Under Semel, Yahoo extended its depth and global reach, but it still couldn't compete against Google.

Terry Semel was pissed. The Yahoo CEO had offered to buy Google for roughly $3 billion, but the young Internet search firm wasn't interested. Once upon a time, Google's founders had come to Yahoo for an infusion of cash; now they were turning up their noses at what Semel believed was a perfectly reasonable offer. Worse, Semel's lieutenants were telling him that, in fact, Google was probably worth at least $5 billion.

This was way back in the summer of 2002, two years before Google went public. An age before Google's stock soared above $500 a share, giving the company a market value of $147 billion – right behind Chevron and just ahead of Intel.

As Semel and his top staff sat around the table in a corporate conference room named after a Ben & Jerry's ice cream flavor (Phish Food), $5 billion sounded unacceptably high. Google's revenue stood at a measly $240 million a year. Yahoo's was about $837 million. And yet, with Yahoo's stock price still hovering at a bubble-busted $7 a share, a $5 billion purchase price would essentially mean that Yahoo would have to spend its entire market value to swing the deal. It would be a merger of equals, not a purchase.

Terry Semel – a legendary Hollywood dealmaker, a guy who didn't even use email – had not come to Silicon Valley to meekly merge with the geeky boys of Google. He had come to turn Yahoo into the next great media giant. Which might explain why the face of the famously serene CEO was slowly turning the color of Yahoo's purple logo, exclamation point included. "Five billion dollars, 7 billion, 10 billion. I don't know what they're really worth – and you don't either," he told his staff. "There's no fucking way we're going to do this!"

Semel could talk tough because he had a backup plan. Yahoo would go out and buy its own top-notch search engine and its own search-advertising technology, and it would beat Google in the emerging arena of little text ads that pop up next to search results. Semel's decision to opt for this plan B was a fateful one. It was a smart play – but Yahoo fumbled, bungled, and mishandled its execution at every step. (More on that in a moment.) As a result, Google today controls nearly 70 percent of the search-related advertising market, an industry worth more than $15 billion a year and growing at roughly 50 percent a year. It's these ads that are the source of Google's riches and the basis for its expanding power.

And what must infuriate Semel: This could have been Yahoo.

Laid low by the tech crash, Yahoo brought in Semel in May 2001, when the company was at its nadir. It rebounded spectacularly under his leadership, but 2006 – a year expected by many to be Yahoo's best – turned out dismally. Brand-advertising growth fell by half, while Yahoo's share of search-related advertising dropped from 32 to 24 percent, according to Piper Jaffray. (During the same period, Google's edged up from 64 to 68 percent.) Analysts at Morgan Stanley predicted that operating profits at Yahoo would fall by 20 percent. (Final 2006 results had not posted by press time.) "It's now a given among advertisers that Google has won the search game," says Jeff Lanctot, vice president of media for Internet ad firm Avenue A Razorfish. No wonder Yahoo's share price fell 36 percent last year.

And the problems don't stop there. Semel's vaunted dealmaking skills seem to have deserted him. Sure, Yahoo snapped up some smaller companies in 2006 and formed partnerships with eBay and a consortium of newspapers. But when it came to the big acquisitions, deals that might have positioned the company for the new world of social networking and online video, Semel came up empty. A months-long dalliance with the social-networking darling Facebook ended in nothing more than a polite kiss on the cheek. Yahoo was interested in buying YouTube, but Google snatched away the Web video star for $1.65 billion.

Meanwhile, Yahoo's much-watched effort to create an entertainment unit in Hollywood fizzled. And its employment listings site, HotJobs, was trounced by the competition. In December, Semel shook up his top management team, leading to the departures of COO Dan Rosensweig and content chief Lloyd Braun and to the streamlining of the company's organizational chart. There's talk that Semel himself may be on the way out.

Worst of all, Yahoo's long-delayed push to aggressively compete in the search-driven advertising business is only now getting off the ground, arguably two years behind schedule. Semel bought a search engine in 2002 and a search-driven ad firm in 2003. All that was left to do was to put the pieces together.

At the end of 2001, few people were saying that there were billions to be made by serving up text ads every time an Internet user ran a search. But Bill Gross, the indefatigable entrepreneur behind the business incubator IdeaLab, was all over the concept. In 1998, he had launched a search site called GoTo.com. Other search engines promised results based on human-built directories or computer-driven algorithms. Gross' search site auctioned its results to the highest bidder.

At the time, the idea seemed radical, even offensive. Who would want results driven by hordes of sellers hawking goods and services? Advertisers would, as it turned out. Although GoTo never became a top-tier search destination, Gross and CEO Ted Meisel quickly saw that the big Web portals and search engines like AltaVista, Yahoo, AOL, and MSN would pay big money for GoTo's auction-driven results. They changed the name to Overture in 2001, and by the end of that year Web surfers had clicked on Overture ads 1.4 billion times. Advertisers understood the value of being able to bid for juicy keywords. The ads would be laser targeted, and the results – clicks – could be measured precisely. The portals and search sites figured out that the sponsored links could be placed alongside a more objective set of search results. It was a brilliant way to turn searches into revenue.

Google saw the power of this approach and decided to grow its own. Engineers at Google took the concept of pay-per-click search results and in 2002 turned it into a smooth-running, money-printing machine called AdWords. The company developed an automated process for advertisers to bid on keywords. It also made the auctions more sophisticated so customers couldn't game the system. Crucially, Google determined ad prominence on a Web page not just by the price advertisers were willing to pay per click – as Overture had done – but also based on how many clickthroughs that ad generated. As a result, Google's system responded quickly to ineffective ads: They disappeared. Google also had a massive database that tracked which ads worked and which didn't, information it could pass on to its customers to help them create better ad campaigns. By the time Google published its financial statements for the first time in 2004, everyone knew that the company had harnessed one of the great innovations of the Internet age.

All this is what prompted Semel to make his bid for Google. When that failed, he pushed ahead with plan B. In late 2002, Yahoo acquired Inktomi, which many believed had the second-best search technology on the planet. (Google was still tops.) The price: a bargain $257 million. Then, in mid-2003, Semel's patient negotiations with Overture bore fruit. He paid $1.4 billion for the search-driven ad pioneer, roughly 25 percent less than the original asking price.

Semel had his search engine, and he had his search-advertising technology. But rolling them into a money-making venture was harder than he and his execs had thought it would be. First, there were what are delicately described in business school as integration issues. Yahoo was the quintessential Silicon Valley startup. Founded by Stanford engineering students Jerry Yang and David Filo in a campus trailer in 1994, bootstrap innovation and hardcore coding were etched into its corporate DNA. Semel set out to modify that. He had to do a lot of internal politicking to convince his engineers that adapting existing technology from Inktomi and Overture was better than building their own versions from scratch.

One way to convince the staff was to appeal to their killer instincts. So after both deals were announced, Semel promised that Yahoo would merge the three to produce a certifiable Google slayer. He told investors, customers, and employees that Yahoo would be the most trafficked site on the Internet, with the best search for consumers and the most effective advertising for customers. "We didn't get into search to do what everyone else was doing," he said back then. "We got into search to change the game."

So far so good. But to pull off the second part of plan B, Semel needed to integrate Overture – the service that sold search keywords by auction and placed them on search-results pages. To start with, the service itself needed a major technological overhaul: The original technology had been created in a hurry during the boom, and it wasn't built to work on a global scale. Also, because of the way it was designed – to allow human review of each ad – it was painfully slow compared to Google. Meanwhile, executives and engineers in Sunnyvale were waffling over whether to merge Overture with Yahoo's operations or to let it remain a quasi-independent service.

It was a hard decision. Revenue from Yahoo's display-advertising business withered with the popping of the Internet bubble. Buying Overture had helped triple Yahoo's profits. No one wanted to mess that up. And then there was the inconvenient fact that Overture's biggest customer (after Yahoo itself) was Microsoft, representing 10 percent of Overture's revenue. Redmond was getting into the search game, too, and wouldn't have been happy about having one of its suppliers so closely associated with a competitor.

Yahoo executives tried to have it both ways. They attempted to placate Microsoft by maintaining Overture as a stand-alone brand. At the same time, they planned an overhaul of Overture's technology, a project code-named Panama. It was a disaster. With no clear delineations, Yahoo and Overture executives fought over turf. Yahoo hired and fired a half-dozen engineering chiefs at Overture during the first year. Overture salespeople competed for business with Yahoo salespeople. And Meisel, Overture's CEO, was ineffective – either inept or hamstrung by bureaucracy, depending on whom you ask. Decisions big and small, from trying out new features to agreeing on budgets, had to be cleared by committee after committee in Sunnyvale. "It was a clusterfuck," one of the participants says.

Semel doesn't appear to have recognized the depth of the problems until the fall of 2005, when Meisel was replaced by Jeff Weiner, a Semel protégé. Semel had decided in March 2005 to finally, fully integrate Overture into Yahoo, but those who worked on the project say it didn't become a truly top priority until Weiner took over. The dithering had done its damage, and by the end of 2005 anyone could see that Yahoo's search-advertising plans were in tatters. "All you had to do was look at Google's numbers compared to ours," says a former Yahoo search exec. When Yahoo decided it was going to buy Overture in 2002, Overture dominated search-related advertising; its revenue was two times Google's. By the time the deal was actually announced in 2003, the two companies were neck and neck. Two years later, Google's revenue was 2.5 times Overture's.

Weiner probably was the right executive to whip Panama into shape. He had performed brilliantly getting Yahoo's Inktomi-fueled search engine out the door in early 2004. But Yahoo was half the size back then, and Weiner had an easier time walling off his team from the rest of the company so it could develop a revamped technology. Now, with Yahoo carrying 10,000 employees and limping along with a semifunctional search-advertising system, holing up undisturbed turned out to be harder. If engineers wanted to try placing search ads on the homepage, the homepage team had to be consulted. If they wanted to experiment with the Yahoo news page, the news team had a voice.

And this project was more complicated than just knitting together a search engine with Yahoo's computer systems. It needed, among other things, a new easy-to-use interface for advertisers to navigate while placing their auction bids. While Google's AdWords service allowed customers to buy ads through a fully automated system, Overture's did not. Nor did Overture have an effective way to push advertising onto blogs with matching subject matter, as Google did.

Another problem was Overture's practice of displaying ads based solely on how much the advertiser had offered to pay per click. Unlike Google's system, Overture's wasn't designed to factor in how much traffic those ads might generate. This meant it was more likely that expensive but irrelevant ads could end up at the top of the column marked "sponsor results." This sounds easy to fix, but it actually entails creating entirely new ranking software and a new database to keep track of millions of clicks on the fly.

And lastly, because Panama was going to handle billions of dollars of customer money, it needed to have billing and cash-management systems as reliable as a bank's. By the end of 2006, Yahoo had already spent three months transitioning advertisers to the new network, something that is to continue into March. "It's been like changing engines in an airplane midair without any of the passengers noticing," says Steve Mitgang, a senior VP at Yahoo.

Though Semel refused to comment for this article, the company did release a statement in response to the idea that Yahoo missed a prime opportunity to beat its rival, Google. "While we recognize in hindsight that certain challenges could have been addressed more rapidly, we've made substantial strides since then and believe we're in the best position ever to exploit Yahoo's considerable strengths," the statement reads, in part. "Sure, our timeline for Project Panama took longer than we had anticipated, but it's live now and we're very excited about it and the early feedback we're receiving. Most people outside of Yahoo aren't aware of the tremendous – in fact, heroic – effort that has taken place in our search advertising business over the past 18 months."

The problem, of course, is that better-late-than-never often fails in technology markets that operate as winner-take-all games. Just as Microsoft boxed out other operating systems in the 1980s and office software in the 1990s and eBay has largely outpaced other auction rivals, Google now dominates search-driven advertising. "They've hit a tipping point," says Peter Hershberg, managing partner of search-marketing firm Reprise Media. "People now use Google because everyone else is using Google."

Steve Brodner

Terry Semel has come full circle – and not in a good way. When he took over Yahoo in 2001, he was laughed at for being a technological neophyte. But the new CEO quickly silenced his doubters, streamlining the management structure, making savvy deals and acquisitions, and improving the company's image, earnings, and stock price.

Indeed, Semel has run the company like a souped-up movie studio: Find stars – be they actors or engineers – and use them to make content that people want to watch or use. Once you have the content – whether it's movies and TV shows or tools like email, search, and news – you sell it directly or sell advertising against it. His view of Yahoo's culture has always been that technology is an important thing but not the only thing. "Growing up, I didn't know how a television worked," he likes to quip. "I just knew you hit On." For all but the geekiest of geeks, that's a line that resonates. Most people can't explain how a TV works, but they understand how much pleasure and value they get from it.

The truth is that when Semel worked in Hollywood, he understood more about how movies and TV shows made it to theaters and TV sets than virtually anyone else on the planet. Early in his career, during stints in New York, Cleveland, and Los Angeles, all Semel did was sell movies to theater chain owners. He'd show up at each theater – there were only a handful of national chains then – with a list of the movies Warner was going to release over the next few months, and each owner would bid on the movies he wanted.

When Semel became co-CEO of Warner Bros. in the early 1980s, he was steeped in the marketing and distribution plumbing of Hollywood. So it's no surprise, in retrospect, that his legacy is as one of Hollywood's biggest innovators and risk takers. In the 1980s, it was Semel who pushed the idea of renting Warner's excess movie-distribution capacity to other moviemakers as a way of creating a more stable income stream. Almost every studio now has such an arrangement. In the 1990s, he and partner Bob Daly financed Batman and made merchandising an integral part of the way movies are financed and marketed. During Semel's tenure, revenue at Warner Bros. grew tenfold to more than $11 billion.

But now, despite Semel's achievements in Hollywood and early success at Yahoo, Silicon Valley is buzzing with a familiar refrain: Wouldn't an executive with a little more technology savvy be a better fit? Semel has been Yahoo's CEO for nearly six years, yet he has never acquired an intuitive sense of the company's plumbing. He understands how to do deals and partnerships, he gets how to market Yahoo's brand, and he knows how to tap Yahoo's giant user base to sell brand advertising to corporations. But the challenges of integrating two giant computer systems or redesigning a database or redoing a user interface? Many who have met with him at Yahoo say he still doesn't know the right questions to ask about technology. "Terry could never pound the table and say, 'This is where we need to go, guys,'" one former Yahoo executive says. "On those subjects, he always had to have someone next to him explaining why it was important." One could have made a convincing argument two years ago that such deep technical knowledge didn't matter much. But now we have empirical evidence: At Yahoo, the marketers rule, and at Google the engineers rule. And for that, Yahoo is finally paying the price.

Contributing editor Fred Vogelstein (fred_vogelstein@wired.com) wrote about Microsoft in issue 14.10.