Commentary: Why AOL Nixed a Microsoft Deal

By Jay Greene

One of the biggest episodes of high-stakes, high-tech brinkmanship ended with a brief phone call on the morning of June 16. AOL Time Warner Inc. (AOL ) wanted to hammer out a deal with Microsoft Corp. (MSFT ) that would have included a link to AOL in Windows XP, the much-anticipated Microsoft operating system. But this time, unlike an earlier pact that won AOL a place in Windows while including Microsoft's Web browser in AOL's online service, Microsoft was demanding more. It wanted its audio and video software included in AOL and AOL's instant messaging to be compatible with its me-too service, MSN Messenger. And it wanted AOL to pledge not to file an antitrust suit against it. Ray Oglethorpe, president of AOL's online service, told James E. Allchin, Microsoft's Windows boss, no thanks.

For the time being, the deal is off. And that makes AOL the winner. Sure, it won't ship on Windows. But AOL learned a hard lesson the last time it played ball with Microsoft. AOL may have gotten into Windows, but putting the browser inside its online service helped Microsoft win the browser war with Netscape Communications Corp. By walking away this time, AOL Chairman Stephen M. Case isn't handing Microsoft the tools to dominate other new markets, such as streaming media and instant messaging. Indeed, AOL kept some potent weapons.

EERILY REMINISCENT. Let's start with the right to sue Microsoft. When AOL bought Netscape in 1999, it also acquired its legal claims. Those include Netscape's claim that Microsoft unfairly trounced it by bolting its Internet Explorer browser into the monopoly Windows operating system. Last year, a federal judge ruled Microsoft's tactics illegal. While legal experts expect an appeals court to overturn key pieces of that decision, AOL could still bring a private antitrust suit against Microsoft. It could get triple damages on the revenue that Netscape lost as a result of Microsoft's actions. "Private lawsuits could have a staggering toll," says George Mason University law professor Ernest Gellhorn.

And that's just the beginning. Microsoft Chairman William H. Gates III had hoped to shield his company from complaints by AOL about its future actions as well. Example: Windows XP, which Microsoft is packing with a raft of technologies--such as instant messaging. "AOL would not engage in that discussion," says Microsoft Vice-President William Poole.

It's easy to understand why. To AOL, Microsoft's moves feel eerily reminiscent of the tactics it used to overpower Netscape. AOL wanted to defend streaming-media leader RealNetworks Inc. because it needs to have alternatives to Microsoft's technology. "If you take the name Netscape out and put the name Real in, the goal is the same," says Kenneth B. Lerer, an AOL Time Warner executive vice-president.

The potential for delivering music via the Web is huge, so it's no wonder these two behemoths would scrap over it. The market is expected to hit $2.7 billion in 2003, according to market researcher Webnoize. Moreover, if Microsoft dominates the business, it will get to set the rules on how consumers receive audio and video signals--and AOL Time Warner would have to dance to its tune.

AOL is worried just as much about instant messaging. Among AOL's big draws are its popular chat service, Instant Messenger, which has 26.7 million users worldwide, according to Jupiter Media Metrix Inc. In the recent talks, Microsoft demanded that its 34.4 million instant-messaging customers be able to connect with those who use AOL's service. That would have made it easier for Microsoft to try to woo AOL's customers to its own services.

AOL still needs Microsoft's browser, and it will be able to include Internet Explorer in its service despite the breakdown in negotiations. IE remains the most popular browser, with 67% of U.S. homes using it, vs. Navigator's 21% share, according to Jupiter Media Metrix. AOL is developing a version of Navigator that it could include in its service, but it won't be ready soon.

The biggest drawback of the scuttled deal for AOL is that its service won't be bundled with Windows. With roughly 160 million Windows PCs shipping next year, it's a tough deal to walk away from. But AOL has already struck agreements with nine of the largest computer makers, ensuring that its software gets into two-thirds of consumer PCs shipped in the U.S. And AOL insists that Windows isn't crucial for landing new customers.

The bottom line is that AOL, with 29 million subscribers, remains highly popular among consumers. MSN Messenger, with 5 million subscribers, is a distant No. 2. "When it comes to who's in the driver's seat on the Internet, it's AOL," says Forrester Research Inc. analyst Bruce Kasrel. By saying no to this deal, the company keeps its hands on the wheel.

Seattle bureau chief Greene covers Microsoft.

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