AT MICROSOFT, IT'S known simply as the Bill Review. At some point in the early stages of any major product or service launch, the richest man in the world would sit in judgment, assessing a team's progress and deciding whether the project should still get the company's backing. Engineers and executives spent days and nights preparing for this session, a grilling that could make or break a career.

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The anxiety was entirely justified. The CEO (and later chief software architect) brought every ounce of his ruthless, superior intellect to the job, and he didn't suffer fools. Tallying the number of times Gates shook his head and said "fuck" became the standard metric for failure throughout the 1990s. Joel Spolsky, a former Microsoft developer, recalled making one presentation in which someone counted only four. "Wow, that's the lowest I can remember," Spolsky's colleague told him. "Bill is getting mellow in his old age."

Now the era of the Bill Review is coming to a close. In June, Gates stepped down from his role as chief software architect (though he'll retain the title of chairman). He'll spend the next two years ratcheting down his work at the company he cofounded 31 years ago, devoting the bulk of his time to philanthropic efforts. His handpicked successor, Ray Ozzie, doesn't like to curse, at least not in meetings. In fact, Ozzie is in many ways the anti-Gates: courtly, soft-spoken, as approachable as your favorite college prof.

But the two men share something important to the past and future of Microsoft: technological brilliance. As the inventor and principal executive behind Lotus Notes in the '80s and '90s, the 50-year-old Ozzie is considered one of the best software minds on the planet. In its day, Lotus Notes was among the most popular applications in corporate America. In 1997, Ozzie started Groove Networks, a company – like the one behind Lotus – created to help office workers collaborate electronically. Microsoft bought Groove in April 2005 for $120 million, and Ozzie signed on as a top executive in Redmond.

But the idea of being put on a pedestal makes Ozzie squirm. For starters, he doesn't like to be in front of crowds and used to suffer from crippling stage fright. More fundamentally, trying to manage from atop a pedestal doesn't work, he says. You lose touch with employees, and that makes it harder to lead an organization and get things done. And at Microsoft – a company many say is clinging to an outdated business model and beset by more-nimble competitors – there's a lot of hard work to be done these days.

Just listen to Ozzie describe his management style. "When I find a hairy bug," he wrote in a 2003 blog posting, "I love having the developer come in and debug it face-to-face. It gives me a chance not only to understand more about the product's internals, but also, you have no idea what I learn chitchatting while waiting for debug files to copy, etc. Design and implementation issues, stuff that people have been building off to the side, things about the organization, rumors, etc." He continued: "I suppose this is just classic 'walking the halls,' but I feel as though without this kind of direct nonhierarchical contact I would lose touch with my organization, and people throughout would know I was disconnected and would lose respect for me."

It's hard to imagine how a guy this self-effacing could survive inside Microsoft's insular, hierarchical, hypercompetitive culture. Redmond is notorious for bringing outsiders into the executive ranks and promptly shredding them. But since joining the company 18 months ago, Ozzie's star has only gotten brighter. He was brought on as one of three chief technical officers, and less than two months into his tenure, he was leading a secret strategy session on how to fight competitors like Google. By November, he was the architect of a new software development strategy for the entire company. And in June of this year, he reached the mountaintop: Gates announced that he was essentially retiring and named Ozzie as the company's technology überboss.

"With Gates, everything was always a production," says one program manager who asked to remain anonymous. "You'd go to Building 34, where he and [CEO Steve] Ballmer have their own separate wings, and then you'd have to get cleared by a security guard, and then you'd have to get cleared by two secretaries – all before you made your presentation." When Ozzie was interested in learning more about a product, he would go to the program manager's conference room, and he went prepared with good questions showing that he had done his homework. And as chief software architect, he shows no signs of changing his approach.

There are, of course, two major reasons for Ozzie's ascendancy at Microsoft: Gates and Ballmer. Ozzie is one of the few technologists anywhere whom they respect; they'd been trying for years to get him to join the company. Now he's carrying their hopes for the future, and it's a heavy load. Ozzie needs to move Microsoft from selling software in a box to selling lightning-fast, powerful online applications ranging from gaming to spreadsheets. The risks are enormous. The mission is to radically alter the way the company sells its most profitable software and to pursue the great unknown of so-called Web services – trading an old cash cow for an as-yet-to-be-determined cash cow. No, Microsoft doesn't think its customers will stop using PCs with hard drives and work entirely online, but the desktop era is drawing to a close, and that promises to force some painful trade-offs.

MICROSOFT HAS BEEN in a funk since 2003. Its travails could be the subject of a Harvard Business School case study on the innovator's dilemma. The company made – and still makes – billions selling desktop software, mainly Windows and Office. But the center of gravity has moved, and desktop software is about as cutting-edge as a nightly network newscast. Instead, Web-based apps are taking hold, and devices other than the PC – smartphones, iPods, digicams – represent the growth markets for software. At the same time, new business models, like search-based advertising and low-cost software subscriptions, are beginning to generate big money.

None of this is news in Redmond. In a 1995 company-wide memo titled "The Internet Tidal Wave," Gates famously recognized the network as a disruptive tsunami. And starting in 2000, he tried to prepare his troops for yet another big shift, with a series of speeches on Web services. Even then, Gates was describing a world where desktop applications would eventually work in concert with high-speed apps delivered over the Internet. Among other benefits, he noted, "you should never have to enter the same information multiple times."

But despite all the visionary pronouncements, Microsoft has been consistently outmatched on this new battleground. Apple Computer completely controls the online music business with the iPod. (In July, Microsoft effectively scrapped its partnerships with hardware makers and has resorted to creating its own music player, named Zune, to try to compete.) Cell phones, BlackBerrys, and PDAs are now arguably the primary way we check email, yet Microsoft trails in supplying software to those devices. Microsoft's game console, the Xbox 360, has been a hit, but competition from Sony's PlayStation 2 has kept prices low, making profits elusive. And when it comes to Internet search – another hugely popular function that doesn't run on a PC – Google is widening its lead over Redmond and exploiting new advertising models that generate billions in revenue. Google is also experimenting with a collection of Web apps, including maps, video, even online word processing and spreadsheets. Meanwhile, Microsoft has been struggling with the sort of things it historically has done best – producing big, integrated software packages. Vista, its new operating system, is due out next year, but it's almost two years late and has no firm release date.

The upshot? Microsoft's stock, which generated better than 50 percent compound annual returns during the '90s, hasn't moved at all in nearly five years. Morale in Redmond, once the envy of corporate America, is the lowest it has been in company history. Employees complain of IBM-like bureaucracy that stifles creativity and innovation. And petty financial jealousies are rampant: Thanks to the stagnant share price, few are getting rich at Microsoft these days. Half the staff – those who joined the ranks in the early '90s – are worth millions of dollars from stock options. The other half – hired after 2000 – are worth a fraction of that.

Perhaps worst of all, five years after Microsoft dodged a breakup and other huge antitrust sanctions for being too aggressive, it's hard to find anyone who is scared of the company anymore. Remember when competing with Redmond used to be considered a death sentence? Now Google taunts it daily. It has hired about 100 Microsofties, half of whom work at a satellite office a few miles away from Microsoft HQ. Apple, for its part, has become so confident of consumers' preference for OS X, its operating system, and software like iPhoto and GarageBand that it now allows users to run Windows on its machines. Early reports indicate the strategy is working: Sales of Mac laptops are booming and have pushed Apple's US market share in the category to 12 percent, doubling in just six months.

Despite all this competition, however, Microsoft looks awfully healthy. General Motors would love to have such problems. The company has developed a robust server software business since the late '90s, and its Windows and Office monopolies still mint $1.5 billion a month. It has almost $35 billion in the bank.

But executives at Microsoft are smart enough to be worried. They're painfully aware of the story of IBM in the 1970s. It was the most powerful corporation in the world – so powerful that the government sued it for antitrust violations. Fifteen years later, it was on its back. In those days Microsoft was the young superstar – much as Google is today – that helped push Big Blue from its perch. Redmond doesn't want to see history repeat itself.

Ozzie's plan – laid out in a 5,000-word memo to executives last fall and in a speech to Wall Street analysts in July – is tough love. Indeed, it's a blunter assessment of Microsoft than any executive, including Gates or Ballmer, has probably ever made. To avoid being marginalized, Ozzie said, Microsoft needs to shift gears fast and concentrate on the software-services world. That means figuring out how to get new ideas out of the lab and into the marketplace faster, rethinking the way the company makes and sells applications, and spending billions of dollars on infrastructure, like giant server farms, to power all those changes. To a corporation that has built some of the most bloated, complex software ever to boot up, Ozzie gave this advice: "Complexity kills. It sucks the life out of developers, it makes products difficult to plan, build, and test, it introduces security challenges, and it causes end-user and administrator frustration." Better, he went on, to "explore and embrace techniques to reduce complexity."

In other words, instead of spending years working on giant, deeply integrated software packages and doing one big, heavily marketed release, Microsoft needs to think more like Google and other next-gen Internet companies – designing and releasing software faster and in smaller interchangeable pieces and then letting online user feedback guide improvements.

The goal is radical and risky: embrace a variety of revenue models, including monthly subscriptions and online advertising, to become more competitive. But the vision is simple: enable users to have access to their data and applications wherever they are and regardless of what device they're using – the laptop at work, the PC at home, the cell phone, the television, whatever. "It should all behave seamlessly," Ozzie says.

He's quick to point out that Microsoft will continue to sell software in a box for a long while. Business customers, in particular, still want a degree of stability and predictability in the software they use, so many may prefer an old-fashioned release cycle. These users may also wait awhile before they let someone like Microsoft – or any outsider – run their servers. It would be bad business to get too far out in front of these customers, Ozzie says.

But he sees lots of ways to use the Web to complement Windows and Office that Microsoft has barely tapped. "Take PowerPoint, for example," he tells a gaggle of analysts crowding around him at a Microsoft cocktail party in July. "Wouldn't it be great if you could hit F5 when you finished preparing a presentation and have your PC automatically upload the file to a Web address? Then people listening to your presentation by phone could see you flipping through your slides in real time, too."

OZZIE'S PLAN will take the company in the right direction. The question is how much progress it will manage to make. Microsoft is a giant corporation with 70,000 employees, and Ozzie is basically telling all of them to change how they think about their jobs. It's probably one of the hardest things Microsoft has ever attempted.

Imagine being an airline mechanic. You're accustomed to waiting for planes to roll into the hangar to be fixed. One day, someone tells you that from now on, you're going to have to maintain the planes while they're in the air. That's what Microsoft is facing. For most of its life, it rolled the Windows and Office planes into the hangar and retooled them. Now it needs to write software that can be maintained more easily on the fly. Once you turn on a service, like an online word processor, "it's on forever," one former Microsoftie says. "It doesn't ever go off. So when you add features or want to fix something, you have to do it while it's running. It changes your mindset in terms of what's possible and what's impossible."

Another challenge Ozzie faces is persuading the organization to follow him. He may hold Gates' title, but everyone at Microsoft understands that he will never hold Gates' sway. And without direct responsibility for any of Microsoft's businesses, he will have to get Robbie Bach, Kevin Johnson, Jeff Raikes, and Craig Mundie – the presidents in charge of Microsoft's three business units and Microsoft Research – to feel that it's in their economic interest to play ball.

That doesn't appear to be a problem right now. Ozzie's reputation, the public backing from Gates and Ballmer, and the fact that Ozzie's proposals don't yet threaten the bottom line have helped him get a huge amount done in a short time. At a San Francisco presentation a year ago, he announced the formation of two groups – Windows Live and Office Live – that, along with three-year-old Xbox Live, would lead Microsoft's latest charge onto the Internet. These groups have already rolled out almost three dozen products and services. Sure, a lot of it is stuff we've seen before on Yahoo or Google, like customized homepages that aggregate all the information you care about – mail, calendar, address book, news. But there are also snappy little innovations like the recently released Windows Live Writer, which simplifies the still-difficult process of adding anything more than text to a blog.

Office Live, meanwhile, expands on the old idea of allowing users to set up domains and email boxes. For $30 a month, Microsoft adds collaboration tools. You can work on a project, save it to Microsoft-run servers in a giant data center somewhere, and allow a colleague to work on it at the same time or later. Tools like this are part of the expensive server software that Microsoft sells to big corporations. But until now they haven't been available to home and small business users on the PC platform.

And company executives have successfully turned Xbox Live – Microsoft's $70-a-year online gaming service – from a secondary offering into a must-have part of the Xbox experience. In the first two years of the service, only about 10 percent of Xbox buyers used the online service. But in the wake of a major upgrade and the rollout of the Xbox 360 last year, 60 percent of the console's buyers are now playing online. Microsoft is on track to sell 10 million Xbox 360 consoles by the time Sony's PlayStation 3 hits stores in November, Gates says.

Among the most intriguing applications to come out of Ozzie's tenure, so far, developers say, is one that Ozzie and his team of a half-dozen developers wrote themselves. Called Live Clipboard, it lets you easily cut and paste elements between online services – a picture from Flickr into Picasa or a contact from your online calendar or some random Web page into Outlook. Ozzie released the elegantly simple application, which he announced in March, in a very un-Microsoft way – under a Creative Commons license. In other words, it's free for developers to use and improve upon, no strings attached. He called it "a little gift to the Web," and so far, most of the development community, long suspicious of Microsoft geeks bearing gifts, has believed him. "When I saw it, I thought, 'Wow, this is a huge innovation, and it's great to get it out so quickly,'" says Alex Hopmann, a 10-year Microsoft developer and manager who left the company 18 months ago for a startup. "It used to be that someone would come up with an idea like that and it wouldn't see daylight for two years, until the next product release."

The true test of progress, of course, will come when Microsoft demonstrates it is actually prepared to gamble with a part of its Office and Windows revenue. Will we someday be able to use portions of Microsoft Office – say Word, Excel, or PowerPoint – as free, online, ad-supported apps that run inside an Internet browser instead of on our hard drive? Will we be able to take a working Excel spreadsheet and paste it into our blog? Those things are being discussed; just don't count on seeing them tomorrow, Microsoft insiders say.

Another topic under discussion: selling cheap, stripped-down versions of Office to suit various niches. Microsoft gets loads of abuse from consumers and businesses for selling an expensive, one-size-fits-all product larded with features that most people ignore (or actively hate – AutoCorrect, anyone?). So, a few midlevel executives are wondering, why not offer customers the option of a cheap subscription with fewer features, but those tailored to their specific needs? The idea is risky for the company, which relies on Office to generate some $12 billion a year in revenue. But that's the kind of tough love Ozzie is proposing.

To see the depth of transformation Ozzie is talking about, spend a few hours with Gary Flake, one of 10 Microsoft employees to hold the coveted title of technical fellow. He joined the company last year after a year-and-a-half stint as Yahoo's head of R&D, and he's clearly a different kind of Microsoft engineer: He doesn't believe in Windows' supremacy or in the software-in-a-box concept. He's proud to tell you that he's written more than 100,000 lines of open source code, an affront to Redmond's traditional businesses. And he's quite willing to question Microsoft's ability to innovate, which would have been considered heresy a few years ago. "In addition to saying, yes, we do some innovative things, and we don't get credit for them, I'd take it a step further," says Flake, who, as head of the 100-engineer Live Labs team, is charged with getting Microsoft's breakthroughs into the marketplace faster. "I'd say we don't always do the innovative things we should do. We need to improve in that dimension."

That Flake can get away with talk like this is perhaps one of the biggest signs of change inside Microsoft. Historically, Gates & Co. have reacted with fury when their bona fides as innovators were questioned. Now Redmond seems to be facing up to the reality that its innovation machine is broken.

IT WAS LOTUS NOTES that made Ozzie's reputation – and got the attention of Microsoft chieftains. "Bill and Steve felt they should have done Notes – that it was their birthright," a former executive says. "The fact that Ray did it first earned him their undying respect."

Indeed, so far Gates, Ballmer, and the rest of Microsoft's executive team have gone to great lengths to put Ozzie in a position to succeed in his new role. A year ago they streamlined Microsoft's corporate structure – compressing seven business units into three – and changed the way top executives in each division are compensated, in hopes of reducing cross-division friction. Historically, the company was organized to encourage each unit to pursue its own agenda, even at the expense of other divisions. Now executives must demonstrate a degree of company-wide cooperation to get a top bonus.

In May, Microsoft also changed its review process for rank-and-file employees, who increasingly felt that the system discouraged risk-taking. It used to be that you were graded on a curve within your group: For every top performer there had to be a subpar one. That worked fine when the company was smaller. But as Microsoft grew, the policy encouraged sloth. Why chance moving to a group of superstar engineers, people reasoned, if it meant you might go from above average status to below average? Now each employee is graded based on individual goals, regardless of how others do. These goals are reset as often as every other month to encourage engineers to ship lots of little software modules and revise them online rather than spend an entire year on one huge release.

Gates and Ballmer have shown that they will do what it takes to retain valued employees, especially those courted by Google. Microsoft's lawsuit against search expert Kai-Fu Lee last year for violating his noncompete agreement when he jumped to Google may have made Gates seem desperate at the time, but it also sent a message to potential defectors. When Google recently poached top marketing exec Vic Gundotra from Microsoft, he agreed to honor his contract and not work for a year rather than get sued. The company has also improved the food in its cafeterias, offered more concierge services like grocery delivery, and, most important, tripled the number of stock options an employee can receive as an annual bonus. One engineer says that when Google tried to hire away a friend of his in his twenties, Microsoft offered the man $250,000 in stock to stay with Redmond. He still left, but the story is an indication of how hard Microsoft is fighting back.

Top management has also pushed to make pay scales and communications in general more transparent. In the Office division, for example, compensation is now directly linked to title so employees know roughly where every colleague stands in the ecosystem.

Gates himself is trying to be more open. This year he made available to the whole company electronic copies of the papers he takes on his annual Think Week vacation. In the past, what Gates perused during his celebrated week of rumination was a closely held secret.

WILL ANY OF THIS pull Microsoft out of its funk, help it compete better with Google, or return it to a position of dominance?

There certainly are reasons to believe it's possible. Everyone in the world of high tech understands that Microsoft is at its toughest when cornered. And so the Ray Ozzie Show should be – and is – getting Silicon Valley's attention. Google may turn heads when it comes to replacing the desktop as a computing platform, says Tim O'Reilly, Web 2.0 guru and founder of computer book publisher O'Reilly Media. "But if you look at how Microsoft is positioning Live, it's clear it understands this new world." In addition to rethinking its innovation process and speeding up product cycles, the company is planning to spend $2 billion more than usual next year. It hasn't explained why, but most observers believe the money is earmarked to expand its Web services and build server farms all over the world to support its new online infrastructure. No other company can bring that much financial muscle to bear so quickly.

And say what you will about incursions by competitors like Apple, Google, and Linux – Microsoft applications still claim more "eyeball time" from more people than any other high tech products in the world. Even now, after all the buzz about Google's panoply of software products, if Microsoft can match it feature for feature – say, with a good desktop search and photo management program in Vista – Redmond could, despite years of false starts, start catching up to the search giant.

But the odds are long, and history is against it. Yes, Microsoft is a unique company, but established corporations with 70,000 employees almost without exception have a hard time learning new tricks. Microsoft has done better than most, with Windows, then Office, and now its server business. But it also has been struggling to become more Internet-centric since it launched MSN more than a decade ago. And with the obvious exception of Internet Explorer, it has had decidedly mixed results. Ten years ago, the world was convinced that Microsoft would use MSN to control the Internet the same way it controlled the desktop: extracting tolls, blocking competitors, regulating which sites surfers could access. Back then, the world worried that Microsoft would take command of the entertainment business by using its cash reserves to buy the best programs and music and using its software in our cable set-top boxes to dictate what we watched. None of those fears came to pass. Instead, Microsoft has been outmaneuvered by faster, hipper competitors, from Apple and Google to Flickr and YouTube.

Ozzie believes things will be different now, thanks to what's come to be known as the cheap revolution. Because broadband, processing power, and storage are so inexpensive and ubiquitous, he says, the high tech landscape is more receptive to the seeds Microsoft is planting than at any other time in history. He also says the time is ripe because there's a business model to support a new generation of online applications – advertising – that previously didn't exist. Every Web-based startup may share these opportunities, he admits, but Microsoft has the wherewithal to capitalize on them on a massive scale.

He'd better be right. In 1995, Bill Gates foresaw the Internet tidal wave and pushed his company to adapt. At the time, that seemed prophetic. Today, Ray Ozzie is pushing the same thing, but this time it's about survival.