Microsoft just walked away from its proposed acquisition of Yahoo!, ending 3 months of speculation on what would ultimately happen.  While I have been generally supportive of the Yahoo! deal,  I was skeptical of the thought of a long protracted proxy battle.  And with Jerry Yang doing everything he could to burn and pillage the company and let Microsoft pick up the pieces, the deal became less desirable as it continued to drag on.

In his letter to Jerry Yang withdrawing the offer, Steve Ballmer alludes to a potential partnership between Yahoo! and Google, one that he sees tearing Yahoo! apart.  Of course that’s only if it is allowed to happen in the first place, and Ballmer will now turn his attention to doing everything in his power to stop the partnership, which would place Google ads on Yahoo! properties.  But even if it does occur, Ballmer makes a good point that it will weaken and demoralize Yahoo!’s Panama search marketing arm.  Ballmer said:

First, it would fundamentally undermine Yahoo!’s own strategy and long-term viability by encouraging advertisers to use Google as opposed to your Panama paid search system. This would also fragment your search advertising and display advertising strategies and the ecosystem surrounding them. This would undermine the reliance on your display advertising business to fuel future growth.

Given this, it would impair Yahoo’s ability to retain the talented engineers working on advertising systems that are important to our interest in a combination of our companies.

Certainly one outcome of the pull-out is going to be an all out attack on Yahoo!.  Steve Ballmer is going to want to make Jerry Yang pay, and the best way for Microsoft to gain share in search is to take it from Yahoo!  Yahoo! stock is widely expected to plummet after Microsoft walks, which it is bound to do on Monday morning.  Yahoo! shareholders are going to be fighting mad to see their stock return to the $19 – 20 range, and if Microsoft makes moves in other directions, making it clear that this isn’t a negotiating ploy, Yahoo! stock could fall well below $19.  Shareholder lawsuits, court battles over a potential Google partnership, a disillusioned workforce who may begin leaving in droves (assuming they can find someplace to go – down the street to Mountain View, perhaps?), and an all out assault by Microsoft all point to rough days ahead for Yahoo!  Remember that Yahoo! had been facing a year of rough days before Microsoft shored up its stock, and now that support is gone.

Yahoo! has made a number of moves to reshape the company in recent months, none of them bringing much more than a yawn to investors.  A vague, too little too late attempt to turn Yahoo! into a social networking platform by offering single sign on to their current mess of services (ever hear of Live ID?), might have well sent the stock price plummeting on its own if it wasn’t for Microsoft shoring it up.

As long as Microsoft doesn’t plan on coming back for Yahoo! at a lower price, and Steve Ballmer hints broadly that they won’t (“We will move forward and will continue to innovate and grow our business at Microsoft with the talented team we have in place and potentially through strategic transactions with other business partners.”), the worse Yahoo comes out of this, the better it is for Microsoft, as a significant share of the search market pie will be up for grabs.

So what else does Microsoft have up its sleeve?  Will it buy AOL?  AOL is clearly for sale, at a much lower price than Yahoo!.  While it doesn’t offer anywhere near the same value, buying AOL would send a strong signal that Microsoft is not just biding its time waiting to come back and save Yahoo!  Will it make a bigger play with Facebook?  Steve Ballmer was spotted outside the Facebook offices last week.  Or instead, will Ballmer himself be on the way out?

It is of course far too early to tell how this latest news will be perceived.  Certainly many at Microsoft will be relieved, this will give the troops in Redmond renewed confidence that their work matters.  While some have criticized Ballmer for making the attempt in the first place, pulling out now rather than engaging in a bloody battle that wasn’t a sure thing could be recognized as a smart move on his part.  There is of course a big danger that all of this will only strengthen Google’s dominance, but that was a danger no matter what transpired.

Microsoft’s attempt to acquire Yahoo! changed the game, whether the deal took place or not.  Microsoft is serious about search and advertising, an online presence.  Live Mesh has shown that there’s more to an online strategy than text ad placement, and Microsoft will be pursuing that strategy across a wide range of properties.  A Yahoo! acquisition might have been the best shot to gain share quickly, but a protracted battle wasn’t worth the hassle, and now it’s on to Plan B.  Can’t wait to see what it is.