Friday Letter: Skype – the deal that keeps delivering

Venture capitalists are supposed to be great visionaries. So maybe the Index Ventures executives who sat down in 2003 to discuss the future prospects of a small technology start-up called Skype with its founders did imagine that eight years later, it would be the subject of an $8.5 billion acquisition by Microsoft.

To be honest, we doubt it. It seems more reasonable to assume that the voice-over-internet-protocol business, which was sold earlier this week to the technology behemoth, has exceeded its founders’ expectations. Certainly, the company has proven to be something of a cash-cow for a succession of venture capital and private equity firms. For Silver Lake Partners and the other investors who sold to Microsoft, the deal – at an eye-popping valuation of 32x EBITDA) yielded more than a 3x return in just 18 months, and was one of the biggest private equity exits in capital gains terms in history.

Back in 2005, Private Equity International spoke to Danny Rimer, an Index partner who worked on the firm’s investment in Skype. Asked to quantify the firm’s return on its investment following its $2.5 billion sale to online auction house eBay earlier that year, Rimer simply said it was the firm’s greatest success up to that point.

Thereafter the deal had important implications for Europe’s venture industry, which had long faced unfavourable comparisons with its bigger US brother. This was reflected in the response Rimer and his colleagues encountered from other European firms. Asked whether fellow European investors congratulated Index on their success with Skype, Rimer replies: “I can't think of a single European firm that didn't.”

Index was just one of several early investors in the business. Other firms which contributed to a $24 million funding round in 2004 included Draper Fisher Jurvetson, Bessemer Venture Partners and Mangrove Capital Partners. Draper Fisher Jurvetson was another early Skype investor.

Fast forward to 2009, when mature technology-focused buyout firm Silver Lake assembled another consortium of investors, including Andreessen Horowitz and the Canadian Pension Plan Investment Board, to purchase a 65 percent stake in the business from eBay. Index, which had attempted to re-invest in Skype, had earlier been muscled out of a deal following a lawsuit brought by Skype’s founders. The $2.7 billion deal that Silver Lake put together was one of the few large buyouts to occur that year.

Silver Lake co-founder Jim Davidson spoke candidly to Private Equity International last year about the Skype investment. eBay had written the business down significantly and deemed it non-core when Silver Lake approached them. “We thought Skype had greater opportunities for growth as a standalone business. There was tremendous potential both as a disruptive technology but also as a mainstream technology in improving the way people communicate,” Davidson said. It also met Silver Lake’s criteria for investment perfectly: “We believe in globalisation, we believe in communications, and we believe in internet technologies affecting a lot of traditional types of businesses.”

In fact, Silver Lake painted such a rosy picture of Skype’s potential future that eBay, which had intended a full exit, retained a 30 percent stake. And it’s probably quite pleased that it did: the Microsoft deal, which is the second-largest global cross-border technology acquisition on record, meant the auction company booked a return of about $800 million, having earlier faced a significant loss on its investment.

There will be others, too, celebrating the Silver Lake syndicate’s triumph this week – and not just those who worked on the deal and Skype’s operational improvements. For it’s a reminder that technology investors stand to profit handsomely when they get it right, but also that  private equity ownership can be the catalyst for a struggling company to  become a big, global success. A bigger one than even the most dare-devil founders ever thought possible, back in the days when the business was still an idea, and a couple of guys in a poorly lit garage. 

PS – PEI will take you behind the scenes on the Skype deal in its June issue. Stay tuned.