The deal, announced Sunday in the U.S., will see Alibaba Group buying back half of its 40 percent stake from Yahoo Inc. for $6.3 billion cash and up to $800 million of Alibaba preferred shares.
The announcement caps at least a year of rocky on-and-off talks as Yahoo tried to sell the stake as part of efforts to turnaround its business. Money from the sale will give Yahoo the financial firepower to return cash to disgruntled shareholders, many of whom are still upset after it squandered an opportunity to sell itself to Microsoft Corp. in May 2008 for $33 per share, or $47.5 billion. Yahoo's stock has sagged since then, trading at $15.42 on Friday.
Yahoo said in a joint statement with Alibaba that it plans to return "substantially all" of the after-tax cash proceeds to shareholders. It said its share buyback program had been increased by $5 billion though a final decision on how to return the cash had not been made.
The deal, which closes in six months, is good for Yahoo because the company gets a "wad of cash" but still has exposure to fast-growing China, said Napoleon Biggs, head of digital integration at public relations firm Fleishman-Hillard Asia Pacific.
"China for them was like a sore tooth," said Biggs, who has worked in the China Internet and media industry since 1997.
Yahoo's interim CEO Ross Levinsohn said the stake sale provides clarity for Yahoo shareholders. Levinsohn stepped into the role earlier this month after Yahoo cast aside CEO Scott Thompson because his official biography included a college degree that he never received.
Thompson had been working on a complex deal earlier this year that would have allowed Yahoo to escape taxes, but it fell apart. The deal announced Sunday is taxable.
Alibaba and Yahoo also have an agreement for Yahoo to sell the remainder of its Alibaba stake in stages later on. Yahoo bought the stake in 2005 for $1 billion and the deal suggests it's now worth $14.2 billion.
The statement also indicates Alibaba may hold an initial public offering in the future.
Under the terms of the deal, if Alibaba Group goes public, it would have to buy back another 10 percent stake from Yahoo or let Yahoo sell those shares in the IPO.
That condition expires in December, 2015, according to a blog post on Alizila, Alibaba's in-house news site.
Alibaba Chairman and CEO Jack Ma said the deal establishes a "balanced ownership structure that enables Alibaba to take our business to the next level as a public company in the future."
Hangzhou, China-based Alibaba started out as a business-to-business website linking factories in China to buyers around the world. It also operates Taobao.com, the country's version of eBay, and TMall, which brands can use to sell directly to consumers.
The relationship between Yahoo and Alibaba began amicably but deteriorated as the Yahoo went through successive CEOs trying to engineer a deal. They also feuded last year after Alibaba spun off its payment service, Alipay, but failed to disclose it right away, rattling Yahoo investors.
Yahoo said at the time the change was necessary because Beijing would only license an electronic payment service wholly owned by Chinese citizens.
By eventually reducing Alibaba's foreign ownership to a minority level, that could help the company if it plans to expand further into e-payments, Biggs said.
Biggs said Ma may be thinking that "I've got the businesses, the consumers, I've got the brands. All I need now is to grow my payment mechanisms."
After the $7.1 billion transaction is completed, Yahoo and Japan's Softbank, which owns about 30 percent of Alibaba, will hold about 50 percent of Alibaba. But the two companies have agreed to cap their collective shareholder voting rights at less than 50 percent, according to the Alizila blog post.
That means Ma will be in the driving seat for any company decisions.
Yahoo and Alibaba also agreed to modify their technology and intellectual property licensing agreements.
Under the changes, Yahoo will grant Alibaba a license to continue using the Yahoo China brand for up to four years. Alibaba will pay Yahoo $550 million and make royalty payments over that period. Yahoo will no longer be restricted from making other investments in China.
Alibaba is in the process of taking Hong Kong-listed unit Alibaba.com private. Shareholders will vote Friday on whether the company should buy back the 27 percent it doesn't already own.