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April 25, 2005

As the Phone World Turns Part 4 – Building Network Value with Skype

Skype and Vonage are two of the most successful of the new breed of retail Internet phone companies.  Their approaches to the marketplace are as radically different from each other as each of them is from the legacy phone companies whose calls they are successfully diverting.  Today’s post is about Skype’s initial successful strategy to build a huge network of users before looking for revenue from them.

Skype’s success in the eighteen months or so since it launched is so great that the company is being compared to Microsoft and there is worry about Skype “dominance” and serious concern about the implications of Skype protocols being proprietary rather than standards-based.  This is an Internet story somewhat reminiscent of Bubble v1.0.  Skype’s success is not measured by profitability (it is not public so its P&L is not known); its success is not measured by revenue because, until very recently, it had no revenue producing services.  Rather Skype’s success is inferred from the 100,000,000 copies which have been downloaded, from the billion and a half minutes of voice traffic it carries each month, and from the typically more than two million users online at any given time.  These are big numbers even if they’re not in dollars or euros.

As I blogged Friday, Metcalfe’s Law (which not everybody believes in) states that the value of a network is proportional to the square of the number of endpoints.  People are the endpoints of a phone network.  A network with only a few people on it doesn’t have nearly the value of a network on which you can reach and be reached by almost everyone who interests you.  So the dilemma in starting a new network is how to ever get enough initial people on it so anyone will want to join given that the first people who sign up will have almost no one to talk to and therefore very little incentive to join.

Skype’s strategy is simplicity itself; the brilliance has been in the execution.  Calls from one Skype user to another are “free” assuming that both users already have broadband connections which do not charge by the amount of traffic transmitted, computers with microphone and speakers, and Skype software.  The Skype software is downloaded at no charge.  The first Skype users were typically college students who had all the prerequisite equipment and connections.  Groups as small as a pair of separated lovers decided together to download Skype software so that they could coo or fight or dream together without having to pay for a phone call.  The initial success was in Europe where a greater percentage of calls are international and expensive than in the US.

Initial users encouraged their friends with whom they were already in email and instant messaging contact to also download Skype.  The circles of users grew.  Parents got Skype to reduce the cost of calls to college.  As the network grows, network effect takes over.  It now makes sense for a college student, for example, to get Skype as automatically just as he or she would get email software without thinking specifically about whom he or she wants to exchange email.

Skype is providing not only free software but a free service.  It is Skype’s own computers which facilitate the initial connection between two users who want to talk to each other and which provide something important called “presence management” – a display which shows you which of your friends are currently online and reachable.  Providing this software and service free was a necessary prerequisite to building the large network of users Skype has today; people would not have paid for the initial service because there were too few users on it for it be worth much.  Even the free software and service would not have been sufficient for success if the software had not been very easy to use and the sound quality generally very good.  The “price” of a difficult installation or of poor audio quality would have damped growth when the network was small and had little value to a new user.  But Skype executed well.

In order for Skype to succeed in building a network, people had to know Skype service existed.  But Skype didn’t and doesn’t advertise.  Instead it relies on “viral” marketing, users recruiting other users.  Viral marketing is particularly effective for a communication service because Sally has a very good reason to recruit John as a new user if she wants to be able to talk to him free.  In a sense, Skype is overlaid on the networks of people already communicating with each other on the Internet.  Existing clusters of people who already typed to each other now use Skype to talk.  They recruited each other easily because they were already in touch via their computers.

Skype also had a head start in publicizing its service.  The Estonian founders of Skype were the developers of Kazaa, a file (aka music) sharing problem which is a European version of what Napster was in the US – only more successful.  According to Kazaa’s website, over 389,392,921 copies have been download as of today.  Kazaa, which started with no visible means of support, is now supported by ad revenue,  selling some music, and paid versions of the software which are ad free.  Kazaa users made natural early adopters of Skype.  The fear Kazaa caused in the music industry gave Skype credibility as an agent of creative disruption in the phone industry and invaluable startup publicity even in main stream media.  The experience the founders had with Kazaa helped them set up the server farms used to download the Skype software and host the interconnection service.  Skype P2P (Peer-to-Peer) technology and its ability to work despite interference from firewalls are very similar to that in Kazaa.

The Skype strategy of building a huge network fast without revenue and relying on the power of “free” and viral marketing depends completely on the Internet.  Obviously, a lightly funded company with no revenue going after a mass consumer market has to keep expenses extremely low.  They couldn’t have afforded to carpet-bomb potential users with disks and CDs the way AOL does and did. They couldn’t have afforded a serious media campaign

If there were a per minute component to Skype’s cost when two users talk endlessly, free service would have been out of the question.  But Skype’s computers are only lightly involved in making users visible to each other and facilitating the connection; they are not all involved in the actual transmission of voice, that computing power all comes from the users own computers. Since these calls are computer to computer and don’t touch the traditional phone network, they don’t pass the toll booths of the phone companies which control last mile phone connections.

Skype customer service is pretty much nonexistent but the software is usually easy to use and our expectations for a free service are less than if we’re paying good money. (note that poor customer service could, however, be an Achilles’ heel as Skype expands beyond the tolerant early adopter market.)

Skype now has a commanding position in the nascent peer-to-peer voice market.  Would-be competitors are disadvantaged by the fact that their users cannot communicate with Skype users because Skype has used proprietary rather than standards-based technology to connect its users.  In other words, the founders of Skype have reserved the benefits of the network value they created for themselves – fair enough since they have made all the investment in creating this network value.  The fact that so many people are already on Skype makes it hard for a competitor to explain to a prospect how it is to the prospect’s advantage to connect to a new network that no one is on yet.  A competitor can’t attack Skype’s Peer-to-Peer calling service on price unless the competitor intends to pay its users for calling (don’t laugh, this will happen in one form or another).

The closed network strategy has its disadvantages as well.  A user who can get close to critical network mass and is open can attract industry support and offer users future value that a closed network can’t.  Skype’s potential competitors include Microsoft – no slouch in either proprietary or standards-based solutions itself.

Future posts will be on Skype’s expansion into revenue-based services, closed vs. open networks as a business strategy, and Vonage’s very different model for a VoIP business.

The first post in this series is everything you ever wanted to know about legacy access charges.

The second is about the cost of “free”.

The third explains Metcalfe’s Law of network value.

The fifth is monetizing Skype’s network value with SkypeOut.

The sixth is about Skype reproducing the OLD telephony business model with SkypeIn.

The seventh is a summary of Skype features.

The eighth begins coverage of Vonage’s strategy.

A related post contains a very short abstract of what Skype founder Niklas Zennstrom said at VON (Voice On the Net) Canada and a way to download the slides of my talk there.

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