Skype investors reap windfall in deal with MS

Egon Durban, a managing director at Silver Lake Partners, which paid nearly $1 billion for its stake in Skype. Silver LakeEgon Durban, a managing director at Silver Lake Partners, which paid nearly $1 billion for its Skype stake.

When a group of investors offered to pay eBay $1.9 billion for a controlling stake in Skype two years ago, the technology veterans were derided for buying a fallen Internet darling hobbled by losses and lawsuits.

After agreeing to sell the company for $8.5 billion to Microsoft, the owners — including a private equity firm, a venture capital firm and a pension fund — are now poised to reap a windfall.

Even eBay, which took a $1.4 billion hit on its original investment, looks to collect more than $2 billion on Skype. With the Microsoft deal, which was announced recently, Skype avoids becoming a technology cliche. Many Internet stars attract lofty bids from deep-pocketed suitors, only to fade a few years later. But few make a splash for a second time.

“It was an orphaned division of eBay,” said Egon Durban, a managing director at Silver Lake Partners, one of the investors in Skype. “But we thought we could take Skype, a great Internet brand, and turn it into an ubiquitous communications platform.” Founded in 2003 by Nordic entrepreneurs Niklas Zennstrom and Janus Friis, Skype quickly became an online sensation.

Within the first two months of its start, more than a billion people had downloaded the communications service. Less than two years later, eBay, the huge online marketplace, rushed to capitalise on Skype’s popularity, offering $2.6 billion for the company, with an additional $1.5 billion in performance-based incentives. The young founders eagerly accepted.

But the marriage soon soured. While the auction site thought Skype’s video-and-voice platform would enhance the user experience, it was an awkward fit. A series of management shuffles only added to the tension between eBay management and Skype’s founders. Although the number of Skype subscribers continued to grow under eBay’s watch, losses swelled. In 2007, eBay took a $1.4 billion write-down on the business, watching it continue to languish. From 2006 to 2009, Skype posted only one year of profitability.

“EBay had reasons to buy the business but they never were able to execute,” said Benedict Evans, an analyst with the London-based research firm Enders Analysis. “They bought the business and, it seems, they just forgot they bought it.”

Amid the recession in 2009, Durban of Silver Lake Partners called the venture capitalist Marc Andreessen, the Canada Pension Plan Investment Board and the venture capital firm Index Ventures, to discuss a possible co-investment in Skype. By the end of the year, the group had hashed out an agreement with eBay to buy a majority of Skype for $1.9 billion.

It was a risky bet. Besides a string of losses and a weak economy, Skype was also wrestling with intellectual property lawsuits filed by its founders. After the acrimonious split, the founders had retained crucial patents that formed the foundation of Skype’s platform.

Even so, the investors remained confident. Price was a big factor. The deal valued Skype at $2.75 billion, slightly less than eBay paid four years earlier. Silver Lake alone paid nearly a billion dollars for its stake —its biggest single investment ever. “Skype was embroiled in a lawsuit the day we signed and the investors were sued the following day after signing,” Durban said. But “we saw an unbelievable potential to transform this company.”

“There was a lot of risk,” said Mark Wiseman, the executive vice president of the Canada Pension Plan Investment Board. “But we did our own due diligence, and we saw a lot of the same things that Microsoft saw — a dominant global brand, with a very solid, growing base of users, and a robust technology platform.”

The investors and eBay settled the outstanding suits in late 2009. As part of the agreement, Skype acquired the intellectual property and a holding company owned by the founders received a 14 per cent stake. Index Ventures also bowed out of the deal.

With their legal issues behind them, Silver Lake and the other investors swiftly moved to spruce up Skype. Over the last two years, they have pushed the Internet company to increase its focus on development, shortened product cycles and forged new partnerships. Skype also moved to build out its services in the mobile and the enterprise space, both considered high-growth markets.

Last year, for instance, the company started an application for Google’s Android mobile phones and signed a deal with Facebook. Since 2009, Skype’s staff has increased by more than 40 per cent, to about 1,000 employees. Last October, the investors hired a new chief executive, Tony Bates, a veteran of Cisco Systems.

“They invested a lot in making money and the quality of the service,” said Ted Schadler, an analyst with Forrester Research. “The move to hire Tony, a world-class IT executive, was a turning point — that move alone said they were growing up very rapidly.”

The changes started to materialise in the numbers last year. Skype recorded $859.8 million in revenue and a net loss of $7 million in 2010, according to a recent filing. The previous year, the loss exceeded $300 million. Skype’s monthly users topped 170 million, nearly double the amount at the end of 2009. Skype’s improving fortunes started to attract the attention of potential suitors.

Technology giants like Google and Facebook were actively looking at the company earlier this year, according to people who were close to the matter but not authorized to speak publicly. The casual talks put a deal in the $4 billion to $5 billion range. Speculation of a sale spurred Microsoft into action.

Steven A Ballmer, Microsoft’s chief executive, who said that he had considered buying Skype in recent years, sent his chief financial officer, Peter W Klein, to Silver Lake’s Silicon Valley offices to make an unsolicited offer. For several weeks, the various parties discussed the potential terms, talking about valuation, Skype’s long-term outlook and the role of the current management team.

In mid-April, Microsoft settled on the price, agreeing to pay $8.5 billion, including the assumption of $725 million in debt. The deal was signed Monday night at 9:30 p.m. Pacific Daylight Time. While some worried that Microsoft paid too much, Skype’s investors stand to profit immensely.

Silver Lake Partners netted nearly $3 billion in the deal, according to people close to the firm who were not authorised to talk publicly. Andreessen Horowitz, which initially invested $50 million, now has a stake valued at an estimated $200 million.

The investment owned by the founders’ holding company is worth around $1.1 billion. Durban, who says he felt a pang of seller’s remorse, was ultimately happy with both the price and the buyer. It was, as he said, “an opportunity to get liquidity in full.” “It was very difficult for us to walk away.”