There’s been a lot of debate and discussion about Microsoft’s offer to acquire Yahoo.

Thus far, Drama 2.0 has shied away from the drama.

But with today’s letter from Yahoo to its shareholders justifying its rejection of Microsoft’s offer, I feel inclined to share my opinion. It’s now crystal clear that Yahoo either doesn’t want to be acquired or is going to play hardball in an attempt to try to squeeze Microsoft for more money.

In its letter, Yahoo outlines why it should be valued at an amount significantly higher than what Microsoft has offered and, most importantly, tries to reassure shareholders that management is making tangible progress towards unlocking the “value” that is inherent within the company’s properties.

I’ve followed the hoopla with interest. From the possibility of Yahoo teaming up with arch nemesis Google to the shareholder lawsuits that are being filed, the potential Microsoft-Yahoo merger has people talking for good reason. 

A merger would not only have a profound impact on two of the most prominent technology companies in the world, it would have a profound impact on the internet business landscape as a whole.

After weighing up both sides of the equation, I’ve come to the conclusion that Yahoo is downright foolish to not accept Microsoft’s offer.

Let me explain.

I do not expect Microsoft’s acquisition of Yahoo to solve Yahoo’s problems or to fully achieve Microsoft’s goals. I also don’t anticipate that the combination of Microsoft and Yahoo is going to create a viable competitor to Google in the search and search advertising markets overnight.

Yahoo has been managed quite poorly and even though Terry Semel is gone, I’m not convinced that Jerry Yang is the right person to revitalise the company. On the Microsoft side of the equation, the integration between the two organisations (and their cultures) will probably be quite distracting and painful.

So why does a deal make sense? I think there are three primary reasons.

1. Microsoft and Yahoo both appear to be stuck in their current positions.

Unless you really believe that Jerry Yang is capable of fixing the problems caused by years of poor management, there’s little to suggest that Yahoo is realistically going to “turn the corner” anytime soon.

And while it’s true that Yahoo is sitting on a lot of potential value, there’s no guarantee that it has a much brighter future even if it does manage to improve its ability to tap it.

Just because Yahoo might be sitting on a proverbial goldmine doesn’t mean that it’s realistically mineable.

Microsoft is a diverse, mature company that has a number of cash-cows. Therefore, it doesn’t necessarily need to dominate every market it enters and it would be unrealistic to expect that it will.

I’d rank its internet efforts as “decent” but clearly the company has a vision that entails a more prominent role in the space. Given the results Microsoft has seen from its already-sizeable investment in the internet, it seems unlikely that a more prominent role is going to develop organically.

Given these things, Yahoo probably needs a company like Microsoft if it wants to remain competitive and Microsoft probably needs a company like Yahoo if it really wants to increase its prominence in the market.

There are significant risks in this marriage but at some point it will probably become necessary for both companies to make bold moves if they want to escape their current positions.

2. Yahoo doesn’t have a whole lot of other good options.

Yahoo has been exploring its options, yet none really make good sense.

As I’ve already noted, I’m not sold on Jerry Yang’s abilities and I’m not convinced that the progress management claims to be making represents a real step towards maximising Yahoo’s potential. Therefore remaining independent seems less-than-ideal.

A partnership with Google doesn’t make any sense. It would only increase Google’s dominance in the search and online advertising markets and thus increase its leverage over not only competitors but partners. In the long run, this is not good for obvious reasons.

If you thought the Microsoft monopoly was bad, a Google monopoly won’t be any better. Fortunately, Google is apparently losing interest anyway.

It’s being reported that Yahoo and News Corp. are talking again about a possible relationship that would see News Corp. getting a significant equity stake in Yahoo as part of a deal that involves Fox Interactive Media properties such as MySpace.

Similar discussions were held in the past. Unfortunately, this makes about as much sense as a Google partnership. While MySpace is still the most dominant social network in the world, Google recently revealed that it is losing money on its $900m advertising deal with MySpace.

This raises questions about the long-term sustainability of such a property; obviously, assuming that social networking remains popular with consumers (which is not guaranteed).

If social networks like MySpace don’t figure out ways to deliver for advertisers, sweetheart advertising deals that guarantee payments aren’t likely to be offered in the future.

Additionally, it’s worth noting that a tie-up between Yahoo and News Corp.’s internet properties might not be of much value. Yahoo already possesses the largest internet audience of any single company and yet it still hasn’t been able to leverage it effectively. Simply expanding that audience isn’t going to help it figure out ways to effectively create value from it.

At the end of the day, Microsoft looks like the best option for Yahoo. There are probably more potential synergies that, in theory, could be leveraged by a combined Microsoft and Yahoo than with all of Yahoo’s other possible suitors combined.

3. Yahoo shareholders deserve an exit.

Even if the market has been unfair to Yahoo and undervalues its assets, I don’t think it’s unfair to say that Yahoo’s management has done a lousy job giving the market good reason to rethink its valuation of the company.

Microsoft’s offer represents a 62%premium to Yahoo’s stock price on the day the offer was made.

The Yahoo management and board have a fiduciary duty to do what’s best for shareholders. Given the company’s current situation, Microsoft’s offer appears to be the most viable way to create shareholder value in the foreseeable future.

I think it’s safe to say that the amount of progress Yahoo would need to make as an independent company to get its stock price to the $31/share Microsoft has offered is quite significant and it’s probably not likely to be achieved anytime soon, especially in light of the gloomy economic landscape.

Clearly, the shareholders filing lawsuits feel the same way.

Conclusion

Yahoo should take the money and run. There are significant long-term risks for both Microsoft and Yahoo, and like most mergers, the outcome probably won’t be anywhere near what was hoped for, but the smartest players know when to cash in their chips.

Is Yahoo a smart player or a foolish gambler who always thinks his luck is about to change? We’ll find out.