• by Wendy Davis  @wendyndavis, November 5, 2008

Faced with the prospect of a lawsuit by federal antitrust authorities, Google decided to pull the plug on its proposed search ad deal with Yahoo.

"After four months of review, including discussions of various possible changes to the agreement, it's clear that government regulators and some advertisers continue to have concerns about the agreement," Google's chief legal officer, David Drummond, wrote on the company's blog Wednesday. "Pressing ahead risked not only a protracted legal battle but also damage to relationships with valued partners."

The deal called for Google to power some paid search ads for Yahoo. The companies estimated that the arrangement, forged to fend off Microsoft's takeover bid for Yahoo, would have increased Yahoo's revenue by around $800 million in the first year. When they announced the deal in June, they said they would delay it for four months, to give the federal authorities time to investigate.

Wednesday, after the companies announced that the deal collapsed, the Department of Justice said it would have sued to block the arrangement. "Google and Yahoo would have become collaborators rather than competitors for a significant portion of their search advertising businesses, materially reducing important competitive rivalry between the two companies," the agency said in a statement.

After the deal unraveled, Yahoo said it was "disappointed" that Google "elected to withdraw from the agreement rather than defend it in court."

The proposed pact drew opposition from a host of parties, ranging from tech rival Microsoft to industry organizations like the Association of National Advertisers. They argued that the deal would lead to increased prices and diminished competition because the two companies together account for over 80% of the search market. Some observers were also afraid that the deal would encourage Yahoo to stop competing in search--leaving Google, which currently accounts for more than 60% of the search market, with near-monopoly power.

At the same time, there was also a fear that without the deal, Yahoo would again be vulnerable to a takeover by Microsoft. For that reason, the pro-enforcement group American Antitrust Institute proposed allowing the deal to go forward, but with limits aimed at keeping Yahoo independent.

Yahoo, which spent millions of dollars developing the paid search platform Panama, said it intended to continue to compete in search. But the Justice Department said it was afraid that the deal would have left Yahoo with "significantly reduced incentives to invest in areas of its search advertising business where outsourcing ads to Google made financial sense."

Kevin Lee, chairman and CEO of search engine marketing company Didit, said the deal would have been more palatable to search marketers if the companies had agreed to restrict it only to companies that did not already advertise on Yahoo.

"I'm surprised that they didn't choose a scenario where only advertisers that weren't already in Panama were put into Yahoo search results," Lee said.

But other industry observers, who viewed the deal more favorably, said it would have made it easier for companies to gain reach in search marketing because they could have arranged for their ads to appear on both Yahoo and Google without spending the time and money required to manage campaigns across two engines. "This deal had some real promise for people who were trying to cut their transaction costs," said Eric Goldman, director of the High Tech Law Institute at Santa Clara University. "There were a bunch of people who clearly were excited by this deal."

It's not yet clear whether Microsoft will now buy all or part of Yahoo, but some marketing executives say the benefits of a potential Microsoft-Yahoo search deal outweigh the potential risks of market consolidation.

Roger Barnette, president of search marketing firm SearchIgnite, said that he believed a Microsoft-Yahoo combination could benefit advertisers because such an entity would pose a greater challenge to Google than either company alone. "It might sound counterintuitive, but a combination of the two might create more competition in the marketplace, because it would create a more viable competitor to the dominant player."

Bob Liodice, president and CEO of the Association of National Advertisers, said he agreed that a potential Microsoft-Yahoo combination would benefit search advertisers. "If Yahoo's share (of search) is destined to decline, and Microsoft's share is destined to stabilize, and be small, then the combination of the two might provide a level of scale," he said.

But Bert Foer, president of the American Antitrust Institute, said he believes the market should have at least three major search engines. "You want separate companies to be pursuing separate strategies," Foer said. "Innovation is stronger when you have more competitors."

In a report issued shortly before the deal fell through, J.P. Morgan analyst Imran Kahn said that outsourcing search to Microsoft would allow Yahoo to focus on its display business. "Without its search business, Yahoo would be very clearly positioned as a content and display advertising entity, thereby clarifying and defining its purpose to advertisers and users," Kahn wrote.