Why Microsoft and Yahoo had to do a deal

    By Patricia Sellers

    “Every key word that every advertiser in every part of the world would put on Google, I want on our system.”

    That’s what Microsoft (MSFT) CEO Steve Ballmer declared last month when I interviewed him onstage at the Cannes Lions International Advertising Festival. He also confessed one great regret since he took the helm from Bill Gates a decade ago: “We should have been earlier in search.”

    So, if you’re at all surprised that Microsoft has at last sealed its hard-fought search deal with Yahoo (YHOO), you shouldn’t be. This partnership, as messy as it was in coming, had to happen.

    Under the terms of the 10-year revenue-sharing partnership announced this morning, Microsoft’s new Bing search engine will handle searches on Yahoo.com. And Yahoo will use its sales force to serve premium advertisers. The joint venture will help Ballmer get the heft he needs to better compete with Google (GOOG). Meanwhile, it will help Carol Bartz, Yahoo’s CEO, who has been working to revive the company since she came on board six months ago from Autodesk (ADSK), to focus on advertising and content–and, according to Yahoo, to increase operating income by some $500 million annually.

    This deal follows last year’s failed attempt by Microsoft to buy Yahoo for $47.5 billion. Last month, after Microsoft launched Bing, some observers (including me) ventured that its early success might diminish the company’s urgency to chase a Yahoo partnership. Watch the video below to see Ballmer’s boisterous response to my query about that. “When you have two players that are fairly low-share, sitting in an advertiser’s shoes, you have to decide how many of the search engines do you bid on, and how many key words do you bid on per platform?” he told an audience of about 1,000 in Cannes last month. “More people, more advertisers bid on more keywords on Google than on Yahoo or Microsoft–even more dramatically outside the U.S. than in.”

    The low share in search pained Ballmer–who went on to tell the crowd about “a friend who rents apartments–mostly to American tourists. She rents apartments in Paris. If I wasn’t her friend, she would not submit bids (on Microsoft’s search engines).” Why not? With barely one-tenth of the search market, Microsoft couldn’t generate enough traffic to give a.) consumers the best search experience, or b.) give advertisers the best value.

    Turns out, committing to Bing–investing in the people and technology behind it and spending $100 million to market the new search engine–increased Microsoft’s urgency to complete a deal with Yahoo. And Yahoo, meanwhile, couldn’t bear the notion of losing its No. 2 position in search . Not that the two companies jointly threaten Google’s preeminence: Yahoo and Microsoft together control about 28% of U.S. search traffic, vs. Google’s 65%.

    Bing also gave Bartz confidence that Yahoo’s search business would be in good hands with Microsoft. At 4:55 this morning–”inhumanly early in California,” she noted—Bartz wrote in a post on Yahoo’s blog site: “This transaction will create a healthy competitor that’ll keep everyone on their toes.” She’s clearly talking about Google. And as she recuperates from a knee replacement, she’s hardly backing down. Neither is Ballmer.