SCO's Suit: A Match Made in Redmond?

For months, rumors have swirled around the Web alleging that Microsoft helped finance a small Utah software company's suit against IBM and two corporations that use Linux software. BusinessWeek has learned that Microsoft ( ) did not put up the money, but did play matchmaker for SCO Group ( ) and BayStar Capital, a San Francisco hedge fund which made a $50 million investment in SCO last October.

March 12, 2004

Microsoft Said to Encourage Big Investment in SCO Group

By STEVE LOHR

ore evidence emerged yesterday about Microsoft's role in encouraging the anti-Linux campaign being waged by the SCO Group, a small Utah company.

BayStar Capital, a private investment firm, said Microsoft suggested that it invest in SCO, which is engaged in a legal campaign against Linux, a rival to Microsoft's Windows.

BayStar took Microsoft's suggestion to heart and invested $50 million in SCO last October. But a spokesman for BayStar, Robert McGrath, said, "Microsoft didn't put money in the transaction and Microsoft is not an investor in BayStar." He added that Microsoft executives were not investors as individuals in the investment firm, which is based in San Francisco.

Mr. McGrath said the suggestion came from unidentified "senior Microsoft executives" but not Bill Gates, the Microsoft chairman, or Steven A. Ballmer, the chief executive.

Microsoft, Mr. McGrath said, is not indemnifying the investment firm against risk or otherwise indirectly supporting BayStar's move. "The issue for BayStar," he said, "is whether there is a good return on its investment in SCO."

Microsoft, Sun Microsystems and a few other companies have struck deals with SCO to license its technology. SCO owns the rights to Unix, an operating system initially developed at Bell Labs. SCO contends that Linux, a variant of Unix, violates its contract rights.

SCO's legal campaign began last year when it sued I.B.M., a leading corporate supporter of Linux, and recently stepped up its legal attack by filing suit against two companies that use Linux, DaimlerChrysler and AutoZone.

The defendants are fighting the lawsuits, saying they have done nothing wrong and challenging SCO's claim that its rights are as broad as the company contends.

Microsoft stands to gain most from any slowing of the advance of Linux, which is maintained and debugged by a network of programmers who share code freely. That model of building software is called open source development.

It is not particularly surprising that Microsoft, given its interests, played the go-between for an investment in SCO. "But this shows is that there is a lot more than meets the eye in SCO's litigation strategy," said Jeffrey D. Neuburger, a technology and intellectual property expert at the law firm of Brown Raysman Millstein Felder & Steiner. "SCO has an agenda, and Microsoft clearly has an agenda, and it's doing whatever it can to further its cause."

The extent of Microsoft's behind-the-scenes role in SCO's legal effort has prompted questions and speculation for months. Last week, a leaked e-mail message from an adviser to SCO to the company added to the controversy in the industry. In the memorandum, sent to two SCO executives, Mike Anderer of S2 Strategic Consulting discussed a role in financing SCO, writing that "Microsoft will have brought in $86 million for us including BayStar."

SCO acknowledged that the e-mail message, obtained by the Open Source Initiative and posted on the open-source advocacy group's Web site, was authentic.

But SCO added that it was a "misunderstanding of the facts by an outside consultant" who was not working on the BayStar financing. SCO added that Microsoft did "not orchestrate or participate in the BayStar transaction."

A SCO spokesman, Blake Stowell, said yesterday, "We stand by that."

Not just a whacky, conspiracy idea after all?

This story just gets weirder every day. If I had just fallen off a turnip truck, I might believe that the principals of this Marin County venture capital house were sitting around one day when the phone rang, and lo and behold, it was some mid- to high-level muckety-muck at Microsoft. He had called them — out of the blue, to hear them tell it — to tip them off about a really great investment opportunity.

The guys who run these kinds of places are not stupid, so the first thing that goes through their minds is, "Microsoft has $50 billion in cash. If it's that good a deal, why aren't they keeping it for themselves?"

The second thing is, "OK, then why are they bringing it to us? They must want something. If a guy who has $50 billion in cash wants something, there might be a way to make a buck here."

Microsoft or not, smart VC's are not going to plunk down $50 million because some guy they never heard of called them on the phone and said they should. Companies like BayStar investigate high tech investment opportunities for a living, so they undoubdedly did that.

If they did do that, they would have seen the high-tech equivalent of Salon.com... went public during the dot-com mania, failed to find its niche, has never made a dime, and is now running out of cash. Most venture capital companies already own all the stock in those kinds of things that they ever want to see. Their rec rooms are wallpapered with the stuff.

So what's here? A lottery ticket on a lawsuit? BayStar doesn't do deals like that. They have a real nice portfolio of real companies with real products. That's what they know how to do: pick likely winners from 5,000 candidates.

Bottom line, these guys knew they were buying a corporate shell that was either going to win the lotto, or go totally bust. There is no middle ground for this company... its products have never made money, and now they are even in revenue decline.

They went ahead with this anyway, which means that they saw it as a way of getting their nose in the tent at Microsoft. They probably wrote the $50 million off — in their minds at least — the day they wrote the check. Now they are waiting to see what they are going to get in return for their favor.

Microsoft plays this same game at the same level. They know very well that they owe these guys one, and the last thing they'll want to do is leave BayStar hung out to dry if Microsoft's "tip" turns out to cost BayStar $50 million.

The easiest way for Microsoft to fix this is to decide that it needs to acquire some essential technology that just so happens to be owned by one of BayStar's mistakes. So Microsoft acquires some defunct startup company for $100 million, and BayStar says, "Nice doing business with you."

That would be a straight forward way for Microsoft to reward Baystar. I don't know if they might have regulation troubles with some government somewhere. Although that scheme would seem to be ok as long as there were no phone calls or memos written. Like from Bill Gates to one of the VP's to go forth and implement this great plan. Those could be turned up in a Court search.

For what Microsoft has gained 100 million would seem like a low price to pay for the havoc SCO has laid on the open systems market. But the scheme seems too grandiose to be hatched by someone not near the top of the Corporate structure.

And surely, surely, Bayshore would want to hear from someone high enough (like Gates or Ballmere ) that there would be payback.

And if not, wouldn't they want some kind of document that they could use to make sure Microsoft performed as promised?

The other possibility could be someone has already put money into the Fund on condition that Baystar pass it through to SCO. Maybe like Paul Allen or some other retired exec of Microsoft that couldn't be directly connected. Are the books of a Venture Capital fund open?

For what Microsoft has gained 100 million would seem like a low price to pay for the havoc SCO has laid on the open systems market

I wonder about that. The trade press pundits never tire of telling us that all this uncertainty surrounding lawsuits is making people gun-shy about using linux. But that's not what the sales numbers are saying. Sales of linux servers grew at a 60% rate from '02 to '03, and that rate appears to be accelerating. There's no way to know whether results would have been even better without all this sturm und drang, but I'm sure the server vendors are quite pleased with 60-plus % growth.

I thought it was telling that IBM moved so quickly to file a "we have no objection" motion when SCO wanted to toss out its old charges and substitute new ones. One thing that could have happened there is that the judge could have tossed out the old SCO suit because they had abandoned their claims, telling them to file a new lawsuit to deal with the new claims. It looks like IBM actually wants this thing to go on, which tells me that their numbers tell them the case is actually helping sales by generating tons of free publicity.

Bayshore would want to hear from someone high enough (like Gates or Ballmere ) that there would be payback.

Any officer of the company would do. $20 million is not that big a number... not even to BayStar. At Microsoft it's chump change. There are probably guys three levels below Gates who can sign off on a $20 million expenditure.

Plus, this isn't the kind of deal where there is ever going to be a contract. No one is going to promise anything, and certainly not in writing. But lots of deals go on like that every day. When they are finally "papered," you can't even tell that one deal has anything to do with the other.

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