FORTUNE — The battle for e-book dollars became a lot more interesting earlier this week when Barnes & Noble (BKS) announced a strategic partnership with Microsoft (MSFT). Over the next five years, the Redmond, Washington-based software giant will invest at least $605 million in a new subsidiary, simply called “Newco” for now, which includes Barnes & Noble’s Nook e-reader and college textbook businesses. For the book retailer, it means the opportunity to enter international markets with its Nook business; for Microsoft, it signals a big bet on a new market.
At the core of the deal, and indeed Barnes & Noble itself, is CEO William Lynch, a Dallas, Texas native who for the last two years has helped grow the Nook into a business valued at $1.7 billion. The day after the news broke, Lynch talked to Fortune about the future of the Nook business, how its software may be used in Windows and why future versions of Nook hardware will include NFC technology as early as this year. What follows is a lightly edited transcript of the conversation.
Fortune: Company shares are up more than 50% since the announcement. Do you take that as a vindication of the resources you’ve invested in Nook?
Lynch: Vindication is a strong word. We understood when we were making these investments that the growth area was going to be in the sale of digital content. We knew that if we built a technology platform with reading technologies, application software, cloud management — and then really the most valuable part is a vast digital content repository that we’ve built with our relationships with now hundreds of thousands of publishers — that was going to be something extremely valuable as the world’s top content goes digital.
That was hard, and it took a lot of money, but we knew that if we had it, and that business was growing, there were going to be opportunities for us from a strategic standpoint in terms of big business development deals like yesterday and also driving meteoric growth through Nook and selling that content. I don’t know if that’s ‘validation.’ It’s nice. It’s a great deal for us and a great deal for Microsoft, but I kind of expected something like this would happen at some point and when we started.
Fortune: So why partner with Microsoft of all companies?
Lynch: Well if you look at what we bring to bear, we bring some really great technology and understanding of readers and reading. And we bring content and these publisher relationships. Microsoft has had a legacy in reading, but primarily what they bring is hundreds of millions of screens and windows, and I think it’s going to be an exciting launch for Windows 8. We looked at that, and we were talking to several companies, and we said distribution is something we need as we go global. We wanted a great technology partner and obviously deep pockets that can help us properly capitalize. Microsoft was the ideal partner in all those areas.
Fortune: Will we see Microsoft engineers and other Redmond-based talent actively working on new Nook devices and software?
Lynch: Currently, we’ve not communicated anything related to the roadmap about any hardware collaboration on Nook. Nook, as you know, uses open sourcing. Microsoft is obviously very entrenched in Windows. On the reading software side, in reading technologies, they’re making interesting integrations into Windows, potentially Office. That kind of work has already started. Definitively yes.
Fortune: With the announcement, there’s a lot of speculation now about what can come out of this partnership, like a potential Nook based on Windows 8, as opposed to Android. What can you tell us about the possibilities there?
Lynch: If you look at the content sort of flow from authoring tools, obviously, Microsoft is one of the leaders, if not the leader in authoring tools with Word, PowerPoint, Excel, their Office franchise, all the way through the transaction buying merchandising, sale or cloud management of the content. You can see us working across that.
So again we haven’t announced anything specifically, but imagine an integration where an information worker, student, author, consumer, creates something in Office and has it immediately published for sale through the Nook book store. It starts to open a lot of exciting possibilities.
Fortune: It’s been a little more than three years since engineers first set to work on the first Nook. In the time that’s passed, what do you think the Nook business has done right?
Lynch: It’s so much easier to start with what we got wrong! But it’s really been about the product innovation and focus on the consumer. That sounds trite. After our first Nook, I think we definitively lead in launching a lot of interesting reading technologies from the software or hardware side, whether it’s virtual lending. We were the first to do that. … We were the first to launch a color reader with Nook Color a year before Kindle Fire launched. GlowLight was our latest innovation.
Fortune: How has Barnes & Noble set itself up to achieve that?
Lynch: The way we develop products, we design them, and then we engineer them and organizationally, the way we’re set up is the top people are heavily involved. I’m heavily involved in product design. We’ve got key engineers heavily involved to be able to execute. Like GlowLight is a perfect example. That is something that’s very hard to do on an e-ink screen. We tried to get that one feature, and we just kep iterating and iterating. We’re a handful of people just working on that. That wasn’t 200 people.
Fortune: When you say you’re hands-on, what does that mean?
Lynch: When we’re designing products, we look at what are our tent pole concepts? What are the things we’re trying to nail? Four or five things we’re trying to nail with this device? And we think through why are those use cases important for readers. We start iterating, and in that iteration., I’m looking at the user experience: the UI [user interface], how the features work.
Fortune: You just launched a new e-reader with a built-in light. How are sales?
Lynch: Well ahead of our expectations. We certainly underestimated the demand for that product early. We’re temporarily sold out, but we’re trying to ramp very quickly. We thought it would it be a hit, but we didn’t quite know. But what we’re seeing is that there are a lot of people who like us read at night. 38% of reading is done in night at bed. We knew that going in.
Fortune: So what’s been the company’s best-selling device?
Lynch: The Nook Color. It was the first really e-reader hybrid tablet and there are a lot of people, you probably remember. That company you referenced [Amazon] said color LCD readers will never work. When we announced that product, there were a lot of people who marginalized it in the press. Once people started using it, it was hard to go back to black-and-white e-readers. There’s still a segment for that. We led that innovation. People recognized quality, and they recognized innovation and that product’s one that keeps going and going for us even though we’ve launched newer models.
Fortune: And since then, we’ve seen a certain other company change their minds on that.
Lynch: Yeah. [laughs] They’ve done well with the Kindle Fire. But they definitely missed the boat early on.
Fortune: We’ve talked about what the Nook business has done largely right, but what could the business have done better?
Lynch: We feel like we still have a lot of opportunity in the offline-online integration, and how we integrate stores. We’ve done I think one of the better jobs in terms of creating a Nook experience in our stores to really improve the overall consumer experience. Certainly on the front end with our stores and show rooms, we worked very hard putting those Nook boutiques in the front of the stores. … But I think there are things we have yet to do. If we had more time, I would try to figure out how to unlock cool experiences.
I’ll give you a perfect example.
Fortune: Let’s hear it.
We’re going to start embedding NFC chips into our Nooks. We can work with the publishers so they would ship a copy of each hardcover with an NFC chip embedded with all the editorial reviews they can get on BN.com. And if you had your Nook, you can walk up to any of our pictures, any our aisles, any of our bestseller lists, and just touch the book, and get information on that physical book on your Nook and have some frictionless purchase experience. That’s coming, and we could lead in that area.
Fortune: And is that NFC experience rolling out this year?
Fortune: One publisher recently said you guys have done a great job of using the physical location to sell e-books. The dilemma now may be figuring out how to use e-books to help sell print books. Is that the case, and if so, do you have a solution for that?
Lynch: What we see in our data is that once someone’s a Nook buyer, they don’t stop buying print books. There’s no such as such a digital reader. certainly there is such a thing as just a physical reader. What we see is when someone buys a Nook, they buy more books from us in total. Their buying power shifts over to digital, but they continue to buy physical books. Are there things like bundling for those who want a physical copy of the book. We’ve tested bundling, but I think we could have executed that better, and I think there’s more opportunity.
Fortune: Before you worked at Barnes and Noble, you’d never sold a book, e-book or otherwise. What have you learned during your time running the company?
Lynch: I’ve learned a lot about publishing. It’s a hit-driven business, more so than I thought. It’s amazing how sensitive our traffic and sales are to hits. The most recent example, this whole Hunger Games phenomenon. I’ve learned how much this country and community appreciates bookstores.
Our first Nook that we launched in 2009 was a decent product, but certainly not up to the standards we’ve subsequently set for ourselves. Now we’re launching the best products in the category.
Fortune: What have you learned from previous jobs that have helped you at B&N?
Lynch: The whole thing with Barnes and Noble was we need to have a sense of urgency here. The world’s changing. We’ve got great assets, but clearly the growth is in an area we haven’t historically participated in, so we need to evolve not only as a great retailer, but also as a technology company.
And I’ve been able to move quickly in other environments, so I think deliberately from an investment standpoint, I think I’ve brought that speed to market to the company.
Fortune: One big book publishing issue in the news these days is pricing. What do you think is the ideal sort of pricing arrangement? Is it the agency model, the wholesale model, or somewhere in between?
Lynch: Well, the philosophical divide here is, do you want the publishers in pricing to compete with each other or do you want sort of one company driving that? I think it’s overly simplistic to say that low price is good and high price is bad. Certainly, we’re a fan of offering consumers value on books and all forms of content. We are a supporter of the agency model because we believe that publishers serve a very important role in society in that they foster these authors and bring this amazing content that otherwise wouldn’t be known.
Dan Brown is a perfect example. Dan Brown was little known before The DaVinci Code, and his publishers [worked] with our fiction book buyer to get Dan on the book tour, and it escalated the sales rank through the book tour in Barnes and Noble. He ended up having a hit. And the books he’s come out with have become national treasures.
Fortune: That’s a convincing argument.
Lynch: The world needs publishers, and we think publishers understand competitive pricing, but they are the better ones to drive that pricing to consumers so that they also can pass along some value to authors and we continue to get the flow of wonderful content we’ve gotten in this country.
Fortune: Is there something media and analysts don’t quite get about Barnes and Noble these days?
Lynch: If I had a wish, I’d say I wish we’d be in a conversation of consumer technology, where they’d say, gosh, Barnes & Noble and those guys in Palo Alto are doing some of the most interesting things we’ve seen.
I don’t think we’ve gotten enough credit as a technology company. That’s not something we spend a whole lot of time thinking about and lamenting, but you look at the products we’ve launched, and the things we’ve done, and the experiences, we’ve out-innovated the world’s third-largest technology company, and I don’t think we get enough credit for that. It’s not because we want the credit. What we want is the recognition from investors and others to say these guys have built something special here.