The story behind the story of the Microsoft withdrawal

Shortly after Microsoft announced its hostile bid for Yahoo, Google objected and raised the prospect that it would lobby government regulators to block any merger.

As it turned out, Google was very much the spoiler in the deal. But its most effective weapon was not threats or coercion, but its very effective, and unconventional, use of its own checkbook.

Google has agreed to sell some search advertising for Yahoo. And since Google earns far more on every search than its rivals do, this will mean an immediate increase in Yahoo’s profits.

Microsoft’s chief executive, Steven A. Ballmer, said the prospect of such a deal that could deprive Microsoft of being able to sell all Yahoo’s search ads made proceeding with a hostile takeover less attractive. And Yahoo hopes the promise of a big check each quarter from Google will placate enough shareholders to head off a revolt over its decision to turn down Microsoft’s offer of $33 a share.

It is a rare company that will help its biggest rival this way. And Google’s offer is all the more unusual because it does not neutralize Yahoo as a potential future competitor, at least explicitly.

According to what we know so far about the arrangement, Google will sell ads on some of the most popular terms on Yahoo’s search engine, giving Yahoo the vast bulk of the revenue (as it always does with sites for which it sells ads). Yahoo’s stated plan is to take that money and continue to develop its own search advertising system that is meant to rival Google. When Yahoo’s own technology is good enough, it will presumably start selling its own ads for all its terms, and try to destroy the company that had thrown it a lifeline in its time of need.

Why would Google do this?

Eric E. Schmidt, Google’s chief executive, portrayed the move as a gesture of friendship.

“It’s nice to be working with Yahoo,” he told analysts last month. “We like them very much.”

There even may be a bit of truth to that. Google’s founders, Larry Page and Sergey Brin, indeed have been friendly with Jerry Yang and David Filo, the founders of Yahoo. All four of them studied, and cooked up their companies, at Stanford.

Moreover, Yahoo gave Google its major break, hiring the fledgling company to power the searches on Yahoo.com. Many suggest that Google would never have established itself with Internet users were it not for the promotion it received from Yahoo, which put Google’s name and logo on every Yahoo search results page. So perhaps Google is indeed trying to return a favor.

The other explanation, not mutually exclusive, is that Google fears Microsoft far more than it fears Yahoo. That’s odd, perhaps, because in Google’s the most important markets, Web search and online advertising, Yahoo now is a bigger and more effective competitor than Microsoft.

But Microsoft has far more money and engineering bench strength than Yahoo does, so Google may fear it more in the long run. Moreover, Microsoft has quite a history trying to best rivals through tough tactics and exploitation of its Windows franchise.

Google has made no secret over the years that the rival it is most concerned about is Microsoft, and it has raised several objections to the prospect of a merger. In any case, a combination of Microsoft and Yahoo could be a tougher competitor to Google than either separately.

Most significantly, Google acts as if it has the confidence that it can win in the market, even if it makes deals that look very advantageous to others. Google has long, for example, provided a very rich advertising deal to Ask.com, a smaller rival. Ask has also tried to build its own search advertising system, with little impact so far.

Google understands that there is a powerful network effect in search advertising. That is, the more search ads it handles, the more money it will make and the harder it will be for anyone else to build a competing system. The more searches it handles, the more advertisers it attracts. And the more bidders in its auction, the higher the prices it will enjoy.

By attracting a commanding share of the search advertising activity, Google also has the best data with which to create equations that maximize the money it makes from each search. It turns out that picking which ad to display when is a subtle art that can have a great effect. Yahoo estimated that until recently, Google earned twice as much on each search than it did.

So while Google is giving Yahoo a fair bit of aid in the short run, I suspect that it is betting that in the long run this deal is going to sap Yahoo’s ability to build an effective search advertising system. That’s because Yahoo will have even less volume of searches to attract customers, raise bids and give it data with which to improve its ad selection technology.

I do believe that Google’s management very much wants to triumph over Microsoft. And I wouldn’t be surprised if they are getting a bit of extra enjoyment because they are doing so by smiling and passing out money, rather than through the bravado and coercion that has often characterized Microsoft.

Via NY Times