(FORTUNE Magazine) – Steve Ballmer made a sudden and unscheduled trip to Munich last winter. The CEO of Microsoft had been vacationing with his family in Europe when he got word that the Bavarian capital was about to scrap the Windows operating system on its 14,000 PCs and switch to free "open source" Linux software to run its machines. Loath to lose a prominent government customer, Ballmer jumped into a business suit and rushed to Munich. But he was too late. The city decided to go open source.

What happened in Germany is a microcosm of a change that is sweeping the $200-billion-a-year software industry. Open-source software is popping up everywhere, in PCs and cellphones and set-top boxes, in servers that power the world's websites and in giant corporate and government systems. Today the biggest challenge confronting Microsoft--and Oracle and IBM and virtually every other major software maker--is chillingly simple: How do you compete with programs that can be had free?

In just a few years, a grassroots approach to creating software has shaken the status quo. In 1991, Linus Torvalds, a college kid in Finland, posted his Linux operating system online and invited friends to use and improve it. The availability of this basic, powerful software, which works on Intel's ubiquitous microprocessors, coincided with the explosive growth of the Internet.

Linux soon began to gain a global following among programmers and business users. Then, during the dot-com boom, mighty IBM got into the act. The $90-billion-a-year giant seized on Linux as a way to sell more hardware and services, and to stymie Microsoft in corporate accounts. Never mind that foes of open source like Microsoft senior VP Craig Mundie denounce free Linux as "socialism," a threat to the very fabric of the industry Bill Gates created; largely because of IBM's endorsement, the use of free software has soared.

The revolution goes far beyond little Linux. Remember how the PC clobbered minicomputer makers Digital Equipment, Wang Labs, and Data General? Some software companies could face a similar fate. Just about any kind of software can be found in open-source form. The SourceForge.net website, a meeting place for programmers, lists an astounding 86,000 programs in progress. Most are minor projects by and for geeks, but hundreds pack real value. If you need a customer-service application for a company of up to $200 million in annual sales, it's there. Free software is also popping up increasingly on PCs. If you hate shelling out $350 for Microsoft Office or $600 for Adobe Photoshop, OpenOffice.org and the Gimp are surprisingly high-quality free alternatives.

Users like open software for more than its price. Whereas most software companies jealously guard the inner workings of their programs to protect their commercial value, open source unveils its essential programming, or "source code," to the world. That makes it easy for users to modify it to suit their needs and for programmers to share improvements. Open-source programs are typically maintained by volunteers, sometimes numbering many thousands. Says Ted Schadler, an analyst at Forrester, a Boston IT-industry watcher that surveys corporate users: "Companies find the quality of mainstream open-source products like Linux to be at least equal to that of commercial alternatives."

You may not realize it, but you probably encounter open source every day. When you search for information about a movie on Google or buy a book on Amazon, your inquiry is shunted through vast farms of servers powered by it. Sabre, the $2-billion-a-year travel-reservations system, uses Linux and open-source database software in its Dallas data center, one of the largest on earth. Open source helps guide the Mars Rover. Some 70% of large companies surveyed recently by Forrester use Linux on at least some of their computers; an even higher percentage reported plans to increase their use of open source. Government leaders, notably in China, are endorsing open source as a way to save money and curb the influence of foreign suppliers, especially Microsoft.

For all Linux's prominence, the most successful open-source program is Apache, software that manages your browser's interaction with the web. It is used by 67% of websites worldwide, according to Netcraft.com, which analyzes the Internet. Another hit program is MySQL, a database that four million customers have downloaded. And so-called application-server programs like JBoss and Tomcat are displacing software sold by BEA Systems, IBM, and Oracle.

For the likes of Microsoft and Oracle, this trend spells trouble. Software is one of IT's few remaining redoubts of profitability now that fierce competition has hammered down the prices of PCs, disk drives, displays, cellphones, and Internet routers. But with open source challenging some of software's most widely used products, outsized profits like Microsoft's astounding 40% operating margins are at risk. Marc Andreessen, who led development of the first web browser, says open source will have the biggest and fastest impact on products "with broad horizontal appeal, where a lot of people use them in the same way." He means programs like Windows, Microsoft Office, low-end Oracle databases, and the Palm OS.

Faced with this tsunami, the giants have a tricky choice: Do they fight the wave or try to flow with it by adopting free-software strategies of their own? IBM, Oracle, SAP, BEA, Veritas, and Intel have all chosen to go with the Linux flow. All have assigned programmers--300 at IBM alone--to work on improving the program. Most of the giants also support the Open Source Development Labs, a Beaverton, Ore., nonprofit that employs Torvalds to oversee Linux's technical evolution. And what does software's Che Guevara think about working for the capitalists? "Open source in no way means noncommercial," Torvalds writes laconically in an e-mail. Adds Dan Woods, an IT executive writing a book on the trend: "Open source has lost its innocence as a bunch of people holding hands on a hilltop." That's for sure: Free software is becoming big business.

Marten Mickos must be Larry Ellison's worst nightmare. This genial Finn (he's the guy with his shoes off in the opening photo) runs a startup called MySQL in Uppsala, Sweden, which gives away database software. (MySQL is pronounced "my sequel.") Mickos has a devilish plan--he wants to make his company a powerhouse by blowing up the industry's price structure, or as he has told friends, "turning the $10-billion-a-year database business into a $1 billion one." That would subvert the plans of the big three in databases--Oracle, IBM, and Microsoft. Too bad, says Mickos: "Software has been overglorified for 20 years. You've been able to overcharge for underperforming software."

But wait. How can anyone expect to build a business by giving away his product? Though MySQL can be downloaded free on its website, more than 4,000 customers have elected to pay for it, at the tiny rate of $495 per server per year. They do so for two reasons--to get MySQL to stand behind the product and provide service, and for the right to incorporate MySQL's code into their own products. Amazon, Cox Communications, and Sabre pay for support; Cisco Systems, Hewlett-Packard, and Ericsson for rights to the code.

To Mickos, the freebie approach makes business sense. He calls it a "smarter way to produce and distribute the goods." For one thing, it lets MySQL attract customers while spending close to nothing on marketing. On average, 35,000 users download MySQL each day. What's more, paying or not, the users serve as a sort of gigantic quality-control team. They can peer into the program and tell the company what needs improving. "We get notes from customers saying, 'We believe the bug is on line 3093,'" says Mickos. "That single hint can be so valuable it's worth 1,000 staff developers." And while MySQL is tiny--sales last year were $12.5 million--venture capital firm Benchmark Capital has pumped more than $8 million into MySQL in expectation of a big IPO.

Nobody claims the MySQL database is as capable as Oracle's or IBM's, programs rich in sophisticated features. But many customers don't care. Phyllis Michaelides, chief technologist for $10-billion-a-year Textron Corp., voices an opinion heard increasingly often in IT departments about open-source products: "MySQL is getting better and better. It may not do everything, but if you don't need it, why pay for it?"

Like Linux, MySQL hit the big time with the help of a powerful ally: For MySQL, it was SAP, the $9-billion-a-year king of enterprise applications. Companies use SAP to automate everything from finance to manufacturing. To run the software, you must also have a database, which SAP generally does not provide. SAP's success in the '90s generated billions of dollars of sales for Oracle, and both companies thrived. But the symbiosis is breaking down, in part because Oracle has been pushing enterprise applications of its own. Its controversial bid to buy PeopleSoft is aimed largely at challenging SAP.

So last year SAP began recommending MySQL to customers and has also contributed to Mickos's company software code to beef up its offerings. CEO Henning Kagermann denies, unconvincingly, that helping MySQL is a thrust against Oracle: "We are not a database company and don't want to be." Other big players have also aligned themselves with MySQL, including Veritas, a $1.8-billion-a-year maker of software to manage data storage gear, and BEA Systems, a $1-billion-a-year maker of application-server software.

Larry Ellison told financial analysts in December that "it's going to be a very long time" before MySQL competes successfully with Oracle in large corporate accounts. Lieutenants at his $10-billion-a-year company scoff that MySQL is anemic and overhyped. Says vice president of product strategy Ken Jacobs: "We see a lot more of them in the press than we do in competitive situations." Maybe so, but free software like MySQL can gain tremendous acceptance without a formal sales pitch. As Mark Andreessen points out, "A truly disruptive technology does not get noticed until it's too late."

Though IBM derives an estimated $3.5 billion of annual sales from DB2, it has taken a welcoming attitude toward open source since it embraced Linux. Software chief Steve Mills explains that Big Blue aims to stay ahead of competition like MySQL by constantly innovating: "The possibility exists that a product at a lower price can take business away from us. But that's always been true. Open source is threatening only if you're not differentiating enough with your product." CEO Alfred Chuang of BEA strikes a similar note. BEA has begun using open-source code to perform basic tasks in its products; that frees its programmers to invent valuable features that open-sourcers may find hard to match. Says Chuang: "Open source in general is very good for BEA."

The open-source tsunami threatens no company more than it does Microsoft. Linux has been a major factor in the recent slowing of the giant; long one of the mightiest growth stocks, Microsoft shares rose just 6% in 2003, vs. 50% for the Nasdaq.

Signs of damage to Microsoft are everywhere. Not only does Linux now have, according to the IDC research firm, a 15% share of operating systems on enterprise server computers--a vast market Microsoft once thought was there for the taking--but also Apache's dominance in web servers represents a huge lost opportunity. Says longtime industry analyst George Gilbert of Tech Strategy Group: "Apache has prevented Microsoft from controlling both ends of the wire on the web--the browser and what the browser talked to. If it hadn't been there, Microsoft could have controlled ... the web itself."

Microsoft's stronghold, desktop computer software, is also under siege. Though Torvalds is careful to clarify that he is "not a Microsoft hater," the open-source consortium he works for recently launched a big campaign to promote desktop Linux. A December survey by Merrill Lynch found 58% of large-company CIOs have a growing interest in open-source desktop software. China, India, and Argentina are proceeding with open-source desktop initiatives.

In the U.S., desktop Linux appeals especially to a market on which Microsoft is counting for growth: small business. A recent full-page newspaper ad in Seattle for Fry's Electronics stores showed why: It offered a Linux PC for $199. Even the most stripped-down Windows machines seldom sell for less than $400.

Faced with the assault of free, Microsoft is cutting prices on its mainstay products far more than ever before. That same Fry's ad offers Microsoft's Office XP program for only $119.99; in recent years it has sold for as much as $500. This version is supposedly only for students and teachers, but anyone can buy it. Fighting Linux in developing countries has prompted even more dramatic price cuts. In Thailand, Microsoft recently experimented with charging just $50 for both Windows and Office. In schools in the developing world and in poor parts of the developed one, the company now offers Windows essentially for free and Office on a subscription basis at $2.50 per year. The price cutting is sure to spread. Says Tony Scott, chief technology officer at General Motors: "You'll see the price Microsoft can charge for its operating system driven down consistently over the next few years."

Microsoft thrives, of course, when faced with competition--remember how it rallied to crush Netscape during the Internet boom. (Nor is it without allies: Tiny SCO of Lindon, Utah, has worried Linux users by claiming copyright ownership of some of the underlying code--a claim that's wending its way through federal court in Salt Lake City.) Today at Microsoft hundreds of employees are working on Linux and other threats, and the word "open" crops up a lot. Martin Taylor, a rising star who recently served as CEO Ballmer's chief of staff, is assigned full-time to the open-source challenge. Says Marshall Phelps, an ex-IBMer whom Microsoft hired in June to develop an intellectual-property licensing program: "Microsoft has been pretty closed as a company. Basically now we're open for business." Jason Matusow, who runs a program that allows selected customers special rights to view Microsoft source code, says, "Customers in large numbers are telling us we need greater transparency."

Then there is Bill Gates. Microsoft's chairman and chief software architect is spending most of his time these days on a top-to-bottom reworking of Windows, the company's $11-billion-a-year mainstay. Code-named Longhorn and not due for release before next year, the software aims to make computers more versatile and less expensive to maintain. It also aims to discourage defection to Linux: It will integrate key functions of Office and database software so that users won't be as easily tempted by free programs like OpenOffice and MySQL.

As the popularity of open source surges and prices and profit margins in software crumble, will the industry be ruined? Microsoft's Mundie warns darkly that the erosion of profits will slow innovation. But Torvalds (sounding positively Gatesian) argues that the demand for innovative software is limitless: Programmers will never lack for moneymaking opportunities as infotech weaves itself into all aspects of our lives. That may be closer to the truth. Software companies have always had to innovate to survive--and fear focuses the mind.

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