AOL talks with Microsoft and Yahoo heat up

Yahoo needs to be convincing because it faces a proxy battle against activist investor Carl Icahn on Aug 1. Icahn, who owns about 5 percent of Yahoo shares, has aligned himself with Microsoft, and seeks to replace Yahoo's board and oust CEO Jerry Yang.

Icahn this week said he and Microsoft had structured a deal to buy out Yahoo's search advertising business that would have guaranteed Yahoo $2.3 billion in search revenue annually for up to 10 years assuming Yahoo's audience remained intact and the parties renewed after five years.

Microsoft's interest in acquiring AOL would serve to bulk up its display advertising business as well as gain more traffic to weaken Yahoo's and Google's position. The software company also needs to convince shareholders it has an Internet strategy independent of its so far unsuccessful pursuit of a Yahoo takeover.

Yahoo rejected the Icahn/Microsoft deal over the weekend and has said it remained open to a full buyout of the company at $33 per share, Microsoft's last offer before walking away.

Microsoft has said it would only strike a deal to buy Yahoo's search business or the entire company if Yahoo's board was replaced.

Since Microsoft walked away from it initial bid to buy Yahoo, Yahoo has separately struck a nonexclusive search advertising deal with Google Inc, which is currently under review by U.S. regulators.

Meanwhile, Time Warner is shopping AOL as part of a strategy to realign its business to focus on content, not distribution. It plans to complete a deal to separate from its Time Warner Cable by the end of the year.

(Additional reporting by Eric Auchard and Anupreeta Das in San Francisco)

(Editing by Kim Coghill)