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Why Microsoft paid $8.5 billion for Skype, which is mostly free

Microsoft acquisition of the growing Internet calling company raises eyebrows. How can Microsoft make money from a service that's free to most users?

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Microsoft Chief Executive Officer (CEO) Steve Ballmer (L) and Skype CEO Tony Bates shake hands at their joint news conference in San Francisco, May 10, 2011. Microsoft and Skype announced Tuesday that they have entered a definitive agreement under which Microsoft will acquire Skype for $8.5 billion from the investor group led by Silver Lake.

Susana Bates / Reuters

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It just feels so good to make a call on Skype.

With its blue, bubbly icons and dreamy dial tones, you half expect Grandma to pick up from Mario Land. The novelty of making a face-to-face video call is slow to wear off, and the price – which is free for the vast majority users – is simply magic.

But in the business world, it's an unusual business model. Only about 9 million of Skype's 145 million users pay for use. So why did Microsoft pony up $8.5 billion for a service that's almost free – and what can Microsoft do to improve that bottom line?

Since Skype started in 2003, it has balanced its checkbook in two ways. First, it gives away core services but charges for upgrades. Currently, users can choose to upgrade to a prepaid credit plan or monthly subscription, which add features like text messaging, calls to phones (instead of just computers), and now, group video calling.

The other way Skype makes money is through business partnerships, with companies of all sizes, including big ones like Nokia and MySpace.

By giving away its services for free, all of Skype’s services become more valuable, explains Marshall Van Alstyne, an associate professor at Boston University's management school.

“If you are a user, the fact that other people who have Skype can now reach you, makes Skype more valuable,” Mr. Van Alstyne says.

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