Barnes & Noble's stock was up more than 70% on the news.
Under the deal, Microsoft will contribute $300 million for a 17.6% stake in the new company, which is valued at $1.7 billion. The agreement also calls for Barnes & Noble to license technology from Microsoft in exchange for Redmond's agreement to drop patent claims related to Nook.
Barnes & Noble also plans to release a Nook app for Microsoft's forthcoming Windows 8 operating system. Windows 8 tablets are expected to hit the market later this year. Amazon last year launched its $199 Kindle Fire e-reader and tablet.
Until a name for the company is decided on, the subsidiary is being referred to as Newco. "The formation of Newco and our relationship with Microsoft are important parts of our strategy to capitalize on the rapid growth of the Nook business, and to solidify our position as a leader in the exploding market for digital content in the consumer and education segments," said Barnes & Noble CEO William Lynch, in a statement.
"Microsoft's investment in Newco, and our exciting collaboration to bring world-class digital reading technologies and content to the Windows platform and its hundreds of millions of users, will allow us to significantly expand the business," said Lynch.
[ How does Nook stack up against Kindle Fire? See: Nook Vs Fire: 5 Comparison Points. ]
Microsoft officials said the deal has the potential to make the company a major presence in the growing market for e-books and other digital content. "Our complementary assets will accelerate e-reading innovation across a broad range of Windows devices, enabling people to not just read stories, but to be part of them. We're at the cusp of a revolution in reading," said Microsoft president Andy Lees.
The deal comes weeks after the U.S Department of Justice filed an antitrust suit against Apple and several major publishers for allegedly colluding in an effort to force Amazon to raise its prices for e-books. Noted media and financial writer James Stewart said the pairing of Microsoft and Barnes & Noble could bring much needed competition to the market.
"The digital book world can't just be Amazon," Stewart said, in an interview on CNBC. "If we're going to have a healthy publishing industry and a healthy exchange of ideas that that represents, we need competition in that field."
Barnes & Noble's stock jumped 77.19%, to $24.24, in opening trading Monday. Microsoft shares were up .22%, to $32.05. Amazon shares opened flat, at $226.99.
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