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Skype: Net Telephony as File-Trading

Niklas Zennstrom and Janus Friis could be the two most dangerous men on the Internet -- dangerous to entrenched business models, that is. The Scandinavian duo created the KaZaA file-swapping software that became the dominant online music-trading platform after lawsuits killed Napster in 2001. With tens of millions of Web surfers trading music files daily, KaZaA, as much as any other factor, forced the big recording labels to agree to offer music downloads for as little as $1 a song.

Now Zennstrom and Friis have drawn a bead on the phone business, where they see voice communications over broadband hookups as a huge, untapped market. Their weapon in this offensive is a piece of software they call Skype. Though it rhymes with hype, Skype is anything but. Distributed by Stockholm-based Skyper, a private company owned by Zennstrom and Friis, the free program gives Windows PCs with a broadband connection the ability to make high-quality computer-to-computer calls anywhere on earth -- as long as both parties are using Skype's software.

The founders plan to make money -- soon -- by charging for additional features such as voice mail or conference calling. But they swear that the basic program will remain free as a come-on to potential customers.

"SCREW THE PHONE SYSTEM" That should frighten not only the established local and long-distance phone carriers but also cable-TV companies and startups that hope to sell Internet phone service. They generally charge $40 a month for unlimited local and domestic long-distance calls, and traditional phone companies charge more. Either price will look ridiculously high should Skype grow large enough to hit critical mass -- as it appears to be doing.

The success of Skype, which debuted only four months ago, raises a question whose answer could define the future of telecom: Can next-generation phone systems take the shape of decentralized, peer-to-peer file-sharing networks that run over the Net and eliminate phone-company middlemen? "What Skype and others like it say is: Screw the phone system.... Let's build a voice app -- software -- that does what the telephone does," says Clay Shirky, a consultant and adjunct professor at New York University who studies peer-to-peer and networking technologies.

Since Skype's software appeared on its Web site in August, it has gone viral. Without spending a dollar on marketing, Zennstrom and Friis have tallied more than 5.2 million downloads, and they figure that perhaps half that many people are using the software. True, that's a blip in the global telecom industry, which serves billions of customers and gathers about $200 billlion in annual revenue. Yet Skype's biggest weakness -- that both parties to a conversation must have it installed to talk via their PCs -- is also what makes it a danger to the telecom Establishment.

GOING MAINSTREAM. Anyone with access to large numbers of desktops -- from Internet service providers to sellers of operating-system software -- could in theory become a phone company by simply installing the software and eschewing investments in phone-system infrastructure. While it's easier to say that than to make it happen, the possibility is real. "There's no way anyone can combat what they're doing," declares Jeff Pulver, a telecom consultant and the founder of a competing no-charge VoIP offering, Free World Dialup.

Most VoIP competitors may not want to. Skype's business model contradicts the thinking of startups such as New Jersey-based Vonage, whose service apes existing phone systems. Though the Vonages of the world use the power of the broadband Internet to deliver cheap and extensive phone service, they remain wedded to the concept of paying the phone companies fees to complete calls.

Even so, the concept behind Skype is hardly new. Technology aficionados have been using Internet connections to create PC-to-PC voice connections for nearly a decade, engendering enough interest for such dot-com startups such as Net2Phone (NTOP) and DialPad to survive.

"MARGINAL NICHE." Now the popularity of this idea appears to be spreading beyond geeks and adventuresome chief information officers. Startup VoIP providers such as Vonage and 8X8 (EGHT) expect to have millions of customers within three years. All of the major instant-messenger clients -- from America Online (TWX), Yahoo! (YHOO), and Microsoft's (MSFT) MSN service -- already have some voice capability. Microsoft has quietly inserted key building blocks of PC-to-PC telephony into its Windows operating system. And Apple's (AAPL) iChat AV software provides voice quality that rivals many cell phones and approaches the quality of a copper line.

Moreover, broadband's rapid adoption in the U.S., Asia, and Europe has made high-speed connections common enough to allow software-based telephony to approach critical mass. A roomful of low-end servers can now handle as much voice traffic as an entire old-line telecom-switching facility. "A company like Skyper can flourish in what for big phone companies would be a marginal niche," says Dave Burstein, publisher of DSL Prime, a telecom-industry newsletter. "They can make profits on a few hundred thousand users. All it takes is a couple of cheap PCs and some good software."

While several companies are trying to tap those dynamics, Skype seems to have broken from the pack -- mainly thanks to its ease of use. Unlike most other Internet voice applications, Skype automatically navigates through firewalls and network address translation systems, elements of broadband systems that commonly trip up phone software for PCs.

GROWING FAST. Furthermore, Skype uses a peer-to-peer configuration that harnesses the broadband capacity of its users' PCs to build an ever-expanding network of nodes that can create highly stable and adaptable systems. This also means that Skyper itself doesn't have to pay for bandwidth to carry calls -- those who use it provide such capacity via their Internet connections.

To date, Skype says its network has handled as many as 170,000 concurrent users without a major outage. Its growth has been impressive enough to secure an initial round of venture-capital funding, rumored to be in the millions of dollars, with Bessemer Venture Partners in Larchmont, N.Y., as the lead investor. Skyper opened a London office in December and has already grown from less than a dozen employees to 25, with lots of new hiring ahead. It plans to introduce its premium products sometime this spring, and in the meantime, Pulver says, it has been talking to other VoIP startups about ways to more easily interconnect their respective customers.

It'll be awhile before Skype scares many phone companies. For one thing, the majority of U.S. households still don't have a broadband connection and therefore can't use it. And even many people with broadband probably remain leery of relying on an Internet-based phone service from an upstart, let alone one founded by the guys who helped bring music piracy to the masses. Further, few experts expect Skyper to become a major telecom provider. "It'll be a cottage industry," says Jeff Kagan, an independent telecommunications industry analyst.

Yet, Skype's experiment could help shape the future of telecom networks. And considering the impact Zennstrom and Friis have had on the online music biz, their influence could be significant -- and arrive sooner than you might think. By Alex Salkever, Technology editor for BusinessWeek Online

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