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Yahoo's new best friend -- rival Google

Microsoft Corp. turned to Internet pioneer Yahoo Inc. for help in fighting its biggest-ever competitive threat, then only made that threat stronger.

Yahoo and Microsoft on Thursday said they had ended nearly five months of merger and partnership talks born of the software giant's frustration with falling far behind Google Inc. in online advertising.

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Yahoo shares plunged more than 10% to $23.52.

But after the stock market closed, the Sunnyvale, Calif., company turned around and struck an online advertising alliance with rival Google. Yahoo said it would get a financial boost by using Google's superior system for placing text ads next to its search results and on some of its Web pages.

The deal between the top two search engines triggered objections from antitrust groups, which said advertisers in effect would lose a major alternative for touting their wares. Consumer groups warned of an increased risk to privacy, and an influential senator pledged to investigate.

Yahoo and Google said they would delay the start of their partnership by as much as 3 1/2 months to give the Justice Department a chance to scrutinize the deal.

For Microsoft, analysts said, the tie-up was the worst possible outcome of the unsolicited, $44.6-billion bid it made to buy Yahoo more than four months ago.

Advertisers pay Google each time someone clicks on one of the text ads it brokers. With Yahoo, Google will get its ads on one of the world's most-visited network of websites, while denying Microsoft the chance to do the same.

"There is no hope for Microsoft in the search space," said Brian Bolan, an analyst with Jackson Securities.

Still, investors were relieved that Microsoft wouldn't have to shell out so much money to acquire an Internet company that is also struggling to keep up. Its shares rose more than 4%, to $28.24, after Yahoo said talks had ended.

Microsoft, based in Redmond, Wash., continues to dominate the markets for operating system software that runs personal computers and productivity tools such as word-processing and presentation programs.

But Google, of Mountain View, Calif., controls the lucrative search-advertising market. The company is bumping up against Microsoft in an increasing number of fields, which already include Internet banner ads, e-mail and software for advanced cellphones.

On Feb. 1, Microsoft announced an offer of $31 a share in cash and stock for Yahoo, more than 60% above where Yahoo's stock was trading. It later offered $33. Yahoo resisted as it held discussions with Google and other parties. When it began talking in earnest with Microsoft, Yahoo co-founder and Chief Executive Jerry Yang asked for $37.

Microsoft Chief Executive Steve Ballmer walked away in frustration May 3 and has since refused to reconsider a full takeover, not even at the price levels he had floated earlier. He instead wanted to acquire only Yahoo's search business.

On May 30, Microsoft proposed doing that, plus taking a 16% stake in Yahoo at $35 a share and paying Yahoo a slice of future search profit that it believed could have reached $1 billion over the course of the deal, according to two people who are familiar with the talks. Yahoo said Thursday that it didn't want to sell its search business.

Two Yahoo investors, speaking on the condition that they not be named, said the matter wasn't over. They said Yahoo stockholders might still want to oust the company's board and resume talks with Microsoft.

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"I'm so irritated it's almost beyond verbalization," said one investor who requested anonymity so he could keep talking to the companies.

Yahoo and prospective partner Google share Stanford University roots, Silicon Valley location and Internet metabolisms.

"We are very excited . . . to be working with Yahoo and that Yahoo remains a very strong independent company," Google co-founder Sergey Brin said in a conference call with analysts and investors.

Executives from the two companies started meeting about a possible deal as far back as February, shortly after Microsoft made its bid, and accelerated talks in recent days. An all-nighter produced the final document signed Thursday.

Yahoo will continue to produce the regular search results and many of the search-related ads that its newly overhauled systems generate. But some of its search users in the U.S. and Canada will also see ads placed by Google. Google will give Yahoo a cut of the fees it charges advertisers.

"The flexibility of the deal lets us get the best of both worlds," Yahoo President Sue Decker said in a conference call.

The two companies will also work to combine their instant-messaging platforms, and Yahoo executives said they might help Google improve its display ads.

Yahoo has come under substantial fire from shareholders for failing to reach a deal with Microsoft. It said the Google arrangement would bring in about $800 million in extra annual revenue and $250 million to $450 million in additional operating cash flow.

That might not be enough to appease major Yahoo investors, some of whom had been expecting a richer Google deal. By May 15, 12 days after the Microsoft talks first broke down, corporate raider and activist investor Carl Icahn amassed a Yahoo stake that included 10 million shares worth $280 million and options to buy 49 million more.

Icahn launched a campaign to replace the Yahoo board with his own slate of nominees at the company's annual meeting, scheduled for Aug. 1. He's running on the platform that he will seal a Microsoft pact.

Assuming he hadn't sold any of his shares, his Yahoo stock holdings lost about $26 million Thursday. Icahn did not comment.

"Yahoo has always said -- and continues to say -- that search is critical to the future of its display advertising efforts and its long-term strategy," said Anthony Valencia, an analyst at Trust Co. of the West. "But here, Yahoo is basically still admitting that its competitor's technology is better."

Though the Yahoo-Google alliance doesn't require the approval of federal regulators, Sen. Herb Kohl (D-Wis.), chairman of the Judiciary Committee's antitrust panel, said lawmakers would probe the risks to privacy and competition that it posed.

Observers doubted, however, that officials would object strenuously enough to scuttle the pact.

Yang said Yahoo would also continue to explore other alternatives. But the deal could add another cost for Microsoft, should it change its mind and make a new bid. If Yahoo is acquired in the next two years and cuts short the initial four-year term of the deal, it must pay Google a termination fee of as much as $250 million.

Yang said he wasn't looking back. "Clearly," he said, "it's time to move on."

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jessica.guynn@latimes.com

Menn reported from Los Angeles, Guynn from San Francisco.

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(BEGIN TEXT OF INFOBOX)

Deal's nuts and bolts

What does this deal do?

It will enable Yahoo to run ads supplied by Google on its Web pages, including alongside its search results. In addition, Yahoo and Google agreed to make their instant messaging services work together.

What's in it for Google?

Advertisers pay Google each time someone clicks on one of the text ads it brokers. By partnering with Yahoo, its ads will appear on one of the world's most-visited network of websites.

What's in it for Yahoo?

Google will share the ad revenue with Yahoo. Google's search-advertising system delivers ads that are more relevant than Yahoo's, resulting in more clicks and greater profit. Yahoo expects to pull in an extra $800 million in annual revenue and $250 million to $450 million in extra operating cash flow.

How long is the deal for?

The agreement has a term of as long as 10 years: a four-year initial term and two three-year renewals at Yahoo's discretion.

When will this start?

The companies will hold off for as long as 3 1/2 months to give the U.S. Justice Department time to review the arrangement.

What's the concern?

Google is the No. 1 search company and Yahoo is No. 2. Antitrust regulators and consumer groups are worried the two will dominate the market.

Times research by Scott J. Wilson

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