Microsoft has offered to buy Yahoo for around US$44.6 billion (NZ$56.2 billion) in cash and shares, to better compete with Google in the market for online services.
CEO Steve Ballmer made the offer in a letter to Yahoo's board of directors on Thursday, telling the board that he would release the letter Friday morning.
On a conference call Friday, Microsoft's President of its Platforms & Services Division Kevin Johnson called a combination of Microsoft and Yahoo a more "credible" alternative to Google in the online advertising and services market.
"By combining the assets of Microsoft and Yahoo we can offer a more competitive choice for consumers, advertisers and publishers," he said.
It was Yahoo's board that first approached Microsoft, in February 2007, Microsoft said.
Yahoo, in a statement, said its board will carefully evaluate Microsoft's proposal, which it described as unsolicited.
Microsoft expects the market for online advertising to almost double in size over the next three years, from US$40 billion in 2007 to US$80 billion by 2010. A merger will allow it to realise economies of scale and reduce capital costs as it addresses this market, it said.
Microsoft expects to cut costs by US$1 billion a year by realising synergies with Yahoo in four areas: obtaining economies of scale as its audience increases; combining its research and development efforts with Yahoo's to innovate faster; eliminating operational redundancy to cut costs, and pooling expertise to innovate in video and mobile.
The companies will work together to develop the merger plan, Microsoft said.
It intends to pay key Yahoo engineers and other staff to stay following the merger.
The offer represents a 62% premium over Yahoo's closing price on Thursday. Microsoft expects to receive all necessary approvals in the second half of this year.
Despite the potential for short-term gain, Yahoo, in its statement, said its goal will be to maximise long-term value for shareholders.
At this premium, even if Yahoo's top managers were opposed to the acquisition, Yahoo's board of directors has an obligation to consider the offer on behalf of shareholders, said industry analyst Greg Sterling from Sterling Market Intelligence.
At the same time, now that Microsoft has made its move, it wouldn't be surprising to see other suitors jump in and make competing bids for Yahoo, Sterling said.
Unless Microsoft were to run Yahoo like an independent unit, there will be significant areas of overlap that would need to be integrated.
"If Microsoft were to seek a more integrated company [with Yahoo], certain products or brands would be favored and others discontinued," Sterling said.
Still, a joint Microsoft-Yahoo would from day one be a formidable player in display advertising and mobile Internet services, he said.
Ever since the first rumblings about a possible acquisition of Yahoo by Microsoft, things have gone downhill for Yahoo, including several reorganisations and management shakeups, so the deal appears more plausible today, Sterling said.
At the same time, despite considerable investments, Microsoft hasn't made as much progress in search engine advertising and usage as it had hoped, he said.
This is something Ballmer acknowledged candidly on Friday's conference call, though the company had been trying to paint a rosy picture of its online advertising market growth since it acquired digital media services firm aQuantive last year. However, the company's online services business has long suffered from lackluster performance, something he said should change once Yahoo is on board.
"We've been losing money [in online services], our plan here is not to lose money in the future," Ballmer said.
A combined Microsoft-Yahoo would improve their respective positions in the search market, but still wouldn't top Google, which has a dominant lead both in search engine usage and advertising, Sterling said.
As Microsoft seeks to grow its online advertising business, it needs to achieve "critical mass" in three key segments - advertisers, publishers and consumers, Ballmer said. While Microsoft's aQuantive acquisition boosted the advertiser and publisher rosters, a Yahoo acquisition would significantly bolster the consumer piece of the strategy.
"We see this announcement as the next major milestone in Microsoft's company-wide transformation to embrace online services overall and to invest very successfully in search and advertising," Ballmer said.
He also pointed out that gaining Yahoo's experience and staff in Internet research and development will help Microsoft advance its push to web-enable its core products like Windows and Office.
"The Windows user wants to be live, the Windows experience needs to increasingly embrace the internet. There will be a Windows Live, there will be an Office Live, as we continue to bring out innovations in which Office transforms and is transformed by the internet," Ballmer said, in a clear reference to the rising popularity of web-hosted productivity software like Google Apps, Zoho and Yahoo's Zimbra.
Microsoft has often been criticised for how slow it's moved to shed its legacy of desktop software to keep up with the innovations of Web 2.0. The addition of Yahoo could indeed help the company do that, if Microsoft takes full advantage of the deal and uses it to alter its current course, said Ron Schmelzer, analyst and managing partner at Zapthink.
"This has to be transformative across all areas of Microsoft," he said.
Ray Ozzie, Microsoft's chief software architect, said Yahoo will help the company fortify its search engine technology and advertising business, an area that he said is ripe for innovation, implying that Microsoft hasn't conceded defeat to Google in search.
"Search now plays a pivotal role in how we find information, how we research, how we shop. For the most part, search is still 10 blue links, but innovations will transform the search user experience and the way ads are delivered," he said.
With Yahoo, Microsoft will also become a stronger player in the so-called social web and will be able to innovate and develop better social applications and platforms not only in the consumer space but also in the workplace, Ozzie said, referring to the popularity of social networks and blogs.
"This social platform will progressively become a new entry point to all that the web can offer. Before long, these same technologies will even transform the productivity side of our lives as the social platform enters the workplace," he said.
Chris Liddell, Microsoft's chief financial officer, said the offer translates into a premium of more than 100% if one takes into consideration that a large part of Yahoo's value lies in non-operating business, meaning essentially, in external investments. "When you look at our offer relative to operating assets it's greater than a hundred percent premium," Liddell said.
Johnson highlighted the importance for Microsoft of achieving scale in online advertising.
"In the online advertising industry, scale matters. Scale economics come into play in driving yield of ad serving whether it's search or non-search related ads. By aggregating a critical mass of inventory on a single ad platform it enables that ad platform to drive higher yields for the publishers," Johnson said.
(Peter Sayer in Paris contributed to this story.