How Yahoo can get its mojo back

May 15, 2012, 3:40 PM UTC

FORTUNE – The train wreck is over. The damage has been done. Yahoo’s perennially troubled board failed to vet the resume of a once-promising CEO. All the company can do now is pick up the pieces and move on. But what exactly does that mean? How does Yahoo move on from here?

Certainly, there is no shortage of wreckage to move on from: Yahoo’s (YHOO) CEO suite has been a revolving door of leaders. Each enters hopeful and exits defeated. The stock has lost 64% of its value since its January 2006 peak. Facebook and Google (GOOG) have been eating Yahoo’s ad-revenue lunch. And the whole time, Yahoo’s board has floundered in complacency, making the easy decisions that only made things worse.

Yahoo began 2012 with hope that its brand-new CEO Scott Thompson had what it took to push the company into the future. Thompson’s success leading eBay’s (EBAY) PayPal unit inspired him to steer the company away from online ads and toward e-commerce and data analysis. It was a strategy bold and unorthodox enough that it just might work. Then activist investor Third Point uncovered a falsehood in a Thomson bio included in a Yahoo proxy statement filed with the SEC. Third Point used it as a thug would wield a cudgel. Within a week, Thompson was gone.

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That has plunged Yahoo into its darkest hour since Microsoft (MSFT) withdrew its $31-a-share takeover bid — perhaps even the bleakest moment of its 18-year history. And yet, those old comforting chestnuts like “it’s always darkest before the dawn” may have some truth in them for Yahoo. It could easily get even darker for the one-time web giant, but let’s not think about that right now. What if the chaos that is shaking the company could — if the right decisions are made — make it stronger?

It would take some hard decisions, big risks and a good deal of cunning.

The first step would be giving Third Point much of what it wants. That seems all but inevitable, now that Yahoo’s board seats three of Third Point’s recommended directors, including the firm’s own Daniel Loeb — until now Yahoo’s gadfly-in-chief. Loeb outlined his “solutions” for Yahoo in nine tidy bullet points. But except for a few significant changes — clearly, his true agenda — Loeb’s plan is as specific as an architect’s blueprint drawn on a cocktail napkin.

ThirdPoint was most specific when it clamored for Yahoo to cash out of its Asian assets like Alibaba and Yahoo Japan. While the value of these assets could increase if Yahoo holds onto them, it’s time for Yahoo to give them up and use that money to invest in select investments of talented web startups that could provide the foundation for the second act of the Yahoo brand.

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But Yahoo should also use whatever leverage it has to insist on some cross-ownership of shares in both Alibaba and Yahoo Japan, cementing already long-standing relationships that could help it establish a presence in two of Asia’s largest web markets.

Third Point’s vague bullet points notwithstanding, the firm wouldn’t be worthy of being called an activist investor if it didn’t immediately insist on returning much, if not all, of that lucre into a shareholder payout. But here’s where Yahoo’s old-school board has a chance to develop a spine: Put most of that money not into shareholder pockets, but into rebuilding Yahoo.

Several pieces of Yahoo’s empire still emit some of the shine of its old brand — sports, news and finance are ones most frequently mentioned. And there have emerged a number of apps and sites that are innovating in these areas. Vox Media, owner of rising-star The Verge and the 321 sports blogs on SB Nation, could be a big expense well worth the price. Apps like Flipboard and Twitter-based services like would give Yahoo a strong foothold in the emerging world of news delivery.

There are other neighborhoods of the web that Yahoo could buy its way into if it would only open up its (potentially) fat wallet. Vimeo, for years YouTube’s potentially talented little brother, could be snatched from IAC/Interactive (IACI) After all, Barry Diller loves nothing more than being involved in a good deal. A music-streaming service like Rhapsody, independent from its long-time parent RealNetworks (RNWK) since 2010, could be the music service Yahoo Music always wanted to be.

Finally, there are valuable assets hidden inside Yahoo’s culture of suffocation. Flickr was once a brilliant acquisition that, despite Yahoo’s intention to leave it to its own devices, was smothered in bureaucratic styrofoam. Why didn’t Yahoo build its social strategy around Flickr, instead of swallowing it into its own ham-fisted social vision? And why did Yahoo never turn Flickr into an app with Instagram-like potential?

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Ah well, we’re here to look at Yahoo’s potential future, not its past missteps. If Yahoo is going to buy up innovative startups to build its future on, it will have to let their ideas guide the company forward — and not engulf them into a dying and stultifying culture that still believes it knows best. Because if anything is clear now, it’s that Yahoo doesn’t know what is best for itself. Facebook paid a steep price for Instagram to learn — and follow — what Instagram knew about the mobile web, not to suck its blood dry.

Finally, Yahoo’s recovery is over if it keeps stooping to the vile level of the patent troll. It will drive away the engineers and independent developers vital to its future success. On the web, nothing taints a brand faster than suing a company that is smart enough to capitalize on ideas you had but didn’t know what to do with. Don’t sue them, work with them to learn from them.

So there’s the road to a Yahoo recovery, as I see it: Sell the Asian assets; don’t give the cash to shareholders but invest it, shrewdly, in smart startups; learn from those startups how to thrive on the web in 2012; and use patents as a defense, not an offense.

If Yahoo can do that, it only has a fighting chance – but perhaps its best fighting chance in five years. If it can’t do that, then it’s better off liquidating everything it’s built for the past 18 years and handing the cash over to shareholders. It’s your call, Yahoo.