Viewpoint July 29, 2009, 2:28PM EST

The Microsoft-Yahoo Deal: Lessons for Startups

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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?

Jason Calacanis is founder and chief executive of Mahalo.com, a human-powered search engine. The founder and former editor of Silicon Alley Reporter magazine, he posts regularly on his personal blog. You can sign up for his newsletter here.