Yahooligans at the Window

As a veteran of the technology world, Yahoo!'s chairman, Jerry Yang, certainly knows how relentless the software giant Microsoft can be. If he had by some chance forgotten it, the phone call he received last Thursday night would have been a handy memory jogger. On the other end of the line was Microsoft CEO Steve Ballmer, who had, during late 2006 and early 2007, vigorously pitched the concept of joining forces, the better to take on the whirlwind search and advertising success of archrival Google. Last February, Yang wrote Ballmer that "now is not the right time to enter into discussions regarding an acquisition transaction." A year later Ballmer was back, telling Yang that Microsoft had unilaterally concluded the time was right. Like it or not, Microsoft was preparing a public offer of $44.6 billion to buy Yahoo, a seemingly irresistible 62 percent premium over the firm's current stock price.

Yang was noncommittal, and after Ballmer announced the offer the next day (Microsoft chairman Bill Gates, due to leave full-time duty in July, wasn't present), Yahoo said only that its board would "evaluate this unsolicited proposal carefully and promptly." But most observers believe that Microsoft's monster offer will force Yahoo to accept, barring the entry of another bidder with $45 billion of spare change in its pocket. This means a mash-up of two household names in technology, both with products that hundreds of millions access every day. The company Microsoft proposes to swallow is an online destination boasting more than 400 million registered users who visit its portal, use its e-mail service, groove to its music and use its social photo-sharing service to swap pictures. If Microsoft holds to its timetable, it will claim its trophy before the next president takes office. Following every turn will be customers of the Internet's No. 1 business-information site: Yahoo Finance.

Driving all this is the wild success of Google, which claims the lion's share of the $40 billion spent yearly in online advertising, a market slated to double in the next two years. Google's dominance in the field (about six of every 10 searches are Googly) is based on a combination of strong tech, simple interface and self-sustaining momentum, and makes competitors feel the way Microsoft's rivals used to feel concerning office apps before most of them went off somewhere to die. Microsoft is promoting the merger as a last chance to thwart the Googlers.

But this is not a case of two struggling companies joining forces against a big bad bully who rules the neighborhood. By taking over Yahoo, Microsoft instantly makes itself the world's biggest online power, with the ability to amplify the reach of its other properties, including the "cloud" applications (which run on the Internet, as opposed to your computer) that many consider the future of software. For more than a decade, Microsoft has been building up its Internet assets, but it still loses money on them (a 2007 deficit of $700 million). In an instant, it becomes dominant in several online categories and mitigates its losses. (Yahoo made $4 billion last year.) According to the Hitwise measuring service, Microsoft is No. 2 in the United States in portal front pages—a vital statistic, since those send users directly to favored sites and services—with a 15 percent market share. Add Yahoo's page hits, and that rises to an 87 percent share. In Web-based e-mail, Microsoft's share would rise from 25 percent to 80 percent (Google's Gmail has a 5 percent share). Because Yahoo draws customers with lots of other services, pairing its assets with those of Microsoft will have broad effects on a variety of companies.

These advantages may well raise regulatory concerns. "I assume that the Federal Trade Commission will look at this, as well as the Antitrust Division of the DOJ, as well as the Europeans," says University of Richmond School of Law professor Carl Tobias. (The Department of Justice and the Senate antitrust subcommittee have indeed said they would look at the merger.)

In a statement, Microsoft claims "the proposed combination would receive all necessary regulatory approvals." That's a bold exclamation for a company that decisively lost a huge antitrust case filed in 1998 concerning its operating-system monopoly; only last week federal Judge Colleen Kollar-Kotelly extended government oversight of Microsoft until November 2009. But Microsoft's general counsel, Brad Smith, says that people will understand that this takeover is all about giving advertising customers a necessary alternative to Google. "Regulators look to what companies in the industry who aren't competitors say about a merger," Smith says. "In this case, companies are telling us, 'Please get together with Yahoo, if that's what it would take [to hold back Google]'."

Still, there is no guarantee that the combined search efforts of Microsoft and Yahoo will make more headway against Google than the companies did competing separately. Both Microsoft and Yahoo have been engaged in full-tilt efforts for years to improve their search engines and the ad platforms that draw money from search. Both insist that their search results are every bit as relevant as Google's, and pull out studies to bolster their claims. Yet Google keeps extending its lead. Clearly neither company is employing the minds that will bring down Google—so why would getting those minds together work any better? In the short term, there will also be the time-consuming and difficult job of merging the two search teams. Microsoft cites its recent acquisitions of the advertising company aQuantive and the voice-recognition firm Tellme as proof it can deftly integrate outsiders, but blending in the freewheeling "purple lifers" of Yahoo is going to be more of a challenge.

It's true that the merged search engines might be able to take advantage of a more powerful and efficient infrastructure of data centers, but that in itself isn't going to draw traffic. As far as the consumer is concerned, of course, the merger means less choice in search, as the second- and third-place engines behind Google would now be a single entity.

After announcing the proposal, Microsoft's Ballmer sent a missive to all Softies crowing about this "major milestone." Yet despite his ebullience, the Microsoft Yahoo takeover is a feel-bad story. The move is a $44.6 billion admission of utter failure in Microsoft's efforts to fight Google on its own.

The really depressing part of the tale is the fate of Yahoo, which at one time was one of the more enchanting entrepreneurial narratives of the Internet age. In 1994, Stanford grad students Jerry Yang and David Filo came up with a novel idea to classify the exploding number of sites on this newfangled thing called the World Wide Web. They named it "Yet Another Hierarchical Officious Oracle," wisely choosing to shorten this to its acronym. Yahoo got $1 million in venture capital and was among the first to accept online advertising. In 1996, it became one of the biggest Internet IPOs. During the peak of the boom, it was worth more than $100 billion. At one point Yahoo used the search technology of a company founded by slightly younger Stanford graduate students named Sergey and Larry (oops).

After taking a hit in the dotcom bust, Yahoo hired former Hollywood studio head Terry Semel, who helped bolster Yahoo's numbers but failed to respond to Google's search lead. This led to his departure last year, and Yang's return to the helm. At the Consumer Electronics Show in January, Yang promised an overhaul. But quarterly results released last month were so dismal that the stock price tumbled.

This made it a no-brainer for Microsoft to revisit its attempts to capture the treasure of a fabled Internet power. Yang could not have been surprised to see who was calling.