AOL said it was selling more than 800 patents related to advertising, search, e-commerce and mobile to Redmond, Wash-based company, surprising investors with the size of the deal and sending AOL shares up more than 40 percent.
The sale includes technology rights from AOL's current and former businesses, ranging from Netscape, ICQ and MapQuest to CompuServe, Advertising.com and others, according to a source close to the matter.
The sale process, which AOL Chief Executive Tim Armstrong described as a "full-blown dynamic auction," started last fall after board approval.
Armstrong said he made a call to Microsoft Chief Executive Steve Ballmer alerting him of the decision to sell the patents.
The auction included e-commerce companies Amazon and eBay, both of which have been largely absent from the recent patent wars, as well as Google and Facebook, according to the source.
Spokesmen for Google, Facebook, eBay and Amazon were not immediately available for comment.
A final buyer was selected late on April 5, Armstrong said.
Technology companies in recent years have sparked a frenzy for patents, bidding up prices in a defensive move to keep competitors at bay.
The AOL deal is one of the larger patent auctions in recent times, representing roughly $1.3 million per issued patent, according to the source.
That compares with the bankrupt Nortel Networks patent auction last year -- considered a blowout $4.5 billion sale of its 6,000 patents -- for roughly $1.05 million per issued patent, the source said.
The Nortel deal sparked a wave of patent sales and litigation and played a part in AOL's decision to launch a patent auction.
Google is in the process of buying Motorola Mobility Holdings for $12.5 billion mainly for its intellectual property. Google also acted as the stalking-horse bid for Nortel Networks' wireless patents.
Microsoft was part of the group led by Apple Inc that won the Nortel patents.
Yahoo has launched a lawsuit against rival Facebook for patent infringement involving advertising.
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AOL and Microsoft are no strangers to partnerships. Last year the two companies along with Yahoo formed an advertising alliance.
Microsoft's latest move with AOL proves it is keen on shoring up its patent portfolio.
"Investors had anticipated little to no value for the portfolio - a few hundred million at the most," said Clayton Moran, an analyst with Benchmark.
AOL said a "significant portion" of the proceeds would be passed on to its shareholders.
As part of the deal, AOL will continue to hold more than 300 patents related to key strategic areas for the company, including advertising, search, and social media, and will receive a license to the patents being sold to Microsoft. Also, Microsoft will be granted a non-exclusive license to the patents AOL retains.
"We think this move is a big win for AOL in both the speed at which the sale was made and the actual amount it received," wrote Anthony DiClemente, an analyst with Barclays Research.
AOL shares soared $7.87 to $26.29 in afternoon trade.
One of the pioneering companies during the early days of the Internet, AOL was known for e-mail and dial-up access services. It has been trying to reshape itself into a media and entertainment powerhouse dependent on advertising revenue.
Activist shareholder Starboard Value LP had pressed AOL management to pursue a patent auction, arguing the portfolio could produce more than $1 billion in licensing income if properly monetized.
The deal, expected to be completed by the end of 2012, includes the sale of an AOL unit, on which AOL expects to record a capital loss for tax purposes.
AOL said it expected to use about $40 million of its existing deferred tax assets -- 20 percent of its total -- to offset any ordinary income taxes resulting from the licensing of its remaining patent portfolio.
Evercore Partners and Goldman Sachs acted as financial advisers to AOL. Wachtell, Lipton, Rosen & Katz and Finnegan, Henderson, Farabow, Garrett & Dunner acted as legal counsel. Covington and Burling LLP offered legal advice to Microsoft.
If the deal falls through, Microsoft may pay AOL a termination fee of $211.2 million, AOL said in a regulatory filing.
(Additional reporting by Sayantani Ghosh in Bangalore and Greg Roumeliotis in New York; Editing by Supriya Kurane and John Wallace)
By Nadia Damouni and Jennifer Saba