Time Warner to Sell 5% AOL Stake to Google for $1 Billion (NYTimes, 12/17/05)

December 17, 2005
Time Warner to Sell 5% AOL Stake to Google for $1 Billion
By SAUL HANSELL and RICHARD SIKLOS
Rebuffing aggressive overtures from Microsoft, Time Warner has agreed to sell a 5 percent stake in America Online to Google for $1 billion in cash as part of an expanded partnership between AOL, once the dominant company on the Internet, and Google, the current online king.
At stake in this battle was leadership in Internet advertising, which is a growing threat to other media companies. The loss is a blow to Microsoft, which had sought AOL as a partner in its advertising venture to undercut Google, its potent rival.
Though Google is only seven years old, its lucrative search advertising business and its technical prowess could enable it to offer consumers free software and services that would directly attack Microsoft's core software business.
While the terms of the proposed five-year deal are largely set, it will not be final until it is ratified Tuesday by the Time Warner board, an executive briefed on the talks said.
Google has agreed to give AOL ads special placement on its site, something it has not done before. Until now, Google prided itself on its auction system for ads, which treated small businesses on an equal footing with its largest customers.
By agreeing to change its business practices for this deal, Google fends off what could have been a significant challenge from a combination of AOL and Microsoft and cements its position as far and away the largest seller of search advertising.
"This is Google's first test as a chess player in a major corporate battle," said John Battelle, the author of "The Search: How Google and its Rivals Rewrote the Rules of Business and Transformed Our Culture."
"They are saying, 'We will take some of our pawns and block the move to our queen by Microsoft,' " he said. "Until now, Google has said, 'We don't think about our competitors. We spend all our time building better products for our users.' "
Negotiations among the companies reached a fevered pitch Thursday night, executives briefed on the talks said, when teams from Google and Microsoft were in separate conference rooms in the Time Warner Center in New York and executives from the media company walked back and forth between them.
At the same time, Time Warner was holding its corporate Christmas party at the Mandarin Oriental Hotel, which is also in the Time Warner Center, overlooking Central Park.
At 9 that evening, Richard D. Parsons, the chief executive of Time Warner, left the party to tell Eric E. Schmidt, Google's chief executive, who was leading its negotiations in another part of the complex, that he would accept Google's recently sweetened offer.
According to one executive, Mr. Parsons called Steven A. Ballmer, Microsoft's chief executive, at 10:30 a.m. Friday to tell him that the deal that Microsoft had so eagerly sought - and had thought it had won - was going to Google.
Microsoft had proposed that it and AOL form a joint venture to sell advertising on their own sites and eventually on other sites. Now Microsoft will compete in the search business as a distant No. 3, behind Yahoo.
Representatives of Time Warner, Google and Microsoft declined to comment about the negotiations.
The deal is a coup for Mr. Parsons because less than a year ago, Wall Street and even people within the company were treating AOL as a declining asset and a drag on Time Warner. The deal is meant to confirm Time Warner's claim that AOL is worth $20 billion, a number many had said was too high.
Yet investors did not immediately see a Google investment as a sign that Time Warner's stock was greatly undervalued, as Mr. Parsons had hoped they would. Time Warner closed yesterday at $18, up 34 cents. Google closed at $430.15, up $20.95. Microsoft ended at $26.90, down 81 cents.
In the last year, Time Warner has pursued a new strategy to replace its declining profits from its Internet access service with advertising revenue from AOL.com and other free Web sites. It has enjoyed enough of a resurgence to attract the courtship of not only Google and Microsoft, but for a time Yahoo, the News Corporation and Comcast.
Time Warner ultimately chose to go with Google because its proposal was simpler than the Microsoft one. Moreover, the lucrative offer promised to help drive more traffic to AOL's Web sites.
Google has been providing Web search and search ads for AOL since 2002. In the new arrangement, Google will offer promotion to AOL in ways it has never done for another company, two executives close to the negotiations said.
If a user searches on Google for a topic for which AOL has content - like information about Madonna - there will be a special section on the bottom right corner of the search results page with links to AOL.com. Technically, AOL will pay for those links, which will be identified as advertising, but Google will give AOL credits to pay for them as part of the deal. They will also carry AOL's logo, the first time Google has agreed to place graphic ads on its search result pages.
Google will also provide technical assistance so AOL can create Web pages that will appear more prominently in the search results list. But this assistance will not change computer formulas that determine the order in which pages are listed in Google's search results.
Google will also make a special effort to incorporate AOL video programming in its expanding video search section and it will feature links to AOL videos on the video search home page. These links will not be marked as advertising.
An executive involved in the talks said Time Warner asked Microsoft to give AOL similar preferred placement in advertising and in its Web index and that Microsoft refused, calling the request unethical.
Mr. Battelle said that while each of Google's accommodations to AOL could be seen as consistent with past practices, "each of them represents a step closer to a slippery slope."
He added, "What they are giving away is the perception in the market place that Google isn't for sale."
An executive involved in the talks said that as recently as two weeks ago, Mr. Parsons told Microsoft executives that he preferred their bid. Still, that executive said, Microsoft had the impression that executives in the AOL unit preferred to work with Google. Yesterday, several AOL executives said that was true. A source close to Mr. Parsons said his only goal was to do the best deal for AOL's future.
But. a turning point, in Microsoft's view, was an article that Stephen M. Case, AOL's co-founder and the architect of the deal with Time Warner, wrote in Sunday's Washington Post calling for the company to be split up, two executives involved with the negotiations who were familiar with Microsoft's views said.
Mr. Case's argument was timed specifically to encourage a Google deal, said one person close to him. Mr. Case's longstanding animosity toward Microsoft played a part, this person said, but his main reasoning was that Google has proved itself far smarter about the Internet than Microsoft. That person said that Mr. Case thought that a deal with Google was the best of all the options other than spinning off AOL. Carl C. Icahn, the financier who, like Mr. Case, has been pressing Time Warner to split up the company, was not mollified by the Google deal.
"I don't want them doing anything that could preclude them from selling or spinning off AOL in the future," Mr. Icahn said. "But the real point is that Parsons shouldn't be running AOL, and I shouldn't be running AOL, either. As Parsons says, 'We're two guys who grew up in Queens 40 years ago.' Neither of us understands the digital world." Then he added, "But I could do infinitely better."
Edward I. Adler, a Time Warner spokesman, said: "We're not going to comment on every little thing Mr. Icahn says. The management team running Time Warner knows AOL's business in great depth and any potential transaction that we may or may not do will be done in the interest of all the shareholders."
While AOL's deal with Google is not as complicated as the proposed joint venture with Microsoft, Google is offering several ways to help AOL enhance its advertising sales business, executives briefed on the negotiations said.
Under the current arrangement, Google sells all the search ads that appear on AOL's sites. This year, Google's revenue from ads on AOL will be roughly $500 million, estimates Jordan Rohan, an analyst with RBC Capital Markets. Of that, Google will pay AOL about $430 million.
Under the new deal, AOL's sales force will also have the ability to sell search advertising that appears only on AOL's sites, even though those ads will compete for placement with those sold by Google. AOL's sales force will also have the right to sell some display advertising that will be placed on the vast network of Web sites for which Google sells ads.
AOL executives are attracted to the idea of offering marketers a full range of Internet advertisements, from splashy ads on the home page of AOL.com to text ads.
Larry Haverty, a fund manager with Gabelli Asset Management, a Time Warner shareholder, said the deal with Google was "very reinforcing to the idea that Parsons is doing what he can to highlight the values."
For Google, he added, "there are two good reasons to do this deal: one, it's chump change; and, two, it really makes life difficult for Microsoft."
Andrew Ross Sorkin contributed reporting for this article.

The Next Retirement Time Bomb (NYTimes, 12/11/05)

December 11, 2005
The Next Retirement Time Bomb
By MILT FREUDENHEIM and MARY WILLIAMS WALSH
SINCE 1983, the city of Duluth, Minn., has been promising free lifetime health care to all of its retired workers, their spouses and their children up to age 26. No one really knew how much it would cost. Three years ago, the city decided to find out.
It took an actuary about three months to identify all the past and current city workers who qualified for the benefits. She tallied their data by age, sex, previous insurance claims and other factors. Then she estimated how much it would cost to provide free lifetime care to such a group.
The total came to about $178 million, or more than double the city's operating budget. And the bill was growing.
"Then we knew we were looking down the barrel of a pretty high-caliber weapon," said Gary Meier, Duluth's human resources manager, who attended the meeting where the actuary presented her findings.
Mayor Herb Bergson was more direct. "We can't pay for it," he said in a recent interview. "The city isn't going to function because it's just going to be in the health care business."
Duluth's doleful discovery is about to be repeated across the country. Thousands of government bodies, including states, cities, towns, school districts and water authorities, are in for the same kind of shock in the next year or so. For years, governments have been promising generous medical benefits to millions of schoolteachers, firefighters and other employees when they retire, yet experts say that virtually none of these governments have kept track of the mounting price tag. The usual practice is to budget for health care a year at a time, and to leave the rest for the future.
Off the government balance sheets - out of sight and out of mind - those obligations have been ballooning as health care costs have spiraled and as the baby-boom generation has approached retirement. And now the accounting rulemaker for the public sector, the Governmental Accounting Standards Board, says it is time for every government to do what Duluth has done: to come to grips with the total value of its promises, and to report it to their taxpayers and bondholders.
The board has issued a new accounting rule that will take effect in less than two years. It has not yet drawn much attention outside specialists' circles, but it threatens to propel radical cutbacks for government retirees and to open the way for powerful economic and social repercussions. Some experts are warning of tax increases, or of an eventual decline in the quality of public services. States, cities and agencies that do not move quickly enough may see their credit ratings fall. In the worst instances, a city might even be forced into bankruptcy if it could not deliver on its promises to retirees.
"It's not going to be pretty, and it's not the fault of the workers," said Mayor Bergson, himself a former police officer from Duluth's sister city of Superior, Wis. "The people here who've retired did earn their benefits."
The new accounting rule is to be phased in over three years, with all 50 states and hundreds of large cities and counties required to comply first. Those governments are beginning to do the necessary research to determine the current costs and the future obligations of their longstanding promises to help pay for retirees' health care. Local health plans vary widely and have to be analyzed one by one. No one is sure what the total will be, only that it will be big.
Stephen T. McElhaney, an actuary and principal at Mercer Human Resources, a benefits consulting firm that advises states and local governments, estimated that the national total could be $1 trillion. "This is a huge liability," said Jan Lazar, an independent benefits consultant in Lansing, Mich. "If anybody understands it, they'll freak out."
Last spring, the state of Alaska was the scene of a showdown over retirement benefits that those involved said was a precursor of fights to come. Conservative lawmakers who supported scaling back traditional retiree health care and pension benefits squared off against union lobbyists, advocates for the elderly and the schools superintendent of Juneau, the state capital, who defended the current benefits.
After saying that Alaska's future combined obligations for pensions and retiree health care were underfunded by $5.7 billion, Gov. Frank H. Murkowski called a special session of the Legislature and pushed through changes in pension and retirement health care benefits for new state employees. (The state Constitution forbids changing the benefits of current employees.)
Instead of having comprehensive, subsidized medical coverage, new public workers will have a high-deductible plan and health savings accounts. The changes cleared the State Senate and passed by a one-vote margin in the House.
Even the White House weighed in on the Alaska problem. Ruben Barrales, President Bush's director of intergovernmental affairs, lobbied wavering Republican legislators, arguing in favor of replacing pensions and traditional retiree health benefits with private savings accounts for new employees. Mr. Barrales noted that the president was seeking similar changes in Social Security, including a plan for private accounts.
The union that represents state employees in Alaska said the narrower benefits would make it harder to recruit qualified teachers and government workers. "They keep chiseling away" at school employees' pay and benefits, said Julia Black, a single mother and union activist who earns $11 an hour as an aide in classes for disabled children in Juneau.
Actuaries say that about 5.5 million retired public employees have health benefits of some kind - and accountants joke that there are not enough actuaries in the country to do all the calculations necessary to estimate how much all these retirees have been promised.
Though it may seem strange after a decade of double-digit health cost inflation, hardly any public agencies have been tracking their programs' total costs, which must be paid out over many years. The promises seemed reasonable when they were initially made, officials say.
In Duluth, Mayor Bergson said the city actually offered free retiree health care as a cost-cutting measure back in 1983. At the time, Duluth was trying to get rid of another ballooning obligation to city workers: the value of unused sick leave and vacation days. Public workers then were in the habit of saving up this time over the course of their careers and cashing it in for a big payout upon retirement. Compared with the big obligations the city had to book for that unused time, substituting free retiree health care seemed cheap. "Basically, they traded one problem for another," Mayor Bergson said.
WITH some exceptions, most states and cities have set aside no money to pay for retiree medical benefits. Instead, they use the pay-as-you-go system - paying for former employees out of current revenue. Agencies did not have to estimate the total size of their commitment to retiree health care, so few did so.
Under the new accounting rule, local governments will still not have to set aside any money for those promises. But they will be required to lay out a theoretical framework for the funding of retiree health plans over the next 30 years, and to disclose what they are doing about it. If they fail to put money behind their promises to retirees, they may feel the unforgiving discipline of the financial markets. Their credit ratings may go down, making it harder and more expensive to sell bonds or otherwise borrow money.
Parry Young, a public finance director at Standard & Poor's, the credit rating agency, said his analysts look at total liabilities, including pension and now other "post-employment" obligations. Many governments, he added, have already been grappling with big deficits in their employee pension funds.
A few agencies are wrestling with the daunting task of estimating their total retiree health obligations and coming up with a way to slice it into a 30-year funding plan. They are finding that under the new method, the benefit costs for a particular year can be anywhere from 2 to 20 times the pay-as-you-go costs they have been showing on their books.
Maryland, for example, now spends about $311 million annually on retiree health premiums. But when that state calculated the value of the retirement benefits it has promised to current employees, the total was $20.4 billion. And the yearly cost will jump to $1.9 billion under the new rule, according to an analysis for the state by actuaries at Aon Consulting, which advises companies on benefits.
That is because Maryland would not be recording just its insurance premiums as the year's expense, but instead would report the value of the coverage its employees have earned in that year as well as a portion of the $20.4 billion they amassed in the past. After 30 years, the entire $20.4 billion should be accounted for.
Michigan says it has made unfunded promises that are now valued at $17 billion for teachers, part of a possible $30 billion total for all public agency retirees. Other places that have done the math include the state of Alabama; the city of Arlington, Tex.; and the Los Angeles Unified School District. New York City has not yet completed an actuarial valuation of its many retiree benefit plans. But in its most recent financial statements, the city said it expected that the new rule would "result in significant additional expenses and liabilities being recorded" in the future.
The numbers can vary wildly by locality, depending on how rich its benefits are, what assumptions its actuary uses about future demographics and investment earnings, and that great unknown: the cost of health care 30 years in the future.
"Fifteen years ago, who would have projected 10 years of double-digit increases in health care costs?" said Frederick H. Nesbitt, executive director of the National Conference on Public Employee Retirement Systems, an advocacy group in Washington. Mr. Nesbitt pointed out that when the accounting rulemakers began requiring a similar change in financial reporting for companies in the 1990's, it was followed by a sharp decline in the retiree medical benefits provided by corporate America.
Today, only one in 20 companies still offers retiree benefits, according to Don Rueckert Jr., an Aon actuary. The rate for large companies is less than one in three, down from more than 40 percent before the private-sector accounting change, according to Mercer Human Resource Consulting. General Motors and Ford are among the big companies that still offer retiree health benefits. But both automakers recently persuaded the United Automobile Workers union to accept certain reductions.
"We expect the same thing in the public sector, unless we help employers do the right thing," said John Abraham, deputy research director for the American Federation of Teachers.
The Governmental Accounting Standards Board, known by the acronym GASB (pronounced GAZ-bee), is a nonprofit organization based in Norwalk, Conn., and a sister to the Financial Accounting Standards Board that writes accounting rules for the private sector. Karl Johnson, the project manager for the retiree-benefits rule, said GASB began hearing from public employees' unions as soon as it issued a first draft of its new standard. The unions said that if governments were forced to disclose the cost of their plans, they would probably cut or drop them, just as companies have done.
Mr. Johnson said the accounting board had no interest in trying to reduce anyone's benefits, and no power to dictate local policy even if it wanted to. "Accounting is just trying to hold up a good mirror to what's happening," he said. "These are very expensive benefits."
Under the new rule - outlined in the board's Statement No. 45 in June 2004, and known widely as GASB 45 - large public governments and school boards with large health care obligations to retirees will have to start reporting their overall benefits cost in 2007 - either on Jan. 1 of that year or, for most big governments, on the start of the fiscal year beginning June 1, 2007. Smaller governments will start using the new method in the two years after that.
The change comes at a rough time for state and local governments. Spending on Medicaid and education has been spiraling, and Congress continues to cut federal taxes and shift burdens of governing away from Washington. In some areas, including parts of Michigan, governments are also suffering from the financial difficulties of important local industries. Max B. Sawicky, an economist at the Economic Policy Institute, a liberal research group in Washington, called the new requirement "another straw on the camel's back" for state and local governments already straining under their budget burdens.
Mr. Johnson said the accounting board had tried to issue the retiree health care rule 10 years ago, when the economic picture was rosier. It did succeed then in issuing an accounting standard for government pension plans, but before it could turn to the related issue of retiree health care, other urgent accounting issues crowded onto its agenda. The board finally cleared its decks and voted to address retiree benefits in 1999. Coming up with the new methodology took five years.
Now that it is here, "the general sense in the marketplace is that GASB 45 is going to lead to a watershed in public-sector health benefits," said Dallas L. Salisbury, president of the Employee Benefit Research Institute, a nonpartisan research center in Washington.
Indeed, the handful of states and cities that have already calculated their obligations to retirees have concluded they must also rein in the costs. Michigan, for example, with its possible $30 billion in largely unfunded health care promises, is already considering legislation that would shift "a considerable amount of the cost for health insurance to the retiree," said Charles Agerstrand, a retirement consultant for the Michigan Education Association, a teachers union. The legislation would require teachers retiring after 20 years to pay 40 percent of their insurance premiums, as well as co-payments and deductibles, he said.
The pressure is greatest in places like Detroit, Flint and Lansing, where school systems offered especially rich benefits during the heyday of the auto plants, aiming to keep teachers from going to work in them. Away from those cities, retiree costs may be easier to manage. In the city of Cadillac, 100 miles north of Grand Rapids, government officials said they felt no urgent need to cut benefits because they promised very little to begin with. Instead, Cadillac has started putting money aside to take care of future retirement benefits for its 85 employees, said Dale M. Walker, the city finance director.
Ohio is one of a few states to set aside significant amounts. Its public employee retirement system has been building a health care trust fund for years, so it has money today to cover at least part of its promises. With active workers contributing 4 percent of their salary, the trust fund has $12 billion. Investment income from the fund pays most current retiree health costs, said Scott Streator, health care director of the Ohio Public Employee Retirement System. "It doesn't mean we can just rest," he said. "It is our belief that almost every state across the country is underfunded." He said his system plans to begin increasing the employee contributions next year.
In Duluth, Mayor Bergson grew quiet for a moment at the thought of a robust trust fund. "There was not a nickel set aside" in Duluth, he said. "The reason was, if you set money aside, you'd do less 'pretty projects.' Less bricks and mortar. Fewer streets. Fewer parks. So no one set the money aside. "If the city had set $1 million aside every year for those 22 years" since the promise was made, he added, "we'd be in really good shape right now."
Mayor Bergson said his city intends to start setting aside money for the first time in 2006, but he is also trying to rein in the growth of new obligations. He raised to 20 from 3 the number of years that an employee must work for the city in order to qualify for retirement benefits.
He also imposed a hiring freeze and pledged not to lift it until Duluth could hire employees without promising them free lifetime health care. As the city has lost police officers, firefighters, an operator of its huge aerial lift bridge and other workers, the remaining employees have racked up more than $2 million in overtime. But Mayor Bergson says that this is still cheaper than dealing with free retirement health care once the new accounting rule takes effect.
Most recently, he reached out for what may prove a political third rail: he took issue with the idea that once a public employee has retired, his benefits can never be reduced. This idea, as applied to pensions, is rooted in the constitutions of about 20 states, and unions argue that it also protects retiree health care.
Active employees in Duluth have had to start paying more for their health care under the city plan, Mayor Bergson said. If active workers must make concessions, he said, retired workers should make concessions, too. Otherwise, in relative terms, they are pulling ahead of the active work force.
"That's not a popular thing to say," Mayor Bergson said. "I'm getting kicked hard by retirees. I'm getting beat up by active employees. The people who are kicking me are the ones I'm trying to protect."
ATTEMPTS to balance the competing interests of retirees, active workers and taxpayers are building tension. Ross Eisenbrey, a former Clinton administration official who is now at the Economic Policy Institute, said that "when taxpayers wake up to these obligations, their first inclination is often to escape them or reduce them."
The problem is that people have counted on those benefits, and many have accepted lower salaries in exchange for better retirement benefits, said Teresa Ghilarducci, an economics professor at the University of Notre Dame. If they are close to retirement, said William R. Pryor, a firefighters' union official who is an elected board member of the Los Angeles County Employees Retirement Association, it may well be too late for them to make up for the loss with their own savings.
The clock is ticking. In Duluth, a city official approached the actuary who made the city's estimate in 2002 and asked her to refine and update her numbers because economic conditions had changed and the new accounting rule had been announced. This time the obligations worked out to $280 million, a 57 percent increase in less than three years.

Hot Technology for Chilly Streets in Estonia (NYTimes, 12/13/05)

December 13, 2005
Hot Technology for Chilly Streets in Estonia
By MARK LANDLER
TALLINN, Estonia, Dec. 8 - Visiting the offices of Skype feels like stumbling on to a secret laboratory in a James Bond movie, where mad scientists are hatching plots for world domination.
The two-year-old company, which offers free calls over the Internet, is hidden at the end of an unmarked corridor in a grim Soviet-era academic building on the outskirts of this Baltic port city. By 5 p.m. at this time of year, it is long past sunset, and a raw wind has emptied the streets.
Inside Skype, however, things are crackling - as they are everywhere in Estonia's technology industry. The company has become a hot calling card for Estonia, a northern outpost that joined the European Union only last year but has turned itself into a sort of Silicon Valley on the Baltic Sea.
"We are recognized as the most dynamic country in Europe" in information technology, said Linnar Viik, a computer science professor who has nurtured start-ups and is regarded as something of a guru by Estonia's entrepreneurs. "The question is, How do we sustain that dynamism?"
Foreign investors are swooping into Tallinn's tiny airport in search of the next Skype (rhymes with pipe). The company most often mentioned, Playtech, designs software for online gambling services. It is contemplating an initial public offering that bankers say could raise up to $1 billion.
Indeed, there is an outlaw mystique to some of Estonia's ventures, drawn here to Europe's eastern frontier. Whether it is online gambling, Internet voice calls or music file-sharing - Skype's founders are also behind the most popular music service, Kazaa - Estonian entrepreneurs are testing the limits of business and law.
And by tapping its scientific legacy from Soviet times and making the best of its vest-pocket size, Estonia is developing an efficient technology industry that generates ingenious products - often dreamed up by a few friends - able to mutate via the Internet into major businesses.
These entrepreneurs grow out of an energetic, youthful society, which has embraced technology as the fastest way to catch up with the West. Eight of 10 Estonians carry cellphones, and even gas stations in Tallinn are equipped with Wi-Fi connections, allowing motorists to visit the Internet after they fill up.
Such ubiquitous connectivity makes Tallinn's location midway between Stockholm and St. Petersburg seem less remote.
Even the short icebound days play a part, people here say, because they shackle software developers to the warm glow of their computer screens. For the 150 people who work at Skype, Estonia is clearly where the action is.
"What Skype has shown the world is that you can take a great idea, with few resources, and conquer the world," said Sten Tamkivi, the 27-year-old head of software development.
Whether Skype poses a mortal threat to telephone companies, as some enthusiasts suggest, is an open question. But it has become an undisputed technology star - a status cemented in September when eBay, the Internet auction giant, bought the company in a deal worth $2.5 billion.
More than 70 million people have downloaded Skype's free software from the Internet, Mr. Tamkivi said, and it is adding registered users at a rate of 190,000 a day. On a recent evening, 3.7 million people were logged on to the service, nearly three times the population of this country.
Professor Viik and others relish the attention that Skype has brought Estonia. But he says his country cannot build a long-lasting technology industry on a single hit or even a few hits: Kazaa was hugely popular before it ran into a blizzard of copyright-infringement lawsuits.
Silicon Valley, Mr. Viik noted, is composed of clusters of companies that feed off one another. Skype is a closed company, with proprietary software and owners who are so secretive about their plans that for a time local journalists did not know where its offices were.
The company's two founders are not even Estonian. Niklas Zennstrom is a Swede, and Janus Friis is a Dane. Skype's legal headquarters are in Luxembourg; its sales and marketing office is in London. Although Estonian developers wrote Skype's basic code, only a fraction of the eBay bonanza went into Estonian pockets.
Part of the problem for Estonia's entrepreneurs is the nation's inexperience in capital markets. It regained its independence only in 1991, after the collapse of the Soviet Union. Estonia's entrepreneurs do not yet have the Rolodexes of their Scandinavian counterparts. Recently, Tallinn got its first high-tech venture capital firm.
Then, too, there is its small size. Estonia's entire software development industry employs roughly 2,500 people, less than the research and development staff at a major American technology company.
"Let's be frank," said Priit Alamae, the 27-year-old founder of Webmedia, another leading software design firm. "Estonia has 1.3 million people; we have 200 I.T. graduates a year; we do not have the resources to develop our own Microsoft."
The competition for talented recruits is driving up salaries more than 20 percent a year, he said. While Estonia remains cheaper than neighbors like Finland or Sweden, the gap is narrowing rapidly.
In some ways, however, Estonia's labor shortage has contributed to its success. Companies here are extraordinarily efficient. And they tend to focus on niche products or on business models - like Skype's or Kazaa's - that can expand from a small base by word of mouth.
Skype and Kazaa are powered by so-called peer-to-peer technology, which allows computers to share files or other information on a network without the need for a centralized server to route the data. In Kazaa's case, the files being swapped are songs. In Skype's case, they are voices.
"There is no new technology in Skype," Mr. Viik said. "It is an example of how you put together bits and pieces of technology in a clever way. Estonians are very good at putting together bits and pieces."
Necessity is the mother of invention, but what is it about Estonians that makes them the Baltic's answer to Bill Gates?
"People here are kind of introverted and into technology," said Jaan Tallinn, a tousled-haired man who looks younger than his 33 years and wrote the software code that is the basis of Kazaa and Skype. "We have long, cold winters when there isn't much to do, so it makes sense."
Other people cite history: Estonia's long subjugation by the Soviet Union, and the euphoria that came with freedom.
"It's as if a young country suddenly came into independence with great hopes but few material resources," said Steve Jurvetson, a venture capitalist in Silicon Valley. Mr. Jurvetson, whose family has Estonian roots, has invested in a few start-ups here, most notably Skype.
Estonia owes one thing to its former oppressor. In the 1950's, the Soviets chose the Baltic states as the site for several scientific institutes. Estonia wound up with the Institute of Cybernetics - basically a computer sciences center - that now houses Skype and many other firms.
That scientific legacy remains embedded in society, people say. It is most visible in Estonia's receptiveness to new technology. Internet penetration is estimated by the telecommunications industry to be 49 percent of the population.
Estonians use mobile phones to pay for parking, among other things. Most conduct their banking online, and more than 70 percent file their taxes on the Internet. The state issues a digital identification card, which allows citizens to vote from their laptops.
In a rare disappointment, less than 2 percent of the electorate, or 10,000 people, voted electronically during recent local elections. One hurdle was that voters had to buy a card reader to authenticate their ID's. The government hopes for better numbers for the next election, in March 2007.
Some people contend that Estonia's success is a function of hard work and happy circumstance rather than raw talent.
"I can't say that Estonians are the greatest software programmers," said Allan Martinson, who last June started the first high-tech venture capital fund to be based here. "You can find more talent in Russia."
While entrepreneurs complain about the shortage of skilled workers, more and more young foreigners are ready to trek to this northernmost Baltic nation for a job. Skype employs people from 30 countries; in the halls, one hears plenty of English, and even some Spanish.
Oliver Wihler, 35, a Swiss software developer, moved to Tallinn from London in 1999, drawn by the heady professional atmosphere and by Estonia's parks and forests. Now he and a business partner, Sander Magi, 28, run a company called Aqris, which reformats Java software.
"The commute in London was a drag, and I missed not having any green space," Mr. Wihler said.
Estonia offers plenty of that. But Skype is relying on more than a pleasant lifestyle; it is taking a more traditional approach in its recruitment by offering stock options in eBay. But Mr. Tallinn says that is only part of the company's appeal.
"The other draw," he said, "is that if you want to work for a company that influences the lives of tens of millions of people, and you want to do it in Tallinn, there really isn't any other choice."

Lines Drawn for Big Suit Over Sodas (NYTimes, 12/05/05)

December 7, 2005
Lines Drawn for Big Suit Over Sodas
By MELANIE WARNER
It is lunchtime at Grover Cleveland High School in Portland, Ore. A steady stream of thirsty teenagers poke dollars into the three Coca-Cola machines in the hallway. By the end of lunch period, the Coke With Lime, Cherry Coke and Vanilla Coke are sold out.
Elsa Peterson, a senior at Grover Cleveland and the student body president, said she knew she could bring healthier juices from home. "But it's easy to walk up with a dollar and just get a pop."
That, says Stephen Gardner, staff lawyer for the Center for Science in the Public Interest, is exactly the problem. In an age of soaring obesity rates among children, he argues that soda and other sugary beverages are harmful to students' health and that selling those drinks in schools sends a message that their regular consumption is perfectly fine.
In a lawsuit they plan to file in the next few months, Mr. Gardner and half a dozen other lawyers, several of them veterans of successful tobacco litigation, will seek to ban sales of sugary beverages in schools.
The lawsuit is to be filed in Massachusetts, which has strong consumer protection laws and happens to be where some of the lawyers are based, and will name Coca-Cola, PepsiCo and their local bottlers, the lawyers say. It will be the first of many such state lawsuits, they say.
The $92 billion beverage industry, dominated by Coca-Cola and PepsiCo, is gearing up for a counterattack. Last week, the American Beverage Association, the lobbying group for the beverage industry, released a study arguing that soda sales in schools are not a significant contributor to rising childhood obesity rates.
The study, which was paid for by the association but conducted by an outside economist, concluded that school vending machine sales of non-diet soda declined by 24 percent from 2002 to 2004 and that the average high school student consumes just one 12-ounce nondiet soda a week from school vending machines.
"This study confirms what previous studies have shown: that consumption of full-calorie sodas purchased from school vending machines during normal school hours is a very minor source of calories in the diets of American youth," said Susan K. Neely, president of the American Beverage Association, which last year changed its name from the National Soft Drink Association.
Across America, almost half of all public schools have exclusive contracts with beverage companies. According to a report published in August by the Government Accountability Office, the investigative arm of Congress, 75 percent of all high schools, 65 percent of all middle schools and 30 percent of elementary schools have beverage contracts.
Such contracts have been promoted as a continuing source of revenue for schools needing cash. The deals often give schools a large upfront payment and a share of the collected revenue. But a study of public school contracts in Oregon concluded that the amount of money received by schools is not that significant and that by far, most of the revenue goes to the companies, not the schools.
The study, done by the Community Health Partnership, a public health advocacy group in Oregon, found that school districts received just $12 to $24 per student annually. "Some people have the perception that there is a huge amount of money in this for schools," said Nicola Pinson, a lawyer who was hired by the Community Health Partnership to do the study, the most extensive analysis done on school contracts to date. "But we need to put it in perspective with overall budgets and how much money the companies are getting."
For the 2005-6 school year, for instance, Portland's school district has projected that it will receive $250,000 from vending sales at its 15 high schools, an amount representing 0.06 percent of a total district budget of $396 million, according to school budget documents.
Ms. Pinson contends that while schools certainly earn some money, Coke and Pepsi bottlers get the better end of the deal. She says that the Hillsboro school district's 12-year contract with the Coca-Cola Bottling Company of Oregon, for instance, requires the district to buy 420,000 beverage cases over the life of the contract; that translates into students spending a total of $10 million. Of that, $3 million will go to the district and $7 million will go to the bottler.
"This is all coming from the community's pockets," Ms. Pinson said. "You have to ask whether this is really an effective way to do fund-raising for schools."
According to the Oregon study, which analyzed 19 contracts covering 186,000 students, some contracts even reward schools when students purchase the most caloric and unhealthiest of options. The Portland school district's contract with the Coca-Cola Bottling Company of Oregon stipulates that schools get 50 percent from every 20-ounce bottle of Coke, but only 35 percent for a 12-ounce can and 30 percent for a bottle of water or juice.
Ms. Neely of the American Beverage Association said that contracts involve "two willing parties" and that schools have the ability to negotiate what they want to sell in vending machines. More broadly, Ms. Neely said that the beverage industry had taken steps to address concerns over soda sales in school.
In August, the beverage association announced that beverage companies would stop selling soda and other drinks with added sugar in elementary schools and would restrict the sale of regular, full-calorie soda in middle schools to after-school hours only. Next month, the association is planning to run an ad campaign about the new policy.
Mr. Gardner of the Center for Science in the Public Interest, a nutrition advocacy group, said that the beverage association's policy did not adequately address the sales of beverages in high schools, which is where the majority of purchases occur.
The Massachusetts lawsuit will focus specifically on sales of what it terms unhealthy beverages (likely to mean full-calorie sodas, sports drinks, iced tea drinks and juice drinks without much juice) in high schools and will argue that such sales constitute unfair and deceptive marketing. The suit will also cite the ways in which the large illuminated Coke and Pepsi machines lining school halls and cafeterias are an "attractive nuisance."
"They're selling to a captive audience that isn't really in a position to fully evaluate all the health risks," said Andrew A. Ranier, a partner at McRoberts, Roberts & Ranier in Boston and one lawyer involved in the suit. "And they're not telling people about the risks."
Three tobacco litigation experts are also involved in the suit: Tim Howard, a Florida lawyer who helped the state win a $17 billion settlement against tobacco companies in 1997; Stephen A. Sheller, a partner at Sheller Ludwig & Badey in Philadelphia, who was involved in a successful $10 billion tobacco class action in Illinois state court that is currently under appeal; and Richard A. Daynard, an associate dean at the Northeastern University School of Law who has served as an adviser to many of the state tobacco lawsuits that led to a $246 billion settlement in 1998.
Mr. Gardner and the rest of the Massachusetts coalition say they think the scientific research linking soda and obesity is strong. Numerous studies have shown, for instance, that people do not compensate for liquid calories in the way they would for, say, a slice of pizza or a handful of cookies because drinks do not create the same sense of fullness.
In a study published in the medical journal Lancet in 2001, Dr. David S. Ludwig, director of the obesity program at Children's Hospital Boston and an associate professor of pediatrics at Harvard Medical School, found that each additional daily serving of a sugar-sweetened beverage increased the risk of obesity by 60 percent.
The American Beverage Association says that there are also studies that show no link between consumption of soft drinks and obesity.
The Massachusetts lawyers say they think that their legal foray is likely to get greater public support than the much-publicized suit against McDonald's by two obese New York teenagers.
"This is different from the fat kid who goes to McDonald's," said Mr. Gardner, speaking at an obesity lawsuit conference organized by Professor Daynard in September. "This is a captive audience and they're using schools to get their brands into the hearts and minds of students."
One detail yet to be decided is whether the group will seek financial damages. Under Massachusetts's consumer protection law, successful plaintiffs are entitled to $25 per violation, which could mean $25 for every time a student has purchased a soda in a public high school in Massachusetts over the past four years.
Mr. Gardner said he and the other lawyers realize that damages could run into the billions. "We haven't decided about this yet," he said. "We don't want this to come off looking like a greedy-lawyer lawsuit."
Brian Libby contributed reporting from Portland, Ore., for this article.