Here is the five-step recipe for creating the most important software companies of the past 30 years:

1. Convince the market leader to give you something big they don’t see the value in for cheap
2. Innovate, innovate, innovate
3. Make a ton of money
4. Eat the market leader’s lunch
5. Bet on everything big

Guess which is the most important step…

The case of Microsoft

About 28 years ago, IBM made one the biggest strategic mistakes in its history. Being a company primarily focused on hardware, it didn’t understand the value in the PC operating system. It outsourced that work to a, at the time, little-known company called Microsoft. From Wikipedia, the ancient lore of the computer industry:

On August 12, 1981, after negotiations with Digital Research failed, IBM awarded a contract to Microsoft to provide a version of the CP/M operating system, which was set to be used in the upcoming IBM Personal Computer (PC). For this deal, Microsoft purchased a CP/M clone called 86-DOS from Seattle Computer Products, which IBM renamed to PC-DOS. Later, the market saw a flood of IBM PC clones after Columbia Data Products successfully cloned the IBM BIOS, and by aggressively marketing MS-DOS to manufacturers of IBM-PC clones, Microsoft rose from a small player to one of the major software vendors in the home computer industry.

The rest is history. Microsoft took the job seriously, created a pretty darn good product for the time and used the PC clone explosion as a way to increase its dominance in the value chain. IBM lost it leadership. The DOS and then Windows franchises generated massive cashflow which MS plowed into innovation (often in the form of cross-subsidies lasting a decade) to create often dominant product lines such as Office, the server business (don’t forget that Sybase in a no less brilliant move licensed core tech to MS enabling them to create SQL Server) and others. Now, the company bets on pretty much all large markets in the software space. If it’s big, there is no way MS would ignore it. In fact, from conversations with execs there, it seems like much of new market development planning begins with a process as simple as ranking future market sizes. That’s why Microsoft will relentlessly pursue search and why it was probably willing to do an even better deal with Yahoo. (Jason Calacanis has a good post on the Yahoo-Microsoft deal.)

The case of Google

In the case of Google, the strategic mistake was Yahoo’s. The company didn’t value search. It outsourced it to Google. Google took the job very seriously. They innovated a ton behind the scenes while smartly keeping the simplicity of their user experience. Through AdWords and later AdSense + the DoubleClick quisition, Google gained significant control of the advertising value chain. They passed by Yahoo and never looked back. The search franchise is so profitable that it gives them freedom to bet on everything from browsers to OSs to mobile, something pretty much no other company save for Microsoft can afford. Google’s version of the cross-subsidy is the perenial beta that just keeps getting better. Very, very hard to compete with that.

The moral of the story

The moral of the story is that the two most important software companies in recent history were enabled by massive strategic errors on behalf of the market leaders in their respective sectors. It was the market leaders who put the companies on the map, gave them distribution and scale and enough revenue to fuel innovation. IBM and Yahoo nursed the companies that nearly killed them. One could argue that without the explicit support of the market leader, a startup wouldn’t have had the chance to grow at a rate that allows it to have Microsoft’s and Google’s escape velocity.

Kudos to IBM for innovating around its business model and evolving into a company which is still a huge industry player. I’m not sure Yahoo will have that chance.

The interesting question is whether this will happen again… Do you think a market leader will make that type of mistake again? Can you point to where this is happening now or likely to happen in the future?