In the realm of CEOs, Satya Nadella of Microsoft has often been likened to the legendary Roman Emperor, Marcus Aurelius. Known for his profound philosophical insights and military prowess, Marcus Aurelius left a lasting legacy in history, even making a memorable appearance in the film “Gladiator.” Similarly, Satya Nadella possesses the qualities of a philosopher and a warrior, and his recent move showcases his warrior side.
Microsoft’s recent integration of OpenAI capabilities into its products is the culmination of years of bold investments. With a staggering $3 billion invested in OpenAI prior to the current $10 billion, Satya and Microsoft now have the opportunity to reap massive returns from these bets, with only a fraction of their investment at risk.
The financial aspects of this deal are intriguing and deserve a closer look. Microsoft’s $10 billion investment in OpenAI has been widely reported and caught the attention of many. But in addition to this investment, Microsoft likely negotiated license deals that allow them to incorporate OpenAI’s services into their various products.
As of now, Microsoft has announced the integration of OpenAI in several key areas: Bing search, CoPilot, Teams, and the Office Suite. By incorporating OpenAI into these products, Microsoft not only enhances its revenue potential (Teams Premium can generate an additional $7 per user, while Copilot can bring in an additional $20 per user) but also rejuvenates the Office Suite. Moreover, this strategic move puts Bing back on the map and positions it to challenge the lucrative profit stream of the tech industry—search. OpenAI, as the provider of these services, will undoubtedly capture a share of the value they have created.
But the brilliance of this deal lies in how funds will flow back to Microsoft. OpenAI has an exclusive deal that allows them to utilize Microsoft’s Azure hosting services for their research and product services. While OpenAI’s research budget is substantial, it pales in comparison to the potential hosting costs required to support Bing queries, Teams call summaries, Copilot code recommendations, and updates for every Office product file. These hosting costs could easily reach millions or even billions of dollars annually. Thus, the mechanics and financial terms of the hosting fees are of utmost importance. Here’s where Microsoft shines—the company will book these hosting fees as Azure cloud services sales, effectively moving billions of dollars from their treasury to their Azure cloud business.
In a unique twist, Microsoft will receive 75% of the profits until OpenAI repays the $10 billion investment. It remains unclear whether the repayment must come solely from profits or if profits combined with Azure spend will count towards repayment. Once the funds are repaid, the original investors and employees will once again receive the full stream of profits until a certain cap is reached, such as 100 times the original investment.
To illustrate the potential outcomes, let’s make a few assumptions. Let’s say OpenAI generates $400 million in revenue per year, which seems achievable by 2023 based on current estimates. Assuming a conservative margin rate of 34% (which may actually be too low), the original investors would receive 25% of the profits, while Microsoft would receive 75%.
Taking into account expenses such as hosting costs (50% of total costs), salaries for 300 employees ($350k each), and other expenses (6% of total costs), Microsoft would receive the largest share of funds exiting OpenAI. In this scenario, Microsoft would claim 59% ($234 million from profit and hosting), while non-hosting expenses would amount to 33% ($132 million) and other investors would receive 8% ($34 million).
Even if these assumptions are incorrect and Microsoft only licenses OpenAI’s products to run on Azure themselves, significantly reducing the hosting costs, the profit margin would still soar. Although Microsoft may not be able to book it as sales of Azure hosting services, they would still secure the lion’s share of profits. Ultimately, this deal would be a tremendous win for Microsoft.
But the greatest part of this entire arrangement is that Microsoft will not only recover their investment, but also enhance their product offerings, solidify OpenAI as a research partner (and potential competitor), and book billions in Azure sales—something pivotal for their investors and an integral part of Satya Nadella’s remarkable legacy. In the end, Microsoft will also hold a substantial equity stake in OpenAI, an organization that holds immense potential value.
This deal between Microsoft and OpenAI exemplifies strategic brilliance in the world of deal-making. Satya Nadella’s foresight and astuteness have positioned Microsoft for a prosperous future, where they stand to make significant gains while minimizing risks. As the warrior-CEO, Satya has once again showcased his strategic prowess, solidifying his reputation as the Marcus Aurelius of our time.