Microsoft needs to change the way it does business if it expects to compete for cutting-edge technology now that it has abandoned its bid to acquire Yahoo, startup entrepreneurs say.

The Redmond, Wash., softwaremaker will need to open its code to young companies so they can more easily build applications to run on Microsoft's platforms, said several startups exhibiting their products at Sun's JavaOne developer conference in San Francisco this week.

In addition, they said, Microsoft will have to convince startups that it understands and supports open-source software - free software that's developed and licensed by a community and open to anyone who abides by the rules. Many startups now run on open-source software.

"Microsoft will need applications to move (itself) forward to catch up with the rest of the world," said Mahshad Koohgoli, CEO of Protecode in Ottawa, which keeps track of the components that go into a software project.

"Microsoft can make life difficult for a startup because they give very little information," he said. "The only way to work with them is to have a direct contact" inside the giant company, and, he said, "We can't do that at the beginning."

In fact, Microsoft rarely acquires startups in their early stages, said Kate Mitchell, a managing director of Scale Venture Partners in Redwood City, which has sold two established startups to Microsoft: PlaceWare and FrontBridge.

But there are signs that Microsoft is changing its approach. For example, Mitchell said, the company appears far more open to doing business with venture capitalists than it used to be.

She also cited several times when Microsoft has made an effort to establish relationships with startups and the venture community, including the hiring of Dan'l Lewin, who worked at several Silicon Valley companies - Apple, NeXT and Go - that competed fiercely against Microsoft before Lewin joined Microsoft in 2001 to develop emerging business.

"Microsoft is a smart company," she said.

In the short term, venture capitalists will be pleased that the Microsoft-Yahoo deal fell apart, said George Hoyem, a managing director of Blueprint Ventures, because Yahoo is a buyer of Web 2.0 companies.

"Microsoft historically has not paid up for venture capital companies, and taking Yahoo off the table would eliminate an exit potential for VCs," he said.

While Microsoft has challenges - Google's hosted free office applications, for example, are viewed as a threat to Microsoft's Office franchise - Yahoo is seen, by several venture capitalists at least, as a poorly managed company whose employees are leaving and whose best days are gone.

By walking away, they said, Microsoft CEO Steve Ballmer used a classic negotiating tactic, and they believe he will wait while Yahoo's shareholders grow impatient with Yahoo's performance and ultimately sell their stock.

Next year, said Paul Maeder, a general partner with Highland Capital Partners, "Microsoft could get Yahoo for $20 a share."

The one thing that could save Yahoo, said Brian Steel, CEO of VoloMedia and a former Yahoo executive, is if Yahoo opens its own applications to developers, which the company said in April it would do. "Silicon Valley is a mercurial place," he said, but if Yahoo manages to convince developers it is "cool" and values cutting-edge technology, opinion could swing in its favor.