The Microsoft-Yahoo standoff could get ugly fast.

Saturday is the deadline that Microsoft set three weeks ago for Yahoo (YHOO) to accept its buyout offer – or face the possibility of a hostile bid or a decision by Microsoft to abandon the deal altogether. The April 26 deadline brings to a head three months of high-profile jockeying during which Yahoo has repeatedly rebuffed Microsoft and demanded a better price.

At stake is Microsoft and Yahoo’s ability to compete with Google as billions of dollars worth of advertising dollars continue to flood the Internet. As Google has risen to become the dominant online ad player, Microsoft and Yahoo have both struggled to gain traction. Most analysts think a merger is the best way for Microsoft and Yahoo to compete with Google.

Microsoft kicked off the battle in late January when it made an unsolicited cash-and-stock bid for Yahoo that was originally valued at $31 a share, or $45 billion. The deal’s value has since dropped to $29.64 as Microsoft’s shares have fallen.

While Microsoft and Yahoo executives have met to discuss the bid, Yahoo has so far spurned Microsoft. Yahoo CEO Jerry Yang has said he’s not opposed to a Microsoft buyout, but argues that the offer “substantially undervalues” Yahoo. To force Microsoft (MSFT) to up the ante, Yahoo has discussed a variety of tieups with Time Warner, News Corp. and Google in recent months.

“Our board and management team continue to be open to any and all alternatives, including a sale to Microsoft,” Yang said on Tuesday, when Yahoo reported first-quarter earnings that beat estimates.

Talks between Microsoft and Yahoo have been anything but friendly. Three weeks ago, Microsoft CEO Steve Ballmer issued the ultimatum that expires Saturday. On Thursday, when Microsoft also reported better-than-expected profits, chief financial officer Chris Liddell voiced his frustration with Yahoo’s recalcitrance – and suggested the company’s prepared to go to war or walk away.

“Unless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives,” said Liddell, suggesting that Microsoft will makes its decision know next week. “The transaction has been anything but speedy as is being characterized by what would appear to be [Yahoo’s] unrealistic expectations of value.”

If Yahoo doesn’t accept Microsoft’s offer by the Saturday deadline, one of the following three scenarios is likely:

• Microsoft walks away. In this case, Microsoft will likely continue to spend money acquiring other online ad companies. In the past 11 months, Microsoft has spent more than $6 billion to acquire aQuantive and Rapt.
• Microsoft turns up the heat and launches a proxy battle. The company has already hired a proxy firm and reportedly nominated 10 candidates and three alternates to its own alternative board. The Wall Street Journal reported that the 10 nominees include former Nextel CEO John Chapple, former Grey Global Group CEO Edward Meyer, former Adelphia Communications chief financial officer Vanessa Wittman, and Jaynie Studenmund, a former executive at Overture Services, the online ad company acquired by Yahoo.
• Status quo. Microsoft extends the proxy deadline while Yahoo tries to convince its shareholders that an alliance with Time Warner’s AOL or Google is more desirable.

Microsoft CEO Steve Ballmer doesn’t want to bid against himself by upping the original deal. Courtesy of Microsoft.

Microsoft clearly needs Yahoo. Ballmer sees the No 2. Internet portal as the ammunition he needs to take on Google as online advertising spend skyrockets. According to eMarketer, advertisers worldwide spent $41 billion online in 2007 — a figure that is expected to double through 2011 as advertisers chase after consumers who are spending more time on the Web and less time watching TV, reading newspapers or listening to the radio. Google controls 40% of the overall market while Yahoo and Microsoft’s MSN have 15% and 5.2%, respectively. Google commands an even greater share in the lucrative search-ad business, with 58.7% of the market compared to 18.1% for Yahoo and 12% for MSN, according to the latest Nielsen data.

Microsoft fears that Google, with its March acquisition of DoubleClick, the world’s biggest online ad server company and big player in the increasingly lucrative market for online display ads, will seize an even bigger portion of the ad market as MSN falls further behind.

Microsoft isn’t the only one worried about Google. A number of media and Internet giants are now circling Yahoo — one of the last independent large-scale online players. “Microsoft’s forcing…everyone to make a move,” says Frank Addante, CEO of Rubicon Project, which helps publishers manage their online ad inventory.

Time Warner (TWX), which owns Fortune.com and CNNMoney, has pursued a deal that would fold AOL into Yahoo in exchange for a 20% stake. Along with aligning with AOL, Yahoo is also looking into outsourcing search advertising to market leader Google (GOOG). Earlier this week Yahoo finished a two-week test that ran Google ads for searches on Yahoo’s homepage. The Justice Dept. is reportedly investigating the test for possible antitrust violations.

News Corp. has approached the deal from different angles. Yahoo and Rupert Murdoch’s News Corp. (NWS) held preliminary talks about a possible partnership after Yahoo rejected Microsoft’s bid. When those discussions stalled, News Corp. began talking with Microsoft about a three-way alliance that would combine News Corp.’s social networking site, MySpace, MSN and Yahoo.

Many analysts argue that ultimately a Microsoft-Yahoo combination is the best option for Yahoo shareholders — and for Microsoft in its war with Google. Wrote Bernstein Research analyst Jeffrey Lindsay in a client note Friday: “We expect the acquisition scenario to play out before the end of July (the theoretical outer limit for the Yahoo! shareholder meeting) and think the outcome is very likely to be a sale to Microsoft at a slightly improved price.”