When Microsoft Corp. finally launched its much-awaited and long-delayed Windows 95 operating system in mid-1995, it was remarkably free of crippling bugs, something in which the company’s technical managers understandably took great pride. Indeed, Microsoft executives confirmed that the operating system had cost “hundreds of millions of dollars” to develop. But here’s what they didn’t mention: The world’s wealthiest software firm had consolidated its market position and greatly enhanced its equity valuation with Windows 95 by, in effect, negotiating a billion-dollar subsidy from many of its best customers and developers.

How so? As part of its product development process, Microsoft had sent out roughly 400,000 beta version copies of Windows 95 to thousands of beta sites worldwide — individuals and organizations willing to help track bugs and suggest improvements in exchange for receiving the software in advance, influencing its development and getting help with any problems that might arise. In so doing, Microsoft essentially drew upon a highly valuable technical population the size of a major city to help improve the quality and capabilities of its new operating system. Even the most conservative back-of-the-envelope calculations reveal this to be an astonishing transfer of wealth.

Assume, for argument’s sake, that one-quarter of the beta versions never got tested or were used in ways that were worthless to Microsoft. That leaves 300,000 beta versions being tested on desktops around the world over several months. At a conservatively estimated cost of $3,000 per version, this means that Microsoft’s final stage of Windows 95 development was effectively subsidized to the tune of $900 million — far more than Microsoft itself invested. Without question, this subsidy enabled Microsoft to produce a far better product for far less money in far less time than it otherwise could have. That’s a powerful business model. Consider how much more competitive an Alcoa, a DuPont or a GE Plastics might be if they received the equivalent of a nearly $1 billion subsidy from Toyota, General Motors and Ford to develop innovative lightweight materials for auto bodies.

A Gray Market

This suggests a provocatively counterintuitive perspective for competitive enterprises. The dominant challenge for the innovative firm may not be to command marketplace premiums for its innovation but to strategically identify and opportunistically exploit subsidies of that innovation. An innovation subsidy may be defined as the deliberate donation of a business resource — money, time, information, expertise, personnel, equipment — in support of the development of a novel offering