Good Deal: Sabheer Bhatia's and Jack Smith's Sale of Hotmail to Microsoft (1997)
Good Deal, Bad Deal

Many people disparaged the original success of Hotmail, saying that the the idea could have been devised by anyone. Hotmail's creators later sold their brainchild to Microsoft for $400M.

What went right:
Bhatia and Smith foresaw the value in freeing e-mail from ISPs. They also recognized that they could offer it for free and still generate multiple streams of revenue. With fast execution and hard bargaining, they built a company from scratch to a sale with Microsoft for $400 million in 18 months.

In 1988, Sabheer Bhatia came to the United States from India. He was a 19-year old student, going to study at Cal Tech. In 1996 he and a colleague at Apple Computer, Jack Smith, developed an idea: free e-mail, accessible through the Internet. E-mail services were exclusively the domain of Internet service providers (ISPs), so the mail was accessible only when obtaining access through the ISP. In addition, the ISP had access to the e-mail.

Bhatia and Smith imagined a Web site where people could access their e-mail over the Web from any computer, and it would not be subject to the whims (or prying eyes) of the system proprietor, such as an employer. The idea came primarily from the two young entrepreneurs' attempts to communicate about their business dreams and goals without using the office e-mail.

In early 1996, Bhatia was pitching another idea to venture capitalists (Smith handled engineering, Bhatia handled money-raising): JavaSoft, a Web-based database program. It evolved into a Trojan Horse for the free e-mail system. To keep unscrupulous venture capitalists from turning him down and stealing the idea, Bhatia would pitch JavaSoft and, if he felt he had the confidence of his audience, would describe the free e-mail feature.

On his 20th try, Bhatia concinved a venture capitalist to come up with initial financing of $300,000. Draper Fisher Jurvetson agreed to provide the financing in exchange for 30-percent ownership. Bhatia, though desperate for money and with nothing more than an idea, insisted that the Draper firm get only 15-percent ownership for its $300,000. Although they were first shocked at Bhatia's hard bargaining, they eventually agreed.

It is typical for a Web venture to go through several levels of financing, raising enough money to do the things necessary to advance the idea, which allows it to raise more money. Bhatia and Smith wanted to keep as much equity for themselves as possible, so they wanted Hotmail - the name is derived from "mail" and HTML, the dominant Web programming language - to be running and gathering subscribers before they needed more money. This would keep them from the bind of most budding entrepreneurs: being subservient to the money source before the project is unfinished and untried.

They managed to make the $300,000 last until July 4, 1996, when Hotmail began operating and signing up subscribers. This made it possible to raise additional money without giving up much equity. The immediate success of Hotmail also allowed them to revise the financing plan; word-of-mouth was so strong that it wasn't necessary to spend much on marketing.

By mid-1997, Hotmail had six million users. Not only did they dispense with marketing costs - a major expense for most Internet start-ups targeting consumers - but they were able to provide content on the site without paying for it. Better still, Hotmail charged content providers for the privilege of carrying the content, on the theory that the content was a form of advertisement for the provider's site.

Many people disparaged the original success of Hotmail, claiming that anyone could have come up with the idea. Those same doubters then said that as soon as a bg company (such as Microsoft) became a competitor, Hotmail would crumble.

Microsoft indeed became interested in the business, but by this time Hotmail had twice as many subscribers as Microsoft Network, so it wanted to acquire Hotmail rather than compete with it. Just a year after starting, Microsoft offered $160 million for the company.

Bhatia turned it down. Negotiating alone against as many as a dozen Microsoft employees - occasionally including Bill Gates - Bhatia held his ground. Microsoft, despite howling at Bhatia's unreasonableness, began raising its offer. It offered $200 million, then $250 million, then $300 million, then $300 million, then $350 million, all of which Bhatia turned down. By this time, Bhatia's employees were begging him to accept and one of Bhatia's venture capitalists, Doug Carlisle, offered to build a life-sized bronze sculpture of him in Menlo Ventures' office. The delays also increased Hotmail's value; it now had 10 million subscribers.

Bhatia finally relented, and Hotmail agreed to be acquired by Microsoft on December 31, 1997, for 2.7 million Microsoft shares, which were at the time worth $400 million. Owning Microsoft stock is in some ways better than cash, as it has more than doubled in value between the time of the deal and August 2000.

On the other hand, some analysts think Bhatia and Smith sold Hotmail too cheap. The service added 200 million subscribers in 1998 and another 20 million in 1999 (though some of this is attributable to Microsoft's marketing muscle). Bhatia was quoted in mid-199 as saying, "When we sold, it was considered an outrageous amount. In hindsight, yes, we sold too low. But I don't regret it because at the time it was considered a great deal."

Still, Bhatia and Smith, if they are still holding it, have more than a half-billion dollars in Microsoft stock. The venture capitalist who put up $300,000 has more than $200 million, and would have had twice as much if Bhatia had not initially struck such a hard bargain. Neither works for Microsoft anymore. both are younger than 35. Bhatia has started an e-commerce company called Arzoo! and plans to participate in the wiring of his native India. Smith has started N3.net, which works with the hardware and software needed to speed up Web sites, and bought a winery in his community.

The sculpture of Bhatia was never completed. He attended a sitting but his mother made him stop.

Michael Craig

3/21/07

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