Yahoo Got Binged

Today, Yahoo died as a search engine. If the deal with Microsoft is approved, what will replace it will be Bing, the search engine that Microsoft launched only two months ago. Within a few months time, Microsoft will go from owning 8 percent of the U.S. search market to 28 percent (comScore). That is still less than half of Google’s 65 percent, but it could give Microsoft a fighting chance in the search wars against Google.

While the agreement was a long time coming, Bing was the cherry on top, so to speak. Earlier today, I spoke with the two executives who oversaw the negotiations for both sides, Yahoo EVP Hillary Schneider and Microsoft SVP Yusuf Mehdi. I asked how big an impact Bing’s sudden success had on bringing the deal to a close. “Seeing Bing as a live experience was a nice assurance,” says Schneider, “but did not change our rationale or timing. This was a conversation that went on over several months. Bing was introduced after we had material momentum in how we wanted to approach this partnership.”

Yet Bing was able to gain market share in its very first month, and it took it from Yahoo, not Google. And Bing is just going to get better. Yahoo faced the very real prospect of market share erosion from below as well as from above. Now in one fell swoop, Microsoft will control all of Yahoo’s search volume. In a conference call today, Steve Ballmer explained how important market share is in search:

Do we think we will have better algorithms for relevance? Yes we do. There is a feedback loop in search. the more searches you serve, the more you learn about what people click on. Scale drives knowledge. There is a return to scale from seeing that much activity [that is more] than Yahoo or MSFT see independently

Microsoft will measure the success of this deal in two ways: increased market share with advertisers and increased market share with consumers. When I asked Mehdi what success would look like a couple years out, he defines it in terms of “shares of queries and spends.” Even before mentioning gaining share with consumers, he says: “Success is a smooth transition for advertisers as they shift more share of wallet from traditional media and competitors to get the better ROI.”

Microsoft will also become the new home for Yahoo’s search technologies. That is a good thing because even before this deal was announced, the spirit of technology innovation at Yahoo which produced projects such as Yahoo Boss and Search Monkey seems to have fizzled. These efforts will now be passed on to Microsoft. The fortunate news is that Mehdi says he wants to keep those projects alive. “For Search Monkey and Boss, we will integrate that technology and determine how to take that forward. There is a lot of goodness there.” At least Microsoft knows a good developer platform when it sees one.

So the deal is good for Microsoft. It puts them in the game, and they didn’t even have to pay $1 billion upfront. But is it good for Yahoo?

Instead of that upfront payment, Yahoo is getting 88 percent of search advertising revenues on Yahoo-owned sites every year for the next five years (at which point the so-called TAC rate will be renegotiated for the last five years of the deal). “This is a materially higher TAC than any of the previous arrangements,” says Schneider. But it’s also not much higher than what big affiliates like AOL are believed to be getting from Google today. And Yahoo needs to keep paying its sales force, but can only keep 88 percent of the revenues they generate. (Although there are some revenue-per-search guarantees baked into the deal to protect Yahoo on the downside).

Investors aren’t thrilled with the deal, and it is not just because they tend to value cash over potential. This is a ten-year arrangement between two lumbering giants that is filled with execution risk. It is a very complicated deal. Yahoo’s sales team has enough trouble communicating with its own engineers. Now they have to learn how to talk to Microsoft’s.

Jason Calacanis argues that Yahoo just committed suicide, while Bill Gurley thinks the opposite, that Yahoo had to get out of Google’s way to survive.

The two companies will work hard to pull this off. Their futures depend on it. And the deal is structured in a way that makes sure both sides make more money the more searches and advertising dollars Bing generates. Getting to that ideal state, though, won’t be easy. In the meantime, as they work through all of the implementation issues, Google could strengthen its position and take even more share.

No matter what happens, Yahoo just took itself out of the search game. It got Binged.