Microsoft's proposed acquisition of Yahoo would marry the world's biggest software maker with one of the leading Internet media companies, shaking up the market for online services such as email and advertising.
Microsoft offered to buy Yahoo for about $44.6 billion in cash and stock on Friday, seeking to join forces against Google in what would be the biggest Internet deal since the Time Warner merger with AOL.
Microsoft and Yahoo have been struggling to compete with Google, and have fallen behind it in the race for online advertising dollars and Internet search market share.
Microsoft offered $31 a share -- payable in the form of $31 in cash or 0.9509 of a Microsoft share -- or a 62 percent premium on Yahoo's closing price on January 31.
Yahoo responded by saying its board will reviewing Microsoft's proposal in the "context of its strategic plans" and will "pursue the best course of action to maximize long-term value" for its shareholders.
Yahoo shares soared on the news, pushing it to its highest levels in months.
The potential deal also was having ripple effects on the technology sector, pushing shares of many stocks, including Time Warner higher. However, Google shares were trading lower after the company reported disappointing earnings after the market's close on Thursday.
Microsoft shares, which have a market capitalization of about $300 billion, fell 6 percent to $30.78.
"We have great respect for Yahoo, and together we can offer an increasingly exciting set of solutions for consumers, publishers and advertisers while becoming better positioned to compete in the online services market," Microsoft Chief Executive Steve Ballmer said in a statement announcing its plans.
Microsoft said it had previously discussed a number of alternatives with Yahoo, ranging from commercial partnerships to a merger proposal, which was rejected.
"While a commercial partnership may have made sense at one time, Microsoft believes that the only alternative now is the combination of Microsoft and Yahoo that we are proposing," Microsoft said in a letter to Yahoo shareholders.
A deal with Microsoft would be a great outcome for Yahoo shareholders, who have grown increasingly frustrated with Yahoo's stock performance, according to RBC Capital Markets analyst Jordan Rohan. He expects Yahoo founders and insiders to support the deal.
"This is a no brainer for Yahoo shareholders," Rohan said in an interview on "Squawk Box." "The company has floundered and this is a great way to save face."
Yahoo management "can try to get a dollar or two more," but "at the end of the day, I've talked to many of the largest shareholders of Yahoo in the past few days -- there's no patience there anymore," Rohan said.
The merger would bring together two companies that have pioneered their respective industries, but have not been as nimble in keeping up with the changing habits of those using its products.
"Microsoft's wanted to do things that could build up its online business dramatically. This is one more thing that allows them to do that," Brendan Barnicle, an analyst at Pacific Crest Securities said.
"This is going to be a big bet for them. But I also think it's where they see the market going, so they really needed to get there," he said. "This is more than a shot across the bow at Google, because you put these two guys together who are basically two and three in search and makes them far more relevant."
Internet audience researcher comScore estimates Google's share of the worldwide Web search market has reached 77 percent, while Yahoo is second with 16 percent and Microsoft was a distant third with 3.7 percent.
A Clash of Cultures
Critics of a tie-up, however, have pointed out that Microsoft and Yahoo have very different corporate cultures and many overlapping businesses, from instant messaging to email and advertising, as well as news, travel and finance sites.
"To me, the premium seems exorbitant, for what is a dwindling business. I personally don't see how the synergies of Microsoft-Yahoo is going to take on Google," said Tim Smalls, head of U.S. stock trading at brokerage firm Execution in Greenwich, Conn.
Yahoo attracts more than 500 million people monthly to a range of media sites including Yahoo Mail, the world's biggest e-mail service for consumers.
It has been losing market share to Google in the increasingly strategic Web search market, and warned earlier this week that Yahoo faced "headwinds" in 2008, forecasting revenue below Wall Street estimates.
Microsoft said the online advertising market is growing rapidly and expected to reach nearly $80 billion by 2010 from over $40 billion in 2007. It added it is "increasingly dominated by one player," referring to Google.
Microsoft, the world's largest software company, said it had identified four areas that would generate at least $1 billion in annual synergies for the combined entity.
Rohan expects Microsoft could realize as much as $2 billion a year in free cash flow from the deal said. He anticipates Microsoft will merge back-end businesses, but keep both the Yahoo and MSN brands.
Microsoft said it expects to offer significant retention packages to Yahoo engineers, key leaders and employees. The company expects it could receive regulatory clearance and close the deal in the second half of 2008.
With its deep pockets, Microsoft is heading into the hostile offer well-armed.
The deal demonstrates the power of cash, said David Kotok, chairman and chief investment officer at Cumberland Advisors, in an interview on "Squawk Box."
Kotok also said the deal is bullish for the tech sector.
"It says the world is not coming to an end, and the people who shorted Yahoo are going to pay," Kotok added. "...It tells you that the tech sector's viable. Tech is not just semiconductors. It's very broad. It includes software, big software companies like Microsoft, and all the various types of specialty services. Yahoo's a great example. This is a very good move."
Mark May, analyst at Needham, said that while the price is a premium to Yahoo's recent trading price, it was in line with its average trading value over the last 2 years.
"I would not be surprised to see this bid have to be raised over time," he said. "I think there are companies out there like Comcast and Viacom and others that still need to address the emergence of online media and haven't. So there are clearly other strategic companies out there."
The Microsoft-Yahoo deal would be the largest in the Internet market since the $182 billion purchase of Time Warner by AOL in 2001, which was seen as the worst merger in recent corporate history, with clashing corporate cultures and many of the promised synergies never materializing.
--Reuters contributed to this report.
--CNBC.com has business relationships with both Yahoo and Microsoft.