Skype caused a storm when first released with its offer of totally free internet calls, but now under the ownership of eBay it needs to evolve to survive, writes Karlin Lillington

IN 2003, the first Skype buzz started on the internet. On blogs, on discussion boards, on e-mail lists where the techheads gather, the chatter was all about a new bit of Voice over Internet Protocol (VoIP) software from Niklas Zennström and Janus Friis. The buzz was that it would let you make calls anywhere in the world, for free.

Voice over Internet Protocol - sending voice packets over the net between two points to generate a phone call - wasn't a new idea.

There were a few early services by the late 1990s that allowed people to make calls using a headset and a reasonably fast internet connection.

However, broadband connections were not that common in the home and, even when you had one, a call often would fade into something that sounded like two people talking underwater.

Skype was easy to use, the quality on the line was usually good enough and free phone calls are, well, free phone calls.

Skype's star ascended quickly. Over 10 million users at the first count, then 50 million, then 100 million, and now over 250 million.

A little "Skype me!" link began to appear on people's weblogs and Skype numbers took their place on business cards along with phone, fax and mobile numbers. The market began to wonder when, no longer if, the company would have its initial public offering.

At the same time there were doubts. How do you monetise "free"?

As it turns out, eBay entered the picture and answered that question for Skype's two founders, by buying the company for $2.5 billion (€1.7billion) in 2005. Not a bad return on a "free" business.

However, as of yet the purchase hasn't worked out in eBay's favour. Skype was supposed to make communication between buyers and sellers easier, but has never been well integrated into the existing eBay service. In a clear sign that Skype has not performed, eBay took a massive $1.4 billion (€950million) write-down on the purchase in 2007.

More troubles followed last year when Skype had a serious outage that lasted over several days. In another embarrassment, users of a Skype premium service, who paid for Skype London numbers, have been told they have to give the numbers back.

Analysts have been harsh. "The Skype service has been tremendously popular as a free service," Jordan Rohan, managing director and internet analyst at RBC Capital Markets told News.com.

"But at some point, free doesn't work anymore. It's not a management problem. It's a business model issue," he says.

Skype is trying to make money through its SkypeOut service, where a user pays to make cheap calls to landlines and mobiles.

However, as Rohan noted, "Skype's core business isn't much different from a really cheap calling card business. The margins are really thin."

Reportedly, eBay was shopping Skype around to potential buyers such as Google and Yahoo last year and Google remains a strong possibility, say analysts. Others feel that eBay will work this year to make the service pay off, before considering a sale.

Already there are signs of a Skype revitalisation. The beta version of Skype 4.0 is out. It moves the service firmly towards video calls, rather than voice.

This is an area where a net connection definitely adds value to the call.

There's a fresh focus on the enterprise, an arena that hasn't really been brought into the Skype fold.

However, some third party vendors such as VoSKY are getting out offerings that would enable enterprises to take advantage of the free to cheap call prices with Skype, while adding the layers of security enterprise will demand.

Skype has also gone mobile. Earlier this year, mobile network operator 3 introduced a Skype-phone, made by Chinese manufacturer Amoi. It has reportedly sold about 100,000 handsets in the UK and Ireland.

The handset allows people to make free Skype-to-Skype calls between handsets and to home Skype connections.

The Skype mobile handset has proven popular with small- to medium-sized businesses in Ireland as employees can make free calls to each other, says Rachel Channing, head of communications for 3 in Ireland.

"It also hasn't just been the younger age group using Skype.

"It's parents and grandparents and especially the international community, who can keep in touch with friends and family outside of Ireland."

A new version of the 3 handset, S2, has just been launched in the UK. It has Facebook, Google and Windows Live Messenger. While it will not be available in Ireland, the next iteration of the that phone with more features, expected out by the start of 2009, will be on offer here, says Channing.

Facebook integration signals potential directions for Skype as an eBay tool.

Analysts have suggested that eBay would do well to try and partner with such social networking sites to gain access of their millions of net-savvy users who would be likely to use eBay for purchases. Skype cut an integration deal with profile site MySpace late last year.

In late August, Skype announced an interesting partnership with Sony to offer free calls over its PlayStation gaming console.

Sony will manufacture a handheld videophone that incorporates Skype for PSP-2000 users.

That Skype changes are on the way was clear earlier this year as the original founders departed and eBay appointed John Silverman, former head of Shopping.com as the new Skype chief executive.

He wrote in an initial post on his blog: "Skype is one of the defining internet technologies of our era . . . it's changing the world. You don't look forward to something like that. You drop what you're doing and jump aboard."

That may be, but Silverman will have a lot to prove in what Scott Sleek, industry analyst at consultancy Pike & Fischer, is calling Skype's "make-or-break year".

Skype - how it works

Skype enables users to make and receive phonecalls over the internet, using voice over internet protocol (VoIP) technology. VoIP takes the analogue audio signals that you'd normally hear through a regular phone and converts them into digital packets of data that can be sent over the internet.

The packets reassemble at the receiving end and are converted back to analog audio that the recipient can hear through a headset or handset.

Skype software enables that conversion and manages the call. Calls can be made from a computer using a headset or a VoIP handset, which looks like a normal phone.

They can also be made from a regular phone connected to a PC with ananalogue telephone adaptor device, or using a 3 VoIP mobile handset.

Theoretically any call using VoIP is "free" because, like email, it will travel across the internet at no cost. However, because the call needs some management, service providers like Skype have looked for ways to charge callers.

Initially all calls with Skype were free, but the company now uses a model where only Skype to Skype calls are free .

Calls made from Skype to landlines or mobiles are charged, generally at far less than calls carried by regular telecommunications providers. More recently, Skype has added other paid services, such as the ability to have a portable Skype number for certain geographies. If you get a Skype number at a San Francisco prefix you appear as someone in the San Francisco area no matter where you might be in the world.

Purchased by eBay in 2005, Skype hasn't proven to be as useful an addition to its portfolio as the auction site had hoped but Skype Mobile and Enterprise may change that.