Microsoft's two latest acquisitions—U.K. game developer Rare and network security company XDegrees—offer some new insight into the company's acquisition strategy. As outlined at its 2002 Financial Analysts' Meeting in July, Microsoft acquires companies for one of several reasons: to rapidly grow its customer base in a new market, to acquire a key technology, or to get employees with expertise in a strategic business area.

Acquisition Strategy Explained

According to Microsoft Chairman and Chief Software Architect Bill Gates, he and CEO Steve Ballmer regularly consult a spreadsheet that lists hundreds of possible acquisitions and look closely at 30 or 40 of these candidates on almost a daily basis.

With acquisitions of larger companies, Gates said, Microsoft's primary concern is the difficulty of merging the codebase of these companies' existing products with the Microsoft codebase. This helps explain why Microsoft often acquires companies, such as Visio and Great Plains, that are early adopters of strategic Microsoft platforms and technologies. Gates also said that Microsoft thinks carefully about its ability to retain the employees of the acquired company. Given these challenges, Microsoft only acquires larger companies if it believes they will help it enter or quickly increase its customer base in a new market.

Ballmer explained that Microsoft is less wary about buying smaller companies, particularly private companies (which are not subject to a run-up in their market price between the time the acquisition is announced and finalized). Microsoft buys these companies for two reasons: to acquire people with expertise in a strategic business area, as the employees of such small companies can be moved to Microsoft's Redmond, WA, headquarters fairly quickly; or to acquire useful technology that could be incorporated into Microsoft products.

Rare and XDegrees illustrate these two types of acquisition.

Rare to Boost Xbox Games

In an effort to increase its share of the console game market, Microsoft acquired U.K. game developer Rare in Sept. 2002 for US$375 million in cash.

Rare is Microsoft's second-largest acquisition in 2002, after the US$1.45 billion purchase of Danish software company Navision in July. Just as Navision was intended to quickly build market share in a new area—business management applications for small and mid-size companies outside of North America—Microsoft hopes Rare will help it quickly grow its share of the console gaming market by creating exclusive titles for Xbox. It also gives Nintendo one less source for exclusive games for its competing GameCube console.

Before the acquisition, Rare made games exclusively for Nintendo. However, Nintendo sold its 49% stake in Rare in Aug. 2002 because of low sales—so far, Rare titles have constituted only 1.5% of game sales for Nintendo in 2002, compared with more than 10% in 2001. Yet, Rare has a history of success on earlier Nintendo platforms, and two of its titles, Donkey Kong Country for Super Nintendo and GoldenEye 007 for N64, each sold more than 8 million copies. (In comparison, the top-selling game for Xbox, Halo, has sold between 1 and 2 million copies.)

Now, Rare will develop console games only for Xbox, although it will retain a separate group that makes games for the Nintendo GameBoy, a handheld device that does not compete with Xbox. (See "GameBoy Gets Xbox Titles" on page 26 of the Aug. 2002 Update.)

Rare is not the first game developer acquired by Microsoft in an effort to increase the number of exclusive titles for Xbox—others include Access Software, Bungie Software (makers of Halo), Digital Anvil, and FASA Interactive Technologies. Nor is it likely to be the last: Microsoft is reportedly looking to acquire a Japanese game manufacturer in hopes of boosting lackluster Xbox sales in Japan.

XDegrees Team Comes to Redmond

Also in Sept. 2002, Microsoft paid an undisclosed amount to acquire XDegrees, a privately held company with fewer than 50 employees. An unknown number of XDegrees employees will relocate to Microsoft's headquarters in Redmond, WA, where they will work on advanced data storage for Windows Server.

XDegrees' main product, XDegrees System, enables companies to set up secure networks for sharing and exchanging large files such as spreadsheets and graphical presentations. Each file in the system is encrypted and assigned a unique link, and users must authenticate themselves before accessing it. The company has also developed a technology, Extensible Resource Name System (XRNS), that assigns each file, machine, application, device, or person on a network a unique address (similar to the way the Internet's Domain Name System works), allowing resources to be discovered and allocated more efficiently.

The acquisition is relevant to at least two initiatives underway in the Windows Division: creating a new Windows data storage system that treats different types of data (e.g., documents, e-mail messages, media files) the same way, allowing such functions as simultaneous searches for different types of data; and improving security as part of the companywide Trustworthy Computing initiative. (See the Sept. 2002 Research Report, "Trustworthy Computing: Making Software More Secure.")

XDegrees is the second small, private company focused on secure network technology into which Microsoft has put money this year: in Mar. 2002, it invested an undisclosed amount in start-up SmartPipes, which sells products to help companies set up secure virtual private networks (VPNs).

More Cautious Investments?

Ballmer distinguished Microsoft's acquisition strategy from its investment strategy. Each year, Microsoft reports many more strategic investments than it does acquisitions, and it is known to make many small (less than US$10 million) and complex investments (usually portrayed as "broad" or "deep" business agreements and involving exchanges of goods and services as well as money) without ever revealing them as investments.

Microsoft has had to write down more than US$9 billion in nonrecoverable losses in its investments’ value in the last two years, and Ballmer admitted that the company "probably got swept away in some of the euphoria" of the dot-com and telecom booms. However, this does not necessarily mean that Microsoft is planning a long-term reduction in its quantity of investments or the amount of money it invests. Rather, Ballmer suggested that Microsoft will choose its investments more carefully, taking care to ensure that the potential commercial upside of any deal is "more commensurate" with Microsoft's "financial capital commitment." This could mean that Microsoft will be less likely to invest in start-ups with untested business models, as it did with application service providers (e.g., Concentric Networks, Futurelink, Winstar) and start-up broadband ISPs (NorthPoint, Rhythms NetConnections), and will instead favor established companies with a known customer base. He called Microsoft's Dec. 2001 investment of US$500 million in Korea Telecom, the leading ISP in South Korea, "an example of the kind of thing you might still anticipate seeing us do." (See "Comcast, Telecom, Expedia Deals" on page 24 of the Feb. 2002 Update.)