GENERAL MILLS’ ACQUISITION OF PILLSBURY

Submitted By:
Pankaj Vaswani: B18095
Subhendu Maharana: B18114
Swapnil Tyagi: B18115

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 CASE BACKGROUND

General mills was a major manufacturer and marketer in consumer foods category. It had a
revenue of $7.5 bn in FY 2000, with a market capitalization of $11 bn. It was the largest
producer of yogurt and 2nd largest producer of breakfast cereals in the US. But each of its
businesses had low organic growth. It pursued expansion opportunities by acquiring businesses
and forming Joint ventures with Nestle and PepsiCo. The firm had also increased its book value,
debt to equity ratio by following a aggressive share purchase in the 1990s.
Eventually, General mills studied of potential growth and value creation towards the end of the
‘90s. Financial advisors suggested the opportunity to buy Pillsbury from Diageo. Through a
couple of talks, the proposed amount to pay was $10 bn, as per General mills’ evaluation. The
asked price by Diageo was $10.5 bn and both sides did not budge to negotiate. Finally, on
mutual agreement, a contingent payment clause was added to the terms of the deal. So the
deal included the following features:

 Payment of shares: General Mills to issue 141 mn shares of its common stock to Diageo
shareholders. After this transaction, Diageo would hold 33% of General mills’ outstanding
shares.
 Assumption of Pillsbury debts: General Mills would assume the debts & liabilities of
approximately $5.142 bn, including $5 bn of new borrowings.
 Contingent payment by Diageo to General Mills: Diageo would establish an escrow fund of
$642 mn. On the first anniversary, Diageo would have to pay from this fund, depending on
the share price of General Mills.
The contingent payment had several provisions based on the share price performance of
General mills. Some professionals hinted at the value for General Mills because of the
provisions while others referred to this as a contingent value right, that would give the seller
confidence in the value of the buyer’s share. As per Merrill Lynch, the transaction cost in this
deal would amount to $55 mn.
From an industry perspective, this kind of use of contingent clauses were rare. This puzzled the
financial analysts. Firstly, the creation of additional shares of common stock would require
authorization of shareholders. Secondly, the amount of debt that GM would carry after the
transaction, would be more than $8.5 bn. Then , there is also the transaction cost to be borne
by the firm. Solving all these issues, would likely to clarify all the questions surrounding the
deal.

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KEY FINANCIAL QUESTIONS:
1. What was the structure of the contingent payment included in this transaction? How
does the “claw-back” affect the attractiveness of the deal ?
Under the contingent payment clause, the payments are dependent on specific events or the
levels of performance. Some examples are: earnouts, seller notes and buyer stocks. Also, this
happens on an ongoing basis, post deal finalization. The valuations of General Mills and Diageo
differed by $500 mn and there was no middle ground initially. Hence, to bridge the gap in the
quoted prices, contingent payment was added to the terms.
In this case, Diageo would have to establish an escrow fund of $642 mn. And, upon the first
anniversary of the closing, the seller had to pay from this fund an amount to General mills,
based on the share price of the firm. Certain provisions:

 If the average daily share price for 20 days were $42.55 or more, then $642 mn to be
paid.
 If the average daily share price were $38 or less, then $0.45 mn to be paid. Because this
share price would be the same as the price when the deal was negotiated and hence,
shows no share price performance improvement.
 Variable amount: if the average daily share price were between $38 and $42.55, then
Diageo would retain the amount by which $42.55 would exceed the average daily price
for 20 days, times the number General Mills shares held by Diageo.
These provisions were hinted by some financial professionals as “claw back” provisions. These
provisions are generally exercised when the buyer has already paid the amount but the money
needs to be returned as a result of a special event or circumstances, as stated in the terms of
the deal. Here, the opportunity to get back parts or full amount from the escrow fund,
represented such a scenario, which will be beneficial to General Mills, in cases where share
prices would rise. As seen from the exhibit-3, we can see the share prices are showing a
increasing trend, relative to when the negotiations took place. So, it made the deal attractive in
the sense that, GIS can redeem itself some amount post the acquisition.
2. What will be the acquisition cost if General Mill’s share price is equal to or greater than $
42.55 per share the end of 1st year?
It is given in the case that the amount Diageo is willing to pay back to General Mills is equal to
the number of shares issued (141 million) times the price difference between $42.55 and the
average 20-day share price of general mills at the end of 1st year provided its share price is
between $38 and $ 42.55. If its equal or above $ 42.55, the entire escrow amount of $ 642
million will be refunded and if below $38 then only $0.45 million will be given.
Based on above figures Diago is willing to pay a maximum amount of 144*4.55= $641.55
million, which is the actual escrow amount. So $ 642 million is a rounded off amount and hence
Diageo will pay $0.45 million even if stock price is $38 or less at the end of 1 year.

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The net value of the transaction totals to about $ 10.5 billion ($5.142 billion of debt and
balance equity). However as per the contingency clause GM has the opportunity to earn back
$642 million.
From General Mill’s perspective- $10.5-$0.642+$0.055(transaction cost)= $ 9.91 billion
From Diago’s perspective- $10.5-0.642+0.642= $ 10.5 billion (Although Diago will loose the
money in the escrow account it will gain 0.642 million or more from capital gains due to
appreciation of its General Mill stock price.)
3. What are the benefits General Mill’s likely to get from this deal?
Product Diversification- The acquisition of Pillsbury gives General Mills the opportunity to
expand its range of products within its operating industry. This help increase its market
penetration in the food industry and enable it to grow. Pillsbury has an excellent presence in
the food service industry, restaurants, etc. which opens up new avenues for growth.
Market Expansion/ Growth- The acquisition of Pillsbury will almost double the size of GIM. This
will help increase sales of the company and accelerate its growth rate as it will open up avenues
of cross selling. With the acquisition of Pillsbury, General Mills will have a global presence as
Pillsbury has operations in Europe, Asia & America.
Financing Benefits- The deal is a combination of cash and equity. General Mills will have to pay
$ 5.142 billion in cash. It will have to borrow this amount which means it will add debt to its
own books. This can have significant tax benefits. Also, from its market capitalization and long-
term debt, General Mills current Debt to equity ratio is less than 10%. Adding $5 billion debt
will increase leverage and provide significant cost saving as debt is cheaper than equity.
The firm expected a pretax saving of $25 mn in FY 2001, $220 mn by FY 2002 and $400 mn by
2003. Also , there was advantages of supply chain improvements, sales efficiencies,
merchandising and marketing and the streamlining of administrative activities, that would
generate more savings.
4. How does the deal benefit Diageo?
The payment structure for Pillsbury acquisition was in the form of stock-for-stock exchange. So,
for tax purposes, it would be treated as an ‘exchange’ rather than a ‘sale’. This implies that the
transaction would be considered a non-taxable offer, hence Diageo was able to avoid
substantial capital gains taxes.
In this kind of nontaxable deals, target shareholders who would receive shares of the acquiring
company’s stock, need not pay any taxes at the time of acquisition; they only have to pay taxes
when they sell their stocks in the acquiring company. This is beneficial from the perspective of
Diageo’s, because it could postpone the payment of capital gains tax. Furthermore, since
Diageo was the major shareholder of GM’s, it will benefit from ‘synergistic gains’ from the
merger.

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5. Why did Diago and General Mills decide on structuring the deal based on Contingent
Value Rights (CVR) and not on Earnout?
Both Earnouts & CVR are used when the busying and selling parties cannot agree on a common
price. However, Earnouts are also used to retain & motivate key managerial persons from the
firm being acquired. In Earnout financial agreements, a portion of the purchase price is to be
paid in future, contingent on achieving certain earnings or other financial or operational
parameters, which is agreed upon earlier. Usually in earnouts the target firm is operated as a
fully owned subsidiary of the acquiring firm to be able to judge the performance. Earnouts
contain an upfront payment and a deferred payment based on certain achievements. The
proportion varies based on nature of the deal and time frame under consideration. The total
amount is higher than an upfront payment as the firm being acquired takes on post-acquisition
risk.
Earnouts are usually used when small firms are being acquired or subsidiaries of comparatively
larger firms are acquired. It is not often used for publicly listed companies. These contracts are
easy to draft and execute if the number of shareholders is small.
CVR is typically issued by the acquiring firm to pay an additional amount based on share price of
acquirer (if it falls below certain level) at some future date. CVRs are usually used for publicly
listed companies or a firm with many shareholders. It is usually used when difference in prices
is significant. It gives the acquiring firm the ability to extract the potential benefit of different
synergies.
Since General Mills is a publicly listed company and has a large number of shareholders, it was
easier to structure the deal based on CVR rather than earnout.

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 Analysis
In given case, we have agreed valuation of target firm but the form of payment to parent of
target firm is hybrid of debt funded dividends plus stock for stock exchange. GM proposed to
exchange 141 Million shares of itself to gain control of Pillsbury. This is a fixed share equity for
equity transaction, in this case there is the risk of selling a undervalued share to Diageo for GM
and for Diageo has the risk of receiving a overvalued share since it’s value might recede in
coming future.
At current price of 38$, they would be issuing equity worth 5.385 Billion $ along with issuance
of debt worth 5 Billion $ which makes the deal worth 10 Billion $, while Diageo wanted
payment to the tune of $10.5 billion. There is a price gap that needs to be bridged and CVR is
the proposed method of doing so.
GM Perspective on deal
In this case, GM has lot to gain from Pillsbury’s portfolio since they are also in business of
frozen foods and expect synergies from transaction through supply chain efficiencies,
merchandising and marketing. GM can also get higher bargaining power by being the 5 th largest
company among competitors. This would be a strategic gain for GM since Pillsbury is a
competitor to GM which means greater pricing power.
This is supposed to lead to pre tax savings of 25 Mn, 220 Mn , 400 Mn in coming years. We can
calculate WACC of this firm and then try to estimate the synergies that can be derived from this
transaction. Current WACC of GM stands at 9.185% but it will take additional debt of 5.142 Bn
which will affect it’s cost of capital.
We take prime lending rate as cost of debt and calculate cost of equity with beta of 0.65 with
current market cap as 11 Bn $, Debt of GM stands at 739 Million $ since LT D/E is 6.719%. We
take price of 41$ in December 2000 as average of given price range – 40 to 42 $ per share. Pre-
merger WACC comes as 8.99%. We can expect the hurdle rate for investors to remain same but
cost of equity will go up since it will take more credit risk due to extra debt of 5.142 Bn, cost of
equity changes to 10.82%, which changes the WACC to 9.76% for the overall firm.
With this discount rate we find the value of synergy derived from per tax savings and post-tax
savings of 507.9 Mn $ and 330 Mn $ respectively for next 3 years.
GM will take Pillsbury as wholly owned subsidiary in future and has lot to gain from this
transaction. We try to estimate the total cost of this transaction to GM and see what price they
might end up paying in different scenarios and see if they can bridge the gap using CVRs.
In this case, Earnouts are difficult to implement since they are more useful in privately traded
and smaller firm with simpler terms but Pillsbury is a large firm with many shareholders and
moreover earnouts cannot be traded in market since they are signed on terms of milestones or
certain performance benchmarks but the biggest problem with earnouts is integration of firms,
given the synergies and complimentary nature of firms , Integration is a priority hence earnouts

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are not the most viable option. Earnouts are buyer biased since they end up sharing risks of
transaction with seller with lower up front money paid , in this case , we are not dealing with
the shareholders but with parent company Diageo whose shareholders have no intention of
realising any performance benchmarks and want their deal to be done as soon as possible since
they want to focus on their beverage business. This means that seller is not interested in lower
pay out upfront, the case would be different if GM was dealing with Pillsbury directly where it
can ask for performance benchmarks.
Due to this earnouts is not a viable option since Seller wants their share price upfront , with GM
more eager to acquire Pillsbury and Diageo wanting to sell off Pillsbury asap.
We need to design a bridge that will give fair price but puts the onus of upfront payment on
acquirer. In this case, CVR would be best option since Seller will be given payment upfront.
However, if there is a price fluctuation then money from a fixed escrow will be moved to GM’s
account. Gm values deal at 10Bn $, with 5 Bn $ in equity financed by 141 Mn shares at 35.46$
and remaining 5Bn in debt which will be given as dividends. Diageo wanted 10.5 Bn $, which
meant 5.5 Bn $ in equity at 39$ per share. GM believed it’s shared to be undervalued and
wanted to ensure that it wasn’t giving away its share only to find out its price increase in future.
If GM is willing to pay out the shares at 39$ then it will end up paying 10.5 Bn $ to Diageo
upfront, but if price of GM goes up then it would have given it’s shares for cheap , hence if they
can receive upside of price appreciation too then the deal becomes more fair.
In given structure, GM in case of appreciation ends up paying no more than 10.3 bn $
(All values in
GM (Price Paid) Million)
Shares
Variation of Price Diluted 141
Deal CVR Final Price Profit/Loss on
Price Equity Debt Price adjustment Paid deal
33.5 4723.5 5000 9723.5 0.45 9723.95 634.05
34 4794 5000 9794 0.45 9794.45 563.55
34.5 4864.5 5000 9864.5 0.45 9864.95 493.05
35 4935 5000 9935 0.45 9935.45 422.55
35.5 5005.5 5000 10005.5 0.45 10005.95 352.05
36 5076 5000 10076 0.45 10076.45 281.55
36.5 5146.5 5000 10146.5 0.45 10146.95 211.05
37 5217 5000 10217 0.45 10217.45 140.55
37.5 5287.5 5000 10287.5 0.45 10287.95 70.05
38 5358 5000 10358 0 10358 0
38.5 5428.5 5000 10428.5 70.5 10358 0
39 5499 5000 10499 141 10358 0
39.5 5569.5 5000 10569.5 211.5 10358 0
40 5640 5000 10640 282 10358 0

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 40.5 5710.5 5000 10710.5 352.5 10358 0
41 5781 5000 10781 423 10358 0
41.5 5851.5 5000 10851.5 493.5 10358 0
42 5922 5000 10922 564 10358 0
42.5 5992.5 5000 10992.5 634.5 10358 0
42.55 5999.55 5000 10999.55 641.55 10358 0
43 6063 5001 11064 642 10422 -64
43.5 6133.5 5002 11135.5 642 10493.5 -135.5
44 6204 5003 11207 642 10565 -207
44.5 6274.5 5004 11278.5 642 10636.5 -278.5
45 6345 5005 11350 642 10708 -350

In case of depreciation of price, It ends up paying exactly the same amount deducting 450,000$.

Profit/Loss on Transaction for GM

800

600

400

200

-200

-400

This essentially ensures that it doesn’t end up over paying for this deal in case it’s stock is undervalued
which is most likely to happen since it’s price is going to shoot up due to synergies and the fact that it is
valued at maximum of 42.25 $ by Merrill Lynch and at 46 $ using DCF analysis. This means that , GM
believes it’s stock to appreciate in future , hence it would be willing to pay upfront for Pillsbury which
will additionally bring in 0.33 Bn $ in after tax synergies of just 3 years , hence it would end up costing
10.35-0.33 ~ 10 Bn dollars , which is exactly they want, hence, CVR seems like a good option from point
of view of GM

For Diageo, we can see that it will also end up receiving 10.3 Bn $ which is less than agreed price but in
case of appreciation it will lose upside only till 642 Mn dollar i.e. till price of underlying is 42.55 $ after
which it will gain all the upside of appreciation since it owns 33% of GM. Hence after 42.55 $ , it’s gains
will be higher than GM’s , hence GM stands to benefit more since in case of appreciation on first
anniversary of deal, GM would have sold a under-valued equity at 38$.

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 Profit/Loss on deal for Diageo
800

600

400

200

0
33.5

34.5

35.5
36
36.5

37.5

38.5

39.5

40.5

41.5

42.5

43.5

44.5
34

35

37

38

39

40

41

42

42.55
43

44

45
-200

-400

-600

-800

CVR Adjustment
This arrangement is possible only if we can arrange for a CVR that can allow for such payoff , in this case
due to CVR , GM is able to gain upside of 642 Mn $ and allow for it to cover losses to the same tune in
case it’s undervalued, however , it does lose any upside if price goes beyond 42.55 $, which is reflected
as loss in above diagram.

CVR adjustment
800
CVR Adjustment

600
400
200
0

Share Price

Profit/Loss for Profit/Loss for

Price GM Digeo
33.5 634.05 -634.95
34 563.55 -564.45
34.5 493.05 -493.95
35 422.55 -423.45

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 35.5 352.05 -352.95
36 281.55 -282.45
36.5 211.05 -211.95
37 140.55 -141.45
37.5 70.05 -70.95
38 0 0
38.5 0 0
39 0 0
39.5 0 0
40 0 0
40.5 0 0
41 0 0
41.5 0 0
42 0 0
42.5 0 0
42.55 0 0
43 -64 127.45
43.5 -135.5 269.45
44 -207 411.45
44.5 -278.5 553.45
45 -350 695.45

GM would be losing some upside but it will end up paying exactly what they want if price appreciates
also but that would have happened otherwise too, hence, CVR is able to solve one of the problems
which is more important than dilution since GM has already taken care of that by issuing fixed shares.
For Diageo , this deal is much more favorable which can be confirmed from below table-

We see loss for GM since it sold an undervalued share a summation of absolute value is equal
to the total upside of appreciation in price, which is enjoyed by Diageo more after price of
42.25$ , moreover , the downside is equally bad for both of them.
This would make sense to implement since GM is more favorable to payment as long as it is not
losing all of upside of an undervalued stock. This means that we can treat this contract as a
option that gives constant payout above 42.55$. This option “covers” GM’s upside and
downside with possible gain in a given range. Hence this is a collar option, which can be
constructed as going short on stocks and shorting put option at higher strike price and by
going long on a call option of lower price, with underlying as GM stocks.
Collar = Short Stocks + Short Put (K=42.55) + Long call (K=38)
We first need to calculate the five parameters of Black-Scholes for CVR. We have strike rate of
all these options along with duration, interest rate and share price , with implied volatility
missing.

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We can calculate implied volatility from Exhibit 4 , Using K=40 , S=35 , Rf=5.43% , T= 92 days and
Price of call = 0.5$. We only need to back calculate volatility. We did it from online
resources(appendix)
Call Option_ Vol=26.6% (Option expiring on 21 October)
Put Option_ Vol=34.4% (same duration)
Call Option_ Vol=39.26% (Option expiring on 20 Jan)
Taking average volatility from above, we use volatility of 0.3342.
We can calculate price of this CVR as selling Put option at K=42.55 and going long on call at
K=38$
Selling Put option – calculated from Black Scholes (on 14th July,2000)
K= 42.55, Vol=33.42%, S=38, Rf=5.43%, T=365 days , Price of Put option = 6.4256
Long on Call Option
K= 38, Vol=33.42%, S=38, Rf=5.43%, T=365 days , Price of Call option = 5.9779
Hence, we sell put options @6.42 and buy call options @5.98 to cover our position, hence,
this CVR will give us 0.044 $ per share.
However, we might face problems in getting buyers for our short position, which is a
limitation of suggested model.

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Recommendation/Conclusion:
Based on our analysis the deal is a financially viable option from General Mills shareholders
perspective due to the different synergies being derived and also significant tax benefits.
Although there is no precedent as far as CVR in the industry are concerned, given the difference
between the price derived by the two companies and nature of the deal CVR seems an apt way
forward.

Based on the analyses by Meryl Lynch and Evercore Partners, Pillsbury is worth between
$11.836 & $13.486 billion and $11.3 & $14.2 billion respectively. Thus, acquiring Pillsbury will
add a significant amount of value to GM. Furthermore, since GM strongly believes that its stock
price will rise post-acquisition, the stock price of GM, post-acquisition, might rise well above
$42.55, thus increasing GM’s value. They will gain back $641.55 million, from the claw back
provision. This deal is absolutely economically attractive from the viewpoint of GM’s
shareholders. Therefore, it is recommended that GM’s shareholders should approve the deal.

We see that our analysis concludes the deal as fair to both parties through use of CVR, since it
doesn’t solve every problem of deal but it does help in both parties achieving their main
objective i.e. GM is able to cover its losses in case it dilutes an undervalued stock , Moreover ,
Diageo is able to get upfront payment and focus on its own business and take benefits of any
appreciation in Price of GM.
The CVR is expected to be a collar arrangement that can be formed by using long call and short
put with different strike prices, which form the range from 38-42.55 $, hence, covering any
losses for both sides in this range. Since Integration and upfront payment are more important,
we also ruled out earnouts as an viable option.
Both parties stand to gain from appreciation and lose from any depreciation, hence we are able
to create an approximate win win situation through use of CVR in this case.

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Appendix

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