I’ve debated chiming in on the economic climate. It’s obvious that folks who’ve devoted their entire academic and professional careers are unable to rationalize what’s going on. What more can I add to the discussion?

There are a few thoughts I can add and those have to do with how bad economic conditions impact startups and how startups might want to navigate these difficult times.

The first reality that people need to come to terms with is that bad economic circumstances impact different companies differently, based on the stage of where the company is. For example, startups that had planned to raise an A round in late 2008 or early 2009 will likely fail at capitalizing their businesses in this climate. Second funding rounds will be equally hard, especially for companies that don’t show strong traction. Companies that recently closed rounds, however, might be in good shape to ride out the downturn.

My advice to startups is to be smart about turning a bad economy into a positive for your company. Here’s what I recommend:

1. Focus on making your best existing customers even more ecstatic. In politics they call this your base constituency, but in business these are your core customers. Keep them happy. They are making tough decisions too.
2. Reduce expenses to extend your runway. The quickest way to reduce expenses is by reducing payroll. Re-evaluate every individual in every role. Are they vital for your existence over the next 6 to 12 months? Are these individuals the ones you’d start the next company with? If the answer is “no” decide whether it makes sense to shrink the team a little.
3. Take advantage of the opportunity to catch up to the competition. Startups already know how to be productive even when resources aren’t abundant. Use your efficiency as a competitive advantage.
4. Accelerate your plans to generate revenue.
5. Nurture and develop strategic, long term business relationships. During boom times it’s easy to be distracted by all that’s going on, often at the expense of business development relationships that amplify distribution and reach. In slow periods, potential partners have time and you have time, so make the best of it.
6. Opportunistically upgrade the caliber of the team. If you have an underperformer or two, there may now be much stronger candidates in the market now. The goal is to come out of tough times even stronger than before.
7. Focus the team on core, top priorities. Now’s not the time to work around the margins.
8. Defer your external capitalization plans. If you have not already received a term sheet, assume angel or venture funding will not happen in the next 12 months.
9. Defer thoughts about your exit strategy.

I do believe there can be a silver lining in bad economic times. I founded MessageRite, an email archiving service, in late 2002. We felt we were able to catch up to our much bigger competition quickly in part because they were all stopped in their tracks, dealing with shrinking revenues and rounds of layoffs. Additionally we failed at raising capital during that economic climate, which forced us to figure out how to succeed with very modest resources. That meant that when we were ultimately acquired, the founding employees of the company owned all the equity which resulted in a much bigger payday for everyone involved. It was also interesting to note that our acquirer was one of the business partners we started working with during the tough times.

[preamble: I started writing this post yesterday, before rumors started circulating that Google was launching a venture fund. My first thought was to abandon the post as some might think I was simply recommending that Microsoft follow Google's lead. But what I have in mind is different and still needs to be said.]

Microsoft is the largest and most profitable software company in the world. It has a market capitalization of $240B with annual revenue of $60B producing $40B gross profit and $17B net profit. It’s a wildly successful business. By comparison Google’s market cap is $150B with annual revenue of $19B producing $10B gross profit and $5B net profit. Microsoft’s revenue and profit are triple Google’s.

Yet you wouldn’t think so by reading the news. Microsoft’s failed attempt to buy Yahoo was characterized as having missed out on its last hope to be a meaningful player in search and the Internet. The issue of course is that its future success is less clear and certain compared to its recent success.

Over the last two decades most software was licensed and installed on servers behind firewalls and PCs on desktops. Annual maintenance agreements provided software companies with healthy annuity streams. No company on the planet benefited from this model as much as Microsoft did.

Gradually things have changed. Design and usability have become primary decision factors when choosing software. Broadband Internet access has become pervasive if not ubiquitous. Robust, functional open source software can be installed on servers and PCs without cost. Open source development tools equip more programmers with tools to create more software to compete with the status quo. Ad supported and freemium business models allow software to be used without cost or at significantly lower costs. Software as a service lowers the barrier for end users to try out software on their own, without necessarily being sanctioned by the IT department. Advances in web development - from techniques like AJAX to Rich Internet Applications (RIAs) - have resulted in browser-based applications being as feature rich and robust as traditional, desktop-installed applications. Low-cost, cloud based utility computing services like those from Amazon and Google allow startups to bootstrap their way into markets which previously had insurmountable barriers.

These changes in the technology landscape and business climate have allowed newer entrants to threaten the incumbent Microsoft in all of its core businesses.

* Windows Server is threatened by Linux and hundreds of SaaS vendors (many small businesses are running entirely without local servers, choosing to consume everything they need from an array of SaaS vendors).

* The significance of any desktop OS, most significantly Windows, has been reduced by advances in the capabilities of browsers and Adobe Flash. If the minimum requirement to run your favorite application is “any browser” or “any browser with Flash 9″ it affords the choice of running Linux or OS X instead of Windows.

* Open Office, Google Docs and a handful of very capable web 2.0 applications threaten the Office franchise.

* Exchange is vulnerable to advances by Google Apps and Zimbra.

* Sharepoint is under attack by Jive Software, 37Signals, Atlassian and other SaaS vendors that offer open source or low cost functional equivalents.

So far I’m probably not citing anything we don’t already know. But I do believe there is hope for Microsoft. It will require the Redmond giant to return to their risk taking, entrepreneurial roots. Insiders at Microsoft call it making big bets. It’s time to make some big bets.

Here’s how I think Microsoft can stay on top.

Microsoft is one of the companies that can afford to invest heavily in cloud computing and has the intellectual horsepower and engineering prowess to succeed. They’ve already started in this area and they should accelerate their efforts.

Everything is moving to the cloud. Microsoft knows that. The big risk though, is that none of the startups writing software for the cloud are using Microsoft development tools or server software. Eventually these twenty-somethings get married, have kids, move to the surburbs and take jobs in IT departments. If what they know is Linux, python and Ruby on Rails, that’s what they’ll bring in and obviously, that’s bad for Microsoft.

Microsoft has a cash-rich balance sheet. They have about $40B of unspent money they had planned to spend to acquire Yahoo. Microsoft suffers from a general lack of innovation that happens in any company as it grows. Additionally there’s a gradual exodus of top engineering talent and senior management to startups and other cooler, more nimble companies. Google (and Yahoo previously) have been buying up innovative companies before Microsoft has a chance to see them.

Microsoft should consider developing its own internally funded Y Combinator like program. It would be similar but different. It might just be the catalyst Microsoft needs to dominate for another couple of decades. Here’s how it would work:

*) A three person team comprised of Ray Ozzie, Don Dodge and Dare Obasanjo would be the investment committee.

*) Anyone can submit a 10-slide business plan. No NDA protection, which is the norm in the VC industry.

*) Plans are reviewed once a quarter. Those that make it through the screening are invited to a 90-minute in person demo and pitch.

*) At the end of the 90-minute demo & pitch, the three-person Ozzie/Dodge/Obasanjo investment committee makes an immediate decision. It’s pass/fail. You’re in or you’re out. American Idol style. You’re going to Hollywood or you aren’t.

*) If you pass, here’s what you get: an investment of $100,000 cash plus $25,000 per founder, but never more than $175,000;  all the Microsoft software you need; unlimited, free use of Microsoft’s cloud computing infrastructure for 3 years; mandatory office space for up to 5 people for the first year in either the Redmond or Silicon Valley Campus; all the non-sense administrative support services that typically saps a startup, a collegial environment working with other Microsoft funded startups.

*) In exchange, Microsoft gets: 10% of the company in common stock with no special preferences or rights; your commitment to exclusively use Microsoft development software and operating systems for 3 years, other than with written exception by Microsoft; your commitment to deploy your software to Microsoft platforms first (i.e. if you build a mobile app, it has to run on Windows Mobile before iPhone).

That’s it. Quid pro quo. Startups need cash, tools, infrastructure and elimination of noise and distraction. Microsoft needs access to innovation and a future generation of folks building software with Microsoft development tools and to be run on Microsoft platforms. My bet is that Microsoft will flat out buy some of the companies during their year of incubation. And if you assume each startup will have 3 to 5 people, even the ones that fail will produce a good stream of folks who could easily become employees. Microsoft probably already spends $50,000 per hire anyway, so it’s not really costing them much if anything at all.

Oh, there’s one more important twist to help stem the tide of people leaving Microsoft to found companies or join startups. Microsoft employees in good standing having spent at least 2 years at Microsoft can quit their job and can be admitted into the incubator program with only a single approval from the investment committe. No business plan, pitch or demo are required. You’re in. Your prior contributions are your ticket. How many young entrepreneurs-to-be are willing to put in two good years at Microsoft just to get into the incubator program? I think more than a few. It’s a VC spin to the army college fund. It’s the Microsoft future entrepreneurs fund.

So how much is this program going to cost Microsoft? Let’s do some rough, back-of-the-envelope math. Let’s guess that they’ll take 100 companies through the program each year. That’s about $15M in cash plus office space and support for up to 500 people.  Office space and support is about another $7M to $8M. Let’s just call it $25M all in. From the perspective of an R&D budget it’s nothing. In fact if I’m Steve Ballmer my first question is “How can we scale this program to $250M or $2B?”

Sunil Bharti Mittal is a self-made billionaire. Well, actually he’s a billionaire 11 times over, but who’s counting?   Follow this link and either watch the video or read the transcript of Mittal being interviewed. It recounts how he started his first business at 18 with $1,500 loaned to him by his father and methodically grew that into a $5B international conglomerate.

That was too fast. You didn’t follow the link. You didn’t watch the video. You didn’t read the transcript. Go on. I’ll wait. The rest of our conversation won’t have context without you doing your part.

OK. Good. Your back.

So, how do you feel? Are you ready to quit your job tomorrow and start your company? If not, you aren’t an entrepreneur. You simply can’t watch that 15 minute video without it moving you in a way that compels you to realize that you must get started right now.

Forget about all of the personality tests and litmus tests that try to measure if you have what it takes to be an entrepreneur. After watching that 15-minute video, if you aren’t ready to leap into entrepreneurship tomorrow, you won’t ever be ready. Feel good about the clarity of that decision and go take a job where you can make the greatest impact. Otherwise, get going! What’s holding you back?