April 21 (Bloomberg) -- Microsoft Corp. has stepped up discussions with Yahoo! Inc. about a partnership designed to challenge Google Inc. in the Internet-search market, people familiar with the matter said.

Qi Lu, president of Microsoft’s online services unit, and Charles Songhurst, an executive who helps oversee acquisitions, are involved, said one of the people, who declined to be identified because the talks are private. The outcome of the negotiations is probably several weeks away, the person said.

Microsoft isn’t seriously considering an outright acquisition of Yahoo’s search unit, the person said. Instead, the companies are looking at proposals to work together to sell sponsored links next to Web searches and graphical-display ads such as banners and videos. It’s too early to say which approach the companies may adopt, the person said.

Yahoo and Microsoft together account for about 30 percent of the U.S. Internet-search market, compared with about 64 percent for Google, according to research firm ComScore Inc. Microsoft will need to keep making capital and research investments in its search engine to compete with Google, Chief Executive Officer Steve Ballmer said last month.

CEO Meeting

Ballmer and Yahoo CEO Carol Bartz met about three weeks ago to discuss the partnership, according to a person familiar with the situation.

Kim Rubey, a spokeswoman for Yahoo, declined to comment. Simon Sproule, a spokesman for Microsoft, also declined to comment.

Ballmer indicated as recently as March 19 that he’s still interested in a search deal with Yahoo, saying he had spoken to Bartz on the phone. Bartz has said she will negotiate in private on any deal and that she doesn’t want Yahoo to be “pulled apart and left for the chickens.”

Microsoft, based in Redmond, Washington, rose 36 cents to $18.97 at 4 p.m. New York time in Nasdaq Stock Market trading. Yahoo, in Sunnyvale, California, added 72 cents, or 5.3 percent, to $14.38.

Microsoft has been working on its Internet search engine for more than five years, without gaining market share on Google. As Google shores up its dominant position, it may become harder for Microsoft to make inroads.

Google’s traffic helps it attract more advertisers. By processing so many queries, the company also can do a better job predicting what users intend when they type in a search term.

Outsourcing Deal

If Yahoo reaches a deal with Microsoft, it could outsource its entire search operation to the company. Or there may be a more limited deal, with Microsoft selling some ads next to Yahoo search results.

By adding Yahoo’s search business, Microsoft could improve its queries results and make ads more relevant to users, said Sandeep Aggarwal, an analyst at Collins Stewart LLC in San Francisco.

Right now, Google has 600 million search users, compared with Yahoo’s 300 million, Aggarwal said. Microsoft has 150 million, but only about 50 million of those use its search product regularly, he said.

Microsoft is currently spending as much as $900 million in capital costs and several hundred million more in operating expenses annually on its search business -- without boosting results, Aggarwal said.

‘Scale Problem’

“Microsoft’s Internet search business is suffering from a scale problem,” he said. “If they get scale, they will probably spend the same amount, but that spending will accomplish something.”

Ballmer has hired away top search executives from Microsoft’s potential partner. Lu and Sean Suchter, general manager of the company’s Silicon Valley Search Technology Center, both came from Yahoo.

Microsoft is also working on an update to its search engine, code-named Kumo. The software aims to help customers find what they’re looking for more quickly by understanding the gist of their query better.

A deal could benefit Yahoo by allowing the company to cut costs related to search research, engineering and advertising software. It might also boost future revenue and include a one- time cash payment, Aggarwal said. He estimates that an agreement would boost Yahoo’s shares by as much as $10.

The talks between Microsoft and Yahoo were reported yesterday on the All Things Digital blog.

To contact the reporter on this story: Dina Bass in Seattle at dbass2@bloomberg.net.

Last Updated: April 21, 2009 16:19 EDT