Why Microsoft thought Skype was worth €8.5 billion

NET RESULTS: One of Europe's most successful internet ventures, Skype could integrate well with Microsoft's products

EBAY BOUGHT Skype for $2.6 billion in 2005, ultimately wrote down the value of its investment by $1.4 billion, got into legal wrangles with its founders and punted 70 per cent of the sorry mess to private equity and venture capital investors.

The deal was seen in many quarters as the first nail in the coffin of Meg Whitman, eBay’s high profile chief executive, who stepped down in late 2007.

So why does Microsoft think it’s a good idea to acquire Skype for $8.5 billion in cash?

To find out why it’s worth stepping back to look at how Skype got to where it is today. Although most Irish people probably know it as a low cost or free way to call relatives overseas, and increasingly to add video to those calls, Skype is in many respects Europe’s most successful internet venture.

Certainly its Scandinavian founders Niklas Zennström and Janus Friis have done handsomely out of Skype even if their investors didn’t always do as well.

The duo initially established Skype in Estonia where its developers were based. Launching in August 2003, it used the same peer-to-peer technology behind Kazaa, the file sharing software which attracted the legal wrath of the music industry; as a result the founders avoided entering the US for a number of years.

Skype was far from the first VoIP service, routing calls over the internet, but the peer-to-peer nature of the service was the key to success. This keeps the cost of providing the service relatively low. The processing power and bandwidth is provided by the user’s PCs and networks not Skype.

The service quickly gained traction among the technology community but even then eyebrows were raised at the price tag eBay was willing to pay. It was little surprise that Zennström and Friis’s entrepreneurial spirit didn’t gel with the corporate culture that Whitman had instilled at the online marketplace.

After the heavy writedowns, a majority stake in Skype was offloaded to an investor group lead by Silver Lake Partners.

The deal wasn’t completed before Zennström and Friis managed to wrangle themselves a 14 per cent stake for just $65 million. They had threatened to bog the deal down in a legal morass as they claimed to own patents on which Skype is based.

The plan was to float Skype on the stock market but the IPO stalled and, with Silver Lake and eBay keen to get their money back, the internet telephony service was quietly put on the block. The documents filed for the IPO shine a light on the financials of the operation and they certainly don’t suggest a company valued at $8.5 billion.

Skype enjoyed rapid growth in 2010. The number of registered users increased from 474 million to 663 million while the average number of people using the service each month grew from 105 million to 145 million.

Most of those were not paying – the average number of monthly paying users was just 8.8 million at the end of 2010. Revenues last year came in at $860 million but Skype still generated a loss of $7 million.

So why is Microsoft interested?

Meg Whitman deluded herself that Skype would enable eBay’s buyers and sellers to communicate better around sales. But Whitman forgot that one of the main reasons people use eBay is that they don’t want to have to communicate with other people – except perhaps via an occasional e-mail.

The fit with Microsoft is far better. Microsoft’s new communications platform – Lync – has been a strong seller for the world’s largest software company. With its instant messaging, voice and video conferencing facilities, integration with Skype would be a no-brainer. Particularly now that, with Office 365, Microsoft is making a big play around software that lives in the cloud.

There is also lots of potential to bake Skype into the new Windows Phones that Nokia and others will be producing. The common view is that Microsoft would risk a backlash from operators who dislike “over the top” apps like Skype, which run on their data network but generate revenues for the software vendor. But there are signs that attitudes are softening.

Openmind Networks, an Irish provider of VoIP software for operators, last week released data showing subscribers of its mobile VoIP and messaging solution are on average talking more than two and a half times longer than average mobile users.

But the real trojan horse could be Kinect on Xbox. The motion capture controller means that Microsoft has an installed base of millions of video cameras in living rooms around the globe. Cracking the home video conferencing market could very easily justify the hefty price tag.

On the downside, Skype is starting to look like a fairly dated service which hasn’t innovated in recent years. New mobile services like Viber are eating its lunch.

Unlike Skype, with Viber you don’t have to mess around with registering or putting in usernames or passwords. Your phone number is your ID and you can quickly see which of your contacts in your phone book is also using the service.

Google is also making fast in-roads to the sector and, cleverly, has built on top of Gmail where most of us keep our contacts anyway.

Even closer to home, VoIP provider Blueface has teamed up with Vennetics to offer Banter – an iPhone app that provides low cost calling but allows you re-direct your landline number to your iPhone.

Microsoft has about $50 billion in the bank or in short-term investments, so the deal is not going to have any material impact on its financials. But as we have learnt through bitter experience in this country, when you start getting blasé about billions, you’ve got serious problems.