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The 10-year deal gives Microsoft access to the Internet's second-largest search engine audience and adds a potentially potent weapon as it tries to better confront Google.
Microsoft will also be able to introduce its recently upgraded search engine Bing to more people. The Redmond, Wash.-based software maker believes Bing is just as good, if not better, than Google's search engine. Taking over the search responsibilities on Yahoo's highly trafficked site gives Microsoft a better chance to convert Web surfers who had been using Google by force of habit.
"Microsoft and Yahoo know there's so much more that search could be," said Microsoft CEO Steve Ballmer. "This agreement gives us the scale and resources to create the future of search."
For allowing Microsoft to run its search engine, Yahoo will keep 88 percent of revenue from search ad sales on its site for five years, plus it will be allowed to sell ads on some Microsoft sites.
Yahoo's market value stands at about $24 billion after coming off a tough quarter in search advertising, with its revenue in that niche falling 15 percent in the April-June period.
Yahoo estimated the deal -- which the companies hope to close next year -- will boost its annual operating profit by $500 million and save the Sunnyvale, Calif.-based company about $275 million on capital expenditures a year because it won't have to invest more in search technology.
If the deal passes antitrust scrutiny, it could give Yahoo a chance to recoup some money squandered in May 2008, when it turned down a chance to sell the entire company to Microsoft for $47.5 billion.
"The reason the deal happened now is the recent success of Bing. I think it put pressure on Yahoo, as well as Yahoo not being able to turn it around on its own," said Gartner Inc. analyst Neil MacDonald, according to the Associated Press.
Yahoo CEO Carol Bartz sealed the deal with Microsoft in just six months -- something neither of her predecessors, Terry Semel and Yahoo co-founder Jerry Yang, seemed interested in doing.
Bartz made it clear she was willing to farm out Yahoo's search engine for "boatloads of money" as long as she as thought the company would still receive adequate information about its users' interests.
An upfront payment from Microsoft "wasn't interesting to us," Bartz said, according to the Mercury-News of San Jose, Calif. "A big cash payment doesn't help us on an operating standpoint," she said in a conference call. "We feel that this is a true partnership," she added later.
Ross Sandler, analyst at RBC Capital Markets, said some people will be disappointed that Microsoft did not give Yahoo an upfront payment, but noted that the partnership was good overall for them.
"Overall, it's a big positive for two companies that have been struggling to keep up with Google. This consolidates their resources and allows them to make a more concerted push as the No. 2 entity," he told Reuters.
Many Yahoo search employees will be asked to take jobs at Microsoft, Bartz said. "Unfortunately, there will be some redundancies at Yahoo," she said in reference to layoffs, adding that the process will take two years and needs the go-ahead from regulators.
The two rivals began talking about a possible alliance as far back as 2005 before Microsoft intensified the courtship with last year's attempt to buy Yahoo.
Under the agreement, Yahoo will have limited access to the data on users' searches -- which yield insights that can be used to pick out ads more likely to pique a person's interest. The value of that information is why Microsoft wants to process more search requests.
Like Yahoo, Microsoft has invested billions in its search technology during the past decade, yet remained a distant third in market share while its online losses piled up. The company's Internet services division lost $2.3 billion in the fiscal year ending in June, nearly doubling from the previous year.
Microsoft is counting on Bing, which was unveiled in early June, to turn things around just as Google is attacking its bread-and-butter business of making software for personal computers.
Google is working on a free operating system for inexpensive personal computers in a move that could threaten Microsoft's ubiquitous Windows franchise. If it gains traction, Google's alternative, called Chrome OS, could divert some revenue from Microsoft while the software maker is trying to grab more of the money pouring into search advertising.
Chrome OS, though, isn't supposed to hit the market until the second half of next year. That means Microsoft could get a head start on Google in the duel to steal each other's financial thunder.
Bing has been getting mostly positive reviews and picking up slightly more traffic with the help of a $100 million marketing campaign. Analysts believe Bing's successful debut pushed Microsoft to reopen negotiations so it could expose its search engine improvements to a wider audience more quickly.
Even with Yahoo's help, Microsoft still has an uphill battle. Combined, Microsoft and Yahoo have a 28 percent share of the Internet search market in the United States, well behind Google's 65 percent, according to online measurement firm comScore Inc. Google is even more dominant in the rest of the world, with a global share of 67 percent compared to a combined 11 percent for Microsoft and Yahoo.
---- Compiled from wire reports and other media sources
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