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|“||I've been working to create an interactive television my entire life. I always knew it was a way of bringing computers to average people.||”|
|— Steve Perlman|
Co-founder Steve Perlman is credited with the idea for the device. He first combined computer and television as a high-school student when he decided his home PC needed a graphics display. He went to build software for companies such as Apple and Atari. While working at the Apple spin-off, General Magic, the idea of bringing TVs and computers together resurfaced.
One night, Perlman was browsing the web and came across a Campbell's soup website with recipes. He thought that the people who might be interested in what the site had to offer were not using the web. It occurred to him that if the television audience was enabled by a device to augment television viewing with receiving information or commercial offers through the television, then perhaps the web address could act as a signal and the television cable could be the conduit.
The company hired many engineers and a few business development employees early on, having about 30 total employees by October 1995. The company operated out of a former BMW car dealership building in Palo Alto, California, which it had been able to obtain for very low rent, but the space was suboptimal for technology development.
WebTV was literally a Silicon Valley garage startup, having been founded in half of a storage building for the Museum of American Heritage on Alma Street in Palo Alto. Two early employees of Artemis who were also from Apple were Andy Rubin, creator of the Android cell phone OS, and Joe Britt, who would be two of the founders of Danger, Inc. (originally Danger Research). WebTV leveraged their limited startup funds, provided in part by Microsoft co-founder Paul Allen, by licensing a reference design for the appliance to Sony and Philips. Eventually other companies would also become licensees and WebTV would profit on the monthly service fees. After 22 months, the company was sold to Microsoft for $425 million, with each of the three founders receiving $64 million.
Before incorporation, the company referred to itself as Artemis Research to disguise the nature of its business. The info page of its original website explained that it was studying "sleep deprivation, poor diet and no social life for extended periods on humans and dwarf rabbits". The dwarf rabbit reference was an inside joke among WebTV's hard-working engineers—Phil Goldman's pet house rabbit Bowser (inspiration for the General Magic logo) was often found roaming the WebTV building late into the night while the engineers were working—although WebTV actually received inquiries from real research groups conducting similar studies and seeking to exchange data.
WebTV closed its first round of financing, US$1,500,000, from Marvin Davis in September, 1995 and developed a prototype WebTV set-top box, based upon a custom chip and custom software, and also developed a WebTV online service that the WebTV set-top boxes would automatically dial into using a dial-up modem that provided subscriber services such as HTML-based email, and proxied websites accessed by the WebTV set-top box so as to make them display more efficiently on a television screen.
WebTV Networks' business model was to license a reference design to consumer electronics companies for a WebTV Internet Terminal, a set-top box that attached to a telephone line and automatically connected to the Internet through a dial-up modem. WebTV's income was derived from operating the WebTV Service, an Internet-based service for which it collected a fee from WebTV subscribers. The consumer electronics companies' income was derived from selling the WebTV set-top box.
Barely surviving to reach announcement
By the spring of 1996 WebTV Networks employed approximately 70 people, many of them finishing their senior year at nearby Stanford University, or former employees of either Apple Computer or General Magic. WebTV had started negotiating with Sony to manufacture and distribute the WebTV set-top box, but negotiations had taken much longer than WebTV had expected, and WebTV had used up its initial funding. Steve Perlman liquidated his assets, ran up his credit cards and mortgaged his house to provide bridge financing while seeking additional venture capital. Because Sony had insisted upon exclusive distribution rights for the first year, WebTV had no other distribution partner in place, and just before WebTV was to close venture capital financing from Brentwood Associates, Sony sent WebTV a certified letter stating it had decided not to proceed with WebTV. It was a critical juncture for WebTV, because the Brentwood financing had been predicated on the expectation of a future relationship with Sony, and if Brentwood had decided to not proceed with the financing after being told that Sony had backed out, WebTV would have gone bankrupt and Perlman would have lost everything. But Brentwood decided to proceed with the financing despite losing Sony's involvement, and further financing from Paul Allen's Vulcan Ventures soon followed.
WebTV then proceeded to close a non-exclusive WebTV set-top box distribution deal with Philips, which provided competitive pressure causing Sony to change its mind, to resume its relationship with WebTV and also to distribute WebTV.
WebTV was announced on July 10, 1996, generating a large wave of press attention as not only the first television-based use of the World Wide Web, but also as the first consumer-electronics device to access the World Wide Web without a personal computer. After the product's announcement, the company closed additional venture financing, including investments from Microsoft Corporation, Citicorp, Seagate Technology, Inc., Soros Capital, L.P., St. Paul Venture Capital and Times Mirror Company.
WebTV was launched on September 18, 1996, within one year after its first round of financing, with WebTV set-top boxes in stores from Sony and Philips, and WebTV's online service running from servers in its tiny office, still based in the former BMW dealership.
The initial price for the WebTV set-top box was US$349 for the Sony version and US$329 for the Philips version, with a wireless keyboard available for about an extra US$50. The monthly service fee initially was US$19.95 per month for unlimited Web surfing and e-mail.
There was little difference between the first Sony and the Philips WebTV set-top boxes, except for the housing and packaging. The WebTV set-top box had very limited processing and memory resources (just a 112 MHz MIPS CPU, 2 megabytes of RAM, 2 megabytes of ROM, 1 megabyte of Flash memory) and the device relied upon a connection through a 33.6 kbit/s dialup modem to connect to the WebTV Service, where powerful servers provide back-end support to the WebTV set-top boxes to support a full Web-browsing and email experience for the subscribers.
Initial sales were slow. By April 1997, WebTV had only 56,000 subscribers, but the pace of subscriber growth accelerated after that, achieving 150,000 subscribers by Autumn 1997, about 325,000 subscribers by April 1998 and about 800,000 subscribers by May 1999. WebTV achieved profitability by Spring 1998, and grossed over US$1.3 billion in revenue through its first 8 years of operation. In 2005 WebTV was still grossing US$150 million per year in revenue with 65% gross margin.
WebTV briefly classified as a weapon
Because WebTV utilized strong encryption, upon launch in 1996, WebTV was classified as munitions (a military weapon) by the United States government and was therefore barred from export under United States security laws at the time. Because WebTV was widely distributed in consumer electronic stores under the Sony and Philips brands for only US$325, its munitions classification was used to argue that the US should no longer consider devices incorporating strong encryption to be munitions, and should permit their export. WebTV obtained a special exemption permitting its export, despite the strong encryption, and shortly thereafter, laws concerning export of cryptography in the United States were changed to generally permit the export of strong encryption.
Microsoft takes notice
In February 1997, in an investor meeting with Microsoft, Steve Perlman was approached by Microsoft's Senior Vice President for Consumer Platforms Division, Craig Mundie. Despite the fact that the initial WebTV sales had been modest, Mundie expressed that Microsoft was impressed with WebTV and saw significant potential both in WebTV's product offering and in applying the technology to other Microsoft consumer and video product offerings. Microsoft offered to acquire WebTV, build a Microsoft campus in Silicon Valley around WebTV, and establish WebTV as a Microsoft division to develop television-based products and services, with Perlman as the division's president.
Discussions proceeded rapidly, involving Bill Gates, then CEO of Microsoft, personally. Gates called Perlman at his home on Easter Sunday in March 1997, and Perlman described to Gates WebTV's next generation products in development, which would be the first consumer devices to incorporate hard disks, including the WebTV Plus, and the WebTV Digital Video Recorders. Gates' interest was piqued, and negotiations between Microsoft and WebTV rapidly proceeded to closure, with both sides working around the clock to get the deal done. Indeed, the parties were unaware that they were losing an hour of negotiation the night before the planned announcement due to the change to Daylight Saving Time, and they almost did not have enough time to close the deal.
On Sunday, April 6, 1997, 20 months after WebTV's founding, and only six weeks after negotiations with Microsoft began, during a scheduled speech at the National Association of Broadcasters conference in Las Vegas, Nevada, Craig Mundie announced that Microsoft had acquired WebTV. The acquisition price was US$503 million, but WebTV was so young a company that most of the employees' stock options had yet to be vested. As such, the vested shares at the time of the announcement amounted to US$425 million, and that was the acquisition price announced.
Subsequent to the acquisition, WebTV became a Silicon Valley-based division of Microsoft, with Steve Perlman as its president. The WebTV division began developing most of Microsoft's television-based products, including the first satellite Digital Video Recorders (the DishPlayer for EchoStar's Dish Network and UltimateTV for DirecTV), Microsoft's cable TV products, the Xbox 360 hardware, and Microsoft's Mediaroom IPTV platform.
Microsoft worked with Sega in that same year and developed Microsoft WebTV for the Dreamcast game console. This was the first TV set-top box from a major vendor that offered high-end online gaming, internet access, and interactive television, as well as the first glimpse at WebTV running on Microsoft's Windows CE operating system. This would later lead Microsoft to create their own game consoles (Xbox & Xbox 360) and use this same technology within it. 
The WebTV set-top box
Since the WebTV set-top box was a dedicated web browser appliance that did not need to be based on a standard operating system, the cost of licensing an operating system could be avoided. The box featured a 64-bit RISC CPU chip, and a smart card reader. The smart card reader was not utilized significantly. The web browser was compatible with both Netscape Navigator and Microsoft Internet Explorer and the WebTV set-top box featured 2 MB of RAM. The first WebTV set-top boxes had a 33.6 kbit/s modem, and later versions had 56kbit/s modems. The WebTV set-top boxes used a caching proxy for acceleration capable of reformatting and compressing web pages, a feature generally unavailable to dialup ISPs users at the time and as such, had to be developed by WebTV. For web browsing purposes, given WebTV's thin client software, there was no need for a hard disk, but by putting the browser in non-volatile memory, upgrades could be downloaded from the WebTV service. Support for Java was being prototyped in late 1997.
One interesting feature of the WebTV set-top box was that, while downloading TV schedule information overnight, it would also check to see if there was any email waiting. If there was, it would illuminate a red LED on the device so the consumer would know it was worth connecting to pick up their mail.
A second model, the "Plus", was introduced a year later. This model featured a tuner to allow watching television in a PIP (Picture-In-Picture) window while waiting for pages to arrive, allowed one to capture video stills from video camera, VCR or broadcast television as a JPEG, and included a video tuner that allowed one to schedule a VCR in a manner like TiVo allowed several years later. The Plus also included a 56k modem. In order to accommodate large nightly downloads of television schedules, a hard drive was included in the original Plus; as chip prices fell faster than hard drive prices, later versions of the Plus used an M-systems DiskOnChip flashrom chip instead. It also supported ATVEF, a technology that allowed users to download special script-laden pages to interact with television shows.
WebTV produced reference designs of models incorporating a disk-based personal video recorder and a satellite tuner for EchoStar's Dish Network (called "Dishplayer") and for DirecTV (called "UltimateTV"). In 2001, EchoStar sued Microsoft for failing to support the WebTV Dishplayer. EchoStar subsequently sought to acquire DirecTV and was the presumptive acquirer, but EchoStar was ultimately blocked by the Federal Communications Commission. While EchoStar's lawsuit against Microsoft was in process, DirecTV (presumptively acquired by EchoStar, and in control by EchoStar) dropped UltimateTV (thus ending Microsoft's satellite product initiatives) and picked TiVo's DirecTV product as its only Digital Video Recorder offering.
As an ease-of-use design consideration, WebTV early decided to reformat pages rather than have users doing sideways scrolling. As entry-level PCs evolved from VGA resolution of 640ⅹ480 to SVGA resolution of 800ⅹ600, and web site dimensions followed suit, reformatting the PC-sized web pages to fit the 560-pixel width of a United States NTSC television screen became less satisfactory. The WebTV browser also translated HTML frames as tables in order to avoid the need for a mouse. To address these problems, the engineers at WebTV developed the MSN Companion, which was another easy-to-use thin client which used an SVGA monitor and mouse. Both Compaq and e-Machines marketed the Companion, Compaq producing it in multiple models. However, being substantially more expensive than WebTV (which at this time was typically $50 after rebate) and lacking many features that PC users and WebTV users found standard, the Companion never found a customer base.
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