel great," he said outside the courtroom. "I can't wait to start work tomorrow morning."
Contrast that with how Lee felt about Microsoft. During the two-day hearing he painted a distinctly unflattering picture of the company's inner workings. Lee, who opened Microsoft's research lab in China in 1998 and moved to headquarters in Redmond, Wash., two years later, fretted over what he saw as repeated missteps. In court he detailed how the more than 20 product-development centers in China tripped over one another, duplicating efforts and even fighting over the same job candidate. Lee called the company "incompetent." After the ruling he praised Google, noting, "the culture is very supportive, collaborative, innovative, and Internet-like -- and that's bottoms-up innovation rather than top-down direction."
For most of its three decades, Microsoft has faced intense criticism. But in the past it came from the outside world. Rivals complained about its heavy-handed tactics. PC makers griped that it was hogging the industry's profits.
Now much of the sharpest criticism comes from within. Dozens of current and former employees are criticizing -- in BusinessWeek interviews, court testimony, and personal blogs -- the way the company operates internally. This spring two researchers sent Chairman William H. Gates III a memo in which they wrote: "Everyone sees a crisis is imminent" and suggested "Ten Crazy Ideas to Shake Up Microsoft." Many workers, like Lee, are in effect saying: "I'm outta here." More than 100 former Microsofties now work for Google, and dozens of others have scattered elsewhere.
It's not a mass exodus. Microsoft has 60,000 employees, and many of them are undoubtedly happy with their jobs and the company's culture. While Microsoft's annual attrition rate rose one percentage point from fiscal 2003 to 2004, it's still just 9%, a bit lower than the industry average. Microsoft says it receives 45,000 to 60,000 job applications a month, and over 90% of the people offered jobs accept.TOO BIG TO MOVE FAST?
Still, there's no doubt that Microsoft is losing some of its most creative managers, marketers, and software developers. Lenn Pryor, director of platform evangelism, left for Internet phone startup Skype Technologies, now being acquired by eBay (). Stephen Walli, who worked in the unit set up to parry the open-source threat, split for an open-source consulting firm. A long list of talent has moved to Google, a trip made easier by the company's recent establishment of an office in nearby Kirkland, Wash. Joe Beda and Gary Burd, respected engineers, left and helped set up the instant messaging service Google Talk. Mark Lucovsky, who had been named one of Microsoft's 16 Distinguished Engineers, defected to Google last November. He blogged that Microsoft's size is getting in its way. "I am not sure I believe anymore that Microsoft knows how to ship software," he wrote.
Employees' complaints are rooted in a number of factors. They resent cuts in compensation and benefits as profits soar. They're disappointed with the stock price, which has barely budged for three years, rendering many of their stock options out of the money. They're frustrated with what they see as swelling bureaucracy, including the many procedures and meetings Chief Executive Steven A. Ballmer has put in place to motivate them. And they're feeling trapped in an organization whose past successes seem to stifle current creativity. "There's a distinct lack of passion," says one engineer, who would talk only on condition of anonymity. "We're missing some spunk."
No question, most companies would kill to have Microsoft's problems. It's comfortably the most profitable player in the tech industry. And it's making more money than ever, with net income of $12.3 billion on revenues of $39.8 billion for the past fiscal year. Its twin monopolies, the Windows PC operating system and the Office suite of desktop applications, give it important advantages when it thrusts into adjacent markets, such as server software for corporations and instant messaging for both businesses and consumers.
Ballmer maintains that the company is in terrific shape. In an interview in a Las Vegas hotel, he says one of Microsoft's strengths has always been its culture of self-criticism. What's different now, he says, is that the internal debate is spilling out into public view because of blogs and e-mail. He says internal surveys show that 85% of the company's employees are satisfied with their jobs, about the same level as in past years. "We have as excited and engaged a team of folks at Microsoft as I can possibly imagine," says Ballmer. "[Employees] love their work. They're passionate about the impact they're having on customers and society. [The 85% number] is a real, real powerful statement about where our people are."
Indeed, there are areas of excitement within Microsoft. One is MSN, the Internet operation, where the search group is the underdog competing against Google. Another is the Xbox group, which is racing full speed against Sony Corp.'s () leading PlayStation 2 to win over the next generation of video gamers. It's launching Xbox 360 this Christmas, months ahead of PlayStation 3. "If you take a look at where we're going with innovation, what we have in the pipeline, I'm very excited. The output of our innovation is great," says Ballmer. "We won the desktop. We won the server. We will win the Web. We will move fast, we will get there. We will win the Web."
The company plans to release a series of major upgrades for most of its core products in the coming 18 months. That'll culminate late next year in the long-awaited update of Windows, called Vista. Analysts such as Drew Brosseau of SG Cowen & Co. expect it to help financial results -- he's predicting that revenues will rise 12% during the next fiscal year, to $44.5 billion, as profits increase 12%, to $13.8 billion. He thinks the stock, now at $27, will follow. "It can be a mid-30s stock in 12 months," says Brosseau.
Still, Microsoft faces serious long-term challenges: the rising popularity of the Linux open-source operating system, a plague of viruses attacking itssoftware, and potent rivals such as Google in the consumer realm and IBM () in corporate computing. It's the company's ability to respond to these challenges that current and former employees fear is being compromised by Microsoft's internal troubles. They're concerned that Ballmer and Gates aren't taking seriously enough the issues of morale and culture. "Why in the world did I start [this blog]?" writes Mini-Microsoft, an anonymous employee who writes a blog that has become a gathering place for the company's internal critics and reformers. "I love Microsoft, and I know we have the innate potential to be great again."
To many employees, Vista, the Windows update, exemplifies the company's struggles. When the project was conceived half a decade ago, it was envisioned as a breakthrough: an operating system that would transform the way users store and retrieve information. But the more revolutionary features have been dropped, and Vista will arrive three years after researcher Gartner Inc. originally predicted that it would ship. Worse yet, they say, nobody has been held accountable. "People look around and say: 'What are those clowns doing?"' says Adam Barr, a program manager in the Windows group.
In the past, when Microsoft faced an emerging threat, Gates could be depended on to lead it in a new direction. Most famously, in 1995 he belatedly recognized the importance of the Internet and led a furious charge to catch up. But in 2000 Gates passed on the chief executive job to Ballmer. When Ballmer took over, he was determined to overcome the looming challenge of corporate middle age. He pored over how-to management books such as Jim Collins' Good to Great. But since Ballmer took the helm, Microsoft has slipped the other way. The stock price has dropped over 40% during his tenure, and the company, whose revenue grew at an average annual clip of 36% through the 1990s, rose just 8% in the fiscal year that ended on June 30. That's good for a company of Microsoft's size, but it is the first time the software giant has had single-digit growth.
The company's performance even has some anonymous writers on the Mini-Microsoft Web site calling on Gates to ask Ballmer to step down. That's very, very unlikely. Gates urged Ballmer to become chief executive nearly six years ago in the wake of the company's antitrust battles with the Justice Dept., when the top job became too overwhelming for him. The two have been close friends since their days at Harvard University, and together they hold 12% of the company's shares. And board members say they stand firmly behind Ballmer. "I am fully supportive of the transformation that Steve is leading the company through," James I. Cash Sr., a director and former professor at Harvard Business School, wrote in an e-mail to BusinessWeek. "He is one of the best leaders I've observed over the last four years I've been on this Board, and the Board stands in full support of him and his efforts."
Ballmer says he should be judged on his overall performance. "At the end of the day the proof is in the output. If you look at any of the critical dimensions, our company has performed well, and I'm bullish about how we will drive to continue."
While Microsoft's internal reformers don't directly criticize Gates, they're frustrated with the sluggish pace of product development. As the company's chief software architect, Gates bears that responsibility. He's the author of a strategy called "integrated innovation." The idea is to get Microsoft's vast product groups to work closely together to take advantage of the Windows and Office monopolies and bolster them at the same time. But with so much more effort placed on cross-group collaboration, workers spend an immense amount of time in meetings making sure products are in sync. It "translates to more dependencies among shipping products, less control of one's product destiny, and longer ship cycles," writes Dare Obasanjo, a program manager in Microsoft's MSN division, on his blog.
To shake Microsoft out of its malaise, radical surgery may be in order. "I think they should break up the company," says Raj Reddy, a professor of computer science and robotics at Carnegie Mellon University. Reddy is no passive industry observer: For the past 15 years he has served on Microsoft's Technical Advisory Board, a group of academics who help guide the company's research efforts. Reddy believes that a handful of Microsoft spin-offs, seeded with some of the company's $37.8 billion in cash, could compete more nimbly in the marketplace. Some insiders agree. Microsoft's Barr recently blogged that the company should be broken up after Gates and Ballmer retire.
There are plenty of bold thoughts floating around Microsoft. The two reseachers who sent the "Ten Crazy Ideas" memo to Gates are Kentaro Toyama and Sean Blagsvedt. The 12-page document, reviewed by BusinessWeek, suggests giving product groups increased autonomy and calls for the creation of "bureaucracy police" with the authority to slash through red tape. "It's said that large organizations won't change their ways until a crisis really hits," the authors write. "Everyone sees a crisis is imminent. Incremental changes aren't enough. Are we the kind of company that can dodge the crisis before it happens?"MAINTAINING, NOT INNOVATING
It's a question that echoes through the corridors in Redmond. To succeed, Microsoft needs motivated workers camping out in their offices at all hours to compete with tenacious rivals such as Google, Yahoo! (), Salesforce.com (), and a reborn Apple () Computer. Yet current and former employees say there are many demoralized workers who are content to punch the clock and zoom out of the parking lot. "At this point there's a traffic jam at 9 o'clock in the morning and 5 o'clock at night," says ex-employee Walli.
Over its three decades of life, Microsoft has become an icon of American capitalism, a company that started with the intellectual firepower and relentless drive of Gates and his high school buddy, Paul Allen. It made billionaires out of its founders and multimillionaires out of thousands of its staff. And it created two of the most lucrative monopolies in American history -- one of them, Windows, so powerful that it ultimately brought trustbusters down on the company.
Now, strange as it seems, those monopolies are at the root of the company's malaise. As Microsoft fought the federal government and litigious rivals, it developed an almost reflexive instinct to protect Windows and Office, sometimes at the expense of looking for groundbreaking innovations. "Every time Bill and Steve made a change to be more like other big companies, we lost a little bit of what made Microsoft special," says a former Microsoft vice-president.
One reason some employees say Microsoft isn't innovating enough: It's too busy upgrading Windows. With some of its key breakthrough features gone, Vista's improvements include better handling of peripheral devices, such as printers and scanners, and cutting in half the time it takes to start up. Those are needed improvements, and there's no doubt that hundreds of millions of copies will be sold as people upgrade to new PCs. But the changes are hardly the stuff of cutting-edge software engineering. "So much of what Microsoft is doing right now is maintenance," says Mike Smith, a former software architect at Microsoft who left the company in 2003 to work for a Bay Area startup.
And that leads to an even more worrisome problem: discontent among its software programmers. Instead of coming up with the next great technology, Microsoft programmers have to cater to its monopolies. But top-flight engineers want to tackle the next great challenge. "They want to create new worlds, not defend old ones," says a former senior executive at Microsoft. "They want to storm the Bastille, not live in Versailles."
If Microsoft loses too many top developers, it will be hard-pressed to succeed in the new markets on which it has pinned so much hope. Google, for example, embarrassed Microsoft in October, 2004, by coming out with software that lets users quickly search the files on their Windows desktop before Microsoft released its own version.
Adding to employee frustration is the company's bureaucracy. After Ballmer became CEO, he put in place processes he hoped would help manage a bigger organization better. But instead of liberating employees to do great work, Ballmer's moves have been stifling, some workers say. With so much effort placed on cross-group collaboration, employees spend more time in meetings making sure product strategies are in sync. The company schedules executive product reviews several times a year, and preparing for them is hugely time-consuming. That prep work cuts into the more interesting work creating new technologies and products.SWEATING THE SMALL STUFF
To Ballmer's Chagrin, some of his up-and-coming programmers have left for Google. He was apoplectic about Lucovsky's departure, according to documents made public during the Lee trial. Lucovsky said in a sworn statement that after he told Ballmer about his plans to move to Google, the beefy CEO threw a chair and cursed Google's chief executive. "F__ing Eric Schmidt is a f__ing pussy. I'm going to f__ing bury that guy.... I'm going to f__ing kill Google," Ballmer said, according to Lucovsky. In a statement, Ballmer calls Lucovsky's account "a gross exaggeration of what actually took place."
Some workers express frustration that Microsoft is so busy protecting its PC-based businesses that it comes up short when competing on the Web. Take the customer relationship management (CRM) market -- software that companies use to track sales and customer service activities. Microsoft targeted it 2 1/2 years ago with a traditional software package, Microsoft CRM. Today roughly 4,000 companies run the software for nearly 100,000 staff. Not bad, but Microsoft hasn't been nearly as successful as Salesforce.com Inc., a trailblazer of Web-based CRM software, with 308,000 users at 17,000 companies.
The secret to Salesforce.com's success: the speed with which it can update its software. Microsoft last updated its original CRM software in January, 2004, with plans for a new version in first quarter, 2006. Meanwhile, Salesforce is constantly fixing bugs and adds features without interruption to the customer or added expense. All customers need to do is open a Web browser to run the program. Microsoft CRM boss Brad Wilson argues that business software is complex and best sold as a package that customers run on their own computers. "This is really about business process where you've got multiple steps," Wilson says. "It is a much more extensive thing that often requires a lot of people, a lot of time, and a lot of resources."
While upstarts like Google and Salesforce have Microsoft on the defense, the biggest threat to the company may be its own moves. With revenue growth slowing, Ballmer has tried to squeeze more down to the bottom line to make the company more appealing to investors. In the past fiscal year he slashed $2.6 billion out of operating expenses. But that came at a price. Microsoft sliced health benefits, introducing, for example, a $40 copayment on some brand-name prescription drugs. Within a week of announcing the benefits proposal in May, 2004, human resources received 700 e-mails. Of those, 80% were negative, and fewer than 1% were positive, according to an internal e-mail obtained by BusinessWeek. One employee wrote in an e-mail: "Small things like this chip away at employee loyalty and morale and in the long run do more harm than benefit."
Even the cuts that seem trivial have dampened morale. Just whisper the word "towels" to any Microsoft employee, and eyes roll. Last year, Microsoft stopped providing a towel service for workers who used company locker rooms after bike rides or workouts. Employees who helped the company build its huge cash stockpile were furious.
And don't even mention stock options. Employees long counted on them to bolster their salaries. Microsoft minted thousands of employee millionaires as the stock climbed 61,000% from its 1986 public offering to its peak in 2001. Now shares are trading exactly were they were seven years ago. Microsoft has doubled its payroll in that time, adding more than 30,000 new employees, not including attrition. That means more than half of Microsoft's employees have received virtually no benefit from their stock holdings. Instead, they're working for a paycheck and not much else.
And even if the stock does begin to climb, employees won't hit the kind of jackpot their predecessors did. Two years ago Microsoft stopped issuing big dollops of stock options, retreating to more modest helpings of stock grants. The idea was to help retain workers by giving them a sure thing -- stock with some value, since so many options were underwater. Meanwhile, 90% of the tech industry still rewards employees with stock options.RECRUITING SLACK
Microsoft's compensation moves have created a haves-vs.-have-nots culture. Newbies work for comfortable but not overly generous wages, while veterans have a lucrative treasure chest of stock options. Now a new pay scheme, scheduled to go into effect this fall, threatens to make the gulf even wider. If they meet incentive goals, the 120 or so vice-presidents will receive an eye-popping $1 million in salary a year, and general managers, the next level down, will get $350,000 to $550,000, according to a high-ranking source. But the rest of the staff is paid at market rates.
The pay disparity is exacerbated by Microsoft's rating system. The company uses a bell curve to rate employees in each group, so the number of top performers is balanced by the same number of underachievers. But Microsoft has a long history of hiring top-notch computer science grads and high-quality talent from the industry. Under the rating system, if a group works hard together to release a product, someone in the group has to get a low score for every high score a manager dishes out. "It creates competition in the ranks, when people really want community," says a former Microsoft vice-president. A company spokesman says managers don't have to apply the curve with smaller groups, where it's not statistically relevant.
Even on college campuses, long a fountain of talent for Microsoft, the tide seems to be turning. On Sept. 7, Massachusetts Institute of Technology's Science & Engineering Business Club held its annual recruiting barbecue, with about a dozen companies setting up booths to recruit as many as 1,500 students. "There was a lot of buzz around the Google table and not a lot around the Microsoft table," says Bob Richard, associate director of employer relations at MIT. How much? When Richard walked through, he says, students were lined up six deep to talk to Google recruiters, while only two students stood at the Microsoft table. Carnegie Mellon's Reddy says his top students opt for Google and Yahoo ahead of Microsoft these days. Microsoft points out that in a survey conducted by market researcher Universum, the company ranks No. 1 among computer science students as employer of choice.
Microsoft is hardly the first company to struggle as it moves from adolescence to maturity. And it could learn some lessons from others that have made the transition more gracefully. Take General Electric Co. () The conglomerate has long boasted an entrepreneurial culture, with hundreds of managers running fiercely independent businesses. Those leaders are given free rein yet are held accountable for their own results -- meaning they can get the boot if they don't perform. "The process is transparent and rigorous and constantly reinforced," says Noel M. Tichy, a University of Michigan professor and leadership guru.
Ballmer says Microsoft is finding its way through the challenges of being a more mature company just fine and that the complaints of some employees simply reflect the kind of company Microsoft is. "We have for ourselves incredibly high expectations," he says. "And that's in some senses is the greatest blessing and opportunity anybody can ever have. Our people, our shareholders, me, Bill Gates, we expect to change the world in every way, to succeed wildly in everything we touch, to have the broadest impact of any company in the world. It's great they're saying: 'Come on, we can still do better.' Great." Ballmer smacks his meaty hands together for emphasis. "We need those high expectations."
Microsoft certainly is chock-full of smart employees who want to do better. Still, many of them say that jumping through bureaucratic hoops and struggling to link products together is preventing them from being the best they can be. There's a plea for action to Gates and Ballmer to do more -- slash the bureaucracy, tend to morale, and make it easier to innovate. But is anyone listening? By Jay Greene, with Steve Hamm, Diane Brady, and Mara Der Hovanesian in New York