Microsoft and Yahoo Russian Roulette

There’s been a lot of debate recently — including here at BusinessWeek — about what Jerry Yang should do with Yahoo’s solid first quarter results. Should he rush to the negotiating table, earnings report in hand, or hold out for a higher bid?

To answer the question, I sought the opinion of a couple game theorists at Princeton and Dartmouth. Here’s what they had to say:

To Princeton University economics professor and game theorist Avinash K. Dixit, the ongoing Microsoft/Yahoo negotiations recall the Russian roulette scene in LA Confidential. Russell Crowe has a loaded revolver in the suspect’s mouth and he’s firing. With each shot, the suspect’s risk of losing everything increases. Does the suspect want to cough up the information now? Click. How about now?

In this case, both Microsoft and Yahoo have guns. The companies are playing a game of brinkmanship, says Dixit. The strategy is a common one in business deals where the costs and risks increase as time passes without a settlement. The rules are that each party holds its position firmly in hope that the other guy has less stomach for the rising risks and costs. The guy who breaks first loses. “There’s this strategy of brinkmanship where the parties make it riskier by holding out,” says Dixit. “Some kind of brinkmanship is key to this.”

Both Microsoft and Yahoo are playing to the right script. Microsoft CEO Steve Ballmer has continually maintained that the Microsoft’s Jan. 31 half cash/half stock offer, now valued at about $43.6 billion, was full and fair. Just this week, Ballmer reiterated that Microsoft has no plans to raise its bid, despite Yahoo delivering strong first quarter results. Meanwhile, Yahoo CEO Jerry Yang has held fast to his board’s rejection of Microsoft’s offer.

Yahoo and Microsoft have also done their best to increase the others cost and risk of delaying. This month, Microsoft set a three week deadline, set to expire April 26, for Yahoo to begin negotiating. Otherwise, Ballmer would move ahead with plans for a proxy fight, including nominating a new Yahoo board of directors likely to approve an even lower Microsoft bid. The move is intended to make Yahoo shareholders more nervous about waiting for a better bid, and thus more likely to either push for the deal or sell their stock in anticipation of a lower bid, weakening the company’s financial position. “I think Microsoft is wise in trying a first-and-final strategy,” says Robert Hansen, senior associate dean at Dartmouth’s Tuck School of Business who studies game theories applications in business. “That’s a good strategy, if the target believes you are committed to it.”

Yahoo has played down Microsoft’s deadline. As far as the company is concerned, Microsoft seeking, or announcing, a slate of proposed directors doesn’t do anything to change the current board’s timetable for considering a variety of options for the company, including the Microsoft deal. The real deadline that matters is when Yahoo has its 2008 annual meeting of stockholders, which has yet to be announced.

Meanwhile, Yahoo has increased Microsoft’s costs as well. Its solid first quarter results have to make Microsoft worry, at least a little bit, that some shareholders will believe Yahoo can go it alone. More time, only gives Yahoo more ability to convince shareholders it deserves its independence.

Moreover, there are costs to continuing negotiations that both companies face. Yahoo spent $14 million in the quarter for outside advisors related to Microsoft’s unsolicited proposal during the quarter. Microsoft faces its own costs for advisors related to the deal as well as the looming threat of a more unfavorable regulatory landscape in China, where a law that would give authorities greeter leeway to scrutinize mergers goes into effect Aug. 1

Ultimately, both companies have to want the deal to go through. Yang knows that none of the alternatives Yahoo has presented to shareholders are as attractive as a sale to Microsoft. And despite statements to the contrary, Ballmer knows that Microsoft’s online ambitions require the kind of scale only Yahoo can provide.

The question that remains is who will blink first, and when. “Often the case is the deal gets done ten minutes to, or five minutes till midnight,” says Dixit.

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