What Microsoft Wants from Yahoo

Microsoft’s now retracted acquisition bid for Yahoo has been endlessly analysed in the media and myriad explanations have been offered for Microsoft’s interest in Yahoo. Analysts have generally assumed the obvious that Microsoft made the bid in order to acquire Yahoo. Yahoo CEO Jerry Yang, though, does not agree with this assumption. He has publicly claimed that Microsoft did not intend to acquire Yahoo. Some analysts have dismissed Jerry Yang’s claim as self-serving, but this can not be so. As part of ongoing shareholder litigation, Jerry Yang may need to defend this claim in a court of law and could not have made the claim lightly. Besides, there is plenty of evidence that supports Jerry Yang’s claim.

Microsoft’s $31 a share bid came just one day after Yahoo’s share price hit a four-and-a-half year low of $19.05. Yahoo shares closed at $31.36 on November 05, 2007; less than three months before the Microsoft bid. Yahoo had not reported a major downturn in its operations in the months leading to decline of the stock from above $30, and Yahoo’s share price exhibits considerable volatility. Share prices on a particular day are meaningless anyway as prices can move drastically even on the basis of insignificant trading volume. This suggests that Yahoo’s $19.18 a share closing price on January 31, 2008 was uncharacteristically low, and did not reflect a realistic valuation of Yahoo. Considering this the much touted 60 percent premium Microsoft offered over Yahoo’s closing price on January 31st appears to be mostly a well-planned and cleverly executed public relations coup.

The Microsoft bid never made sense from a business perspective either. Yahoo has always had stale search offerings, second rate search technology, and a mediocre unmotivated workforce. Yahoo derives its value primarily from the massive web-traffic the company controls, but the cost of controlling this web-traffic is likely to be prohibitive for Microsoft. In case of an acquisition, Microsoft needs to assimilate Yahoo’s 10,000 employee workforce into its corporate culture, and it is questionable if the “synergies” Microsoft is after outweigh the inefficiencies that will result from having to take on an army of sub-par and unmotivated employees.

Interestingly, Microsoft’s Yahoo bid does not make sense even after assuming a strong business case for a Microsoft Yahoo merger. Had Yahoo’s board accepted Microsoft’s $31 a share bid, the deal still could not have gone through because of antitrust issues. A Microsoft Yahoo merger is not a problem for anyone in search but it is a massive threat to Adobe Systems and its dominant rich internet application (RIA) development platform: Flash. Microsoft’s RIA platform, Microsoft Silverlight, competes directly against Flash and in the case Microsoft acquires Yahoo, Silverlight will get a hold over some of the web’s most popular websites and more than 50 percent of the webmail market. Consequently, any Microsoft attempt to acquire Yahoo is bound to be challenged by Adobe on antitrust grounds. More than that, because of Adobe’s legitimate concerns, Microsoft has to accommodate Adobe, which it can not do without divesting most of Yahoo’s valuable web-assets.

Evidently, Microsoft’s bid for Yahoo had no realistic chance of being successful. But why did Microsoft bid at all? Microsoft’s bid has to be an unconventional tactic for putting pressure on Yahoo, but to what end?

The precise nature of Microsoft’s interest in Yahoo has been clear for years. Even before Microsoft’s acquisition bid for Yahoo the two companies had been talking for years. Back in 2006, in an interview with New Yorker journalist Ken Auletta (video of interview no longer available), then Yahoo CEO Terry Semel publicly acknowledged that Microsoft and Yahoo were talking. In the interview Terry Semel said, “Microsoft taking over Yahoo — that conversation has never come up,” Terry continued, “[We discussed] search, and Microsoft co-owning some of our search. I will not sell a piece of search. It is like selling your right arm while keeping your left — it does not make any sense.”

The idea of a competitor co-owning Yahoo’s core business is extremely odd if not outright nonsensical, and Terry Semel rightly spurned Microsoft. However, Terry Semel did not stop at not wanting to sell anything to Microsoft, but made an astonishing remark that received extensive media coverage at that time. He said, “My impartial advice to Microsoft is that you have no chance. The search business has been formed.”

The above remark was all the more surprising as Yahoo was not even close to being dominant in the search market at the time. In fact, in the very same interview Terry Semel admits to Yahoo not even being in the search business just 2-3 years back. Terry Semel further credits Yahoo’s June 2003 acquisition of paid search specialist Overture Services in getting it into search. He says of the Overture Services acquisition, “Turns out we earned over $200 million that year (from Overture) and that was the start of search”

Yahoo’s Overture Services acquisition is the crucial link between Yahoo and Microsoft and is the key to understanding Terry Semel’s Microsoft comments. Yahoo’s Overture acquisition was not about search technology even though Overture owned the AltaVista and AllTheWeb search engines. By the time of the Overture acquisition, Yahoo already owned search technology via its acquisition of the Inktomi search engine in December 2002. Overture Services specialized in paid search. Overture Services’ 2002 annual report reads:

Overture Services, Inc. is the global leader in Pay-For-Performance search (also known as paid search) on the Internet. Overture’s search service is comprised of advertiser’s listings, which are screened for relevance and accessed by consumers and businesses through Overture’s affiliates, a network of Web properties that have integrated Overture’s search service into their sites or that direct user traffic to Overture’s own site. In some cases, consumers and businesses access our search listings directly at our site. The search listings are ranked by the advertisers’ bid; the higher the bid, the higher the ranking. Advertisers pay Overture the bid price for clicks on the advertisers’ search listing (also known as a paid introduction, click-through or a paid click).

The above reads like a description of the Google AdSense and AdWords paid-search solutions and it is. Google is generally credited with pioneering the paid-search text ad, but it was Overture that originally came up with the idea. Overture not only pioneered the paid search business model but it also managed to patent the core ideas behind paid-search. In July 2001, the US patent office granted Overture US patent number 6,269,361. Also known as the ‘361 patent, it covered the basic paid-search bid-for-placement advertising model. The ‘361 patent effectively granted Overture the right to monopolize the lucrative US paid-search market and subsequently dictated the evolution of the global paid-search market.

After getting the ‘361 patent, Overture wasted no time going after its paid-search competitors and quickly mobilized its lawyers to corner the paid-search market. Initially, Microsoft, Yahoo, and most of the other paid search players chose to license the ‘361 patent. However, Google and Miva (a small paid search operator formerly known as FindWhat) chose to challenge the patent in court, and subsequently got sued by Overture for patent infringement.

Google and Miva accused Overture of inequitable conduct in the filing of ‘361 patent. Inequitable conduct is a legal term that implies noncompliance with patent filing procedures or misdirection in the filing of the patent application. Google and Miva contended that Overture filed the patent application for ‘361 patent more than a year after releasing a product based on the ideas for which it was seeking patent protection. Under US patent law, companies have one year to file patent applications after they disclose their inventions, and Overture missed the one year window. Google and Miva effectively claimed that Overture lied to the US patent office in order to obtain the ‘361 patent.

Challenging the ‘361 patent made a lot of sense as Overture was demanding hefty fees for the patent’s use. Overture’s financial statements from 2002 indicate that the company on average retained 38 percent of ad revenue generated by its paid search ads at customer websites. Microsoft and Yahoo were two of Overture’s biggest customers in 2002 and were responsible for 60 percent of Overture’s revenue that year.

Overture reported sizable growth in 2002, but also started looking for a buyer. By that time, Google was taking over paid search via its in-house paid search solutions and Overture must have anticipated Yahoo and Microsoft bypassing it and rolling out paid-search solutions of their own. Overture did own ‘361 patent and could use it to block Yahoo and Microsoft but the patent was being challenged in court. Any setback in court would have devastated Overture, and on account of the questions surrounding the ‘361 patent filing, the company had good reasons to expect a less than favorable outcome in court.

Overture initially tried to market itself to Microsoft. There was enthusiasm for acquiring Overture inside of Microsoft too. According to Fortune magazine, Chris Payne, a Microsoft manager, wanted Bill Gates to go ahead with an Overture acquisition. The deal made sense for both companies. Overture needed to hedge against setbacks in court and Microsoft needed to get into paid-search. Surprisingly, Bill Gates rejected the deal. Bill Gates must have seen the Overture deal primarily as a patent play and realized that Microsoft could not afford to enforce the ‘361 patent because of antitrust issues. However, Microsoft needed the patent for itself too and this is where Bill Gates miscalculated.

With Microsoft out, Overture was practically driven into Yahoo’s arms. Terry Semel at Yahoo had no qualms about enforcing patents, so he was able to justify a higher valuation for Overture than Bill Gates. In July 2003 Yahoo acquired Overture in a mostly stock deal valued at $1.63 billion. The purchase price amounted to more than 8.5 percent of Yahoo’s valuation at that time, but from Terry Semel’s perspective this was a sweet bargain for a chance to control the paid search market and make Yahoo relevant again.

Yahoo’s Overture acquisition completely cornered Microsoft in the paid-search market. Microsoft had been licensing the ‘361 patent and in doing so it had admitted to the patent being valid. Microsoft could still challenge the patent in court but it did not have a good case. Yahoo now effectively dictated what Microsoft could and could not do in the paid-search market. Microsoft’s only hope was the challenge to the ‘361 patent by Google and Miva.

The subsequent resolution of the ‘361 patent litigation did not lead to a favorable change in Microsoft’s position. In a very shady deal just before its IPO (more on this ahead), Google chose to settle with Yahoo. Google claimed to have won royalty free use of Yahoo’s paid search patents for around $300 million in stock, but Google’s own financial statements contradict this and suggest that of the $300 million settlement only around $30 million was for settling Yahoo’s patent claims. The rest of the money was compensation for settling a completely separate dispute.

Miva, the other ‘361 patent litigant, persisted with the litigation, and the case eventually went to trial in April 2005. In May 2005, the case resulted in a mistrial after a jury failed to reach a verdict. The marketing portal ClickZ reports on the Yahoo Miva trial:

A jury was unable to reach a verdict after deliberating since Friday in the U.S. District Court trial in California. The jury did find that FindWhat [Miva] infringed on 18 claims within the patent held by Yahoo Search Marketing (formerly Overture). They also found that FindWhat had proven six of those claims invalid during the trial, but they were unable to reach a decision on the 12 other claims.

The ClickZ report continues:

Judge Cormac J. Carney has scheduled a hearing for June 24, 2005. At that time, he may rule on the issue of inequitable conduct, and he could potentially enter the parts of the jury’s verdict where a decision was reached into the record, though he is not required to do so. The judge will not have a set time limit to make his decision, but he has generally tried to keep the trial moving quickly.

The jury found invalid two of the main claims in the patent describing the overall method of selling bid-for-placement search ads. If the judge accepts the jury’s decisions on those two claims, FindWhat, and the industry in general, will score a big win. Most of the remaining issues relate to lesser issues that could force FindWhat and others to alter the way they do business without changing it completely.

The above seems to be a middling outcome for both sides, but this is not so. Judge Cormac was in a position to dismiss the major claims of ‘361 patent, and there were reports in the media that he was inclined to do just that. Additionally, Judge Cormac was reported as favoring Miva in the inequitable conduct dispute about the ‘361 patent. Yahoo could have appealed an unfavorable ruling but such a ruling would have been a massive setback nevertheless.

Inexplicably, Yahoo pushed the Miva patent litigation to trial and was itself responsible for the ensuing fiasco. After settling with Google, Yahoo had patent licensing deals with all significant paid-search operators, and there was no obvious rationale for going after, at best, a marginal player.

Unsurprisingly, with the threat of a potentially devastating setback just around the corner, Yahoo relented and settled with Miva. Miva ended up paying Yahoo $8 million in cash and undisclosed royalties. Again, inexplicably, Yahoo insisted on getting royalties from a marginal player when it allowed Google to use the ‘361 patent royalty free.

The Miva settlement is all the more interesting because it directly contradicts Google’s claims of having settled with Yahoo for $300 million in stock with no ongoing royalties. (The settlement amounted to roughly $30 million according to Google’s own financial statements.) Both companies’ business models depended on having access to ‘361 patent, but Miva’s was less dependent on account of its having acquired paid-search assets overseas where the ‘361 patent could not be enforced. More importantly, Miva settled from a position of strength as Yahoo could not afford to have major claims of the ‘361 patent dismissed, but Google settled from a position of weakness as its IPO was at stake when it settled. Even ignoring the massive competitive threat Google posed to Yahoo, Google’s settlement should have been at least two orders of magnitude bigger than Miva’s on account of Google’s size, growth potential, and weak bargaining position.

The Miva settlement consolidated Yahoo’s control over Microsoft’s paid-search business. Microsoft’s subsequent experience with its adCenter paid-search product outlines just how extreme and damaging Yahoo’s control over paid-search became. An article published in May 2006 by The Register says:

Microsoft is taking on the great Google Money Machine with an inhouse answer to Google Adwords.

Step forward Microsoft adCenter, launched yesterday to pump out all-paid search traffic on MSN and other Microsoft online properties in the US. Microsoft’s adCenter replaces Yahoo!’s Overture as the paid-for search engine on MSN. The only surprise is how long it took Microsoft to make the switcheroo — predicted ever since Yahoo! bought Overture in 2003 — and confirmed this time last year by Microsoft at its annual MSN Strategic Account Summit.

Microsoft adCenter is already running in Singapore and France and will trial in the UK with select advertisers in June.

The Register reporter is unclear as to the reason for Microsoft adCenter roll out delay, but there was an obvious reason for the delay: Yahoo refused to license the ‘361 patent to Microsoft on terms agreeable to Microsoft. Typically US companies launch their products first in the US and then elsewhere but due to Yahoo’s persistent stalling Microsoft launched adCenter outside the US first where the ‘361 patent is not enforceable.

Microsoft’s launch of adCenter in the US does not imply that it managed to buy its way out of Yahoo’s influence. In fact, it did not. Terry Semel’s “I will not sell a piece of search” and “My impartial advice to Microsoft is that you have no chance” comments came less than ten days after Microsoft adCenter’s US debut. The timing of Terry Semel’s comments unequivocally conveys the information that the Microsoft Yahoo negotiations Terry Semel talked about in the New Yorker interview concerned Microsoft adCenter. The comments further suggest that Microsoft failed to win any concessions in the negotiations and Microsoft’s paid search operations are severely handicapped because of Yahoo imposed restrictions and licensing fees.

The paid search situation for Microsoft has not changed since then. Microsoft is still chafing under Yahoo’s influence and is desperate for unfettered access to the ‘361 patent. It is quite possible that the size of the royalties Microsoft is paying to Yahoo are forcing Microsoft to neglect its paid search operations in order to minimize payments to Yahoo, and to minimize the size of an eventual settlement with Yahoo.

Microsoft has kept on negotiating with Yahoo since Terry Semel’s interview back in 2006, and details of talks between the two companies have emerged from time to time. The peculiar thing about Microsoft Yahoo negotiations is Microsoft’s insistence on owning/co-owning Yahoo’s paid-search assets. This is odd as Microsoft only needs access to Yahoo’s paid-search patent portfolio. Microsoft has not stopped eyeing Yahoo’s paid-search assets even after the withdrawl of its acquisition bid for Yahoo, and recently Microsoft proposed yet again to buy Yahoo’s paid-search assets. The latest proposed deal asked for Yahoo to accept a $8 billion stock investment and $1 billion in cash from Microsoft in exchange for Yahoo’s paid-search assets.

As previously discussed the idea of Yahoo letting a competitor control Yahoo’s paid-search operations is nonsensical. In the latest proposal, Microsoft is spinning the idea as being beneficial to Yahoo. Microsoft is claiming that Yahoo can improve returns for its search operations by selling and out-sourcing all its paid-search operations to Microsoft. This rationale holds absolutely no water. It is like Toyota wanting to takeover General Motors’s manufacturing in order to improve margins for General Motors. Microsoft’s rationale is even more incomprehensible as Toyota can be relied on to deliver gains for General Motors, but Microsoft is itself struggling in paid-search and can not possibly deliver any long term gains to Yahoo. The whole gains argument is a recent invention anyway, and can not explain why Microsoft has been trying to co-own Yahoo’s paid-search operations since even before its in-house paid-search infrastructure was operational.

Yahoo had little choice but to reject Microsoft’s terms. The money Microsoft offered may have been good in the short-term but it was questionable if Yahoo could have stayed independent after losing its search assets. Additionally, Yahoo managed to arrange a better deal with Google that does not involve Google co-owning/buying Yahoo’s paid-search assets and actually improves Yahoo’s paid-search monetization. Surprisingly, Microsoft instead of proposing a more competitive deal has been busy trying to subvert the Yahoo Google deal by raising antitrust concerns, and even seems to have succeeded at getting the US Department of Justice to investigate the Yahoo Google ad deal.

Microsoft is completely aware of the ludicrousness of its attempts to buy Yahoo’s paid-search assets and Microsoft’s earlier acquisition bid seems to have been an attempt to soften up Yahoo’s opposition to a paid-search asset acquisition. Microsoft’s publicized $31 a share bid was preceded by an unpublicized $40 a share bid in January of 2007. The initial $40 bid seems to have conveyed the message that if Yahoo refuses to let Microsoft co-own paid search, it can expect a public bid from Microsoft at some inopportune time, and consequent trouble from share-holders and corporate raiders. Yahoo responded to the threat by handing over the CEO job to Jerry Yang, a founder and a major shareholder, and attempting to shore up its share price by cost-cutting. Of course, this did not help and eventually Yahoo’s share price fell to a point where Microsoft felt that it could make a safe play for Yahoo’s paid search assets.

Microsoft’s $31 a share bid could not have gone through, so it was no surprise it got retracted. However, this was not the end of Microsoft’s play for Yahoo’s paid search assets. Microsoft seems to have waited for corporate raider Carl Icahn to buy into Yahoo before retracting its bid. Additionally, Microsoft disclosed the terms of its made-to-be-rejected $9 billion offer for Yahoo’s paid-search assets after Yahoo declined the offer. This particular action can only be interpreted as a thinly veiled invitation for corporate raiders to target Yahoo. The idea at Microsoft seems to be to dangle carrots in front of corporate raiders to get them to buy large chunks of Yahoo and force changes in the composition of Yahoo’s management. Microsoft is hoping that eventually the composition of Yahoo’s management will change enough that Microsoft will be able to push the paid-search asset acquisition deal it wants.

Interestingly, Yahoo’s refusal to sell paid-search assets is perfectly understandable, but its persistent refusal to license its paid-search portfolio to Microsoft is not. Microsoft is a distant third in the paid-search market, and it is not obvious why Yahoo doesn’t get Microsoft and the Microsoft sponsored corporate raiders off its back by licensing Microsoft the paid-search patents it needs. After all Microsoft only needs Yahoo’s paid-search portfolio and can do without Yahoo’s paid-search assets. Also, didn’t Yahoo grant its biggest competitor Google a royalty free license to its paid-search patents for a mere pittance?

Actually, Yahoo has gotten into a situation where it would be happy to license Microsoft the patents it wants, but it can not do that. Relenting on patent licensing terms is not an option for Yahoo. Remember Miva? Miva was the niche paid-search operator who almost prevailed in court but even then Yahoo insisted on collecting patent royalties from it. The reason for Yahoo’s obstinance with licensing terms is obvious: it can not give anyone a good patent licensing deal in isolation. Giving someone a good deal will trigger an escape clause in a lucrative patent licensing agreement with a big fish third-party, allowing that patent licensee the better terms as well.

Microsoft is perfectly aware of Yahoo’s constraints. Microsoft knows who the big fish is and understands that it cannot compensate Yahoo for the loss that would result from Yahoo giving Microsoft good paid-search patent licensing terms, so it is not even proposing to license Yahoo’s patents. Instead, it is proposing to buy/co-own Yahoo’s paid-search operations. The motivation behind such a convoluted structuring of what could have been a simple patent licensing agreement is to subvert escape clauses in Yahoo’s lucrative patent licensing with its big fish patent licensee.

There is another reason for structuring the deal that way. Microsoft believes that by being clever about the deal terms Microsoft can practically get Yahoo’s big fish patent licensee to fully reimburse Microsoft for whatever Microsoft pays for Yahoo’s paid search assets.

So, who is Yahoo’s big fish patent licensee, and why would it compensate Microsoft for buying Yahoo’s assets? There are only three major paid-search players: Yahoo, Microsoft, and Google. Clearly, the big fish is one of them, and it is not Yahoo. It can not be Microsoft either. By simple elimination it has to be Google. Google though claims to have obtained a perpetual royalty-free license to Yahoo’s paid-search patents for a one-time payment. Surely, Google can not be the big fish?

Google may have done a lot of things right but its paid-search patent settlement with Yahoo is not one of them. Too many fingers point to Google hiding a monster of a bad deal from the public. First, Google was evasive about its paid search patent settlement with Yahoo and tried to pass-off the impression that it paid $300 million in stock for licensing Yahoo’s paid-search patents; however, Google’s own financial statements contradict this and prove that Google only paid an unbelievable $30 million or so in stock for Yahoo’s patents. Second, Yahoo’s financial statements confirm that Google only paid around $30 million as payment for patent licenses. Third, even the $300 million Google says it paid for patent-licensing was too low in the context of the Miva settlement. Fourth, the control Yahoo exercised over Microsoft’s paid-search operations and Terry Semel’s comments clearly indicate that Yahoo did not grant a good patent licensing deal to anyone. Fifth, Microsoft is willing to spend billions to secure access to the very same patents that Google says it got for next to nothing.

Google does have a perpetual royalty-free license, but $30 million was not all Google paid for the license. Evidently, Google is hiding some material terms of its patent settlement with Yahoo from the general public and its investors. Google had a legal obligation to disclose anything material that was likely to influence its future business operations, but Google’s management subverted that obligation. It seems that the terms Google did not disclose were covered by a “grace period” of several years during which Google got free use of the patent, and escape clauses; so back in 2004, Google’s management under pressure of an imminent IPO convinced itself that the terms covered by the grace period were unlikely if ever to come into play even after the grace period ended, and so were immaterial and did not need to be disclosed. The thinking at Google must have been that either the ‘361 patent is not going to hold-up in court, or Miva is going to extract a good settlement out of Yahoo triggering escape clauses in the agreement, or somebody else is going to get a good deal out of Yahoo.

Google may have been helped in its decision not to disclose all the terms of the deal by Yahoo. Yahoo was patent trolling, and must have wanted to avoid scrutiny of its patent licensing deals. Additionally, Yahoo may have wanted to avoid disclosure of the escape clauses and the grace period in order to keep this information secret from its other patent licensees.

Yahoo may have had legitimate reasons for keeping the settlement terms secret but Google didn’t. Google’s rationale was just self-serving thinking: Yahoo had too much to lose in case the escape clauses triggered and it structured all its paid-search licensing deals to ensure that the escape clauses did not trigger.

The actual terms of the Google Yahoo patent settlement are largely academic now. Yahoo understands that there is no simple way for it to enforce the original terms of the agreement. If Yahoo tries to publicize or enforce the original terms of the agreement in order to get a share price boost, Google will flatly dispute owing anything to Yahoo. Admitting to all the material terms of the patent settlement with Yahoo is not an option for Google as this is tantamount to admitting to fraud. Instead, Google will prefer to assert that Yahoo is misinterpreting the terms of the patent settlement because of greed and desperation. Consequently, a flood of negative PR will get unleashed at Yahoo and the media will be happy to denounce Yahoo as a patent troll (which happens to be true). Additionally, this may result in renewed legal challenges to the ‘361 patent or a review of the patent by the patent office. Under such a scenario Yahoo will be forced to go to court in order to resolve the dispute, but courts move slowly and are unpredictable. Yahoo may manage to destroy Google by going to court but it is uncertain if it will recover anything substantial anytime soon.

The other option for Yahoo, which it seems to be pursuing, is to ask Google to quietly compensate it. Google can structure the compensation as an investment similar to the $9 billion deal Microsoft offered for Yahoo’s paid search assets. Basically, Google can acquire 20-30 percent of Yahoo at an inflated price as a “strategic investment”, and decline all voting rights to the stock in order to avoid antitrust scrutiny. Of course, after getting a generous enough compensation Yahoo will forget all about the problem licensing terms.

The problem for both Yahoo and Google is that Microsoft wants to force itself into the deal. Microsoft knows that it can block any compensation deal between Yahoo and Google by beating up the antitrust drum. Microsoft is using this as leverage to goad Yahoo into selling its paid-search assets. Essentially, Microsoft has conveyed to Yahoo that there can be no payday for Yahoo if Microsoft does not get Yahoo’s paid-search assets, but if Yahoo acts sensibly Microsoft can conveniently look the other way when Google comes knocking with the ransom.

Not only that, but Microsoft is actively positioning itself to benefit from any cash infusion from Google in Yahoo. The $9 billion deal Microsoft offered to Yahoo asked for Microsoft buying $8 billion in Yahoo stock at $35 a share. This amounts to 228.5 million shares of Yahoo. The $35 a share may seem like a good premium for Yahoo shares but it really isn’t for three reasons. First, the premium should be calculated with reference to the average price of Yahoo shares in the months preceding the Microsoft bid, and not the $19.18 closing price on January 31st, and this would raise the reference price to around $25. Second, after a cash infusion from Microsoft at $35 a share, Yahoo shares will become more valuable. Third, Yahoo’s share price does not reflect the value of Yahoo’s Google deal, but once Yahoo accepts Microsoft’s terms, the Google deal will become a certainty.

Now, if Microsoft manages to get such a deal from Yahoo, Yahoo’s share price will immediately pop to around $30. If Microsoft were to sell its Yahoo stake at this point (which won’t be possible) Microsoft will have effectively paid less than $2.5 billion for Yahoo’s search assets. This is an awesomely sweet deal by itself, but this is not all Microsoft will be getting.

The Microsoft deal will be quickly followed by rumors of Google acquiring a stake in Yahoo, and this will likely result in further upwards momentum for Yahoo’s stock. Eventually, once Yahoo’s stock has hit a suitable high of around $36-40, Google will come through with its “strategic investment” to “counterbalance” Microsoft’s influence at Yahoo. Google will likely buy around 25 percent of Yahoo at more than $50 a share, and this will raise Yahoo’s share price above $40. If at that point Microsoft chooses to exit Yahoo, it will realize a gain in excess of $1.14 billion on its 228.5 million Yahoo shares. So even if Microsoft in addition to its $8 billion stock investment pays Yahoo $1 billion for Yahoo’s search assets, overall it will come out ahead with a gain in excess of $140 million.

Microsoft is unlikely to exit Yahoo in order to make its gains concrete, but the above sequence of events is central to Microsoft’s strategy. Microsoft is counting on the huge gap that exists between Yahoo’s current valuation and Yahoo’s potential valuation if it sells its paid-search assets to Microsoft. Microsoft is hoping that by quietly advertising the gap in Yahoo’s valuation and the associated loot to be had, it can get corporate raiders and short-term profit seekers to flock to Yahoo and force Yahoo management’s hand.

So far Microsoft has only had limited success getting corporate raiders do its bidding. The problem for Microsoft is that it has to be discreet; otherwise, some of its executives might end-up behind bars for conspiracy to manipulate Yahoo’s stock. Fortunately for Microsoft, Yahoo does not have many options and Microsoft has plenty of time to get its act right.

Yahoo has mostly itself to blame for the situation. The terms Microsoft is offering for Yahoo’s paid-search assets are incredibly harsh and humiliating, but Microsoft is unlikely to sweeten them. The original deal Microsoft proposed in 2006 involved Microsoft “co-owning” and not outright owning Yahoo’s paid-search assets but Terry Semel dismissed it. Since then Yahoo’s management has proven completely hostile to Microsoft overtures and has been unwilling to make concessions. Consequently, Microsoft does not owe Yahoo any favors and it has “earned” the right to own Yahoo’s paid-search assets. Besides, if Microsoft offers a decent deal it may lead to a rise in Yahoo’s share-price and release pressure on Yahoo’s management.

Some rumors suggest Yahoo maybe seeking a merger with a third-party but it is unclear how such a merger will help Yahoo collect the “dues” from Google. Such an attempt can only help Microsoft as it can join the deal by offering to unlock Yahoo’s hidden value in exchange for Yahoo’s paid-search assets. The only thing Yahoo can do is to get Google to bid for its non-search assets, and collect its “dues” that way. Effectively, Yahoo can try to sacrifice some of its non-core assets to save paid-search; however, Microsoft may get antitrust regulators to block that exit as well.

Currently, there seems to be stalemate. Yahoo is under siege but it is not yielding, and Microsoft can’t afford to back off. Time though is on Microsoft’s side. If Yahoo fails to extricate itself from the siege quickly, it may only be a question of how much Microsoft gets paid for taking over Yahoo’s paid-search assets.

LAST UPDATED by Usman Latif  [Jul 07, 2008]

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