It started with walks along China's Great Wall and culminated at California's Pebble Beach resort, where Yahoo! co-founder Jerry Yang decided...

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It started with walks along China’s Great Wall and culminated at California’s Pebble Beach resort, where Yahoo! co-founder Jerry Yang decided to make a $1 billion bet on Alibaba.com Chief Executive Jack Ma.

The friendship the two formed on their wall hikes led to Yahoo!’s purchase of 40 percent of Ma’s privately held Alibaba, China’s biggest electronic-commerce company and No. 2 online auctioneer.

Now the question is whether the goodwill that spurred the acquisition will help Yahoo! overtake eBay, China’s leading online auctioneer, and win more search-engine customers in the second-biggest Internet market after the U.S.

“The Alibaba purchase gives Yahoo! a strong local entrepreneur, a heavyweight in the industry, who can drive the company to success,” says Duncan Clark, managing director of Beijing-based technology consultant BDA China.

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“China is a high-maintenance market. It is highly regulated, highly sensitive and difficult to manage from 15 hours’ time difference away.”

Yahoo! controls just 3 percent of China’s online-auction market and ranks second among search engines.

To turn the company into a leader, Ma faces the challenges of winning over Yahoo!’s 600 China-based employees and attracting customers in an undeveloped electronic-commerce market.

“Chinese Internet users tend to focus on online games and spend a lot less on e-commerce,” says Frank Shi, an analyst at CLSA in Hong Kong. “The Chinese market is still immature, and there is a lot of potential.”

A bad match?

Ma also has to ensure that Yahoo! employees in China don’t defect, says Victor Gao, CEO of China state-owned Enterprise Investment, a Beijing-based merger consultant.

“There is a risk that the staff at Yahoo! China may not want to follow Ma,” Gao says. “He needs to move quickly to win them over.”

Zhou Hongyi, Yahoo! China’s president, said in an Aug. 8 interview that he didn’t think the Alibaba transaction made sense. Zhou said that he would resign at the end of the month to join IDG Venture Capital.

“Alibaba has its own business-to-business and consumer-to-consumer revenue models, while Yahoo! is strong in search engines and e-mails,” says Zhou, who sold 3721 Network Software, the operator of a Chinese search engine, to Yahoo! in 2003. “The revenue models don’t match.”

Yahoo! agreed on Aug. 11 to swap $1 billion in cash and its local unit for 40 percent of Hangzhou-based Alibaba.

In addition to its auction site, Taobao.com, Alibaba runs an online trading service with more than 6 million business subscribers in China, according to the company.

Yahoo!, which runs the world’s most-visited Web portal, is expanding in China to tap a market where the number of Web users has grown sevenfold in eight years to 94 million. China’s online-auction market will expand sixfold to $2.6 billion by 2007, Beijing-based market researcher iResearch forecasts.

Yahoo! China failed to raise its share of the nation’s Internet auction market above the 3 percent iResearch estimates it has.

Yahoo! began competing in that market last year, investing an undisclosed amount to form online auctioneer 1pai.com through a venture with Sina, which operates China’s most popular Internet portal.

Bigger than eBay

Together, Alibaba and Yahoo! will knock San Jose, Calif.-based eBay from the No. 1 spot. eBay’s EachNet site controlled 39 percent of China’s consumer online-auction market at the end of 2004, and Alibaba’s Taobao.com had 37 percent, iResearch says.

EachNet charges a fee, while Taobao.com and 1pai.com are free.

Yahoo! doesn’t routinely disclose its Chinese unit’s market share. eBay had been detailing sales in the country until the recent quarter.

Alibaba also releases scant information on its financial performance. The company said earlier this year that it had sales of $46 million in 2004, mostly from online advertising. It didn’t provide a year-earlier figure.

Laurence Brahm, a lawyer and the chairman of Beijing-based investment company Naga Group, says Chinese companies often aren’t accountable to shareholders.

“Corporations are run like personal bank accounts in China,” says Brahm, who helps multinationals set up in China. “There is no accountability.” Government censorship makes the Internet market especially risky for overseas investors, Brahm says.

Yahoo! entered China when it bought Zhou’s Hong Kong-based 3721 Network Software for about $120 million in November 2003, gaining control of what’s now China’s No. 2 Internet search engine.

3721, China’s biggest search engine when Yahoo! bought it, had a 32 percent market share as of March 31, according to iResearch. Market leader Baidu.com had a 37 percent share, and No. 3 Google — which bought a 2.6 percent stake in Baidu.com last year — had 19 percent. Alibaba doesn’t operate a search engine for consumers.

Ma says he plans to spend some of the proceeds from Yahoo!’s investment to strengthen the search-engine unit.

“We’re going after Baidu.com for the No. 1 spot in China,” Ma said at the Aug. 11 Beijing news conference announcing the Alibaba deal. “Google is history as far as I’m concerned.”

Digging for treasure

Alibaba’s trading site, which lets small- and medium-sized companies exchange and export goods, has more than 15 million subscribers worldwide, according to the company.

Alibaba.com is the nation’s No. 1 business-to-business site, according to Analysys, a Beijing-based technology consulting firm. Yahoo! China doesn’t have a site that lets companies trade with each other.

Alibaba also runs an online-payment site, alipay.com, that allows companies to complete transactions on line — also a service Yahoo! lacks in China. Alibaba.com and Taobao, which means “digging for treasure” in Chinese, will keep their existing names, according to Yang.

Combining with Alibaba gives Yahoo! millions of new customers for its e-mail and search services, says Analysys CEO Edward Yu.

“Yahoo!’s search engines, combined with Alibaba’s more than 6 million Chinese online businesses, provide Yahoo! with a powerful combination,” Yu says. “Ma and his executives are a strong team.”

A native of Hangzhou in southeastern Zhejiang province, Ma studied English at Hangzhou Teachers’ Institute, graduating in 1988. To improve his English, Ma gave foreigners free tours of Hangzhou. The city is known for its West Lake, which produces the hairy crabs that are a Chinese delicacy.

The Yahoo!-Alibaba deal, negotiated over the past three months by Ma and Yang, was hatched in early May during the U.S.-China IT Executive Summit in Pebble Beach, Erisman says.

Ma says he became friends with Yang in 1998, four years after Yahoo!’s founding. Yang, who was born in Taiwan and grew up in San Jose, was visiting China to explore his cultural homeland and the country’s Internet market, Erisman says.

At the time, Ma’s first project — Hangzhou Hope Networks Consulting, an online directory of Chinese businesses that he founded in 1995 — had just been shut in a government crackdown on Internet sites.

Combining forces

Ma founded Alibaba in 1999 with $25 million from venture capitalists, according to Alibaba’s Web site.

Current shareholders include Fidelity Capital, a unit of Boston-based Fidelity Investments; Granite Global Ventures, based in Menlo Park, California; and Singapore-based Venture TDF and Transpac Capital, according to the Web site.

“We used to take these great hikes on the Great Wall,” Ma says. “From our hikes, we developed a friendship that ended up with us combining forces in forming this new Chinese company.”

A photo of the two together on the Great Wall was displayed at the news conference announcing the deal.

Yahoo! expects the transaction to be completed in the fourth quarter of 2005.

Ma will be the chief executive of the combined company and sit on the board of directors with Yang, Softbank President Masayoshi Son — an original Yahoo! shareholder — and Tsai, the companies say. Unlike Yahoo! China’s Zhou, who ultimately reported to Yahoo! CEO Terry Semel, Ma will be accountable only to the Alibaba board, Rosensweig says.

Ma is the man to take Yahoo! forward in China, says Son, whose Tokyo-based Softbank is Japan’s No. 2 provider of high-speed Internet access. Son is also chairman of Yahoo! Japan, which is 42 percent owned by Softbank.

Softbank is selling part of its 40 percent stake in Taobao to Yahoo! for $360 million, the Japanese company said Aug. 11. It will have a 27 percent stake in the merged company.

“Jack, Jerry and I had been talking about the merger for a while,” says Son, adding he also considers Ma a friend. “Jerry and I would like to leave the operation up to Jack. We trust his skills.”