The two sides decided they could work together after Icahn held "frequent" discussions with Microsoft Chief Executive Steve Ballmer and some of his top lieutenants during the past week, according to a letter that Icahn sent Monday to Yahoo shareholders. (See the accompanying video for more.)
Industry analysts said Icahn now has more credibility with Yahoo shareholders because he has been arguing that a purge of Yahoo's board is the only way to salvage a deal with Microsoft.
"This breathes new life into Icahn's proposal," said Stanford Group analyst Clayton Moran. "It really pushes the power to Icahn and his board (nominees)."The prospect that a changing of the guard at Yahoo might pave the way to a friendly deal with Microsoft lifted Yahoo shares $2.56, or 12 percent, to finish Wednesday at $23.91.
Echoing previous remarks in its battle with Icahn, Yahoo questioned Microsoft's interest in buying the entire company.
"If Microsoft and Mr. Ballmer really want to purchase Yahoo, we again invite them to make a proposal immediately," Yahoo said.
But Icahn said Microsoft doesn't want to risk making a bid under Yahoo's current regime, because the software maker fears Yahoo's management would make more poordecisions during an antitrust review that would take at least nine months.
"If the current board and management team of Yahoo mismanage the company (and their recent track record is far from reassuring), Microsoft would be putting its money at risk and a great deal could be lost," Icahn wrote in his letter to shareholders.
Microsoft's willingness to work with Icahn undermines one of Yahoo's chief arguments for re-electing its board.
Yahoo has maintained that it would be foolhardy to back Icahn's slate of alternate nominees because Icahn had no concrete ideas besides selling the company to Microsoft -- something that Yahoo has been depicting as a pipe dream since Microsoft withdrew a $47.5 billion offer in early May.
Microsoft reinforced that perception by refusing to revive its bid last month even after Yahoo's board signaled its willingness to accept the earlier offer.
With Microsoft in Icahn's corner, "the dynamic has changed," Sanford C. Bernstein & Co. analyst Jeffrey Lindsay said. "There is now a rationale for voting for Icahn's board because there now seems to be a real possibility for a deal again."
Monday's turn of events amplifies the pressure on Yahoo co-founder and CEO Jerry Yang, whose handling of the earlier negotiations with Microsoft infuriated many shareholders.
Yahoo's stock price had plunged by more than 30 percent to fall below $20 during Yang's first six months as CEO. Then, in January, Microsoft raised hopes for a quick windfall with its unsolicited takeover bid, only to be repeatedly rebuffed.
If he seizes control of the board, Icahn has promised to fire the 39-year-old Yang as CEO and replace him with a more seasoned leader.
Yang has been meeting with Yahoo's major stockholders during the past week, hoping to persuade them to give him a chance to prove the Sunnyvale-based company is worth more than the $33 per share that Microsoft previously offered.
Ballmer withdrew that bid after Yang sought $37 per share—a height the stock hasn't reached in 2 1/2 years.
In its Monday statement, Microsoft didn't mention how much it thinks Yahoo is worth now.
Industry analysts estimated Microsoft would likely pay anywhere from $28 to $33 per share if it takes another stab at swallowing Yahoo whole.
"Microsoft is still asking Yahoo shareholders to make a big decision with incomplete information," said Standard & Poor's Internet analyst Scott Kessler.
"I could still see a scenario where the Yahoo board is replaced and Microsoft comes in with a bid that is lower than people want. Then what do you do?"
Microsoft more recently has been trying to pry away Yahoo's search engine for $1 billion, plus an additional $8 billion investment for a 16 percent stake in Yahoo's remaining operations.
Yahoo instead opted for an online advertising partnership with rival Google that is supposed to boost its annual revenue by $800 million. That alliance faces an antitrust review by the U.S. Justice Department because Google and Yahoo combined control more than 80 percent of the U.S. search advertising market.
In its Monday statement, Yahoo asserted Microsoft is trying to use Icahn to engineer a purchase of Yahoo's search engine in a deal that would hurt the company in the long run, by hindering its ability to compete in the Internet's rapidly growing ad market.