• by Gavin O'Malley  @mp_gavin, Mark Walsh  @markfwal, May 5, 2008

It looks like Microsoft has to find another way to outdo Google now that the software giant has withdrawn its offer to acquire Yahoo. Even after Microsoft raised its bid by nearly $5 billion to $47.5 billion, the two companies were unable to make a deal this weekend.

CEO Steve Ballmer said Microsoft increased its offer to $33 per share --up from its initial bid of $31 per share in cash-and-stock--but Yahoo management would not go below $37 a share.

"Despite our best efforts, including raising our bid by roughly $5 billion, Yahoo has not moved toward accepting our offer," Ballmer said in a statement released Saturday.

Following weeks of negotiation, Yahoo chief executive Jerry Yang and its co-founder David Filo met once more with Ballmer and Microsoft's platforms and services division President Kevin Johnson in Seattle on Saturday.

"After careful consideration, we believe the economics demanded by Yahoo do not make sense for us, and it is in the best interests of Microsoft stockholders, employees and other stakeholders to withdraw our proposal," Ballmer said.

In a letter to Yang released Saturday, Ballmer said a hostile takeover attempt by Microsoft would lead Yahoo to take actions that would only devalue the company further.

Ballmer was also wary of pushing Yahoo into Google's arms. To fend off Microsoft, Yahoo has been exploring a search advertising partnership with Google, along with a potential deal with AOL.

"We regard with particular concern your apparent planning to respond to a 'hostile' bid by pursuing a new arrangement that would involve or lead to the outsourcing to Google of key paid Internet search terms offered by Yahoo today," Ballmer wrote Yang.

"In our view, such an arrangement with the dominant search provider would make an acquisition of Yahoo undesirable to us."

Yahoo investors and others will now be watching closely to see if the portal's test to outsource a portion of its search ads to Google will result in a broader agreement between the companies.

Yahoo President Sue Decker recently acknowledged that Google earns 60% to 70% more on average per search than Yahoo, despite gains made through its upgraded Panama search advertising platform.

Short of turning paid search completely over to Google, analysts say the companies could forge a partnership in which Yahoo would continue to deliver ads on the most popular search terms, while Google would monetize "long tail" keywords.

Narrowing the scope of the deal would also help allay antitrust concerns that have already been raised about a Yahoo-Google search alliance. And it would allow Yahoo to continue improving Panama while moving toward its goal of closer integration of search and display advertising.

Still, analysts expect shareholder lawsuits to begin pouring in this week on the grounds that Yahoo is unlikely to create the value that Microsoft was prepared to give it overnight. If the company's stock plunges today as widely predicted, that will only add grist to shareholder claims.

Likewise, analysts this weekend were quick to criticize Yahoo for not accepting Microsoft's offer.

"We think Yahoo is taking a big risk not accepting $33, especially if the offer was cash--and we imagine Yahoo shareholder frustration will be intense," Henry Blodget said on his Silicon Alley Insider blog.

Added Blodget: "We hope Yahoo continues to pursue its search outsourcing deal with Google, as well as its discussions with Time Warner over AOL. We suspect Microsoft might immediately emerge as a counter-bidder for AOL."

Yahoo had previously refused to enter formal negotiations with Microsoft, saying its first offer in February improperly valued Yahoo's search and display ad technology.

With Yahoo, Microsoft had been seeking better positioning against Google, which has dominated automated online advertising, while making overtures in the world of Web-based applications.

The deal would have given Microsoft access to Yahoo's 137 million monthly visitors, along with expertise in the key area of display advertising.

Blodget, for one, believes that a Microsoft/Yahoo deal could still emerge at some point in the future. "We think there is a reasonable chance that Microsoft might be able to buy Yahoo for less than $30 in six months to a year if Yahoo can't get its act together."

Whatever the future holds for Yahoo, its management is expressing optimism and painting the failed acquisition as a victory.

"From the beginning of this process, our independent board and our management have been steadfast in our belief that Microsoft's offer undervalued the company and we are pleased that so many of our shareholders joined us in expressing that view," said Roy Bostock, chairman of the Yahoo board, in a statement. "Yahoo is profitable, growing, and executing well on its strategic plan to capture the large opportunities in the relatively young online advertising market."

Added Yahoo's Yang: "With the distraction of Microsoft's unsolicited proposal now behind us, we will be able to focus all of our energies on executing the most important transition in our history so that we can maximize our potential to the benefit of our shareholders, employees, partners and users."