Skype’s So-Called Free Business Model Drives Revenue

hen you hear the name Skype, what do you think?  Probably: free phone calls.

Some thought Meg Whitman, former CEO of eBay, was nuts when eBay bought Skype back in 2005 for $2.6 Billion.  Analysts questioned what relevance Skype had to eBay’s business.  Many also questioned the business model of a service that was about making free voice calls.

It looks like Skype is getting its act together from a business perspective. They’ve figured out the “free plus paid services” model — and are making money at it.  Here is a chart from a recent press briefing  on March 31, 2009 showing their combination of free and paid services model:

Skype free plus paid business model

Free by itself is not a business model.  But free coupled with a compelling upgrade path to paid services, is.  How much of a business model?  Try $551 Million for 2008. This chart shows the Skype revenue growth since 2005:

Granted, it’s taken Skype awhile to get it together with a focused strategy.

They had some early mis-starts and distractions with goofy free services like Personal Skypecasts. The last time I tried that service, it seemed to be overrun with spammers and broadcasts consisting of nothing but complete silence except for the occasional word or grunt here and there.  Skypecasts was quietly shut down last September.

Then there was some experimentation with a feature that let you send money via Skype.  However, when your corporate parent also owns PayPal, such a product is a distraction from your core competency. The send money service has been shut down, too.

Instead, Skype is now focusing on their core competency: telecommunications. Their new enhanced interface (version 4.0) has a larger window and better audio/visual quality.  It’s designed for improved video calls, which Skype sees as a big part of their future. They are also investing in linkage between mobile phones and Skype, with new capabilities to use Skype on the iPhone and the BlackBerry (coming soon).  And they are investing in partnerships for services that business users value, such as partnering with a virtual PBX provider.

Most importantly, they are focusing on the kinds of features that people and businesses are likely to pay for.

By keeping the basic service free, they continue to grow their user base by 350,000 customers a day. That provides a good base that can be upsold to these new fee-based services.

Not everyone agrees that a free user base will help them grow revenues, however.   Om Malik of GigaOm suggests that this free user base is their achilles heel, noting:

“Skype grows because of its viral nature. Most people try and get their friends to download Skype so they can make free calls, a behavior unlikely to change. And once you have all your pals on the network, you don’t really need to use SkypeOut as much.”

While I respect Om’s opinion as it relates to early adopters like him, I view things much differently.  I think it all depends on how compelling a value proposition Skype makes it for users to upgrade.

Let me give you an example:  I use Skype daily, but almost never make Skype-to-Skype calls. Almost always I have to call a land line or mobile phone, because the other person is not on Skype or is out of the office, etc.  Plus, when I am making business calls (as most of my Skype calls are) I can’t ask people to download Skype just for my convenience so I can make a call to them for free.  Hence, the SkypeOut service — where I can dial out to regular phones — is the single most compelling feature for me.  I have to pay to get that service.

If Skype is smart, they will make their fee-based services more and more attractive over time.  Then it becomes a no-brainer for a certain percentage of new users to choose paid services.

About 35% of Skype’s users are businesses (probably small businesses). This is also important because business users are more likely to pay for advanced features, rather than sucking up the free version only.

The cost for Skype of adding new free users virally, and getting XX percent to upgrade, has to be much lower than the cost of other telecom providers to acquire new customers. I see nothing but upside in this business model.

The reason I spent so much time writing about Skype today is that I think there are 2 important lessons here for your own business:

(1) Focus on a clear strategy that sticks to your core competency — don’t get distracted and off track.

(2) Make sure that if you are offering free services, you also have a paid-services business model to go along with it and a compelling value proposition to entice free users to convert to paying users.