By Yi-Wyn Yen

Shares of Yahoo spiked more than 6% in afternoon trading Tuesday as a CNBC report said that billionaire activist Carl Icahn is “mulling” the idea of leading a shareholder revolt to oust the company’s board of directors.

“There’s every chance in the world that the stock is being influenced by the speculation of Carl Icahn,” said S&P Internet analyst Scott Kessler.

Yahoo’s board has come under fire from shareholders since Microsoft (MSFT) walked away from the $47.5 billion deal. Should Icahn lead an activist charge and convince enough shareholders that he can nominate a slate that would favor a sale to Microsoft, the move could signal Microsoft to resurrect its offer to buy Yahoo (YHOO).

A call placed to Icahn’s office was not immediately returned.

Icahn would need at least a 5% stake of Yahoo’s shares to run a proxy fight. Some major Yahoo shareholders have signaled they’d be willing to back a hedge fund activist to lead a campaign to bring Microsoft back. Microsoft raised its offer from $31 to $33 in the final days before walking away.

“If I were an activist, the first call I’d make would be to Microsoft and make sure that offer of $33 would still be available,” Kessler said.

During the three-month saga, Microsoft CEO Steve Ballmer threatened to go hostile and launch a proxy fight to remove Yahoo’s board if the company didn’t accept its offer of $33 a share. Then on May 3, Ballmer withdrew the offer and said the company planned to pursue alternatives to beef up its online advertising business. Last week, Microsoft also released the proxy firm it had hired to go after Yahoo.

The deadline for Icahn or any other activist to run an alternate slate of directors is May 15.

By Michael V. Copeland

The last time Microsoft walked away from a major acquisition was more than a decade ago. It was 1995 and a $2 billion bid to buy financial software company Intuit fell apart under scrutiny from the U.S. Department of Justice. While there are clear differences between Microsoft’s Intuit deal and its failed attempt to buy Yahoo, a look at what happened within Microsoft after the Intuit bid collapsed offers a preview how things might play out now.

Intuit (INTU) makes Quicken, the leading personal financial software program. And before trying to buy Intuit, Microsoft had tried to beat it with its own software program, Microsoft Money. Microsoft (MSFT) launched Money in 1991 as a way to get a bigger chunk of the consumer software business (Microsoft Office was yet to come to market), and specifically to get a piece of computerized banking. Personal finance was one of the tasks that helped drive personal computer sales. Think back: in the pre-Internet era of the early ‘90s, a PC let you write documents, build a spreadsheet, and track your spending - that was about it.

Microsoft Money did not capture the hearts and checkbooks of anyone, and became a perennial also-ran (not unlike Microsoft’s web effort MSN). Quicken captured about 90% of the market, the rest was divided among three or four other players including Microsoft’s Money. By 1994, Microsoft was done playing around. Rather than try to beat Intuit, it would simply buy it. Here’s how it went down according to several former Money folks.

On a morning in October1994 everyone on the Money team received a phone call at around 7 a.m., telling them to be at a work by 8 a.m. No explanations. At 8 a.m. an unmarked bus rolls up to the Microsoft campus, and the money team is told to get in. No explanations. The team is deposited in a drab conference room at a Bellevue, Wash., hotel and told to wait. No explanations. About 45 minutes later Bill Gates walks in and explains that Microsoft is about to announce its intention to buy Intuit, and answers a few questions. The Money team waits at the hotel until the market closes.

But Gates and his team knew that there might be anti-competitive flags raised. The weirdest part of whole day was the explanation that not only did Gates want to replace the Money product with Quicken, but to do that Microsoft needed to sell off a new version of Money to Novell and therefore sidestep what were likely be complaints from the Justice Department. So the Money team had to get back to work on a product that Microsoft didn’t really want, to buy a company it did want. (Again, what are you thinking if you are hunkered down at MSN?)

Unlike Yahoo (YHOO), Intuit Chairman Scott Cook agreed to the purchase. (Though according to some on the Money team, it was implied that if had not he and Intuit would face the full Microsoft Death Star fury, that is, they would put everything they had smarts-wise and money-wise in to beating Quicken if he didn’t acquiesce.) It was left to the Department of Justice to raise enough questions that it became obvious to Gates and his team that fighting a protracted battle to buy Intuit might ultimately fail, and in the process kill off whatever audience Microsoft Money had. So Gates bailed on Intuit.

That didn’t mean he bailed on the space, and here is where you are likely to see a similar push post-Yahoo (if it is indeed over). Microsoft took all its focus and much of its money and doubled down on Money. The product improved dramatically. Money 1995 actually found an audience, and all the sudden it was a two-horse race with Intuit. Money grabbed about 35% to 40% of the market, Quicken the rest.

MSN in many ways is like Microsoft Money - it has never been on top. But the culture at Microsoft has always been one of intelligence if not arrogance. It doesn’t matter if MSN isn’t on top, there is a belief that Microsoft’s bench will figure out a way to put it there. “People at Microsoft still believe that they are smarter than everyone else,” says one former Money team member who asked not to be identified. “So just because the current team hasn’t unlocked the door to the Web, doesn’t mean another team won’t. And if they do, they’ll be heroes.”

If the Yahoo deal is indeed dead, you can bet that MSN will get the people and the resources it needs to make a run at Yahoo and in the grander scheme, Google (GOOG). Microsoft has already shown its commitment - $46 billion worth in the Yahoo bid - putting up a real contender in the fight for the web. As with Microsoft Money it’s likely to double, quadruple down it’s own efforts. But as one former Money team member points out, the question is, can Microsoft win or just put up a good fight?

“The epilogue is, as good as we all thought it was, as much progress as we made, Money never became the dominant player,” says Jan Miksovsky, the lead designer on Money 1995 and part of the Money team through 2000. “Intuit remained the market leader and has gotten stronger in other areas. When I look back I was personally gratified to see the Intuit deal fall apart, says Miksovsky, who went on to co-found online calendaring startup Cozi. “But my sense now is that Microsoft would have been in a much stronger position had the deal gone through and they acquired Intuit.”

The question for Microsoft now is, can MSN battle Google with the team and the audience it has or does it remain an also-ran. You will see Microsoft make a move within MSN to catch its competition - it has to. But it needs to be at a pace that will allow the software giant to catch up, and fast.

By Yi-Wyn Yen

Google may be getting cold feet. In a last-ditch effort to avoid a merger with Microsoft, Yahoo said it was considering teaming with Google in a search advertising deal. But some Google executives are now questioning whether that’s a good idea, the Wall Street Journal reported Thursday.

One major hurdle: A Google-Yahoo tieup could face tough scrutiny from regulators in Washington and the European Union. Last month Yahoo (YHOO) ran a two-week test displaying some of Google’s (GOOG) search ads on Yahoo’s homepage. Both Yahoo and Google executives said the experiment went well. The two are reportedly in talks to outsource Google’s search technology in a non-exclusive arrangement.

Spokespeople from both Google and Yahoo declined to comment.

Google may have wedged its way into the mix in order to break up Microsoft (MSFT) and Yahoo. Microsoft CEO Steve Ballmer admitted that Google was a factor when the software giant walked away from its $47.5 billion offer last Saturday. In a letter to Yahoo CEO Jerry Yang, Ballmer said his company would not be willing to deal with the “host of regulatory and legal problems” that it would inevitably inherit if Yahoo partnered with Google.

Last month Microsoft’s general counsel Brad Smith lashed out at the two big Internet sites for partnering even in a limited test. He argued that a Google-Yahoo combo would give Google a 90% share of online search advertising and that “this would make the market far less competitive. It would be fair to say that Microsoft would aggressively lobby against a long-term partnership between Google and Yahoo.

Microsoft was one of Google’s biggest detractors when the search giant said it was going to buy DoubleClick, the top firm in online display advertising. Google got approval from both the Federal Trade Commission and the European Committee to acquire DoubleClick, but the approval took the big G nearly a whole year.

Both the FTC and the European Committee ruled that text-based search advertising and display advertising, which is the preferred way that big brands like to advertise, are two different markets, and therefore the merger was not anticompetitive. But regulators may be more wary if the two biggest players in search want to team up.

“Google has incredible chutzpa,” said Jeffrey Chester, the executive director of the Center for Digital Democracy. The public interest group had opposed Google’s DoubleClick deal because it would give Google an overwhelming lead in online advertising.

Chester said both Microsoft and Google have approached him to support their political message on the Hill. He has not yet endorsed either party, and is waiting for a deal - whether it’s Microsoft and Yahoo or Google and Yahoo - to be announced.

However, Chester said he is wary of a Google-Yahoo tieup. “Whatever happens, we don’t want Google to operate Yahoo out of its back pocket,” Chester said. “Whether or not regulators do something about it, we’ll do something.”

By Scott Moritz

Yahoo (YHOO) chief Jerry Yang has lost a deal and gained some enemies.

Yes, Microsoft (MSFT) walked away from the proposed blockbuster merger - but no, the new enemy is not Microsoft CEO Steve Ballmer.

Instead, it’s Gordon Crawford of Capital Research Global Investors, a holder of 6% of Yahoo’s shares.

Crawford voiced his extreme disappointment in Yang in press reports, including a piece in Tuesday’s Wall Street Journal taking direct aim at Yang and his hamhanded treatment of the Microsoft offer. “I think he overplayed a weak hand,” Crawford told the Journal.

He’s not alone. Other Yahoo investors have taken issue with the way Yang tried to hardball his way to a higher bid.

“This $37 price was ridiculous,” said one Yahoo investor referring to Yang’s deal-breaking counter offer to Ballmer in Seattle on Saturday. “I would have had no problem taking the thing at $31,” the investor said.

Yang has since protested that the $37 pitch was merely a starting point to get the talks going. But after three months, two rejections and a ad outsourcing pact with rival Google (GOOG), Microsoft’s Ballmer decided to use Yang’s starter as an end to the discussions.

The move puts Yang under the spotlight as big investors and small watched Yahoo’s value shrink - on Monday, the stock closed 15% below its closing price Friday.

“This is a clear example where the management didn’t have the best interest of the shareholders at heart. I think a lot of shareholders would have been very happy to do this deal at $33,” said Jacob Internet Fund manager and Yahoo shareholder Darren Chervitz, in Fortune Techland story Monday.

Another big stakeholder, Bill Miller of Legg Mason, whose firm swung to a $256 million loss in the first quarter on bad bets in Countrywide and Bear Stearns, is also feeling the pressure of having more than a 6% position in Yahoo. Miller told Bloomberg that he’s holding out hope that Microsoft and Yahoo can rekindle the discussions.

“There’s probably a lot of people jumping up and down today,” Miller told Bloomberg.

He expects Microsoft to come back. “If I’m sitting in their shoes, I’ll go away and see what happens,” Miller said . “I can come back and the worst case is, I’ll pay six months more of my free cash flow.”

For Microsoft, while the software giant may have averted overpaying for Yahoo, it hasn’t solved the bigger problem: How to compete with Google for the Internet advertising bounty.

Meanwhile, Yang and Yahoo will have a chance to feel some of the investor blowback at the annual shareholder meeting scheduled for July 3.

Observers such as Fortune’s Go West columnist Adam Lashinsky ask: “What will happen to Yahoo’s board? Will angry shareholders kick out its value-destroying board?”

By Yi-Wyn Yen

The deadline that Microsoft set three weeks ago for Yahoo (YHOO) to accept its buyout offer passed this weekend without either side making a move. While some analysts expect Microsoft to launch a hostile bid, it’s possible that CEO Steve Ballmer will follow through on his threat and walk away from the deal.

The three-month-old battle between Microsoft and Yahoo could come to a head fast. Yahoo has repeatedly rebuffed Microsoft and demanded a higher price - step that Ballmer has said he won’t take.

Earlier news reports indicated that Yahoo’s board of directors would meet on Sunday to consider their options, but there was no official confirmation of a meeting. The Wall Street Journal reported Monday that Microsoft and Yahoo did not have direct contact over the weekend. Microsoft could move as early as Tuesday, according to the Journal.

At stake is Microsoft and Yahoo’s ability to compete with Google as billions of advertising dollars continue to flood the Internet. As Google has risen to become the dominant online ad player, Microsoft and Yahoo have both struggled to gain traction. Most analysts think a merger is the best way for Microsoft and Yahoo to compete with Google.

Microsoft kicked off the battle in late January when it made an unsolicited cash-and-stock bid for Yahoo that was originally valued at $31 a share, or $45 billion. The deal’s value has since dropped to $29.64 as Microsoft’s shares have fallen.

While Microsoft and Yahoo executives have met to discuss the bid, Yahoo has so far spurned Microsoft. Yahoo CEO Jerry Yang has said he’s not opposed to a Microsoft buyout, but argues that the offer “substantially undervalues” Yahoo. To force Microsoft (MSFT) to up the ante, Yahoo has discussed a variety of tieups with Time Warner, News Corp. and Google in recent months.

“Our board and management team continue to be open to any and all alternatives, including a sale to Microsoft,” Yang said last week, when Yahoo reported first-quarter earnings that beat estimates.

Talks between Microsoft and Yahoo have been anything but friendly. Three weeks ago, Microsoft CEO Steve Ballmer issued the ultimatum that expired Saturday. On Thursday, when Microsoft also reported better-than-expected profits, chief financial officer Chris Liddell voiced his frustration with Yahoo’s recalcitrance - and suggested the company’s prepared to go to war or walk away.

“Unless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives,” said Liddell, suggesting that Microsoft will makes its decision know next week. “The transaction has been anything but speedy as is being characterized by what would appear to be [Yahoo's] unrealistic expectations of value.”

Now that Yahoo has missed Microsoft’s deadline, one of the following three scenarios is likely:

• Microsoft turns up the heat and launches a proxy battle. The company has already hired a proxy firm and reportedly nominated candidates to an alternative board of directors. That slate would come up for a vote at Yahoo’s annual shareholder meeting, sometime before the end of July. (In an attempt to stymie Microsoft, Yahoo delayed its original March 14 shareholder meeting and has not yet announced a new date. According to Yahoo’s bylaws, however, the company must hold the meeting every 13 months, which means by the end of July.)
• Microsoft walks away. The Journalreported that this seems unlikely, although abandoning the bid could increase the pressure on Yahoo to come to the negotiating table. If Microsoft drops its bid for Yahoo, the company is likely to continue acquiring online ad companies. In the past 11 months, Microsoft has spent more than $6 billion to acquire aQuantive and Rapt.
• Status quo. Microsoft extends the proxy deadline while Yahoo tries to convince its shareholders that an alliance with Time Warner’s AOL or Google is more desirable.

Microsoft CEO Steve Ballmer doesn’t want to bid against himself by upping the original deal. Photo courtesy of Microsoft.

It’s not clear how much Microsoft could accomplish without Yahoo. Ballmer clearly sees Yahoo as the ammunition he needs to take on Google as online advertising spend skyrockets. According to eMarketer, advertisers worldwide spent $41 billion online in 2007 — a figure that is expected to double through 2011 as advertisers chase after consumers who are spending more time on the Web and less time watching TV, reading newspapers or listening to the radio. Google controls 40% of the overall market while Yahoo and Microsoft’s MSN have 15% and 5.2%, respectively. Google commands an even greater share in the lucrative search-ad business, with 58.7% of the market compared to 18.1% for Yahoo and 12% for MSN, according to the latest Nielsen data.

Microsoft fears that Google, with its March acquisition of DoubleClick, the world’s biggest online ad server company and big player in the increasingly lucrative market for online display ads, will seize an even bigger portion of the ad market as MSN falls further behind.

Microsoft isn’t the only one worried about Google. A number of media and Internet giants are now circling Yahoo — one of the last independent large-scale online players. “Microsoft’s forcing…everyone to make a move,” says Frank Addante, CEO of Rubicon Project, which helps publishers manage their online ad inventory.

Time Warner (TWX), which owns Fortune.com and CNNMoney, has pursued a deal that would fold AOL into Yahoo in exchange for a 20% stake. Along with aligning with AOL, Yahoo is also looking into outsourcing search advertising to market leader Google (GOOG). Last week Yahoo finished a two-week test that ran Google ads for searches on Yahoo’s homepage. The Justice Dept. is reportedly investigating the test for possible antitrust violations.

News Corp. has approached the deal from different angles. Yahoo and Rupert Murdoch’s News Corp. (NWS) held preliminary talks about a possible partnership after Yahoo rejected Microsoft’s bid. When those discussions stalled, News Corp. began talking with Microsoft about a three-way alliance that would combine News Corp.’s social networking site, MySpace, MSN and Yahoo.

Many analysts argue that ultimately a Microsoft-Yahoo combination is the best option for Yahoo shareholders — and for Microsoft in its war with Google. Wrote Bernstein Research analyst Jeffrey Lindsay in a note to investors on Friday: “We expect the acquisition scenario to play out before the end of July (the theoretical outer limit for the Yahoo! shareholder meeting) and think the outcome is very likely to be a sale to Microsoft at a slightly improved price.”

By Scott Moritz, writer

There may be more than money to consider in the Microsoft-Yahoo standoff.

Microsoft (MSFT) has given Yahoo a deadline of Saturday to accept its buyout offer (or, presumably, at least at start serious talks) or risk triggering a hostile takeover battle. Yahoo wants a higher offer — a demand that Microsoft has so far rebuffed.

But the focus on price may be missing a key subtlety behind the impasse.

One possible stumbling block might be Yahoo CEO and co-founder Jerry Yang’s role in a combined company. As displeased as Yang may be by the prospect of joining forces with Yahoo’s culturally-mismatched rival, some observers say he could be open to a leadership role in the merged Internet division.

“I’ve always believed Jerry Yang wants do something bigger with Yahoo,” as opposed to watching it dissolve into the works of a bigger company, says an analyst who has known Yang since Yahoo went public in 1996. ”He’s Jerry Yahoo, that’s really who he is.”

Yahoo has been exploring other options, including a possible tie up with the AOL division of Time Warner (TWX) and an advertising partnership with rival Google (GOOG) to help outsource some of its ads and trim costs. But almost any type of hookup between the No.1 and No.2 online ad giants seemed fraught with antitrust concerns.

Without a better offer in sight, Yang and the board will likely have to sit down with Microsoft over the weekend and negotiate. If Microsoft told Yang that he would play a top role in the combined company, it might sway the Yahoo founder, says the analyst, who did not want to be identified.

“He’s already a billionaire,” adds the analyst, referring to Yang. “What he wants is his brand to be massive. When the history of the Internet is written it will feature names like [Amazon (AMZN) chief Jeff] Bezos, [Google CEO] Schmidt, Page, [AOL founder Steve] Case. Yang wants to be there.”

Stay tuned.

Yahoo has until Saturday to accept Microsoft’s offer. Courtesy of Yahoo.

By Yi-Wyn Yen

The Microsoft-Yahoo standoff could get ugly fast.

Saturday is the deadline that Microsoft set three weeks ago for Yahoo (YHOO) to accept its buyout offer - or face the possibility of a hostile bid or a decision by Microsoft to abandon the deal altogether. The April 26 deadline brings to a head three months of high-profile jockeying during which Yahoo has repeatedly rebuffed Microsoft and demanded a better price.

At stake is Microsoft and Yahoo’s ability to compete with Google as billions of dollars worth of advertising dollars continue to flood the Internet. As Google has risen to become the dominant online ad player, Microsoft and Yahoo have both struggled to gain traction. Most analysts think a merger is the best way for Microsoft and Yahoo to compete with Google.

Microsoft kicked off the battle in late January when it made an unsolicited cash-and-stock bid for Yahoo that was originally valued at $31 a share, or $45 billion. The deal’s value has since dropped to $29.64 as Microsoft’s shares have fallen.

While Microsoft and Yahoo executives have met to discuss the bid, Yahoo has so far spurned Microsoft. Yahoo CEO Jerry Yang has said he’s not opposed to a Microsoft buyout, but argues that the offer “substantially undervalues” Yahoo. To force Microsoft (MSFT) to up the ante, Yahoo has discussed a variety of tieups with Time Warner, News Corp. and Google in recent months.

“Our board and management team continue to be open to any and all alternatives, including a sale to Microsoft,” Yang said on Tuesday, when Yahoo reported first-quarter earnings that beat estimates.

Talks between Microsoft and Yahoo have been anything but friendly. Three weeks ago, Microsoft CEO Steve Ballmer issued the ultimatum that expires Saturday. On Thursday, when Microsoft also reported better-than-expected profits, chief financial officer Chris Liddell voiced his frustration with Yahoo’s recalcitrance - and suggested the company’s prepared to go to war or walk away.

“Unless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives,” said Liddell, suggesting that Microsoft will makes its decision know next week. “The transaction has been anything but speedy as is being characterized by what would appear to be [Yahoo's] unrealistic expectations of value.”

If Yahoo doesn’t accept Microsoft’s offer by the Saturday deadline, one of the following three scenarios is likely:

• Microsoft walks away. In this case, Microsoft will likely continue to spend money acquiring other online ad companies. In the past 11 months, Microsoft has spent more than $6 billion to acquire aQuantive and Rapt.
• Microsoft turns up the heat and launches a proxy battle. The company has already hired a proxy firm and reportedly nominated 10 candidates and three alternates to its own alternative board. The Wall Street Journal reported that the 10 nominees include former Nextel CEO John Chapple, former Grey Global Group CEO Edward Meyer, former Adelphia Communications chief financial officer Vanessa Wittman, and Jaynie Studenmund, a former executive at Overture Services, the online ad company acquired by Yahoo.
• Status quo. Microsoft extends the proxy deadline while Yahoo tries to convince its shareholders that an alliance with Time Warner’s AOL or Google is more desirable.

Microsoft CEO Steve Ballmer doesn’t want to bid against himself by upping the original deal. Courtesy of Microsoft.

Microsoft clearly needs Yahoo. Ballmer sees the No 2. Internet portal as the ammunition he needs to take on Google as online advertising spend skyrockets. According to eMarketer, advertisers worldwide spent $41 billion online in 2007 — a figure that is expected to double through 2011 as advertisers chase after consumers who are spending more time on the Web and less time watching TV, reading newspapers or listening to the radio. Google controls 40% of the overall market while Yahoo and Microsoft’s MSN have 15% and 5.2%, respectively. Google commands an even greater share in the lucrative search-ad business, with 58.7% of the market compared to 18.1% for Yahoo and 12% for MSN, according to the latest Nielsen data.

Microsoft fears that Google, with its March acquisition of DoubleClick, the world’s biggest online ad server company and big player in the increasingly lucrative market for online display ads, will seize an even bigger portion of the ad market as MSN falls further behind.

Microsoft isn’t the only one worried about Google. A number of media and Internet giants are now circling Yahoo — one of the last independent large-scale online players. “Microsoft’s forcing…everyone to make a move,” says Frank Addante, CEO of Rubicon Project, which helps publishers manage their online ad inventory.

Time Warner (TWX), which owns Fortune.com and CNNMoney, has pursued a deal that would fold AOL into Yahoo in exchange for a 20% stake. Along with aligning with AOL, Yahoo is also looking into outsourcing search advertising to market leader Google (GOOG). Earlier this week Yahoo finished a two-week test that ran Google ads for searches on Yahoo’s homepage. The Justice Dept. is reportedly investigating the test for possible antitrust violations.

News Corp. has approached the deal from different angles. Yahoo and Rupert Murdoch’s News Corp. (NWS) held preliminary talks about a possible partnership after Yahoo rejected Microsoft’s bid. When those discussions stalled, News Corp. began talking with Microsoft about a three-way alliance that would combine News Corp.’s social networking site, MySpace, MSN and Yahoo.

Many analysts argue that ultimately a Microsoft-Yahoo combination is the best option for Yahoo shareholders — and for Microsoft in its war with Google. Wrote Bernstein Research analyst Jeffrey Lindsay in a client note Friday: “We expect the acquisition scenario to play out before the end of July (the theoretical outer limit for the Yahoo! shareholder meeting) and think the outcome is very likely to be a sale to Microsoft at a slightly improved price.”

Microsoft (MSFT) signaled its ready to play hardball with Yahoo (YHOO) in its bid to acquire the Internet giant, and antitrust regulators are scrutinizing a trial advertising partnership that Google (GOOG) and Yahoo recently struck.

Microsoft put some substance behind its threat to take its three-month-old buyout offer to Yahoo shareholders by naming 13 people as potential candidates to the company’s board, according to Thursday’s The Wall Street Journal.

The list includes former Nextel Partners CEO John Chapple; Edward Meyer, former chief of Grey Global Group; Jaynie Studenmund, the former chief operating officer at Overture Services, a company Yahoo acquired a few years ago; and former Adelphia Chief financial officer Vanessa Wittman, the Journal reported.

Microsoft’s tougher stance comes amid news reports that the Justice Department is looking into Yahoo’s outsourcing of some of its advertising to Google. The companies’ two-week trial ended Wednesday. Yahoo has said it involved about 3% of its search results.

Yahoo has been looking for ways to reduce the cost of operating its search service and, in an effort to thwart Microsoft, to demonstrate it can thrive as a standalone business. But the cooperation between the No.1 and No.2 two search engine shops immediately raised anticompetitive flags when the pact was announced earlier this month.

Google says it “informed the Justice Department before we launched this test, and we have been responsive to their questions about it,” according to the Los Angeles Times. Yahoo said it too had given the Justice Department a heads up prior to the test, according to the Times report.

Microsoft has given Yahoo until Saturday to come up with a counter proposal or answer to its $43 billion takeover offer.

By Scott Moritz, writer

The yelling phase of the proposed Microsoft/Yahoo merger got a bit louder as Yahoo (YHOO) turned in good numbers ahead of the deal negotiation deadline.

In the wake of a solid first quarter performance from Yahoo Tuesday, Microsoft (MSFT) chief Steve Ballmer said his company was standing pat on its original $31 a share unsolicited takeover offer. Microsoft has given Yahoo until Saturday to come to the table with a counter proposal, or face a proxy battle.

“We know what Yahoo is worth to us. We offered a lot of money: $44 billion,” Ballmer said in Milan Wednesday, according to a Reuters report. “If their board thinks that’s fair, great. If not, we’ll move forward,” Ballmer said.

Ballmer is likely waiting to see what Yahoo does come Saturday — the end of the three-week period Microsoft gave Yahoo to consider its options. Microsoft has threatened to start a proxy fight if the two companies fail to come to terms. This would open up an ugly process where Microsoft takes its appeal to shareholders calling for the ouster of Yahoo’s top management and key board members.

Last week, Yahoo rejected the Microsoft bid for a second time saying the proposal undervalued the company. Yahoo also held discussions with Time Warner (TWX) about a deal involving a 20% stake to be held by Time Warner in exchange for AOL and a pile of cash for share buybacks.

But many analysts and investors favor a more amicable conclusion that seems to call for a slightly sweeter offer from Microsoft, either a price higher than $31 a share or an all-cash offer.

Yahoo’s earnings Tuesday, while far from dazzling, did show that the company is not deteriorating as quickly as Microsoft may have suggested. Both companies, however, continue to lose business to Google (GOOG) a point that industry observers say makes the Microsoft Yahoo merger a growing necessity.

The trouble for Yahoo is that it must convince Microsoft to outbid itself, says Darren Chervitz analyst with the Jacob Internet Fund, a big Yahoo investor.

It’s well known that Yahoo has long been losing Net search traffic to Google. And by passing on the acquisition of Facebook last year, they’ve done little to improve their competitive position, says Chervitz.

And for its part, Microsoft has gained very little traction on the Internet. Efforts like MSN mail and .Net haven’t exactly hit any jackpots. Meanwhile, Google has expanded into Microsoft’s software domain with word processing and other office applications available to users online for free.

An even bigger threat to Microsoft is Google’s push into wireless applications. The Google-sponsored Android project hopes to create an operating system for a new generation of mobile devices, a direct threat to Microsoft’s Windows Mobile system. Microsoft can’t easily afford to miss the mobile Internet opportunity, says Chervitz.

“Yahoo,” says Chervitz, “is the only acquisition that gets Microsoft into the game.”

By Yi-Wyn Yen

It’s time for Microsoft to sweeten the bid.

Hours before Yahoo (YHOO) beat easy quarterly estimates on Tuesday, Microsoft CEO Steve Ballmer said his company wouldn’t raise its $43 billion offer no matter how well Yahoo performed. Nevertheless, Ballmer must up the ante if Microsoft (MSFT) intends to get a deal done with Yahoo.

In a call with analysts Tuesday, Yahoo CEO Jerry Yang signaled that his company wasn’t interested in a deal unless his company was offered more money. Microsoft’s No. 1 takeover target has until Saturday to accept the bid that would buy out Yahoo at slightly less than $30 a share or else face a proxy fight.

It took Yang a mere five minutes into Yahoo’s highly-anticipated earnings call to let Microsoft know he wasn’t going to be the first to back down. For the millionth time, Yang said the deal “substantially undervalues” his company.

Then he threw the ball back into Microsoft’s court. “Our board and management team continue to be open to any and all alternatives,” Yang said, “including a sale to Microsoft.”

Surely, Ballmer, who was halfway around the world in Morocco to launch the company’s MSN portal, is weighing his options: Go hostile or throw a few billion more at Yahoo, which has twice rejected its original offer. “We think we can accelerate our strategy by buying Yahoo and will pay what makes sense for our shareholders,” Ballmer said before the earnings Tuesday.

On Wednesday, Ballmer let Yang know he wasn’t going to be bullied around. “We know what Yahoo is worth. We offered a lot of money,” Ballmer said at a conference in Milan, according to Reuters. “If their board thinks that’s fair, great. If not, we’ll move forward.” Likely the move will be to begin a hostile takeover Saturday. Microsoft has hired Innisfree M&A to help it oust Yahoo’s 10-member board.

On the call, Yang and president Sue Decker insisted that the company is headed in the right direction. Yahoo offered its latest numbers as a final defense to its shareholders that it’s worth more than Microsoft is offering. Yahoo posted earnings per share of 11 cents, beating analyst forecasts by 2 cents. Its revenues, which exclude money it shares with advertising partners, climbed 14% to $1.35 billion, $20 million ahead of the consensus. Yang highlighted Yahoo’s display advertising revenues, which grew 25% from a year ago, and praised the company for its satisfactory quarter, calling it “impressive” under the circumstances.

But let’s face it. Those estimates weren’t too difficult to beat given that analysts had started with such low expectations. Yahoo also didn’t change its guidance for the year on annual revenues of $7.2 billion to $8 billion, which analysts considered a weak forecast when it was issued in January.

Yang said the company is still exploring “strategic alternatives” as Microsoft decides its next move. Yahoo ends its two-week test using Google’s search advertising on Wednesday and the company is in talks with Fortune’s parent Time Warner (TWX) to strike a partnership with AOL.

Analysts argue that Yahoo is playing for time. “Yahoo puts in numbers slightly better than expectations and wants a little more time to pursue alternatives. It’s time Microsoft doesn’t want [them to have], which means they will have to increase their offer to get investors over,” says Youssef Squali, an analyst with Jefferies.

As Google continues to gain online advertising share, Yahoo and Microsoft continue to fight with one another and fall further behind. The best way to quickly catch up is to start with Microsoft raising its bid. Analysts have suggested that an offer between $31 to $35 a share will make the deal possible. “If I’m a Yahoo shareholder looking at Yahoo’s performance and Microsoft as a potential buyer, I would think Microsoft is going to come in and sweeten the bid,” Squali says.

Expect that to happen or things will start to get ugly fast.