The Clever Crafting of Microsoft’s Open AI Deal
Satya Nadella is undoubtedly the Marcus Aurelius of CEOs. The venerated Roman emperor was known as a nuanced philosopher and warrior (as well as making a memorable Gladiator appearance). While Satya has waxed on with great insight into both competitive and mental landscapes, this time he is flexing the warrior side.
The recent incorporation of OpenAI capabilities in Microsoft products is the culmination of years of astronomically large bets — $3 billion into OpenAI before the current $10 billion. Now Satya and Microsoft may generate astronomically large returns from those bets. Microsoft may do so while placing the minority of its giant investment at risk.
Let’s dig into the elements of this deal.
Funds to OpenAI
Giant Investment. Microsoft’s eye catching $10 billion investment in OpenAI has been widely reported so no need to rehash.
License Fees. In addition to the investment, OpenAI likely negotiated license deals for the use of their services within Microsoft’s many products. As of writing, Microsoft has announced incorporating OpenAI in:
- Bing search: ad revenue!
- CoPilot: code completion for software developers
- Teams: meeting summarization and action items
- Office Suite (Word, Excel, PPT, etc.)
This enhances Microsoft’s ability to drive incremental revenue (additional $7 / user for Teams Premium and $20 / user for Copilot) and reinvigorate the Office Suite. Strategically, it also places Bing back on the map to take a shot at the most lucrative profit stream in the tech industry — search. OpenAI should capture some of the value they’ve created.
Funds Returning to Microsoft
This is where the genius happens.
Azure Hosting Services. OpenAI has an exclusive deal to use Microsoft’s Azure hosting services for its internal research and product services. While OpenAI’s research budget is giant (hundreds of millions), it does not hold a candle to the potential hosting costs to support all Bing queries, Teams call summaries, Copilot code recommendations, and every Office product file update. These hosting costs may reach into the hundreds of millions or billions of dollars per year. The price of the hosting fees is one of the most important financial terms of the deal. And guess what? It all goes to Microsoft to book as Azure cloud services sales.
In a sense, Microsoft is moving billions of dollars from the corporate treasury to the Azure cloud business.
Profits. In this unusual deal structure, Microsoft will receive 75% of the profits until OpenAI repays the $10 billion. It is unclear if the repayment must originate exclusively from profits or if profits + Azure spend count toward repayment.
After the funds are repaid, the original investors and employees will again receive the full profit stream until a certain cap is reached e.g. 100x original investment.
Bringing It Together
What might this look like in practice? Let’s make a few assumptions:
- OpenAI generates revenue of $400 million a year. This seems reasonable for 2023 based on current estimates.
- OpenAI’s margin rate is 34% (this may be too low). Original investors receive 25% and Microsoft receives 75% of the profit dollars.
- Expenses: hosting expense (50% of total costs), salaries (300 people at $350k each), and other expenses (6% of total costs).
Using those assumptions, Microsoft receives the largest share of funds exiting OpenAI. As a percent of the total money exiting the organization:
- Microsoft: 59% ($234 million from Profit + Hosting)
- Non-Hosting Expenses: 33% ($132 million)
- Other Investors: 8% ($34 million)
Even if these assumptions are incorrect and Microsoft only licenses OpenAI’s products to run in Azure themselves (thereby massively decreasing the hosting costs), the profit margin will balloon. In that scenario, Microsoft still receives the lion share; they just won’t be able to book it as sales of Azure hosting services. Still a big win.
The Best Part
Microsoft will get its money back, significantly improve its products’ position in the market, lock down a formidable research partner / potential competitor, and book billions in Azure sales (a key investor indicator and part of Satya’s legacy). And, at the end of the day, it will have a large equity stake in a potentially highly valuable organization — OpenAI.
This is strategic deal-making gold.
Feel free to reach out with questions and thoughts. No AI used to generate this post.
