OpenAI eclipses Microsoft in AI model sales, igniting a friendly rivalry

OpenAI eclipses Microsoft in AI model sales, igniting a friendly rivalryOpenAI, the startup behind the ChatGPT chatbot, has surpassed Microsoft in revenue from selling access to its AI models, including GPT-4, despite only establishing a sales team last year. This remarkable achievement, particularly compared to Microsoft, the world's largest enterprise and cloud software seller, has been achieved through a simple yet effective strategy: offering early access to new versions of generative AI capabilities and customizing software requirements for its biggest clients

OpenAI eclipses Microsoft in AI model sales, igniting a friendly rivalry

OpenAI, the startup behind the ChatGPT chatbot, has surpassed Microsoft in revenue from selling access to its AI models, including GPT-4, despite only establishing a sales team last year. This remarkable achievement, particularly compared to Microsoft, the world's largest enterprise and cloud software seller, has been achieved through a simple yet effective strategy: offering early access to new versions of generative AI capabilities and customizing software requirements for its biggest clients.

OpenAI's annualized revenue from model access sales reached an estimated $1 billion by March, according to a person familiar with the internal business data. This contrasts with Microsoft's comparable product, Azure OpenAI Service, which only recently crossed the $1 billion annual recurring revenue (ARR) mark, as revealed by OpenAI CEO Sam Altman to employees this month.

OpenAI, which has been selling models since 2020, achieved market leadership this year, while Microsoft launched its Azure OpenAI Service broadly in January 2023. Both services are known as APIs (application programming interfaces). The growth of OpenAI's API business has put increased pressure on Microsoft's business of reselling OpenAI models.

Microsoft executives expect Azure OpenAI Service to reach $2 billion ARR within a year, equivalent to $166 million per month. It remains unclear how fast OpenAI anticipates its API business to grow, but it has more than tripled in the past year.

This surge highlights the strong interest from commercial clients in large language models, AI systems adept at mimicking human responses and analyzing data. Despite their flaws, companies are employing these models to develop automated customer service, accelerate drug discovery, and identify trading opportunities within public securities filings.

Friendly Competition

The latest revenue data reveals that the unusual partnership between the two companies could be tested by escalating competition. Currently, this competition is largely friendly, with both parties actively planning the construction of giant supercomputers that will take years to complete.

Driven by anticipated growth in products like Azure OpenAI Service and Copilot, a suite of AI features for software developers and Office 365 users relying on OpenAI technology, Microsoft's stock price has nearly doubled. But OpenAI has now become a formidable competitor to Microsoft in both product categories.

However, in the long run, Microsoft will still benefit from OpenAI's success. Microsoft not only gets to permanently use OpenAI's technology in its own products, but it also receives 75% of OpenAI's profits after OpenAI repays its early investors. This share will later decrease to 49% until a theoretical cap, likely to be raised soon, is reached.

Even if Microsoft loses the sales competition with OpenAI, the software giant won't go empty-handed. OpenAI is obligated to pay Microsoft for running its AI operations in Azure data centers and a 20% commission on API sales. However, the profit Microsoft derives from this arrangement is far less appealing than directly reselling OpenAI models.

Market dynamics, however, appear to be tilting towards customers buying directly from OpenAI. "There's a profound shift happening where enterprises are now more likely to choose AI-native companies like OpenAI rather than getting the models through cloud providers," said Igor Jablokov, founder and CEO of Pryon, a company focused on selling software tools to developers of AI applications.

Holiday Extras, a European travel booking website competing with Expedia, exemplifies this trend. After multiple meetings between its employees and OpenAI's sales and engineering staff in London, the company secured a customized internal chatbot and decided to directly pay OpenAI for model access and ChatGPT access.

David Lee, Innovation Director at Holiday Extras, said the chatbot, which helps customer service agents recommend travel resources or insurance policies based on clients' travel destinations, saves employees $800,000 per year in time costs. "Azure's products are certainly good... but what we really crave is to get the products directly from the developers," he said.

Profitability: A Win-Win for Both

Azure's annual revenue exceeds $55 billion, encompassing server rentals and services like Azure OpenAI Service. Analysts estimate that Microsoft generated approximately $1.6 billion in additional revenue last year from AI-related cloud services, exceeding $1 billion in the quarter ending in March. This is largely attributed to the growth of Azure OpenAI Service and the fees OpenAI pays for renting Microsoft servers.

OpenAI's ability to afford these fees stems from Microsoft's equity investment of up to $10 billion in the company early last year. For Microsoft, directly selling OpenAI technology to businesses holds greater profit potential than merely collecting cloud server rental fees from OpenAI.

Initially, according to a person directly familiar with the arrangement, the fees OpenAI paid only covered the cost of its computational resources used on Azure. (OpenAI also pays an additional commission to Microsoft.) The gross margin for Microsoft's Azure OpenAI Service is approximately 40%, according to people familiar with the business. This percentage has improved as AI models have become more efficient.

Due to the reduced server usage fees OpenAI pays to Microsoft, OpenAI's API business has the potential to achieve comparable profit margins. The gross margin figures for both companies include their respective commissions: Microsoft pays OpenAI 20 cents for every $1 earned from Azure OpenAI Service, while OpenAI pays Microsoft 20 cents for every $1 earned through its API sales. Currently, the revenue splits between the two companies largely offset each other.

The impact of Microsoft's Copilot competing with OpenAI's enterprise-focused ChatGPT is more difficult to quantify. Both companies declined to disclose specific sales figures. While Microsoft boasts millions of paying users for its Office 365 application suite and claims 60% of Fortune 500 companies pay for its Copilot service, this advantage has not been reflected in its financial reports. In fact, enterprise sales growth for Office applications slowed by 2 percentage points from the fourth quarter of 2023 to the first quarter of this year.

Competition Was Anticipated Early On

The relationship between Microsoft and OpenAI has always been tinged with competition, even in its initial stages. When Microsoft first invested in OpenAI in 2019, both parties agreed to be partners, jointly selling AI models and sharing revenue.

By 2022, OpenAI's total revenue was just $28 million, almost entirely generated from API sales to startups like Jasper, as it did not yet charge for ChatGPT. During renegotiations of the partnership agreement in late 2022, as revealed by a person familiar with contract details, Microsoft added its $10 billion investment. At that time, Microsoft made it clear that the two companies would operate as independent entities and compete for customers in the market.

This decision was partly motivated by the desire to minimize potential antitrust scrutiny. By March 2023, Microsoft had begun actively seeking to convince businesses to purchase its technology through Azure rather than directly from OpenAI, arguing that Azure offered greater privacy and security.

Meanwhile, OpenAI's API business continued to grow, reaching an annual recurring revenue of $333 million by the end of June 2023, representing one-third of its total revenue at the time. James Dyett, OpenAI's head of strategic customers, revealed in a recent podcast interview that the company had also increased its investment in sales, expanding its sales team from around 10 individuals a year ago to over 200 today.

Dyett stated that his current priority is to acquire and satisfy several major clients. For instance, payment company Stripe had previously purchased OpenAI's models through both Azure and directly from OpenAI, but recently seems to have shifted more spending towards OpenAI, according to people familiar with the situation. AI search startup Perplexity has undergone a similar transition.

One significant advantage for OpenAI is its ability to sell the latest models to clients before Microsoft does. This stems from their agreement, which requires OpenAI to hand over the models to Microsoft only after they are complete. This gives OpenAI the opportunity to charge customers for early previews, which are often almost as good as the final product.

This scenario played out last year when OpenAI provided access to its GPT-4 model to clients weeks before Microsoft's version of GPT-4 became operational through Azure.

Microsoft is Always Ready with Discounts

To win deals, Microsoft leverages its biggest asset: bundled sales. Throughout this year, Ken Numoto, Microsoft's chief marketing officer responsible for the company's cloud bundling strategy, has repeatedly questioned Azure's leadership team, asking them if they are able to attract customers for Azure OpenAI Service and ultimately induce them to spend more on other Microsoft products and services.

The issue, according to several Microsoft employees and several Azure service clients, is that many Azure OpenAI Service clients, such as Intuit, primarily use services from competitors like Amazon Web Services. For example, Rajesh Naidu, senior vice president at Expedia, said the company opted to buy models directly from OpenAI instead of through Azure partly because most of Expedia's cloud services are on AWS, and OpenAI's customer service seemed more "agile". He added that the company would still be open to considering a shift to Azure in the future.

However, Microsoft's bundling strategy has proven successful with some notable clients. Earlier this year,