> ##### October 12, 2003

> ## To Whom May I Direct Your Free Call?

> By NICHOLAS THOMPSON

> IN the fall of 2000, Niklas Zennstrom and Janus Friis had not yet earned any powerful enemies, at least so far as they were aware. They were just two obscure Swedish entrepreneurs who had worked with three Estonian programmers to write a file-sharing application called Kazaa. At the time, the free program was merely one of Napster's several weak stepsisters, lumped together in news reports with the likes of Snarfzilla and ToadNode.

> But a few months later, the record industry and its lawyers swatted down Napster. And Kazaa, with its easy-to-use interface and reliable technology, quickly began scooping up users. Kazaa does essentially everything Napster did, with one important difference.

> Because Kazaa's file sharing relies on routing requests through individual users' computers instead of central servers, the record industry has been unable to shut down the service in court - but not for lack of trying.

> As their legal bills mounted, Mr. Zennstrom and Mr. Friis decided to sell the company to Sharman Networks last year. But the two have since hatched a plan that has a chance at causing another, potentially bigger uproar.

> Mr. Zennstrom and Mr. Friis have reunited with the same team of Estonian programmers who wrote the code for Kazaa and have created a way to allow people to make high-quality phone calls over the Internet without having to pay a penny.

> On Aug. 29, their new company, called Skype, released a preliminary version of the program. Already, more than a million people have downloaded it, the company's Web site says.

> It is "a real opportunity to do something that is disruptive in a very positive way," Mr. Zennstrom said. "We have a big ambition with Skype: it is to make it the global telephone company."

> Skype, which rhymes with "hype" and has no particular meaning, allows free calls between any two users who have downloaded the software. It is simple to use and provides clear connections to anyone with a broadband connection and a basic headset.

> The program relies on a technology called "voice over Internet protocol,'' or VoIP. By routing calls over the Internet, VoIP essentially turns computers into phones. It is the core technology driving a number of small phone companies and is causing headaches for traditional providers, who are trying to fend off new rivals even as they attempt to integrate VoIP into their own systems.

> Everyone, it seems, is getting into the act. Cable companies like Time Warner Cable are starting to offer VoIP calling plans; Microsoft and Yahoo are using the technology to power their instant-messaging programs; and Cisco Systems is selling hardware that allows businesses to convert their internal phone systems to VoIP.

> What makes Skype so special? Well, it's free.

> And unlike other VoIP offerings, Skype's software and audio connections are based entirely on the same peer-to-peer infrastructure that powers Kazaa. For example, if two users want to call each other, the call can be routed directly between their computers instead of having to pass through central servers. Peer-to-peer routing also frees the company from having to buy and maintain much equipment, because its system relies entirely on the computers of individual users.

> Even Mr. Zennstrom, 37, and Mr. Friis, 27, say they are surprised by how fast Skype is catching on. Based in Stockholm, the company is controlled by a privately held holding company called Skyper Limited. It has spent no money on marketing the software.

> The company does not earn any money right now, but is betting that consumers will eventually pay for premium services, like voice mail. This winter, Skype plans to introduce a feature that will enable users to call people on regular telephones - for a fee it says will be "substantially lower'' than current phone service. That means that Skype wouldn't just allow computer-savvy users to call one another; it would allow them to call anybody with regular phone service.

> IN a recent report on the telecommunications industry, Daiwa Securities wrote that Skype "is something to be scared of, and is probably set to become the biggest story of the year'' in the telecom sector. "We think the Skype offering (and whatever may follow it) is akin to a giant meteor hurtling on a collision course toward Earth," the report said.

> Other analysts are more skeptical. Eventually, they say, Skype's growth will depend on customers who do not understand peer-to-peer networking or have computer headsets. Moreover, the program works best over broadband connections, which just 16 percent of Americans have at home, according to a May report from the Pew Research Center.

> "Will Skype be important and influential? It absolutely has the potential to be that and to drive regulatory debates and to be a financial disruption," said Blair Levin, a former chief of staff at the Federal Communications Commission who now works as a senior telecommunications analyst at Legg Mason. "But I don't think it's as scary to the phone companies as Napster and Kazaa were to the record companies." If the phone companies are scared, they're certainly not showing it. "Skype has a couple of challenges,'' said Vint Cerf, senior vice president of technology strategy at MCI. Most of all, he said, Skype "needs to deal with the fact that there are a lot of people who need to be reached who are not on the Internet.''

> Skype, which has been around for only a month, doesn't dispute that. But the company says that enabling its users to call regular telephones is one of its chief priorities.

> And even skeptics who do not think that Skype is much of a threat agree that the basic technology that drives it - VoIP - will lead to fundamental changes in the industry.

> "VoIP is going to change everything," says Jeff Kagan, a telecommunications consultant based in Atlanta.

> "The big telecom companies worry that VoIP could completely undermine their business within 12 months," says Berge Ayvazian, a senior research fellow at the Yankee Group.

> With VoIP, when someone speaks into the telephone, or microphone, the sounds are broken down into ones and zeros, sorted into packets of information, and then shot across the worldwide network of fiber lines, just like e-mail messages. At the designated end points, the packets of binary code are reassembled and turned back into sounds. In the regular phone network, calls initially pass over less efficient copper wires and the phone companies must maintain dedicated connections between users, instead of just mixing the information in with the rest of the Internet.

> The first VoIP companies were established in the mid-1990's, but they were plagued by confusing technology and connections that made users sound as though they were talking in caves, and with mouths full of cotton candy. Now, though, new engineering, faster connections and agreements on standards have solved many of those problems. All the interviews for this article were conducted either using Skype or an alternate VoIP service.

> A few start-ups - most notably Vonage, based in Edison, N.J. - offer customers complete VoIP calling plans for a fee, using standard telephones connected to VoIP adapters. Vonage already has 55,000 subscribers and offers unlimited calls within the United States and Canada for $35 a month. The presidential campaign of Howard Dean has installed Vonage's system in several of its field offices.

> THE major phone companies have responded with a two-pronged strategy. On the one hand, they are rapidly building the technology into their own offerings. MCI expects to have made a complete transition to VoIP by 2005. AT&T will offer a major digital voice service to businesses in 2004 and has begun a consumer pilot program, based mainly in New Jersey.

> On the other hand, the regional Bell companies are arguing for new regulations that would tie up VoIP companies that let consumers make calls to customers on the regular phone network, as Skype hopes to do soon.

> According to critics, VoIP companies receive an unfair advantage because the F.C.C. and state governments regulate them as information, not phone, companies because they rely completely on the Internet. That frees them from multiple tax and regulatory commitments, like directly paying into the federal "universal service fund" that subsidizes rural telephone access. Some state governments are considering that issue; in Minnesota last week, a federal judge overruled a decision by the state's Public Utilities Commission to force Vonage and other VoIP companies to submit to the state's traditional phone regulations. The F.C.C. and Congress will almost certainly take up the issue soon, too.

> "When Congress looks at it, it will be an interesting collision of two mantras: One, you shouldn't regulate the Internet; and two, there should be regularity parity," says Representative Edward J. Markey of Massachusetts, the ranking Democrat on the House telecommunications subcommittee.

> UNLIKE their experience with Kazaa, Mr. Zennstrom and Mr. Friis said they did not see any fundamental problems on the legal front for Skype, a contention that major phone companies agree with. Skype's main use will almost certainly be social - making phone calls.

> Ultimately, Mr. Zennstrom said, Skype will have to deal with regulations once the company allows users to call the existing public phone network. But he said he hoped that the Internet service providers that give subscribers access to Skype would end up paying the universal service fees.

> For the most part, Mr. Zennstrom is taking the same position with Skype that he adopted with Kazaa. He says that the company is just providing software; that users can do with it what they want; and that there are too many potential legal issues internationally to worry about them all.

> "We don't know if Skype will be banned in Bhutan," Mr. Zennstrom said. "The only thing that we know for sure is that we are providing something very competitive that is very good for the consumers using it. If a country were to ban it, that would be very bad for consumers there."

> Skype also faces a potential standoff with the F.B.I. Because traffic over Skype is strongly encrypted and distributed over wide-ranging sources, it could hamper authorities' ability to wiretap.

> Paul Bresson, an F.B.I. spokesman, said, "It is legal; it is a concern; and it is something that we are looking into."

> For now, Mr. Zennstrom and Mr. Friis are charging ahead. "I am here to have fun and to have some challenges and try to achieve them and to make an impact,'' Mr. Zennstrom said. "Of course, I want to make money, too."

> Does Mr. Zennstrom relish the idea of causing trouble for the telecom industry? He laughed, then said, "Yes, that's fun."

> Copyright 2003 The New York Times Company