By Daisuke Wakabayashi and Eric Auchard
SEATTLE/SAN FRANCISCO (Reuters) - Yahoo Inc rejected Microsoft Corp's unsolicited $41.6 billion takeover offer as too low on Monday, forcing the software maker either to sweeten the bid or adopt a hostile approach to clinch a deal.
Microsoft responded by calling its offer full and fair, but stopped short of saying it would not raise its offer. Microsoft said in a statement it reserves the right "to pursue all necessary steps" without specifying whether it plans to take its bid straight to Yahoo shareholders.
Still, analysts say Microsoft will probably raise its bid, originally valued at $31 a share, to at least $35, but could be persuaded to go as high as $40. Yahoo's statement did not suggest what price its board was seeking.
"The proposal is not in the best interests of Yahoo and our stockholders," Chief Executive Jerry Yang wrote in an e-mail to employees on Monday. "We believe Microsoft's proposal substantially undervalues Yahoo."
Microsoft wants to complete the largest-ever computer technology merger in a bold strategic move aimed at creating a formidable rival to Web search leader Google Inc.
Yahoo said the offer did not properly assess its audience of 500 million users worldwide, investments in its online advertising platform and its ability to generate cash.
The offer also does not take into account growth prospects or overseas holdings, which include a large minority stake in Yahoo Japan Corp, the company said. Yahoo said its board was evaluating all its strategic options.
Redmond, Washington-based Microsoft now must decide whether to sweeten its offer, launch a proxy fight or, the least likely option, withdraw.
"The most likely outcome is they negotiate a higher price," said William Blair & Co analyst Troy Mastin. "It seems Microsoft has expressed a willingness" to go to $35 a share or $36 a share, he said.
Yahoo shares rose 67 cents, or 2.3 percent, to close at $29.87. The stock is now trading at a 3.3 percent premium to Microsoft's cash-and-stock deal value, indicating investors are expecting Microsoft to raise its bid.
A more hostile alternative could be to propose a tender offer to buy shares directly from Yahoo shareholders, although Yahoo could use a "poison pill" defense to dilute the stock holdings purchased in the market by an unwanted aggressor.
Microsoft could seek to replace Yahoo's board with directors more favorable to its point of view. Yahoo has set a March 14 deadline for shareholders to nominate directors.
"Acquisitions, especially in technology, are prone to high risk and high failure rates. Hostile transactions make it even more difficult for acquisitions to be a success," said Andy Miedler, technology analyst at Edward Jones. "Microsoft clearly knows this."
RBC Capital cut its rating on Microsoft to "sector perform" from "outperform" and cut its target price to $31 from $40, saying the company would be distracted with the acquisition and extended integration with Yahoo if successful.
Microsoft shares fell 1.2 percent to $28.21 in Nasdaq trade. The stock has lost 13 percent since the company went public with its bid for Yahoo, losing about $41 billion in market value -- close, ironically, to the amount of the bid.
A Very Public Negotiation
Microsoft announced the half-stock, half-cash offer on Feb. 1. At the time, the bid represented a 62 percent premium to Yahoo's stock price. The offer was originally worth $44.6 billion, but is now worth $41.6 billion.
Yang, who founded Yahoo with David Filo as a graduate student at Stanford University, has taken steps to try to keep the company independent, including considering an alternate tie-up in which Google would handle its search operations.
Shareholders of the Sunnyvale, California-based company may not have much patience for a drawn-out battle, particularly as Yahoo continues to lose market share to Google. Last month it disappointed Wall Street with its 2008 revenue outlook as it promised to cut jobs and invest more in Web advertising work.
A dissident group of Yahoo shareholders said on Sunday it had launched a campaign to sell their shares as a block. Eric Jackson, leader of a group of shareholders representing less than 1 percent of Yahoo shares, said his group was prepared to negotiate separately with Microsoft or any other bidder.
Among Yahoo's top 100 institutional investors at the end of September 2007, 53 also owned Microsoft stock, according to a Reuters analysis of Factset data. These powerful swing shareholders held 42.2 percent of Yahoo's outstanding shares.
Yahoo insiders, including co-founders Filo and Yang, owned 10.1 percent of the company at the time, the data showed.
While some long-term shareholders have since sold out to short-term investors betting on the outcome of the deal, the big funds with a stake in both companies are in a tough spot. On one hand, they do not want Microsoft to overpay for Yahoo, but they also want Yahoo to fetch as much as possible.
Most institutional shareholders have not publicly endorsed or rejected Microsoft's bid. T. Rowe Price, a Baltimore-based money manager that owned 18 million Yahoo shares and 129.4 million Microsoft shares as of the end of September, said it is still evaluating the bid.
Goldman, Sachs & Co, Lehman Brothers and Moelis & Co are working as financial advisers to Yahoo; Skadden, Arps, Slate, Meagher & Flom is Yahoo's legal adviser. Munger Tolles & Olson is acting as counsel to Yahoo's outside directors.
(Additional reporting by Megan Davies, Ken Li and Michele Gershberg in New York, Svea Herbst-Bayliss in Boston; editing by Gerald E. McCormick and Braden Reddall)
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