The highly anticipated cash deal announced Thursday also merges Yahoo's search operations--China's second-largest after Baidu--and Alibaba's business-to-business and consumer Web auction operations, which trail only eBay's.
Yahoo will also fold its Chinese mail, messaging and other operations into Alibaba.
Analyst, Forun Technologies
The newly merged entity is valued at $4 billion, and will be headed by Alibaba's chief executive, Jack Ma. Yahoo gets 35 percent voting rights, with co-founder Jerry Yang taking a seat on a new four-member board.
"We feel this is the best approach for the Chinese market," Yahoo chief operating officer Daniel Rosensweig told reporters at a news briefing in Beijing.
"The most important and unique assets on the Internet are e-commerce, search, communications and portals, and the combination of Alibaba and Yahoo here in China will be the largest company on the Internet with all of the most successful assets," Rosensweig said.
The deal comes as interest in China Internet plays is heating up, as highlighted when shares in Baidu.com more than quadrupled in their Nasdaq debut last week.
With Internet users expected to hit 120 million by the end of this year, China is the world's second-biggest online market, and Ma said he expected it to surpass the United States to claim the top spot in five years.
The deal would give Alibaba cash to fund its operations and future expansion, said Forun Technologies analyst Qiu Changhua.
Yahoo, which has a small online auctions joint venture with Sina, also gains a strong presence in the online commerce market, Qiu said.
"It's a good deal for Yahoo and a good deal for Alibaba," Qiu said. "Now, with Yahoo, Alibaba will get a lot of credibility...For Yahoo, now they have a solid foothold in China."
Made in Japan
The deal's structure is similar to the one for Yahoo Japan, in which Yahoo holds a 33 percent stake, while Softbank, the Japanese Internet communications groups, holds a controlling 42 percent.
"If you look at what we've done in Japan...we've built a great asset there," Yahoo's Yang said in a phone interview.
Softbank, an investor in Alibaba, is said to have brokered the current China deal, though an Alibaba representative said Ma and Yang had begun discussing a possible deal early this year during a meeting at California's famed Pebble Beach golf course.
Softbank Chief Executive Masayoshi Son disagreed with comments that the $4 billion valuation of the new company was too high, and said the fact that Softbank was not selling its entire stake was a sign of confidence that Alibaba would grow.
Softbank is keeping 27.4 percent of Alibaba and can boost that to 30.5 percent by exercising convertible bond rights.
Alibaba's chief financial officer, Joe Tsai, told Reuters his company would eventually like to list shares.
"There's always a view that in the long run we would like to see the company be a public company," Tsai said by telephone.
"But in the medium term, our focus is really on building the business...and really executing."
Building a business
Based in the eastern city of Hangzhou--about two hours from Shanghai--Alibaba has operations that include a business-to-business e-commerce site, an online auction site called TaoBao that vies with eBay's and a recently launched online payment system.
The company generated cash revenue of $68 million last year and GAAP revenue of $46 million.
The Alibaba business marketplace handled $4.5 billion in domestic and international transactions in 2004, while TaoBao handled $200 million in the second quarter of 2005.
Yahoo's main China business consists of a search service that it got two years ago when it purchased local search site 3721.com for $120 million.
eBay entered China though a $180 million purchase of Shanghai-based EachNet, and has pledged to invest another $100 million in China. InterActiveCorp paid $168 million for 52 percent of Chinese online travel agent eLong.
Online retailer Amazon.comfor $75 million, and job search leader Monster.com paid $50 million for a 40 percent stake in ChinaHR.com.