At its core, this agreement means that Yahoo has given up on its search engine business. Microsoft will be able to increase its market share in the search engine and search advertising market. Yahoo will receive revenue from Bing searches generated on Yahoo's sites and become "the exclusive worldwide relationship sales force for both companies' premium search advertisers." What remains to be seen, though, is what will happen to Yahoo's investments in interesting search technologies like BOSS and Search Monkey. Integrating these technologies, which are tied to Yahoo's search engine, could prove rather difficult for Microsoft. We will also have to wait and see what's going to happen to Yahoo's search APIs.

If anything, the Yahoo Search team will probably not be too happy to hear Yahoo suggest on its blog that Yahoo used to offer a "great" search experience but that Bing will offer an "awesome" one. In a call earlier this morning, Yahoo CEO Carol Bartz announced that some employees from the Yahoo search team will move to Microsoft, while others will move to the display business.

Creating Competition for Google

As we pointed out before, we think Bing is a worthy competitor to Google's search engine, which both Microsoft and Yahoo try not to mention in all their press materials but whose shadow obviously looms large over this deal. Advertisers aren't likely to spend a lot of money on a search engine that only commands less than 10% of the market, but once combined with Yahoo Search, Bing could easily reach 20% or more. At this point, advertising on Bing becomes far more interesting.

In a taped video statement Microsoft's CEO Steve Ballmer argues that the agreement will bring choice back to consumers (a Silverlight version is embedded below, a WMV version is available for download here). We can't help but note that consumers always had lots of choices with regards to search engines - in the past, most just didn't make the choice Ballmer would have preferred.

It's important to note, though, that neither Microsoft nor Yahoo seem to have worked out all the details of this deal, and that users won't see any changes before early 2010. The companies expect the agreement to be reviewed by industry and government regulators before this.

The Details

Here are the details of the search/ad pact between the two companies, according to this morning's press release:

• The term of the agreement is 10 years;
• Microsoft will acquire an exclusive 10 year license to Yahoo!'s core search technologies, and Microsoft will have the ability to integrate Yahoo! search technologies into its existing web search platforms;
• Microsoft's Bing will be the exclusive algorithmic search and paid search platform for Yahoo! sites. Yahoo! will continue to use its technology and data in other areas of its business such as enhancing display advertising technology.
• Yahoo! will become the exclusive worldwide relationship sales force for both companies' premium search advertisers. Self-serve advertising for both companies will be fulfilled by Microsoft's AdCenter platform, and prices for all search ads will continue to be set by AdCenter's automated auction process.
• Each company will maintain its own separate display advertising business and sales force.
• Yahoo! will innovate and "own" the user experience on Yahoo! properties, including the user experience for search, even though it will be powered by Microsoft technology.
• Microsoft will compensate Yahoo! through a revenue sharing agreement on traffic generated on Yahoo!'s network of both owned and operated (O&O) and affiliate sites.
• Microsoft will pay traffic acquisition costs (TAC) to Yahoo! at an initial rate of 88% of search revenue generated on Yahoo!'s O&O sites during the first 5 years of the agreement.
• Yahoo! will continue to syndicate its existing search affiliate partnerships.
• Microsoft will guarantee Yahoo!'s O&O revenue per search (RPS) in each country for the first 18 months following initial implementation in that country.
• At full implementation (expected to occur within 24 months following regulatory approval), Yahoo! estimates, based on current levels of revenue and current operating expenses, that this agreement will provide a benefit to annual GAAP operating income of approximately $500 million and capital expenditure savings of approximately $200 million. Yahoo! also estimates that this agreement will provide a benefit to annual operating cash flow of approximately $275 million.
• The agreement protects consumer privacy by limiting the data shared between the companies to the minimum necessary to operate and improve the combined search platform, and restricts the use of search data shared between the companies. The agreement maintains the industry-leading privacy practices that each company follows today.

$3 Billion?

Kara Swisher reports that on the financial side of things, it looks like the latest deal would include Microsoft paying several billion dollars to Yahoo upfront to take over its search advertising business. If this deal goes through, Swisher reports, Yahoo would also take over Microsoft's display ads business. Concrete numbers are still hard to come by, but 27/7 Wall Street reports that Yahoo would get $3 billion upfront and "will get 11% of the revenue that its searches provide after traffic acquisition costs in each of the first two years. In the third year, that figure would go to 90%."

As always, we will keep a close eye on this story as it unfolds. For now, there are still rumors, but they seem to be quite substantial, and a deal between Microsoft and Yahoo (though not a merger of the two companies) would definitely make sense at this point.

Microsoft has issued a public statement that they will continue to explore alternatives. While Microsoft notes of possibly venturing to third parties, they haven't taken their eyes off of Yahoo! yet. Instead Microsoft intends to talk with Yahoo and explore alternative angles to their former strategy. With little to no reassurance that any transactions will result, Microsoft states that:

In light of developments since the withdrawal of the Microsoft proposal to acquire Yahoo! Inc., Microsoft announced that it is continuing to explore and pursue its alternatives to improve and expand its online services and advertising business. Microsoft is considering and has raised with Yahoo! an alternative that would involve a transaction with Yahoo! but not an acquisition of all of Yahoo! Microsoft is not proposing to make a new bid to acquire all of Yahoo! at this time, but reserves the right to reconsider that alternative depending on future developments and discussions that may take place with Yahoo! or discussions with shareholders of Yahoo! or Microsoft or with other third parties.

Yahoo!'s Response

To ensure that things would go over smoothly on Yahoo!'s end, Yahoo! also issued a public statement about the talks:

Yahoo! has confirmed with Microsoft that it is not interested in pursuing an acquisition of all of Yahoo! at this time. Yahoo! and its Board of Directors continue to consider a number of value maximizing strategic alternatives for Yahoo!, and we remain open to pursuing any transaction which is in the best interest of our stockholders. Yahoo!'s Board of Directors will evaluate each of our alternatives, including any Microsoft proposal, consistent with its fiduciary duties, with a focus on maximizing stockholder value.

What really stands out about this statement is the following line:
"[...] Microsoft that it is not interested in pursuing an acquisition of all of Yahoo! at this time."

Microsoft may no longer want all of Yahoo!, but Yahoo!'s search engine would be a very nice "alternative".

More Buzz

Leading industry experts are abuzz with news of what's really going on between Microsoft and Yahoo. Kara Swisher of Boomtown makes a note of an internal Microsoft memo with a strategy update from Kevin Johnson the president of the company's Platforms & Services division. The memo gives a little more insight into Microsoft's strategy for Yahoo, concluding that they can compete.

John Furrier the Founder and recent CEO of PodTech Network released even more interesting news today. While it's only a rumor thus far, Furrier says this:

My sources say that the Yahoo and Microsoft teams are bunkered down in a Palo Alto hotel hammering out the final stages of a transaction that will have Microsoft picking up the Yahoo search business. Word is that this deal will be done this week. While this is not surprising, it does bring to question the motives and plans of Microsoft.

Furrier also identifies why Microsoft would go through all the twists and turns to accomplish this. According to Furrier, with a failed bid for over $40 billion, Microsoft intends to buy the search business from Yahoo and move on to Facebook with a $20 million bid. "Integrating the search team at Yahoo with Facebook puts a formidable army to take on Google." Scoble seems to be taking a similar stance and even goes as far as stating how the situation explains Facebook's hostile behavior towards Google this past week.

War of the Worlds Part II

Is one of the biggest showdowns in tech history about to play out between Microsoft, Yahoo, Google, and Facebook. Can Google continue to lead the search industry with the best of Microsoft, Yahoo, and Facebook fighting against them? While, this remains to be seen, we fully intend to keep you posted as the story unfolds.

It's often said that Flickr is the new heart of Yahoo! and many early adopters (like our readers) are probably more likely to use Yahoo! services like Del.icio.us, Upcoming or even the new FireEagle than they are to be big Yahoo! Sports or Finance fans. Instead of putting the most innovative Yahoo! properties in Microsoft's hands, we'd like to see them put at the heart of the company's strategy for the future.

Yahoo's acquisitions of innovative startups hasn't gone off without a hitch, and Microsoft seems aimed to be less evil by some standards than Google, but a big buy-out is not the kind of change many Yahoo! fans have been hoping for. Microsoft is widely understood as monopolistic and kludgy despite recent moves towards openness.

Wouldn't it be great to see Yahoo! continue in the direction it moved when it transfered Yahoo! Photo users to Flickr? How about breathing some new life into Del.icio.us and using it to supplement the fast ascending Yahoo! Buzz? Innovation is fast and furious over at MyBlogLog, Yahoo! could certainly leverage that technology far more heavily than it seems to have to date.

Yahoo's semantic search and SearchMonkey structured search platform both have huge potential. The location aware FireEagle is a model of best practices - from user permissioning to standards based authentication protocols.

I probably use Yahoo Pipes more than any other Yahoo service and despite its relative lack of support from the big co. - I'd hate to see that project go to Microsoft or shut down. Here's a list of all the Yahoo! assets - there's so much potential there! (Thanks, Mark Evans, for that link.)

It would be great to see Yahoo! put its own money where its mouth is and really leverage the innovation that much of its rank and file are clearly big believers in. The company has incredible opportunities to move away from the Hollywood-centric paradigm advanced by former CEO Terry Semel. If any large player could monetize web and standards based technology in an innovative way, it could well be Yahoo!

Big banner ads aren't a sound long-term monetization strategy. Leveraging personalization, data mining and machine intelligence is. Yahoo! can make that strategic change.

The Big Risk

When Yahoo! underwent an employee purge earlier this year, one thing we didn't hear about was the departure of many people working on the smallest and most innovative properties there. We won't comment on the business perspective here, but if business at Yahoo! continues to take a turn for the worst and the company responds by cutting its most forward looking innovators - that would be terrible.

Our favorite apps may not be safe for long. Hopefully they will be put at the center of a new Yahoo! strategy. In a worst-case scenario, we can at least be thankful that many Yahoo! properties support easy data export. For now though, the failure of the Microhoo deal may be great news for innovation.

We like where Yahoo! is going and we hope that they'll put their most exciting assets at the center of their strategy for the future.

Don’t the Google guys realise how big and dominant they have become? Sure they do, but “only the paranoid survive” and Microhoo does give some room for paranoia in the Googleplex.

• Email is 49% of Impressions. Portals and Search Engines is 10% by contrast. This is some free data from Nielsen-Netratings. click on Top Site Genres.
• 56% is Microsoft and Yahoo combined market share of webmail. Gmail is down at 7%. This data is via Fred Wilson’s back of envelope calculations.

Yes both data sets can have a pretty wide margin of error, but even discounting that, this would be cause for worry.

Sure, in the early adopter world we live in, Gmail rocks and who would be seen dead with AOL or Hotmail? But that 50% market share for Microhoo is what you will see in the real world.

Hotmail has lagged terribly. Most people who used it would not return, I cannot imagine who would switch (an AOL user maybe) and most people already have email. So it is a lost cause. One major reason it lagged IMHO was Microsoft fear of cannibalizing Outlook. So they won’t offer the features that users want that both Google and Yahoo have been rushing to fill. Yahoo is reputed to have the most “Outlook-like” interface and that matters massively to people making the switch.

Microsoft will probably do the smart thing and let the Yahoo team run with email. Hotmail will die as a separate brand, eventually.

Feature for feature, Google and Microhoo will slug it out for a long time. Today Gmail looks to be ahead but that position is not written in the stars. With the “don’t cannibalize Outlook” shackles off, its just needs some well-directed R&D dollars and they have plenty of that.

The real battle of course remains around search within email and thus monetization. Google is better at relevant ads in Gmail because they have a better search engine. But if Microhoo gets its act together in search, they have the bigger content/audience to monetize. Technically improving search is not that hard. Microsoft have all the R&D money they need and, more importantly, every search start-up looking to exit to them. If you really can improve search you have one fat valuation offer coming down the pike!

Here is the really interesting bit. Improving ad relevance within email does not require any searching behavior change. That is worth repeating. Say after me, “if we have 56% of 49% we have something like 25% of ad impressions and all we need to do is serve relevant ads”. Come on developers, you can fix that, right? Page rank is not relevant. Getting people to switch from Google to another search engine is not required.

So, in the final analysis, it is not really as much about search quality as it is about Ad Networks; both Microsoft and Yahoo have good Networks and advertisers always want a choice. So nobody can dominate this for too long. The Adwords auction model is brilliant but is self-limiting in the end; when the price gets too high, advertisers seek out alternatives.

However email is not just fodder for search it is the key to ad relevance, via the social graph. As Fred Wilson puts it, email is “the biggest social graph“. What is social networking except in-site messaging? Add in messaging within Facebook, where Microsoft has the ad deal, and I can see some 3am wake-ups among the Google team.

The social graph is key to ad relevance because it enables “SEO resistant search”. This is what Scoble calls it in this great series of Podcasts. Skip to # 3 if you know the basics. His closing remark (made in August 2007 for historical record) is kinda fun in the circumstances “watch Yahoo, they are the wild card”.

He is right, look at all Yahoo’s social assets. Massively underexploited but great. If the social graph is the key to SEO resistant search and thus search relevance and webmail is the key to the social graph….

When two gorillas duke it out, watch out! You can get crushed by accident - oops sorry, Chimp, did not see you there - but it is also full of opportunity for entrepreneurs.