Microsoft has offered to buy Yahoo for around US$44.6 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 today, Ballmer 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.
The market for online advertising is increasingly dominated by one player, Microsoft said, and merging with Yahoo will allow it to offer a competitive alternative.
Yahoo's board first approached Microsoft, in February 2007, Microsoft said, but Yahoo, in a statement, said Microsoft's proposal was described as unsolicited. The Yahoo its board will carefully evaluate the proposal, the statement added.
Microsoft expects the market for online advertising to almost double in size over the next three years, from £20bn in 2007 to £40bn by 2010. A merger will allow it to realise economies of scale and reduce capital costs as it addresses this market, it said.
"The combination of these two great teams would enable us to jointly deliver a broad range of new experiences to our customers that neither of us would have achieved on our own," said Ray Ozzie, chief software architect at Microsoft, in a statement.
Microsoft expects to cut costs by £500m a year through 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.
Nick Patience, managing analyst at The 451 Group said, “This combination comes a day after Google's first sign of a financial misstep after it missed Q4 estimates, but Google is still the reason for this move. Google dominates Web search, and this would combine the number two and three players in that field.
“Microsoft also sees Google encroaching on its desktop productivity business and neither Microsoft nor Yahoo have done much to counter that yet, plus both are battling Google for leadership of the online advertising business.”
Microsoft wants the companies to work together to develop the merger plan, and intends to incentivise 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.
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, Yahoo has struggled. It has endured 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.
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, he said.
Yahoo didn't immediately reply to requests for comment.