Microsoft bid $31 per share for Yahoo, representing a 62 percent premium to Yahoo's closing stock price Thursday.
"We see this announcement as the company's next major milestone to embrace online services," Steve Ballmer, Microsoft's chief executive officer, said on a conference call this morning.
The unexpected announcement Friday comes as Yahoo and Microsoft have fallen behind Google in the race to capture online advertising dollars. The deal could also give lift to the entire technology market.
"The Windows experience needs to increasingly embrace the Internet," Ballmer said. "When you combine the strengths of our two companies, the results will be very competitive."
Microsoft officials noted that Google, which has about 75 percent worldwide market share in the online search business, is prevented by antitrust laws from acquiring Yahoo itself, and that the online advertising industry - which today stands at more than $40 billion - is forecast to reach $80 billion in the next three years.
"Today the market in increasingly dominated by one player," said Kevin Johnson, president of Microsoft's Platforms & Services Division. "By combining assets of Microsoft and Yahoo, the industry will be better served."
"Microsoft didn't leave any doubt that one of the reasons for the acquisition is to better compete with Google," said CBS News technology analyst Larry Magid. "Yahoo has been struggling lately and Microsoft has never had a dominant online product. Perhaps by combining forces, they can give Google the competition that it now lacks."
If the deal goes through, analysts expect scrutiny from Congress, Justice and other enforcement agencies, but they say any concerns about search engine or online advertising market power may not be significant enough to stop the transaction.
The Justice Department on Friday said it is "interested" in reviewing antitrust issues associated with Microsoft's bid.
"The antitrust division would be interested in looking at the competitive effects of the transaction," said Justice Department spokeswoman Gina Talamona. [See more on anti-trust issues below]
In a letter to Yahoo's board of directors, Ballmer said the world's biggest software company had been told a year ago that the Yahoo board felt it was not the right time to enter into discussions regarding a deal.
"According to that letter, the principal reason for this view was the Yahoo board's confidence in the 'potential upside' if management successfully executed on a reformulated strategy based on certain operational initiatives, such as Project Panama, and a significant organizational realignment."
"A year has gone by, and the competitive situation has not improved," Ballmer added.
Under terms of the proposed deal, Yahoo shareholders could choose to receive cash or Microsoft common shares, with the total purchase consisting of 50 percent each cash and stock.
Microsoft said it sees at least $1 billion cost savings generated by the merger, and intends to offer significant retention packages to Yahoo engineers, key leaders and employees. The software giant said it believes the takeover would receive regulatory clearance and close in the second half of 2008.
Ballmer said Microsoft expects Yahoo's board will review its proposal, but "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."
Ray Ozzie, Microsoft's chief software architect, said joining the R&D capabilities of the two companies together would bring "a broad range of experience to our customers that neither could have achieved on our own."
The company is targeting the second half of calendar year 2008 for a close to the transaction.
Shares of Yahoo added $8.67, or 45 percent, to $27.85 in morning trading, while Microsoft fell $1.88, or 5.8 percent, to $30.72.
The announcement follows word on Thursday that Terry Semel stepped down as Yahoo's chairman, severing his ties 7-1/2 months after he resigned as chief executive under shareholder pressure. He had been criticized for failing to cash in on the Web advertising surge as effectively as main rival Google Inc.
Yahoo Inc.'s financial funk deepened at the end of 2007, prompting the slumping Internet icon to draw up plans to.
The Sunnyvale, Calif.-based company disclosed the upcoming 7 percent reduction in its 14,300-employee work force Tuesday while reviewing a 23 percent drop in fourth-quarter profit and a cautious 2008 outlook. The bad news sent Yahoo shares skidding to their lowest levels in more than four years.
In a prepared statement, Yahoo Chief Executive Jerry Yang warned Wednesday of looming "headwinds," indicating that the company's tortuous turnaround efforts aren't likely to pay off this year.
"This is certainly coming at a good time for Yahoo," said Magid. "$44.6 billion has got to be looking pretty good right now."
While there were few specifics about what the merger would mean for each company's employees and shareholders, Microsoft officials proclaimed the deal would be good for both camps, though there was the intimation that its integration plan necessitated the "right amount of head count."
Yahoo shares dropped $2.09, or more than 10 percent, in extended trading Tuesday after finishing the regular session at $20.81, up 3 cents. The company's market value has plunged more than 50 percent since the end of 2005, wiping out $35 billion in shareholder wealth.
Yang, Yahoo's co-founder, took over as CEO seven months ago in an attempt to shake things up, but his overhaul hasn't impressed Wall Street so far. The mass firings represent Yang's most dramatic move yet.
Meanwhile, Microsoft last week forecast a rosy 2008 - despite broader economic worries - after it blew by Wall Street's expectations for a second consecutive quarter.
Experts Expect Government Approval
Keith Hylton, a professor of antitrust law at Boston University, said Google's success in online search and advertising means a combined Microsoft-Yahoo would have significant competition.
"The fact that Google dominates this business will be a big factor in their (Microsoft's) favor in trying to get this approved by the regulators," Hylton said.
A spokesman from the Federal Trade Commission, which in December approved Google Inc.'s $3.1 billion purchase of online advertising company DoubleClick Inc., declined to comment. That deal still faces antitrust scrutiny in Europe.
A federal judge this week extended by 18 months court oversight of Microsoft's market power, which began in 2002 after a landmark antitrust settlement. Hylton said Justice has been relatively lenient with Microsoft, compared to state attorneys general.
It was a group of states that pushed for the extension of court oversight of the software giant, while Justice officials said the 2002 antitrust settlement had largely served its purpose and should expire.
"If this deal goes through, there will be a lot of very close scrutiny ... there appears to be lots of overlap," said Harry First, a professor at New York University's School of Law. "It's complicated and very big, and a lot of enforcement agencies will be interested."
Sen. Herb Kohl, D-Wis., chairman of the Senate antitrust subcommittee, said the same issues that prompted lawmakers to review the Google-DoubleClick deal exist in a potential Microsoft-Yahoo combination, including examining how it affects consumers, advertisers and businesses "who increasingly use the Internet for their news, commerce and entertainment."
If Yahoo accepts Microsoft's offer, the subcommittee expects to hold hearings to "explore the competitive and privacy implications of the deal," Kohl said.