TIRED of paying for phone calls? A small software company, operating in London and Estonia, has a solution: make calls free over the internet.

Skype, the company in question, may be tiny, employing just 30 people. It has not earned a penny in revenue in its 18 months of existence. Yet its early success is making the rest of the telecoms industry nervous.

Last week 100,000 people downloaded Skype’s free phone software each day. In all, the software has been downloaded ten million times since it was released six months ago and Skype estimates that it has 4.5 million regular users.

Already the Skype-hype is forcing traditional phone companies and internet service providers to respond. BT plans to launch a rival service in September, with functions that it says will exceed its tiny rival.

Meanwhile, AOL, the world’s biggest internet provider, has launched an extension to its popular Instant Messenger product, allowing people to talk if they are simultaneously online. Others will follow. Vonage, the leader in the US, which has 130,000 customers, is hoping to launch in the UK in the next few weeks.

Behind Skype is a partnership of Niklas Zennström and Janus Friis, two Swedes who run the company from a serviced office in Shaftesbury Avenue, in the West End of London. The software, however, is developed in the Estonian capital of Tallinn by a team with whom Skype’s founders have worked over the past five years.

The myopic Zennström, who bears a passing resemblance to a youthful Bill Gates, and Friis are serial entrepreneurs. Before Skype, they set up Kazaa, a popular music file-swapping service, but sold out “for not much money” early in 2002 as legal pressure from the record industry mounted.

“What we were asking is how we could apply our knowledge from Kazaa in the consumer space to disrupt the status quo. Why should people make phone calls using 100-year-old technology — it’s like using fax to communicate instead of e-mail,” says Zennström.

Skype did not take long to get going. The two initially raised money from friends and developed the software in a little over half a year. Two rounds of financing followed, the last of which was $18.8 million, completed in March. Skype’s backers include Tim Draper, the Silicon Valley venture capitalist who was one of the original backers of the Hotmail e-mail service.

Skype’s product is not without its limitations. Andrew Burke, BT’s head of online services, knows his company “has to embrace the trend” but goes on to to criticise Skype’s relatively limited functionality. “The game here is about talking to who you want to, when you want to.”

Burke has a point. It works only between Skype users, requires a £25-a-month broadband connection and there is no voicemail. Users also have to buy a headset.

BT, meanwhile, wants to add a critical feature to its planned product: the ability to call people on the normal phone network. However, calling people on their normal phones will cost. Only calls between BT internet phone users will be free.

The direction is one in which Skype will have to follow. Zennström, hoping to turn Skype’s weakness in functional terms into a financial strength, says: “Our plan is to charge for making calls to the public phone network, and for other value-added services such as voicemail.”

At least, that is the plan soon. For now Zennström, speaking with the mentality of an internet entrepreneur, concedes that revenue is “not a focus area for us right now”.

That sounds worse than it is. Skype’s cost base is so tiny that it would not take much in revenue to post a useful profit. Starting with a free service is how a string of successful internet businesses has been built, including Yahoo! and Google.

In the longer term, the company hopes to compete with mobile operators. Last week Skype brandished new software that runs on Windows-compatible handhelds and can route calls through a WiFi hotspot — a high-speed wireless internet link that is prevalent in airports and a growing number of coffee bars.

Skype’s software appears certain to revolutionise the telecoms sector but it is unlikely to lead to the rapid ruin of the world’s fixed-line phone giants. A substantial core of BT’s 20 million customers are unlikely to want to use an internet phone. BT thinks internet calls will hit somewhere between 10 and 20 per cent of the overall retail market.

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