The last four years at Skype have been anything but dull. In a $4 billion deal in 2005 that raised plenty of eyebrows, eBay bought the popular service provider which enables free phone calls anywhere around the world via the Internet. EBay’s bold dream? To merge Skype’s communications network with eBay’s e-commerce acumen. But it wasn’t meant to be, as a bevy of external deal watchers predicted at the time. Thus, with eBay’s $2.75 billion sale of Skype to an investor group on September 1, one whirlwind era closes and another one begins.
The good news is that although Skype wasn’t eBay’s best acquisition — that would be its 2002 PayPal purchase — both companies have emerged relatively unscathed. EBay “got away with a black eye,” receiving a reasonable selling price despite its struggle to manage the startup, says Saikat Chaudhuri, a management professor at Wharton. As for Skype, it became a profitable unit under eBay’s ownership. “The best thing about the whole deal is that eBay didn’t damage the company,” notes Wharton business and public policy professor Gerald Faulhaber.
With Skype being set free, the future is arguably even brighter today than when it was a hot startup in 2003. But while it has the most subscribers of any telecom provider in the world, Skype still needs to hone its growth strategy as competitors such as Google and Microsoft loom, say experts at Wharton. Now, it must find new ways to monetize a service that most of its customers are used to getting for free.
Will eBay Make Money?
EBay had previously planned to spin off Skype in an initial public offering, but a lawsuit threatened to delay those plans into late 2010. EBay and Joltid, a company controlled by Skype founders Niklas Zennstrom and Janus Friis, are suing each other over the licensing of the “peer-to-peer” technology that Skype uses to distribute calls. (Peer-to-peer technology pools individual PCs connected over the Internet to share computing power and data resources.)
In addition, Joltid, along with Zennstrom and Friis, filed a copyright lawsuit this week against eBay, claiming the company illegally used and shared a peer-to-peer technology called “global index,” owned by Joltid, that forms the basis for Skype’s Internet calling software. The suit, which also names the investor group planning to purchase Skype, seeks damages that could rise as high as $75 million a day, according to press reports.
Meanwhile, it’s unclear whether eBay will make money from Skype should the deal close later this year. Not surprisingly, John Donahoe, eBay’s CEO, put a positive spin on the sale, noting in a statement, “This deal achieves our goal of delivering short- and long-term value to eBay and its stockholders, without the possible delays and market risk of an IPO…. Selling Skype now at this great valuation, while retaining an equity stake [of 35%], makes sense for [eBay]. And it allows us to focus all of our energies on the opportunities in front of PayPal and eBay.”
As part of September’s agreement, eBay will receive $1.9 billion in cash and a $125 million note from an investor group, which includes private equity firms Silver Lake and Index Ventures as well as Andreessen Horowitz, a venture firm created by Netscape’s co-founder Marc Andreessen and his long-time business partner Ben Horowitz. And because eBay retains a stake in Skype, it will benefit in the event of an IPO or another sale.
EBay paid $2.6 billion for Skype in 2005, with another $1.5 billion for “performance-based considerations,” or earn-outs to its shareholders if the company hit undisclosed revenue, gross margin and active user targets. In its 2007 annual report, eBay said it settled with shareholders on the earn-outs for $530 million. In other words, eBay didn’t pay the full $4.1 billion price for Skype. It also wrote down Skype’s value by $1.4 billion (including $530 million in performance bonuses) in 2007.
In the meantime, Skype has surged ahead. In 2006, the first full year under eBay ownership, sales increased to $195 million from $24 million in 2005. By 2008, revenues were $551 million and in the first six months of 2009, Skype, which has 480.5 million registered users, reported revenues of $323 million. “Skype wasn’t a bad acquisition,” says Kevin Werbach, a legal studies and business ethics professor at Wharton. “It never produced the synergies eBay hoped for, but Skype today is a much stronger, more profitable company than it was when eBay bought it.”
All told, eBay’s Skype acquisition was “far better than many high-tech mergers and acquisitions, where the target company is completely wasted,” he says. “Now that Skype is on a solid business footing, I think it will be better off independent.”
But what now? “Certainly Skype has a huge audience and a lot of happy users in addition to its strong brand recognition,” says Kendall Whitehouse, director of new media at Wharton. “That’s a good place to start from.”
At this point, the cards seem stacked in Skype’s favor. “I’ll be curious to see what investors do with Skype,” notes Andrea Matwyshyn, professor of legal studies and business ethics at Wharton. “There’s a lot of unrealized potential here. It has a loyal following and first-mover advantage. Every foreign student I’ve ever run across is a Skype devotee and when I travel abroad I use it too.”
A Better Business Model?
While Xavier Dreze, a former Wharton marketing professor who is now at UCLA, agrees that Skype “has a bright future,” he says it will need to generate more revenues from users. Skype has no shortage of services to do that, but none of them has been fully developed. According to eBay’s filings with the Securities and Exchange Commission, Skype’s primary source of revenue is the relatively inexpensive rates it charges customers to call phone landlines and cell phones from its service. Known as SkypeOut, the service is based on per-minute usage. (A subscription for unlimited calls to landlines in more than 40 countries from the U.S. is $12.95 a month.) A call from Skype to a non-Skype number is a little more than 2 cents a minute, while calls within its network are free. According to Jim Friedland, an analyst at investment bank Cowen & Co., Skype generates revenue from 10% to 15% of its users, primarily through SkypeOut.
Skype also sells numbers to use on mobile phones in several countries. These numbers allow a caller to secure local rates when traveling and save on long-distance calling charges. For instance, a caller in London can dial a local Skype number, which rings a U.S. based mobile phone without routing the original phone call across the globe. Various partnerships, meanwhile, integrate Skype’s software with mobile phones and conferencing systems from such players as Nokia and Hutchinson.
“Skype’s promise was always to transform telephony. That’s still on the table,” says Werbach. “Skype is the world’s largest phone company by subscribers, which is nothing to sneeze at. Real-time voice communication is a trillion-dollar global business, so there have to be ways for a company like Skype to further monetize its assets.” In many respects, Skype resembles a typical phone company, says Faulhaber. “Clearly Skype is the market leader and no one has come along to beat them in the low-end of the market.”
Skype uses what’s known as a “freemium” business model, which is based on offering free services to attract initial customers, with hopes that many will upgrade to additional services for a fee. “Skype is looking to make money around the edges,” notes Whitehouse.
But if it is to succeed in doing that — eBay doesn’t report the division’s profits separately, but analysts say it is in the black — it will need to develop new lines of business or ramp up existing ones. “Skype has improved its product, but it still isn’t monetizing as much as it could. I don’t know why I can’t get a fax on Skype. I’d pay for that,” says Dreze. “Skype hasn’t come up with new ways to monetize things and that’s disappointing.” What Skype — and its CEO Josh Silverman — should aim to do now is generate revenues from beyond the current 10% to 15% of its users. “Skype has chosen a free path to consumers and then ‘nickels and dimes’ them. But it works. Skype just has to do a better job of coming up with more premium services,” says Dreze.
The big premium area is corporate services. Skype could branch out into collaboration software similar to WebEx, which is owned by Cisco Systems. It could also offer videoconferencing services. “Skype can grow the business by leveraging the Internet for business purposes,” states Chaudhuri. “By offering teleconferencing and videoconferencing, it can get a bigger piece of the revenue pie.”
Skype has, in fact, been going after the business market more aggressively. In March, it announced a test program called Skype for SIP — based on Session Initiation Protocol, a standard for voice over Internet protocol (VoIP) telephony in corporate networks. That means companies can use its network to get low rates for calls. The program got a boost in early September when ShoreTel, which provides corporate phone services, said its system will connect to Skype for SIP.
Challengers on the Horizon
Successfully cornering the corporate market will require Skype to go head-to-head against competitors, something experts say will be a new experience for it. The company has always competed with many companies, yet few directly. EBay’s regulatory filings list telecommunications companies that provide bundled services as Skype’s competitors as well as companies such as Microsoft, Yahoo, AOL and Google, which allow voice communications in their instant messaging services. Yet, as Faulhaber notes, Skype operates in a niche which, up until now, has kept it out of the sights of giants like AT&T and Verizon and of VoIP players like Vonage. The upshot: Skype has thrived as a small unit of a larger company. It won’t be an enormous leap, Faulhaber suggests. “Skype doesn’t have to change too much.”
However, Matwyshyn adds that Skype’s presence has driven various players to raise the bar even while it has kept its service roughly the same. “Skype has pushed other players to innovate,” she says. “Google, Microsoft and Yahoo now offer voice for free in their instant messaging systems. When Skype came on the scene, that wasn’t the case.” Another entrant to this growing competition is Boston, Mass.-based Vivox, which is partnering with Facebook to provide voice chat capabilities on the popular social networking site.
There was a time when Google was viewed as the biggest challenger to Skype. Its Google Voice service provides, among other things, free phone calls within the U.S. While Google Voice isn’t a direct rival, it is expected to become more like Skype. “Depending on how Google Voice rolls out, it may look similar to Skype’s approach,” says Matwyshyn.
According to Werbach, Skype is facing a fast-moving landscape. Two things have changed since eBay acquired the company, he says. First, Google has emerged as a telephony competitor with Google Voice, and Microsoft has moved into enterprise telephony with its 2007 acquisition of Tellme, a developer of telephone-based applications. “Those are potentially serious competitors, although neither has the massive customer base and global footprint of clients that Skype enjoys,” Werbach notes. The other major event is the rise of smartphones. “Skype is limited on the iPhone and barred from some other mobile phone platforms. The critical challenge for Skype will be to figure out where it sits in the new communication ecosystem. Who does it partner with, and who does it see as competitors?”
As eBay and Skype part ways, there are lingering questions. Chaudhuri credits eBay for refocusing on its core business — online auctions and e-commerce. He assumes that eBay acquired Skype to help it diversify its revenue base so it could continue growing while other rivals — Yahoo, Microsoft and Google — were also acquiring companies rapidly. For now, eBay needs to keep an eye on Amazon.com, its primary rival, but in the future the e-commerce company could find its strategy under heavy scrutiny. “Does eBay remain an auction provider or look to expand into new services?” wonders Chaudhuri. “Focus is nice, but eBay will ultimately have to ask, ‘Where do we want to go?’ All of these questions remain open.”
Skype faces different issues. For one thing, the presence of one of its new owners, Andreessen, may portend interesting possibilities. He has a history of innovation, having founded Netscape, which he then sold to AOL. Along with Horowitz, he also formed a venture called Loudcloud, which later became Opsware. Opsware, which focused on corporate software, was eventually sold to Hewlett-Packard. Matwyshyn expects Andreessen to push Skype to evolve its services and develop more revenue streams, particularly in the corporate market.
For his part, Chaudhuri is struck by the composition of Skype’s new investors. “This sale looks like an interim solution,” he notes. “The role of private equity and other financial investors is to provide an interim solution and then generate returns.”
Indeed, Skype isn’t likely to remain independent forever. Cisco, Google and others could all be potential suitors. If the IPO market doesn’t open up, the company’s future owners may find “the easier solution will be to sell,” says Chaudhuri.
Whether that happens remains to be seen, but Skype can expect a few more whirlwind years.