Yahoo and AOL are close to merging

Yahoo Inc. and Time Warner Inc.'s AOL are closing in on a deal to combine their Internet operations, a move that could thwart Microsoft Corp.'s effort to acquire Yahoo, people familiar with the matter said Wednesday.

The possible Yahoo-AOL tie-up is part of a threefold plan by Yahoo to present shareholders with an alternative to Microsoft's unsolicited offer. Yahoo would also propose repurchasing billions of dollars of its own shares and is negotiating with Google Inc. about an advertising tie-up. On Wednesday, Yahoo announced a short-term test under which it will carry search advertising from Google.

At the least, Yahoo's plan may give it more leverage to negotiate a higher price from Microsoft. However, Yahoo might have difficulty convincing its shareholders that a Yahoo-AOL combination is attractive. Microsoft has threatened to take its offer directly to shareholders via a proxy fight.

If consummated, the Yahoo-AOL discussions would unite two of the Internet's largest Web sites. One person involved in the discussions cautioned that there was still "a lot of work to do" before a final agreement between AOL and Yahoo. Yet there is also incentive for Time Warner to complete a deal. It has been struggling to find a viable strategy for AOL for years. AOL has lost most of its value since it combined with Time Warner in 2000.