Quickly: It’s good for Microsoft that it didn’t buy Yahoo — now it has to reform itself.

Steve Ballmer unintentionally dodged a bullet today when the Yahoo/Microsoft deal collapsed. Yahoo + Microsoft would have been a disaster — the best and the brightest from Yahoo would have gone to Google, the culture clash would have been destructive, it would have put Microsoft back in the sights of the regulators. And Yahoo wouldn’t have helped Microsoft with its biggest task at hand — adapting to the emerging executable Internet software model.

Without a quick fix, Ballmer now has to truly lead the company through a painful and arduous period of reform — he can’t just write a check and get the company back in the game. In its scale I would put the required change right up there with IBM in the early 1980’s, moving from mainframes to distributed computing, Intel in the 1970’s going from selling memory to selling microprocessors, and IBM in the 1990’s moving into the services business.

What must be changed at Microsoft? First and foremost, the financial business model. The company has been running at net profits in the mid-20s for decades — a product of the company’s monopoly position in several important markets. To redeploy assets and strategy, the company will have to re-direct investment, lowering net profit into the teens, at least. But that’s just a start. Ballmer will have to reform: the culture, the people, the company’s speed, how it sees software (it’s not on shiny disks anymore), its design sense, its quality standards, its tired and annoying strategy of migrating its customers through predictable software versions, its old method of developing software (which produced the Vista flop). Ballmer’s got a long way to go — in his email to employees explaining why Yahoo got dropped, he spoke in the vaguest of generalities about strategy change.

Ballmer has time (I’d give him four years given the company’s sustained control over the desktop) but he’s going to have leave the Microsoft of Bill Gates behind and create a new company according to his own vision. If he doesn’t begin to move, Google is going to use its citadel of advertising to attack Microsoft’s heart — software. Advice to Bill: give Steve the space to change the company.

I’ll be writing more about Microsoft’s future in some upcoming posts. I’d love to get your thoughts about how, why, if Microsoft should change.