Shares of Sun Microsystems Inc tumbled 22.5 percent after it rejected a $7 billion buyout bid from IBM, leaving the smaller server and software maker vulnerable to lawsuits from shareholders nervous about its viability as a stand-alone

company.

While some on Wall Street held out hopes for bargaining to resume, a source with knowledge of the matter said that talks broke down over the weekend after Sun turned down International Business Machines Corp's offer of up to $9.40 per share.

Sun shares tumbled to $6.58 on Monday afternoon from their close last week at $8.49. But they remain above the $4.97 level before the talks with IBM were first reported on March 18.

Many analysts said that selling itself to IBM may have been the best move for Sun, which has been losing market share, and that the stalled talks underscored its significantly weaker position at the bargaining table.

It looks like they're in somewhat of a dilemma. It's (Sun's) operational history of the past four to eight quarters doesn't seem to be working well for them, nor have their efforts to sell assets, said Tom Smith, analyst at S&P Equity Research. He downgraded Sun's shares to sell from hold and lowered its 12-month price target to $6 from $9.50.

Banking sources say Sun has been shopping itself for the past several months, and it appears no bidder other than IBM has raised its hand.

Failed negotiations with IBM could mean Sun would have to contend with an even lower offer, or worse, none at all.

Some analysts said Sun could sell itself in parts to software companies which do not want, or cannot afford, the whole company. Many said such sales would likely bring in less than a sale of the whole company.

Credit default swaps insuring Sun's debt jumped to around 143 basis points, or $143,000 per year for five years to insure $10 million in debt, from around 95 basis points on Friday, according to Markit Intraday.

ANOTHER YAHOO

Some predicted Sun could face anger from shareholders, in the same way that Yahoo Inc co-founder and previous Chief Executive Officer Jerry Yang did after he rejected Microsoft Corp's $47.5 billion bid last year.

Yang eventually stepped down under strong criticism, and was replaced by Carol Bartz. Some analysts say accepting Microsoft's offer would have meant $30 billion in value creation for Yahoo shareholders.

We sure hope that shareholders don't experience a Yahoo, said Keith Wirtz, president and chief investment officer at Fifth Third Asset Management, which owns both Sun and IBM shares.

While IBM had been negotiating the price downwards, according to a source, the last bid still represented a premium of up to 89 percent on Sun's shares before deal talks were first reported in mid-March.

Given the size of the premium and the fact that Sun's board has presided over a decline in the company's stock price over the last eight years from over $250 per share to less than $5, we believe that Sun is likely to face significant shareholder unrest, similar to what occurred when Yahoo declined Microsoft's offer, Sanford C. Bernstein analyst Toni Sacconaghi said in a research note.

Sun is currently led by Jonathan Schwartz, who replaced Scott McNealy in 2006. McNealy, one of the founders of the Silicon Valley start-up, stayed on as chairman.

BRINKMANSHIP

Some said the breakdown of the talks might just be brinkmanship and the two sides could come back to the table.

We don't think the final chapter of this conversation's been written, said Wirtz, adding that shareholders would likely demand an explanation if talks didn't resume.

If there's no deal, all shareholders of Sun want to hear an articulation of why this company will work independently. A lot of people own the stock and you may see some noisy investors, he said.

But analysts said that further negotiations could prove lengthy and weigh on Sun's shares. Even if the two sides agreed to a deal soon, they would likely face intense regulatory scrutiny due to the strong position a combined company would have in the high-end server market.

Many said IBM had less to lose either way, as the company has fared relatively well despite the current economic downtrend, helped by aggressive cost cuts and a shift from hardware to higher-margin technology services.

Analysts have said IBM could benefit from buying Sun by bolstering its market share in high end servers against competitors such as Hewlett-Packard Co. But Sun's assets, such as its Java programing language and Solaris operating system, were nice to have to IBM, rather than crucial for future growth.

IBM shares were down 1.7 percent at $100.47 in afternoon trade on Monday, but outperformed the Nasdaq's decline of around 2.3 percent.

(Reporting by Ritsuko Ando, editing by Tiffany Wu and Gerald E. McCormick)

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