Microsoftis still open to negotiating with Yahooafter offering $1 billion in cash to buy its search business in a deal that would have delivered $1 billion in additional annual operating income to Yahoo.
In an alternative to a full acquisition, Microsoft would have taken control of Yahoo's search business, delivering the company better rates for advertisements tied to its search results than Yahoo's current Panama advertising, a source said.
The rejected Microsoft proposal would have given Microsoft an exclusive 10-year deal to handle Yahoo's search advertising, a source familiar with the matter told Reuters on Friday.
As part of that deal, Microsoft would have guaranteed income payments to Yahoo for only three out of 10 years, the source said.
A source familiar with Microsoft's thinking said earlier on Friday that talks with Yahoo centered on a $9 billion transaction to buy a 16 percent stake in Yahoo and its search business. The source said Microsoft's proposal would have delivered $1 billion in additional annual operating income to Yahoo.
Microsoft's plan to establish a strong footing in online advertising suffered a big blow on Thursday as merger talks with Yahoo finally, formally failed and Yahoo said it would let Google sell search ads on its site.
Yahoo shares shaved a bit off earlier losses on the news but was still down more than 4 percent for the session.
Separate statements Thursday from Microsoft and Yahoo signaled a real rift between the two after their agonizing on-again, off-again talks, and Yahoo shares fell as final hopes of a full or partial acquisition faded.
Microsoft shares rose as investors showed relief that the company would not be paying too high a price for a deal they considered risky—even though its biggest rivals on the Web aimed to work together.
Yahoo said it had agreed to let Google put search ads--advertisements placed next to search results--on its site in what it called an $800 million annual revenue opportunity that would boost cash flow by $250 million to $450 million in the first 12 months.
"Google has made an enormous gain strategically. This move might well have shut Microsoft out of the online space altogether," said Sanford Bernstein analyst Jeffrey Lindsay.
Google and Yahoo, No. 1 and No. 2 in search, will pit ads against each other in auctions for the ad that pays the most.
"Yahoo is being a reseller of Google whenever it makes sense, and that is likely to be a lot of the time, given how much more effective Google Web search ads have proven to be," Global Crown Capital analyst Martin Pyykkonen said.
The process is nonexclusive, meaning others could join in the bidding to place ads, a factor that could make a deal easier to pass regulatory approval.
The companies agreed to wait 3-1/2 months for regulatory approval and to offer a way to end it if Yahoo is taken over.
But the prospect of combining the top search ad vendors in one system immediately raised fears. Sen. Herb Kohl, a Wisconsin Democrat and chairman of a Senate antitrust subcommittee, said lawmakers would "closely examine" the plan.
Google Chief Executive Eric Schmidt likened the deal to ones in other industries where rivals find ways to cooperate even as they compete.
"The decision of showing ads is a Yahoo decision, not a Google decision," he said.
Yahoo rejected Microsoft's latest proposal, which sources briefed on the subject said included an offer to buy 16 percent of Yahoo for $35 per share, plus to buy its search business.
Yahoo simply said that an alternative Microsoft proposal to buy only its search business did not fit into its plan to grow search and display advertising.
Microsoft's offer for a minority stake was at a premium per share to its early May offer to buy the entire company for $47.5 billion, or $33 per share.
Microsoft, which said it was still open to an alternative deal, had hoped a Yahoo deal would accelerate its ability to capitalize on Web advertising growth and compete with Google, which is increasingly fighting for the same Internet audience.
Yahoo said on Thursday that Microsoft had made it clear in a meeting on June 8 that it was no longer interested in buying the company outright, even at the $33 per share price Microsoft had most recently proposed.
That may not appease Yahoo shareholders--including billionaire Carl Icahn--who have been pressuring Yahoo to reach a deal with Microsoft. Icahn has called for Chief Executive Jerry Yang to be ousted.
Analysts said they did not expect that Yahoo and Microsoft would try another round of negotiations.
"It certainly seems to be the end," said Derek Brown, an analyst at Cantor Fitzgerald. "In their most recent discussions, they were talking about totally separate visions of both a deal and the future."
Microsoft is expected soon to be on the prowl for other acquisition targets because it has not given up its goal for online advertising.
"Microsoft will keep trying," said Morningstar analyst Toan Tran. "Yahoo is one of the most popular sites on the Web, and there is no one else with as much traffic. AOL may be one option, and it may not be as expensive."
Icahn, who has waged a proxy battle to remove Yahoo's board at its Aug. 1 annual meeting, had urged Yahoo to secure a higher price from Microsoft. Icahn has said a partnership with Google should only be a second choice.
Icahn could not be reached for comment.
Yahoo shares sank to their lowest level since Jan. 31, the day before Microsoft announced its offer for the company.
Google announced a non-exclusive advertising services agreement with Yahoo, only hours after a decision by Microsoft to walk away from talks to acquire Yahoo.
Meanwhile, an important antitrust voice in Washington said he would "closely examine" the deal. (More below.)
The ad deal gives Yahoo the option to display Google ads alongside its own natural search results. The agreement has a term of up to 10 years.
Google said the agreement, which applies to the United States and Canada, will also enable interoperabililty between the two online media firms' instant messaging services.
Financial terms of the pact were not disclosed.
"This commercial agreement provides Yahoo with the opportunity to deliver more relevant ads to users and provide advertisers and publishers with better advertising technology to help them succeed in their own businesses," Eric Schmidt, chairman and CEO of Google, said in a statement. "This agreement will preserve the competitive and dynamic online advertising space."
Senator Vows Scrutiny
The chairman of a U.S. Senate antitrust subcommittee said on Thursday lawmakers would "closely examine" the collaboration between Google and Yahoo
Democratic Sen. Herb Kohl of Wisconsin said the deal between Google and Yahoo "raises significant competition concerns."
"The consequences for advertisers and consumers could be far-reaching and warrant careful review, and we plan to investigate the competitive and privacy implications of this deal further in the Antitrust Subcommittee," Kohl said in a statement.
Microsoft Bows Out
Earlier Thursday, Yahoo said that Microsoft was no longer willing to acquire it for $33 per share.
"The conclusion of discussions follows numerous meetings and conversations with Microsoft regarding a number of transaction alternatives, including a meeting between Yahoo and Microsoft on June 8 in which Chairman Roy Bostock and other independent Board members from Yahoo participated," Yahoo said.
"At that meeting, Microsoft representatives stated unequivocally that Microsoft is not interested in pursuing an acquisition of all of Yahoo, even at the price range it had previously suggested," the statement said.
Yahoo added that it determined that an acquisition of its search business alone by Microsoft was not in the best interest of its shareholders.
Microsoft said in a statement that it's not interested in "rebidding" for all of Yahoo, but that it was still open to an "alternative transaction" with the firm.
Microsoft had recently offered $35 a share for 16 percent of Yahoo as an alternative to an outright acquisition of the company, the Wall Street Journal reported.
Shares of Yahoo finished more than 10 percent lower Thursday at $23.52, while Microsoft shares rose 4.13 percent to $28.24.
Google shares finished up 1.42 percent, at $552.95.
See more in the accompanying CNBC video report.
On Monday, Yahoo President Susan Decker told CNBC that Yahoo remained open to deals with other firms if it failed to reach an agreement with Microsoft. "Our board remains absolutely open to any conversation w any company that would maximize shareholder value," she said.
Google's dominance in Web search prompted Microsoft to offer up to $47.5 billion to buy Yahoo. Microsoft hoped an acquisition would accelerate its ability to capitalize on Internet advertising growth and better compete with Google, which is increasingly fighting for the same audience of Internet users.
"It was pretty clear it was going to be one or the other. Yahoo wasn't going to do a deal with Google and then partner with Microsoft," Global Crown Capital analyst Martin Pyykkonen said.
The more recent proposal by Microsoft to only buy Yahoo's search business did not fit into Yahoo's view of benefiting from growth in both the search and display advertising businesses combined.
Yahoo faces mounting pressure from investors, including billionaire Carl Icahn, who urged the company to seal a deal with Microsoft but for a higher price. Icahn said a partnership with Google should only be a second choice.
Icahn could not immediately be reached.
- Reuters contributed to this report.