The Microsoft-Yahoo Deal: Lessons for Startups

The founder of Silicon Alley Reporter and parses the long-awaited pairing and draws some lessons for entrepreneurs

Editor's note: This column is adapted from a recent essay Calacanis sent to his newsletter subscribers.

Yahoo (YHOO) committed seppuku today.

The once-proud warrior of the Internet space laid down its sword, knelt at the feet of Microsoft, (MSFT), and gutted itself today. There was no honor in this death: It was brought about by the shame of losing to Google (GOOG) and a lack of faith in its ability to compete in the space it created. To be clear, Yahoo didn't need to do this deal; Microsoft did. Ultimately Yahoo will look back at this moment as the second—and perhaps fatal—mistake in its epic history.

Search is the most important business of the 21st century, and owning a commanding lead in second place is not insignificant. At one time, Yahoo was the No. 1 search engine and portal. However, it didn't see the value in search and decided to syndicate that piece of its business to a small company called Google. For a couple of years we all experienced Google in Yahoo's wrapper. Our only indication of who made this wonderful tool was a tiny "Powered by Google" logo on the top right of the page.

We noticed, and we learned. The thought leaders went directly to Google and dragged everyone but the laggards (Yahoo's current 20% market share) with us. Yahoo accelerated the ascent of the master. Had Yahoo not given its search franchise over to Google back then, there is a good chance that the race for the most important business of the 21st century would be a dead heat. Certainly it would be closer.

Buy, Don't Sell

Today, with its Microsoft deal, Yahoo again undervalues its search asset. Again, it will be "Powered by..." and again it will destroy its brand and its value.

All that being said, Microsoft's obsession with taking Yahoo's second-place position and adding it to its third-place position is not an indication that it's time to sell. Far from it. When Microsoft is interested in a space it is a clear sign that you should be investing in it—not selling it.

Microsoft's deep dive into a graphical user interface on an operating system, Windows, was a clear sign to Steve Jobs that his bet was correct. Steve doubled and tripled down, and that is why Apple (AAPL) is Apple. Microsoft's deep dive into word processors and spreadsheets was the clear sign to WordPerfect and Lotus 1-2-3 that this was a space worth fighting for.

Microsoft's massive investment into video games, mobile operating systems, and search are clear indications that Sony's PlayStation (SNE), Google's Android, the iPhone, Google, and Yahoo are very important products and companies.

Nintendo (NTDOY) didn't give up when Microsoft came into the video game space—it innovated. Now the Wii outsells the mighty Xbox 50 million to 30 million. That is how you fight Microsoft: You innovate. Steve Jobs knows this, Nintendo knows this, and Oracle (ORCL) knows this. Yahoo, apparently, did not get the 40-year-old memo.

Aggression and innovation win. Period.

To say it clearly: Microsoft does not enter a market unless it's important, huge, and on the way to becoming even bigger. Microsoft is the buy sign, not the sell sign.

The people at Microsoft are brilliant and not to be underestimated—history has shown this to be true.

The Right Move

The proper move when someone wants something you own badly is to invest more in it. "Oh, you like my house and you're willing to pay double what I paid for it? Did I mention I just redid the kitchen, bought the lot next door, and put in a new HVAC system?" How much is it worth to you now? That's gangster CEO-level poker playing. You raise and raise while you develop your hand and increase its value.

If I were the CEO of Yahoo, I would have bought Powerset and five other innovative search-related startups in the past three years, taken bold steps to innovate in search design, and spent $100 million in marketing the service.

Oh wait, that's exactly what Microsoft did! Zing! Pow!

What did Yahoo do instead? While playing tough guy with Microsoft's war chest of money, debating $31 or $33 a share, it took its eyes off the prize and stopped innovating. The founders of Flickr and Delicious left, Yahoo's once promising think tank, was shut down, the products didn't advance, and all the cool kids left. What a disaster.

While Rome was burning in Sunnyvale, what did Microsoft do? The opposite: It invested in search, hired the cool kids, and gave Yahoo, its shareholders, and the public one very clear message: Yahoo is dying on the vine, incompetent, and we're solving the problem. You can sell to us or get run over by us. What did Yahoo do? It took a page out of TimeWarner/AOL's (TWX) handbook and brought in someone who had never worked in the consumer Internet before to clean up the mess.

(Note: I've never met Carol Bartz, so I can't speak to her abilities. Clearly she is a very competent deal maker and operator. However, she's not in the league of the growing "product genius" Google cabal of Larry, Sergey, Marrisa, Chad, and Salar.)

Yahoo's shareholders should be in full revolt right now, but the truth is the shareholders of Yahoo lost faith long ago. From the Yahoo shareholders I've talked to over the last couple of years—and I've met the big institutional ones who own large chunks of it—they want to get the best possible price out of Microsoft and move on. They were tired of the war and thought gutting the pig and selling the pork was better than building a farm. Well, maybe that isn't the best analogy in the world, but I think you get my point: cut it up and ship it out.

We're done here.

Round Three

And so ends the second chapter of search and begins the third.

Chapter One was inception up until the launch of Google.

Chapter Two was Google's rise and Yahoo's death.

Chapter Three will be the two-horse race of Microsoft and Google, with the inevitable emergence of a third and fourth player.

That's the silver lining for startups in all of this. As Google and Microsoft lock into a dogfight for revenue and market share, leaving the Yahoo carcass on the side of the road, the bevy of crafty startups will get their chance to take the third, fourth, and fifth positions in this very important race.

The lesson for all startups—and BDCs (big dumb companies)—is that innovation is all you have. Once you stop innovating, you lose your talent, and you lose the race. Never. Stop. Innovating. Never. Never. Never.

Man, I love this game.

Question: Who got the best of this deal, and why?

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