The co-founder of Hotmail, the web-based e-mail service bought by Microsoft for $400 million a decade ago, is challenging the American software giant’s core $20 billion (£9.7 billion) office desktop business.

Yesterday Sabeer Bhatia released a free online rival to the bestselling Office suite of applications that will allow users to view, share and edit documents from any computer.

The Indian-born Stanford graduate said that Live Documents would pose a “significant” challenge to Microsoft’s propriety software business, which eventually would be made redundant by the evolving internet applications industry. Office, bundling the Word word-processing, Excel spreadsheet and PowerPoint presentation tools, accounted for a third of Microsoft’s total revenues last year. It is forecast to top $20 billion this year.

“We are just a few years away from the end of the shrink-wrapped software business. By 2010, people will not be buying software,” Mr Bhatia said. “This is a significant challenge to a proportion of Microsoft’s revenues.”

The latest rival product was developed by InstaColl, a Bangalore-based company that is chaired by Mr Bhatia and backed by SoftBank’s Bodhi Fund. He admitted that “a few million bucks” of Microsoft’s payment from the sale of Hotmail went into its creation.

Designed to help consumers avoid expensive upgrades and to foster collaboration on a secure internet platform, Live Documents matches features found in Office 2007, the most recent version. It will be given away to individuals with 100MB of free data storage space per user. Companies will pay for the system, either hosted remotely or on an internal server, at a discount to Microsoft’s licensed technology. Aricent, an Indian software services group with 6,700 employees, is the first client.

Live Documents is similar to Google Apps, launched in February and used by companies including Proctor & Gamble, General Electric and Capgemini as a cheaper alternative to Microsoft. However, Mr Bhatia claims that his product is superior to Google’s in its range and quality, most crucially because it mimics Office 2007. Most of Office’s estimated 500 million customers have yet to upgrade from the 2003 version, while it is not available for Apple computers.

He said. “This will do for documents what Hotmail did for e-mail. Why spend $400 on an upgrade when you can get it for free?”

Office 2007, the biggest advance in the system in ten years, took more than 2,000 Microsoft programmers three years to develop. Thirty-two software engineers in Bangalore, India’s IT hub, took four years to break Microsoft’s code so that they could replicate it online.

InstaColl said that it was not infringing copyright because of a legal ruling that concluded that it was not possible to patent the “look and feel” of a computer interface.

Microsoft itself was instrumental in setting the precedent. In 1994, it won a lawsuit brought by Apple for copying graphics from the Macintosh operating systems for use in Windows.

Microsoft has toyed with the idea of putting its word processing and spreadsheet applications online but fears the cannibalisation of its core business. Instead it has focused on enhancing its desktop product with online extras.

The threat of free web-based applications is still nascent. Most of Office’s sales are to companies buying licences in volume; about 40 per cent come from the sale of packaged software.

Mr Bhatia and Jack Smith devised Hotmail, named after HTML, the language of the web, soon after leaving Apple in the mid1990s. Today it has more than 450 million users.

Crowded Office

IBM offfers Lotus Symphony, a suite of free desktop applications that includes document, spreadsheet and presentation software

Google Docs is a suite of free web-based applications that lets users create, edit and upload documents, spreadsheets and presentations or create new ones from scratch

Yahoo! bought Zimbra - a start-up that specialises in online e-mail tools similar to Microsoft Exchange and Outlook, key parts of the Office family – in September

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