As of last weekend, Yahoo (YHOO) had two deals on the table: A Microsoft (MSFT) search deal and a Google (GOOG) search deal. Yahoo chose the Google deal. After speaking with a person familiar with Microsoft's thinking and a person familiar with Yahoo's thinking, we now have a better sense of why Yahoo chose the Google deal.

According to the person familiar with Microsoft's thinking, the Microsoft deal was as follows:

• Microsoft buys Yahoo's search assets for $1 billion. The search assets include: Code, people, servers, and data centers associated with both Yahoo's organic search (algorithmic) and paid search (Panama).
  
• Microsoft and Yahoo enter into a search monetization agreement similar to the one Yahoo just signed with Google. In this deal, Microsoft would serve Yahoo's search results--organic and paid--handle the relationships with advertisers, and pay Yahoo a standard revenue split on each paid query. The main differences between this deal and the Google deal would be:
  • Microsoft serves both organic and paid results
  • Microsoft serves ALL Yahoo paid results (the Google deal is partial)
  • Yahoo discontinues any investment in Panama or organic search
• Microsoft estimates that the combination of cost savings and revenue boost would drive $1 billion in incremental operating income to Yahoo per year. This is far more than the $250-$450 million expected from the Google deal. It is also, according to the person familiar with Yahoo's thinking, "a made up number" that depends on assumptions about how much cost Yahoo will eliminate. The person familiar with Yahoo's thinking says the incremental operating income from the Microsoft deal would be much lower than $1 billion. The familiar-with-Yahoo-thinking person also says that Microsoft's per-query revenue guarantee was lower than Yahoo is generating today and much lower that the Google deal will generate (i.e., lower revenue to Yahoo). The familiar-with-Microsoft-thinking person says, no, the deal guaranteed more revenue than Yahoo is generating [but not as much as Google.]
  
• Microsoft buys 16% of Yahoo stock (existing shares) for $35 a share, or $8 billion. This would allow Yahoo shareholders to receive $35 for about 1 in every 6 Yahoo shares they own. It would not result in any additional dilution (or cash on the balance sheet) for Yahoo. The person familiar with Yahoo's thinking does not dispute this.
  

ANALYSIS

Financially, the main difference between the deals was that, in Microsoft's view, the Microsoft deal provided 2X-3X as much operating income and $1 billion of cash. TPFW Yahoo's thinking disagrees with the operating income assumption and views the $1 billion as chump change. If one takes TPFW Microsoft's thinking at face value, the Microsoft deal was the financial winner. Yahoo shareholders eager to get $35 for at least SOME of their Yahoo shares no doubt wholeheartedly agree with this.

Strategically, the Microsoft deal would have closed the door on Panama (no going back) and therefore provided Yahoo less flexibility. It also would have forced Yahoo to tell advertisers to book search campaigns using Microsoft instead of allowing them to sell search campaigns directly.

Operationally, the Microsoft deal would have freed Yahoo from having to worry about hiring and managing search engineers, as well as investing in search long term. This would allow it to focus 100% of its energies on display advertising. It would also have deprived it of control over a critical revenue stream and user product. The person familiar with Yahoo's thinking says this is a risk Yahoo simply wasn't willing to take (What would happen if the companies entered into a decade-long deal and Microsoft screwed up?

CONCLUSION

Yahoo decided that the strategic drawbacks of the Microsoft deal outweighed the potentially huge financial and operational benefits...and told Microsoft to take a hike.