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Yahoo! Starts Sweetened-Bid Bonanza

Updated from 3:33 p.m. EST

SAN FRANCISCO - Yahoo!'s (YHOO - Get Report) rejection of Microsoft's (MSFT - Get Report) offer could just be a lesson in Negotiation 101, but look for the Internet search veteran to take more evasive actions.

The rejection letter from Yahoo! on Monday is a typical first step in a well-tread mating ritual, much like BEA Systems' (BEAS) rejection of Oracle's (ORCL - Get Report) public takeover offer in October, which was later accepted at a higher price.

Yahoo's board has set the stage for further negotiations by suggesting a price of $40 a share, according to the Wall Street Journal, capping an ultimate settlement in a range starting at Microsoft's $31-a-share bid. The value of that half-cash/half-stock offer has already fallen due to the drop in Microsoft's share price since the bid was announced Feb. 1.

Later Monday, Microsoft responded to Yahoo!'s rejection in a press release, calling it "unfortunate," and saying that "we are confident that moving forward promptly to consummate a transaction is in the best interests of all parties."

The company also held up the not-so-veiled threat of a hostile bid: "Microsoft reserves the right to pursue all necessary steps to ensure that Yahoo!'s shareholders are provided with the opportunity to realize the value inherent in our proposal."

Yet reports that Yahoo! is looking for any out that doesn't involve Microsoft, if true, indicates the company is desperate, akin to Jaws' Quint grasping for any straw that could keep him from the maw of the shark.

Over the weekend, the Times of London reported that Yahoo! investigating a tie-up with Time Warner's (TWX - Get Report) AOL unit as a counter to Microsoft's bid.

Continued resistance from Yahoo! may force the Redmond, Wash., company into more hostile measures. For example, Microsoft could take its offer directly to shareholders. In doing so, it may start the clock on the anticipated antitrust review. Speeding that process would be in Microsoft's best interests. The company has said it hopes to conclude the acquisition by late 2008.

RBC analyst Robert Breza expects the two companies to come to terms within the next month, followed by an antitrust regulatory process that could take from 8 to 12 months, he wrote Monday. RBC Capital makes a market in Microsoft. Yahoo! is an investment banking client of the firm.

"We believe a deal will likely get done between $35 to $40 per share and possibly carry a higher cash/debt component" than the 50-50 split Microsoft previously outlined, Breza wrote.

The deal strategically makes sense for Microsoft, Breza noted.

Late last week, Citigroup analyst Brent Thill also viewed the scenario of a sweetened bid as the most likely outcome, followed by a deal in which Yahoo! outsources search advertising to Microsoft arch-competitor Google (GOOG). Microsoft and Yahoo! are investment banking clients of Citigroup.

With a market share in text-based search of more than 50% and growing, Google enjoys a "natural monopoly" that Microsoft is unlikely to break, said Kevin Kemmerer, senior vice president at venture investor Safeguard Scientifics (SFE). The merger "will only lead to a reduction in market share for a combined Microsoft."

The merger has big implications for Safeguard Scientifics, which has equity stakes in smaller Internet properties such as Bridgevine and Beyond.com. The success of these sites is tied directly to the ability of these search engines to convert queries into hits.

Kemmerer views both Microsoft and Yahoo! as potential bidders for the VC firm's startup Internet properties. "I need as many bidders as possible. Take one out, and I lose a potential acquirer," he said.

While that's an argument for regulators to take a hard look at Microsoft's designs on Yahoo!, Kemmerer says it is a bad deal for both companies and, inevitably, Microsoft shareholders.

"The only way to overcome Google is to innovate," Kemmerer said. Any of the three companies that either improves its search engine or tunes its ad-serving algorithms derives a distinct advantage. If a combined Microsoft and Yahoo! can't come up with innovation in one of those areas, Google will continue to take search and ad-serving market share.

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