By Ina Fried
Staff Writer, CNET News.com
April 26, 2006 4:00 AM PST

MOUNTAIN VIEW, Calif.--After an hour-long discussion at a status meeting last month, the Hotmail redesign really boiled down to one key decision: one big ad, or two?

After months of reworking the venerable Web mail program, Microsoft's team had made all the easy fixes: They'd added more colors and even offered a way to make the new Windows Live Mail look just like the old Hotmail.

But sitting around a table in the nondescript Pyre conference room in Microsoft's Silicon Valley offices, the half-dozen developers and managers couldn't avoid the thorny issue that remained. A significant number of people believed that the new design had too much space devoted to ads, making it hard to use some of the mail program's new features.

The ad placement decision may seem minor. But it's a key one for Microsoft, which is trying to turn Hotmail's hundreds of millions of casual e-mail users into customers for a wide variety of Windows Live personal services.

Offer too many ads and the company risks alienating users and sending them flocking to rival online services. But if it forsakes the second ad, it risks choking the revenue the business needs to compete with the likes of Yahoo and Google.

"Removing one of those ad products is a very costly thing," product planner Richard Sim told his colleagues during a meeting about the ad issue, among others. But in the end, everyone knew what had to be done. Painful as it was, they had to side with their users and hope the dollars would be there.

It's a big bet for Microsoft, which has spent the past two years overhauling Hotmail into what is now dubbed Windows Live Mail. After years of leaving the e-mail service largely on autopilot, Microsoft was jolted into action on April Fools' Day 2004, when Google launched Gmail, a Web-based e-mail service with a gigabyte of free storage. Since then, Microsoft has been racing to catch up.

Sara Radicati, who heads the analyst firm Radicati Group, said an overhaul is definitely needed.

"The Hotmail service has kind of lagged behind some of the others," Radicati said. By being early to the market with a free service, Hotmail for years found it easy to sign up more and more users. "Probably, they became a little bit complacent."

Even those inside the company generally agree that the launch of Gmail was a giant wake-up call.

"When Gmail came, it basically raised the bar on expectations and also capabilities of what is a modern Web browser application," said Richard Craddock, the development manager for Windows Live Mail, which is set for launch later this year.

Microsoft had been kicking around ideas on how to revamp Hotmail since at least 2002, but the ideas stayed on the drawing board until Gmail came around.

"It became very clear...this is what we should be doing,'" Craddock said. "Somewhere along the way, we realized there was probably a lot more money in this free e-mail service than we recognized before."

Off the back burner
Microsoft was early to spot the potential of free e-mail. Back in late 1997, it opted to spend hundreds of millions of dollars to buy Hotmail. But after that, the service remained essentially the same for a decade. Microsoft invested in more servers and additional data centers as the service grew, but Hotmail itself only saw modest, incremental changes.

Although the unit's product changed little, the company did manage to retain some key talent over the years.

Among these people was Reeves Little, who enjoyed the MacGyver-like charge that came from seeing what could be added to the nearly decade-old code. But prior designs required the software equivalent of bubble gum to stick on new features, Little said.

But when it came time for the redesign, code-named Kahuna, Microsoft knew it needed some new in-house blood to augment the Hotmail veterans. (Fewer than a dozen people remain from the original Hotmail team.)

One of the recruits was Mike Schackwitz, who had been working at Microsoft's Redmond, Wash., campus on Internet projects destined to become part of Windows Live. The group program manager said the job, based in Silicon Valley, had twin allures.

One was that Hotmail was the company's single-biggest Web asset. The other was the weather. "Frankly, it rains a lot in Seattle," he said.

A week after he accepted the job, Google launched Gmail. "There was a moment of, 'Oh, yes, this does really matter," Schackwitz said.

While Schackwitz may have been motivated by the California sun, others noticed his move and decided something interesting might be going on at Hotmail. Omar Shahine moved there from the Mac business unit and brought a half-dozen good people with him. Suddenly, stodgy old Hotmail was, well, hot.

By last July, the company had a revamped version ready for the outside world to get its first look. Gone were the check boxes beside each message. In their place, Windows Live Mail offered a layout not unlike that of Outlook, Microsoft's desktop e-mail that lets people preview messages before they are opened and move items by dragging and dropping them into folders.

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