Microsoft Corp. is kicking its bid for Yahoo! Inc. up a notch and advised the Internet giant's directors that it will proceed with a hostile takeover if they don't agree to a deal within the next three weeks.

In a letter delivered Saturday, April 5, Microsoft chief executive Steven Ballmer said: "By choosing not to enter into substantive negotiations with us, you have failed to give due consideration to a transaction that has tremendous benefits for Yahoo!'s shareholders and employees."

If a deal isn't reached within three weeks, Microsoft would be "compelled" to take its offer directly to shareholders and wage a proxy fight to replace Yahoo!'s directors, Ballmer wrote. By issuing a deadline, Microsoft is gambling that Yahoo!'s investors will pressure the board to reconsider.

Ballmer also implied that any offer made after the April 26 deadline would be lower, quashing any speculation that it would raise its offer to seal a deal.

"If we are forced to take an offer directly to your shareholders, that action will have an undesirable impact on the value of your company from our perspective which will be reflected in the terms of our proposal," he wrote.

Ballmer argued in the letter that, given the recent downturn in the stock market, and in particular Internet stocks, Yahoo!'s shares could be worth less today than Microsoft's original bid.

But by Monday morning, Yahoo! responded to Microsoft's threat with its own public letter saying it doesn't oppose a deal - just wants a better one.

Jerry Yang, Yahoo!'s chief executive, and Roy Bostock, its chairman, said in their reply to Ballmer that both management and much of the Internet giant's investor base believe the offer "substantially undervalues" the company.

"We are open to all alternatives that maximize stockholder value," Yang and Bostock wrote. "To be clear, this includes a transaction with Microsoft if it represents a price that fully recognizes the value of Yahoo! on a standalone basis and to Microsoft, is superior to our other alternatives, and provides certainty of value and certainty of closing."

Microsoft offered to acquire Yahoo! for $31 per share or $44.6 billion in cash and stock on Jan. 31. Yahoo's board rejected the offer saying it undervalued the company. That offer, however, is now valued at about $40 billion due to a decline in Microsoft's share price. Microsoft shares closed at $29.16 on Friday.

That's a fact not lost on the Yahoo! executives, who noted that Microsoft's declining share price makes the value of the proposal today, significantly lower than when it was made initially.

The executives also took exception to Ballmer's claim that Yahoo! has refused to enter into negotiations with Microsoft. "Steve, you personally attended two of these meetings and could have advanced discussions in any way you saw fit," they added.

In the meantime, Yahoo! has been trying to work out an alternative deal with a number of other parties including News Corp., AOL parent Time Warner Inc. or Google Inc.

Ballmer acknowledged the alternative negotiations and questioned why, in the absence of another offer, Sunnyvale, Calif.-based Yahoo was unable to make a decision.

"This is despite the fact that our proposal is the only alternative put forward that offers your shareholders full and fair value for their shares," Ballmer wrote in the letter. Ballmer said the Microsoft offer has grown stronger as the economic climate has weakened.

Yang and Bostock responded to the claim that Yahoo! will have trouble weathering the current economy, noting that "business forecasts are consistent with what we outlined" after releasing its fourth-quarter results.

Yahoo! said its three-year strategic plan demonstrates "upside not previously communicated to the financial markets."

"This plan has received positive feedback from our stockholders, further strengthening the view that Yahoo! is worth well more as a standalone company than the value offered in your proposal, and would be even more valuable to Microsoft," they said.

Redmond, Wash.-based Microsoft could launch a tender offer to buy shares directly from investors, but Yahoo! has a "poison pill" takeover defense that empowers the board to make such a campaign prohibitively expensive.

For that reason it is likely that a proxy battle to elect directors will escalate the battle if Yahoo! doesn't accept Microsoft's bid or secure a comparable or better offer from another party. Yahoo called Microsoft's threat to nominate board members "inconsistent with your stated objective of a friendly transaction." -- Donna Block