The depth of Microsoft’s online problem became clear 18 months ago, when Google trumped its bid to handle search advertising for MySpace, the popular social networking site.

MySpace owner News Corp. (NWS) liked Microsoft (MSFT) well enough. But it had to go with the money. Because Google (GOOG), the top search engine, could guarantee a larger audience and thus more revenue in a search deal, it won the MySpace account. “They said to Microsoft, ‘Look, if you can get there in revenue we’d prefer to go with you,’ ” said a source familiar with Microsoft’s side of the negotiations. “It came down to a pure economic decision.”

Technology battles often unfold like sumo matches, where the biggest companies win by pushing opponents around – and Microsoft, the world’s largest technology company by market value, has dominated the wrestling ring for years. But in the online world, Microsoft finds itself in the unusual position of small fry, getting shoved aside by Google.

Microsoft CEO Steve Ballmer has cited Microsoft’s online size disadvantage as the reason he is pushing ahead with a hostile bid of more than $40 billion for Yahoo (YHOO). To get the deal done, he is prepared to break two unspoken rules that have guided Microsoft purchases in the past: Microsoft never buys mega-companies, and it never forces itself on folks who don’t want to be bought.

The reason why Ballmer is willing to take drastic measures? Google is doing to the online advertising market what Wal-Mart (WMT) did to small-town retailers. Much as Wal-Mart turned its huge selection and crowds of customers to out-sell competitors, Google has used its search engine’s popularity to pull in advertisers and get them more bang for their marketing buck. Just as many manufacturers feel they must sell their products through Wal-Mart to reach consumers, advertisers feel they must deal with Google to get results. As Microsoft has lost ad deals time and again, it has become clear to executives that they need to take a bold step.

“Microsoft has been slow to gain critical mass in an area where this is the key to success,” Goldman Sachs analysts wrote in a note earlier this year. “The online advertising industry has the growth and market potential to move the needle, even for a company of Microsoft’s size.” A combination with Yahoo would arguably give Microsoft a greater share of the online audience, which should drive more searches, attract more advertisers, and bring in more money.

Back to the wrestling metaphor, there is more at stake for Microsoft than just the embarrassment of losing. The software giant, which rakes in billions of dollars in cash every quarter from sales of its Windows operating system and Office productivity software, is used to getting occasionally manhandled by opponents when it enters new markets. But in the past, Microsoft has always been able to use its juggernaut size and financial resources to gradually wear down opponents. But with Google, that old wrestling technique just isn’t working in online advertising.

By itself, Google’s advertising dominance might not be such a big problem – except that the online company is using its advertising bulk to wrestle its way into markets that Microsoft has long dominated. Google’s online-based software for documents and spreadsheets offers an alternative to Microsoft Office, and its relationship with the organization behind the Firefox web browser threatens Internet Explorer. Perhaps most alarming to Microsoft, Google has aggressively supported non-Microsoft cell phone software through its promotion of its own Android phone software and its services for Apple’s (AAPL) iPhone.

Microsoft has pooh-poohed Google’s software efforts, pointing out that Google’s software lacks the features and polish of more mature offerings, and that Google’s software efforts aren’t profitable. But even as it downplays Google’s efforts, there’s clear cause for worry: These are the same put downs Microsoft competitors like Apple, Netscape and Palm (PALM) once aimed at Microsoft when it challenged their products with Windows, Internet Explorer and Pocket PC. Tech historians know how those battles turned out; because Microsoft’s core businesses allowed it to keep improving its new products, it eventually surpassed its rivals.

To keep Google from accomplishing the same trick, Microsoft needs to mount a convincing challenge in online advertising. And to do that, Microsoft has to get big, fast. That’s why, even though Yahoo is resisting a deal, Microsoft will likely move quickly to get a deal done as soon as the end of 2008. A source with knowledge of Microsoft’s legal strategy says that once Microsoft makes shareholders an official offer to buy out their shares, federal regulators can begin reviewing the deal – a process that Microsoft believes could be wrapped up in six to nine months.

Why the need for speed? Google gets stronger by the day. And once Google gets international approval for its purchase of ad powerhouse DoubleClick — a development that could happen soon — its Internet empire will begin to gather so much momentum, and size, that it might shove Microsoft out of the online advertising ring for good.

(Source: Fortune Magazine)

– Sakin