After months of posturing by both sides, technology titans Yahoo Inc. and Microsoft Corp. have suspended their tough talk and have entered serious negotiations on a deal to unite against Internet search king Google Inc., people briefed on the talks said Friday.
Microsoft, which had been threatening to abandon a bid now valued at about $42 billion, instead offered to pay billions of dollars more for the company, those people said. The sweetened bid brought Yahoo, a reluctant seller, to the bargaining table to see whether it could hammer out an agreement that would combine two of the world's largest Internet companies.
The two appeared late Friday to be on pace to reach a deal over the weekend, the people said, but they warned that talks could still fall apart. Yahoo plans to continue negotiating an alternative arrangement with Time Warner Inc. that would let the Internet pioneer remain an independent company, as its top executives prefer.
The first serious talks between Yahoo and Microsoft marked a dramatic change in tone after three months of sniping.
"Everybody -- shareholders, management alike -- is getting more reasonable. All of a sudden it seems like something is going to happen," said one person briefed on the negotiations. Like others involved in the drama, he asked not to be named because the discussions were confidential.
Both companies declined to comment, as did Time Warner.
Yahoo and Microsoft are powerhouses in such advertising-supported online services as Web-based e-mail and instant messaging. But they lag far behind Google in the most profitable one: Web search.
Since announcing its unsolicited bid Feb. 1, Microsoft has said it preferred to reach a friendly acquisition deal with Sunnyvale, Calif.-based Yahoo. But Redmond, Wash.-based Microsoft had threatened in recent weeks to turn the bid hostile by seeking to take control of Yahoo's board of directors.
Yahoo investors had long predicted a raised price and an amicable deal, and they were relieved to see that prospect come closer to fruition. They sent the company's shares up $1.86, or 7%, to $28.67 on Friday. Microsoft shares fell 16 cents, or 0.5%, to $29.24.
"It has been a foregone conclusion on Wall Street that this is a deal that is going to get done," said analyst Anthony Valencia of Trust Co. of the West, which owns Yahoo shares. "While there have been some delays, it's clear that the parties are moving closer and closer together."
Time Warner is in talks to take a roughly 18% stake in Yahoo, which would absorb the New York-based media company's AOL online division. Seeking alternatives to Microsoft's unsolicited bid, Yahoo co-founder and Chief Executive Jerry Yang has pushed the exploration of that deal and a separate arrangement to let the more efficient Google sell search-based advertising on Yahoo's pages. That would bring in more money even as Yahoo concedes the lucrative territory to the already dominant Google.
Timing played a crucial role in driving the two sides to the table after months of dickering, said people familiar with the thinking at Microsoft. The maker of Windows and Office software is worried that it would face a greater risk of federal antitrust objections if it couldn't complete a takeover by Jan. 20, when the next administration will take office.
Many complex mergers take nine months to get cleared by antitrust regulators, prompting Microsoft to set a deadline of last Saturday for the companies to enter into meaningful talks.
For its part, Yahoo was concerned that a merger process might linger on, only to be blocked in court by a new administration, which would leave the company in worse shape for competing with Google. Its executives sought a stronger bid from Microsoft to justify taking that risk.
Yahoo's board rejected the initial offer, which was valued at $31 a share in cash and stock, or $44.6 billion, saying it was too little for the leader in online display advertising. The bid's value has declined with Microsoft's stock price to $29.39 a share Friday, or $42 billion.
Yahoo executives floated a figure of $40 a share, which enraged executives at Microsoft, the world's largest software company.
Without formal merger talks, Microsoft declined to raise the bid. Yahoo refused to enter talks without first getting a higher bid.
"It was all kind of silly," said a well-connected hedge fund manager who owns stock in both companies. "There's been a certain amount of dysfunction along the way, perhaps on both sides."
Divisions of opinion about whether a tie-up made sense existed inside both companies, employees said. As the standoff dragged on longer than initially expected, it threatened to exacerbate what would have been, even under the best of circumstances, a difficult combination of corporate cultures and technologies.
Microsoft remains a software company at its core, albeit one trying to evolve and compete with Google as people perform more tasks over the Internet. Its Internet division is unprofitable.
Yahoo, which depends on Internet ads, is closer to Google in temperament but far behind it in execution.
A combination "is in the long-term interests of both companies," Valencia said.
Growing impatient, Microsoft had threatened to nominate a slate of Yahoo directors and ask investors to oust the board if no agreement was reached by last Saturday. As that date neared Microsoft feinted again, saying it might walk away, which would send Yahoo shares tumbling.
But Microsoft later left open a small door in the rhetoric, declaring that it would consider its options unless "significant progress" had been made by the deadline.
Against that backdrop, the two sides informally discussed figures between $31 and $40 a share.
"Clearly, Microsoft was bluffing about the ultimatum," a major Yahoo investor said. "Their next best option is worse than Yahoo's next best option -- their next best option is slow death, and Yahoo's next best option is a Google deal and an AOL deal."
On Thursday morning, Microsoft CEO Steve Ballmer told a major gathering of employees that the company could gain a big piece of the online ad market without Yahoo.
"Yahoo is not a strategy, it's a part of a strategy," Ballmer said, according to a transcript. "We're willing to pay for that at some level, and beyond that level we're not willing to pay for it."
But he acknowledged that Microsoft's technology needed momentum, and that Yahoo's customers and advertisers would provide that.
"I know exactly what I think Yahoo is worth to me, exactly," Ballmer said, implying to anyone who read the widely distributed speech that the figure was above $31 a share. "I won't go a dime above, and I will go to what I think it's worth if that gets the deal done."
Talks began to heat up that afternoon.
"Everyone checked around more with their shareholders, and it seems like that encouraged coming to a compromise," said a person briefed on the effort.
As Yahoo's board met Friday, people familiar with the talks between the two companies said the most likely compromise was a per-share price in the mid-$30s.
A determining issue might be just how successful Yahoo was with a recent two-week test in which Google sold some ads next to Yahoo's search results. That test has drawn scrutiny from antitrust regulators.
Menn reported from Los Angeles, Guynn from San Francisco.
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At a glance
Headquarters: Sunnyvale, Calif.
Chief Executive: Jerry Yang
Employees: 14,300 (2007)
2007 revenue: $6.97 billion
Products: Online services including e-mail, news, sports, instant messaging, search and advertising
Headquarters: Redmond, Wash.
CEO: Steven A. Ballmer
2007 revenue: $51.12 billion
Products: Software including Windows operating system and Office productivity suite. Xbox video game console. Online services including e-mail, news, sports, instant messaging, search and advertising.