Gates' 4 golden rules

Think of software as a utopian tool. "Thirty-three years ago the company was founded on the proposition that software would be important," says Gates. "Looking at the next decade, the value that will be created by software and popular software platforms will be greater than ever."

Gates takes what colleagues call a utopian view of software. He believes it can do anything. That means the revolution is just beginning. Says longtime executive Craig Mundie: "Today Microsoft actually thinks about itself as just a software company - not a specific type of software company, not a PC software company, not a word-processor software company. And that has been many years in coming."

Let the engineers rule. Microsoft employs about 30,000 programmers among its 90,000 people. In operating groups engineers are involved in every major decision. Not only that, engineers typically get paid more than businesspeople.

The geeks also get lots of toys: Microsoft's $8 billion computer science R&D lab is the world's largest. At a recent executive retreat, Gates said he thought every great businessperson at Microsoft should cultivate at least five close relationships with engineers.

Institutionalize paranoia. "It's very Microsoft to prepare for the worst," says Gates. His heirs agree, and they want to keep it that way. The collective worry a few years ago was that Linux and open-source software could wipe out Microsoft. Today there are products across the company that take for granted that customers will use opensource products alongside Microsoft's own.

Meanwhile, Windows Server is finally gaining market share against Linux. Fear is what enabled the company to make that necessary transition. "Bill and Steve created what I guess I'd characterize as a culture of crisis," says chief software architect Ray Ozzie. "There's always someone who's going to take the company down. It's mythical, but at any given point in time there might be two or three big competitive things that the company is juggling. It's something people here are used to, and it's accretive in terms of making things more resilient over time."

Invest for the long term. One of Microsoft's most successful products at the moment is SharePoint, a set of tools to enable companies to build both internal and external websites - everything from collaboration and blogs to a flagship dot-com. This year it will generate about $1 billion in revenue. But that product has been evolving for a decade.

"Whatever the cycle is, we will keep investing through the cycle," says Entertainment division president Robbie Bach, "because we know on the other side of whatever cycle happens, there is opportunity. That's just the way the company thinks about itself."

Microsoft without Gates

Steve Ballmer was sobbing. He repeatedly tried to speak and couldn't get the words out. Minutes passed as he tried to regain his composure. But the audience of 130 of Microsoft's senior leaders waited patiently, many of them crying too. They knew that the CEO was choked up because this executive retreat, held in late March at a resort north of Seattle, was the last ever for company co-founder Bill Gates, as well as for Jeff Raikes, one of the company's longest-tenured executives. "I've spent more time with these two human beings than with anyone else in my life," Ballmer finally said. "Bill and Jeff have been my North Star and kept me going. Now I'm going to count on all of you to be there for me."

What the executives were witnessing was the end of an era. On July 1, Gates officially retires from daily duties at the software giant. He's leaving in order to begin a second life as a full-time philanthropist and to explore his dizzying range of intellectual interests.

But his departure raises some obvious and very large questions about the future of Microsoft: Can the now $60 billion behemoth keep finding new ways to grow? Will Ballmer and his lieutenants be able to successfully adapt their products to an increasingly web-driven world? In short, does the company have what it takes to thrive without its iconic founder at the helm?

All in the timing

There are plenty of reasons this may seem like an inauspicious time for Gates, 52, to be leaving his life's work behind. This spring Microsoft (MSFT, Fortune 500), led by Ballmer, failed to consummate a big deal with Yahoo (YHOO, Fortune 500), which it now seems to have pushed into the arms of archrival Google (GOOG, Fortune 500). Last year's rollout of the latest version of Windows, called Vista, was a public relations and consumer marketing disaster. The rest of the software industry, meanwhile, is either supporting its products with advertising, like Google, or starting to rent them as online services. Microsoft has yet to gain traction in either business.

And then there's Apple (AAPL, Fortune 500). From the iPod to the iMac to the iPhone, its products have cornered the market on cool. Apple's small share of the PC market in the U.S. is growing fast - it was 7.4% in the first quarter of 2008, up from 5.1% a year earlier, according to International Data Corp. (IDC). Perhaps even more alarming, its ubiquitous "Get a Mac" TV ads have painted the personal computer loaded with Windows software - the central achievement of Gates' 33 years at Microsoft - as a loser. To a lot of consumers out there, Microsoft really does seem like that bumbling nebbish played by Daily Show contributor John Hodgman.

But despite setbacks, despite image problems, and despite Google, Microsoft is in many ways stronger than it has ever been. Just look at the numbers. Revenues grew 18% in the just-ending June 2008 fiscal year. And net profit is up even more, rising 27% to a stunning $18 billion, according to the consensus of Wall Street analysts who follow the company.

From this position of financial strength, the software giant is going on the offensive. In interviews with Microsoft's leadership, it is clear that those pesky Mac ads have managed to shake some complacency out of the company. Sometime later this year, Microsoft will launch a rebranding campaign for Windows, its core product. It's Ballmer's answer to "Get a Mac." And while Yahoo may have turned down Ballmer's $47.5 billion acquisition bid, the CEO says he'll spend as much as it takes to build a business that challenges Google on the web. The famously competitive Gates may be leaving, but Ballmer insists Microsoft will be no less aggressive without him.

It takes two

The post-Gates era has actually begun already, for all practical purposes. And that is much to the relief of Gates himself. The Microsoft co-founder spent a full decade executing a painstaking succession plan. Mostly he did it by progressively passing business leadership of Microsoft to his college pal Ballmer, 52, who became president in 1998 and CEO in 2000. Four years ago Gates told Ballmer privately he wanted to leave, and then two years ago announced publicly he would do it this July. "I've been No. 2," Gates says of his role in recent years. "I haven't been the decision-maker on anything."

Of course, he also had to find a replacement for himself as product master planner and technology strategist. He and Ballmer decided to split those jobs up. After Gates arranged to purchase technology soulmate Ray Ozzie's faltering startup Groove Networks in 2005, he quickly set about grooming 52-year-old Ozzie, best known as the father of Lotus Notes, to succeed him as Microsoft's chief software architect. The other half of his technical responsibilities went to longtime colleague Craig Mundie, 59, who oversees Microsoft's $8 billion in annual R&D and spearheads long-term technical strategy.

But one thing is clear: There wouldn't be any post-Gates Microsoft, at least not anytime soon, were it not for Ballmer's willingness to stay around and mind the store. "Every conversation Bill has had with me about being able to transition from Microsoft is always in the vein of he couldn't be transitioning if Steve wasn't there," says Melinda Gates, Bill's wife. "You don't walk away from your life's work if it's not going well. He just could never do that."

Ballmer's management style has matured in the eight years he's been CEO. "He used to be in everyone's shorts, in every detail," says marketing boss Mich Mathews. "But he has changed profoundly. He is a general manager now." Ballmer made a conscious decision to step back from day-to-day management and take a larger view as he realized that his partner Gates was no longer going to be there to strategize alongside him.

Even though he never was a serious computer programmer, by all accounts Ballmer is just as good at math as Gates is. He lives and breathes data. "Steve has a computer in his head," says Bob Muglia, a 20-year company man who heads the Server and Tools division. Ballmer expects his subordinates to be adept in math as well. He distributes 11-by-17 sheets filled with numbers detailing the progress of various operations. The numerals are so small that executives use transparent magnifier rulers to see them. But there are never any columns showing percentage changes. Ballmer believes people ought to do that in their heads. It saves space on the paper for more numbers.

Ballmer has spent the past few years surrounding himself with a seasoned group of lieutenants. Kevin Johnson, 47, a 16-year company veteran who previously ran worldwide sales, now oversees both Windows and online services. To replace Raikes, who is about to become CEO of the Gates Foundation, Ballmer recently hired Stephen Elop, 44, to run the $19 billion Business division, which centers on Microsoft Office. Elop was CEO of software maker Macromedia until he sold it to Adobe, and more recently No. 2 at Juniper Networks. Bob Muglia, 48, the Server division chief, oversees development of the complex software employed inside business infrastructures. And Robbie Bach, 46, another 20-year veteran, runs Entertainment and Devices, which includes the Xbox game system and software for mobile phones.

Growing a giant

The CEO hasn't been afraid to look outside the tech world for leaders or ideas. Two years ago Ballmer lured away International Paper CFO Chris Liddell, 50, for the same job at Microsoft. And around the same time, he persuaded Kevin Turner to leave his job as Wal-Mart's (WMT, Fortune 500) CIO to join Microsoft in a newly created chief operating officer role. Turner, 43, is a stickler for accountability and measurement. At Microsoft, he's developed a 30-metric "scorecard" with concrete annual goals - in everything from customer satisfaction to growing Windows market share - or every manager in 65 countries where the company sells its products. Each month Turner gets a report on what he calls ROB, the rhythm of the business. It's the list of 30 metrics, each with a color next to it - red, yellow, or green. You don't want to be a manager with more than one red.

The challenges that Microsoft faces are - literally - enormous. At its scale, growing means confronting the law of large numbers. Ballmer notes with exasperation that to increase earnings by 15% for 2009, the company will have to create $4 billion in new pretax operating income. At that size, can Microsoft still possibly be a growth company?

Wall Street is not hopeful about the prospects. According to Reuters, the consensus of analysts is that earnings growth will slow in each of the next two years, to 13% in fiscal 2009 and 10% in 2010. Microsoft's stock price has been more or less flat - in the mid-to-high 20s - for about six years. (Late last year it got up into the mid-30s, but its bid for Yahoo caused it to plummet back to the 20s, where it remains.) Right now Microsoft trades for just 16 times its trailing 12 months' earnings, below the S&P 500's trailing P/E of 22. Yet analysts agree that Microsoft will report earnings-per-share growth of 31% for fiscal 2008. By contrast, Standard & Poor's estimates that the S&P 500's earnings per share will grow just 8.3% this year.

The biggest reason that Microsoft can pull off that kind of performance is that its venerable Windows operating system monopoly remains wildly profitable. Despite the problems with Vista, Windows sales grew 11.3% in the 2008 fiscal year, to $16.7 billion, according to Goldman Sachs. About 75% of that is operating profit.

One key to Microsoft's growth plan is for the company to stay resolutely global. Two-thirds of revenues already come from outside the U.S., and Ballmer and his team expect that percentage to increase significantly. There is an enormous appetite around the world for the software Microsoft produces. IDC figures show that Microsoft's fastest growing markets are Central and Eastern Europe and Latin America, as well as countries like Vietnam. In Russia, now the company's fifth-largest market, business grew 100% this year, according to CFO Liddell. He says that in conversations with Wall Street, "most discussion is driven around what's happening in the U.S. economy in the next quarter. And - well, I try not to be facetious, but it matters less and less as time goes by." According to Microsoft, there are now more people using Windows in the world than there are English speakers.

The Ulitimate nemisis

When Liddell talks to investors, he often gets the sense that they don't appreciate the breadth of Microsoft's business. As evidence, he estimates that about half the questions he's asked on conference calls concern the money-losing $3.3 billion Online division - or Windows Live Services, which includes Microsoft's search product and Hotmail - even though it represents only about 6% of company revenues. Of course, that's the division that competes with Google.

Investors aren't the only ones obsessed with Google. The one concrete commitment Gates has made to Ballmer, other than continuing to chair board meetings, is that he will keep working with the search and advertising team. He's promised he'll spend two and a half hours on it each week. Why did Gates decide to focus on this particular problem? Google's overwhelming dominance of online advertising continues to thwart Microsoft's ability to grow its online consumer business. Inside the company, the subject inspires almost daily handwringing sessions.

While Gates talks casually about the likelihood of a "share breakthrough in the search market that's still very much in front of us," at the moment Microsoft is almost hopelessly behind in both market share and mind share when it comes to searching on the Internet. Concedes Gates: "Today you'd definitely say about consumer search and advertising, Couldn't we have gotten in sooner and understood those things?"

There is more involved here than just simple Google envy. Ballmer et al. believe that online advertising is the business where its greatest potential revenue and profit growth lie. So far only about $40 billion of the world's $500 billion in ad spending has moved online. But Ballmer expects the Internet portion to be $80 billion in just two years. While total worldwide spending on business technology is much bigger, around $1.6 trillion, it isn't growing nearly so fast.

So Microsoft is making unprecedented investments in infrastructure. "You have to throw so much in the pot just to play," says Ballmer. This year Microsoft will put about $1.7 billion into data centers and servers for its online business. In addition, the company has been pouring resources into the basic technology of search for almost five years. And it has caught up with its rival by at least one fundamental measure - the relevance of results at Live.com, its search home page. Independent experts now rate Microsoft roughly on a par with Google.

The problem is attracting search traffic in the first place - and right now Microsoft is going in the wrong direction. Its market share of U.S. searches has steadily declined this year, from 9.8% in January to 8.5% in May, according to Comscore. Google, meanwhile, scored 62% of searches in May, and 21% were on Yahoo. Taking a page from the U.S. auto industry, Microsoft recently announced a "cash back" program, in which certain retailers will give a consumers a discount if they buy products they found using Live Search.

The man who would run Yahoo

He made his mark at Microsoft as head of the company's worldwide sales force at a time when it seemed everyone hated the company - most of all its customers. In 2 1/2 years Kevin Johnson achieved a miracle: He turned Microsoft's customer satisfaction numbers around.

After that, CEO Steve Ballmer gave Johnson a really hard job: Figure out what to do about Google, which now garners more revenue from online advertising than Microsoft does from Windows.

Plan A, which Johnson spearheaded, was to buy Yahoo (YHOO, Fortune 500), a company that for all its problems commands roughly twice as much online-ad revenue as Microsoft (MSFT, Fortune 500). Plan B, it would appear, is to acquire Yahoo's search business and leave the rest. In the middle of all this, while immersed in Yahoo talks "seven days a week," the affable Johnson, 47, known to insiders as KJ, agreed to talk to Fortune twice, once in April and once in late May.

"Online is a very, very significant growth opportunity for us," he says. It's also something of an obsession for his boss. It was the only part of Microsoft's business that Ballmer talked about in his presentation at the company's annual CEO summit in early May. He showed a PowerPoint slide that displayed approximate ad revenue for the largest media companies in the U.S.: GE/NBC (GE, Fortune 500) on top at $15 billion, Google (GOOG, Fortune 500) in the middle at $8 billion, Microsoft down near the bottom, with a measly $2 billion. Ballmer estimates that the $40 billion spent this year on online advertising will double by 2010. If Microsoft is ever going to approach the growth it achieved during the PC boom, it has to grab some of that action before Google takes it all.

That's where Johnson comes in. He holds an unwieldy portfolio at Microsoft. On one hand, he's in charge of the company's core Windows monopoly - for better or worse, it was on his watch that the company released the much criticized yet highly profitable Windows Vista. With his other hand he runs Windows Live Services - a division whose failures he described bluntly in a May 18 memo to his staff: "The fact is we are not where we want to be in [online services] yet, and we've been in this position longer than we'd all like."

There's an important link between these two seemingly unrelated businesses. Ballmer wants Johnson to take Microsoft's so-called platform business - its PC-based Windows software franchise - and migrate it toward what Microsoft calls "software plus services." Just as Windows was the framework on which software ran in the PC era, Windows Live Services could be the framework for Internet computing. It's unlikely that Microsoft will ever create the kind of monopoly on the web that it enjoyed in PCs, but the company is deploying its considerable resources to control as much of it as possible.

During a long conversation, Johnson draws a simple chart on a whiteboard. Four vertical rectangles represent industries that profit from online advertising: search, information and content, communications and social networking, and online productivity services (e.g., word processing on the web rather than on the desktop with Microsoft Word).

Underneath all four is a horizontal box - the revenue-generating ad platform on which the other industries rely. That box is key to Microsoft's online aspirations. "There will be a small number of big-scale players in that underlying platform," Johnson says. Microsoft has been building its platform though acquisitions, but before its $50 billion bid for Yahoo, the most it had ventured was $6 billion last year for aQuantive's system for buying and placing ads.

But for a platform to work properly, Johnson says, it needs scale. "The more ad inventory you can get, the better job you can do to target ads, drive efficiency, and deliver better yield for publishers." Google has scale; Microsoft doesn't. But it does have a lot of money. Thus the Yahoo pursuit.

Jerky might not top everyone's list of hot products for a cold economy. But recently I met an entrepreneur who is prospering in the jerky business against all odds. Her story is instructive for any business owner trying to swim against the economic current - which is most of us nowadays.

Her name is Janie Honeycutt. Along with her husband Ron Hargett, Honeycutt runs House of Jerky. They sell the usual beef varieties, plus exotic jerkies such as ostrich and alligator. Honeycutt and Hargett also sell pre-packaged "Soldier Jerky" that you can send to your favorite troops in Iraq or Afghanistan.

Honeycutt and her husband have seen their share of economic cycles since 1997, when they launched House of Jerky in Temecula, Calif. Last year their wholesale operation, which distributes to a dozen branded stores around the country, grew 15% over 2006.

How did they achieve such torrid growth at a time when sales of so many other "optional" products are hitting a wall of gloomy consumer sentiment?

Enter the Internet.

House of Jerky's online retail sales more than doubled from 2006 to 2007. All told, the couple sold $600,000 of jerky last year, and is on a 2008 run rate to beat that number. If you consider that a typical one-pound order runs $34, that's a lot of jerky going out the shipping and receiving dock.

Honeycutt shared some of the strategies that have helped her rev up her web sales so fast. Most of her business comes from referrals, bringing in new customers who spawn yet more new customers by gobbling up and then gabbing about her unique jerky offerings. Honeycutt says that she regularly hears from customers who "share [the jerky] with everyone they can."

But the big surge in online interest, Honeycutt says, has come from her search engine optimization efforts. Just try typing in "ostrich jerky" into Google. House of Jerky landed in first and second place on the results page. Instead of buying online advertising, she transformed her site into a search engine magnet.

House of Jerky's homepage is packed with keywords associated with jerky. It's light on images, which search engines tend to ignore.

Honeycutt also used social networking to raise her site's profile. After she scattered mentions and links to her site on various social networking sites (including StartupNation.com, where I first learned about House of Jerky), she confirmed that the search engines started ranking her higher. Those online bulletin boards aren't sounding like such a waste of time anymore, are they?

House of Jerky's 15% wholesale growth is a major achievement, especially when you consider that their product is distributed mostly in recession-sensitive resort towns. But the company's online growth has been nothing short of spectacular. Honeycutt's search engine savvy sets her firmly apart from the thousands of small retailers that have been sucking wind of late.

Next week I'll highlight another entrepreneur whose smart strategies generated more than $1 million in revenue in 2007.

The iPhone gets a $100 million iFund

Silicon Valley venture capital giant John Doerr said Thursdsay that his firm will launch a $100 million "iFund" to help finance the development of software applications for Apple's iPhone.

The fund raised by Kleiner Perkins Caufield & Byers is intended to ignite a flurry of new games, productivity tools and so-called widgets using Apple's software development kit unveiled Thursday. Kleiner Perkins will essentially open a bank for startups focused on iPhone applications.

"We're all here today because we love Apple products," Doerr said at an Apple's event at the company's Cupertino, Calif. "And I'm here because I love Apple entrepreneurs."

Apple, which also announced new software to make the iPhone compatible with corporate e-mail systems, plans to open "the App Store" with the next release of iPhone software. The feature will allow people to purchase and download new applications for their phones.

According to the business plan, as explained by Apple, developers will participate in a revenue-sharing arrangement. Apple will keep 30 percent of sales from every app sold. Plus Apple will host and take care of credit card fees. The software developers get to keep 70% of the proceeds, said Jobs.

The move comes four months after Google announced its $10 million Android fund. Unlike Apple's revenue sharing model, Android is structured like a bakeoff where the best mobile applications written for Google's open-source mobile platform will receive as much as $100,000 in prize money.

Both efforts aim to break wireless carriers' near-monopoly on what applications can be downloaded to cell phones.

In typical Silicon Valley hyperbole Doerr summed up the move as the beginning of a new world order. The iPhone, he said, is "bigger than the personal computer. If you want to invent the future, the iFund wants to help you build

Is nanotechnology the key to curing cancer?

In nanotechnology, we think small -- very small. A nanometer is the length of ten hydrogen atoms placed end to end. If you take the nanoparticles that we make, 30 of them, and string them end to end like beads on a pearl necklace they would span the tiniest blood vessel in the human body.

What does working at that scale enable us to do?

Naomi Halas has a vision of a world where cancer is no longer a threat

NH: They're the perfect size to interact in the most effective ways with biological systems because it's a size where one is just a little bit bigger than the fundamental natural building blocks - atoms and molecules. In just the same way that Mother Nature controls atoms and molecules when our bodies make cells or make new types of molecules like proteins or DNA, with nanotechnology we can start to do some of that control ourselves.

Tell us about your nanoparticles.

NH: We invented a particle that we called nanoshells. The structure is basically a coated sphere. The inner core of this particle is made out of glass and the outer shell is made out of g

How do they work?

NH: Nanoshells are essentially nanolenses. They capture and focus light around themselves. By controlling the inner and outer thickness of this metallic shell we can control the wavelength of light that this nanoparticle will absorb. They can be effectively delivered to a specific organ or tumor through the bloodstream.

Once in place, infrared light is shone through the skin and to the tumor. The nanoshells have dramatic heating properties. They absorb the light and convert light to heat with incredible efficiency. This raises the temperature of their local environment by ten to twenty degrees. It turns out, of course, that we are very temperature-stable organisms, so if you raise the temperature of our cells by twenty degrees our cells will die. So this is a way of very gently and very non-invasively inducing cell death. If I take a nanoshell and I attach it or place it directly next to a cell that I want to destroy and shine light on it then it will convert the light to heat and it will very gently destroy the cell.

How do nanoshells compare to conventional cancer treatments?

NH: Compared to current cancer treatments, this will be very safe and non-invasive. Obviously, there might be several adjacent cells [that also get destroyed] but that's microns, very tiny dimensions. If you compare that to traditional types of surgery, the precision is just extraordinary.

The computer that decides if we live or die

A serious injury leaves a loved one in a coma. Relatives may face the hardest decision of their lives: to wait it out or turn off the life-support machine.

The program may help families decide what action to take if a loved one is critically ill

But now, that critical decision may be turned over to a sophisticated computer program. New software should soon be able to predict more accurately than loved ones how comatose patients would choose to be treated, if they were able to make the decision themselves.

Bioethicist David Wendler at the U.S. National Institutes of Health in Washington D.C., and his colleagues, used very elementary past research to build up patterns in patients' choices. "There was very little data available and the approach we used was incredibly simplistic," Wendler concedes. "But even with a little amount of data, we did very well."

The study compared how accurately their computer-based tool predicted a patient's preferred treatments compared with what loved ones said. Results showed both methods got it right around two-thirds to three-quarters of the time.

Wendler hopes to build up a broader data bank of personal profiles, which will include age, gender, religious and ethnic background, to advance the software. He is confident that will enable more accurate patient predictions. "We have very good reason to believe we can get significantly better results," Wendler says. "Maybe ten or fifteen percent more accurate than (next of kin)."

Patients have gained more control over their medical care in recent years but many still fail to sign a directive looking to the future. Few discuss treatment preferences they would elect if they lost the ability to make decisions. Without a self-directed advance medical plan for a patient, relatives are often asked to step in and act on a loved one's behalf.

"We've always gone with the idea that people who know the patient best are also best positioned to make the decision about treatment," Wendler says. "My concerns were that this process puts a burden on families. I wanted to develop an alternate approach."

Wendler is acutely aware of the problems a software program like this might pose for the community at large. "Some people say, 'of course this is good' and others think 'this is crazy'," Wendler says.