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Jul 01

Proposing The Optimal Contract Structure Technique

In my last article I pointed out that the new type of contract structure that has emerged under the 2011 CBA possesses the advantage of allowing the teams that use it to trade dead money to other teams, rather than absorb such dead money onto their own salary cap. Today, I will propose a new contract structure that incorporates both this benefit and the advantages of the other common contract structure types, while avoiding the disadvantages of each.

An optimal contract structure is one that provides the team with maximum salary cap flexibility. There are two characteristics of a contract that provides maximum salary cap flexibility. First, such a contract would allocate salary cap charges in a back loaded fashion. Second, such a contract would provide the team with the opportunity to completely mitigate dead money that the team would incur upon termination of the contract. The three prominent contract structure types – the Signing Bonus Contract, Roster Bonus Contract, and Post-2011 Contract – possess both of these characteristics to differing degrees. The Optimal Contract, which borrows characteristics of each of the other structure types, is characterized by partially fully guaranteed base salaries throughout the course of the contract.

One characteristic of an optimal contract structure is that it would allocate compensation in a back loaded fashion. In terms of game theory, a back loaded contract structure is a “dominant strategy.” This is a direct result of the fact that cap space can be carried forward from one year to the next at the complete discretion of the team. Because each team has the ability to carry cap space forward at will, it possesses the ability to erase any of the adverse consequences of a back loaded structure (future cap trouble), while at the same time preserving the ability to capitalize on the advantages of the back loaded structure (present opportunity) if it determines that the circumstances dictate that those advantages outweigh the disadvantages.

For example, Team X signs Player A to a 3-year contract for a total of $15 million. Player A’s salary cap charges are allocated to be $5 million in each year of the contract. Team X has avoided the disadvantage of future cap trouble, as Player A’s cap charge remains constant. Team Y signs Player B to a 3-year contract for a total of $15 million. Player B’s cap charges are allocated to be $3 million in Year 1 and $6 million in both Year 2 and Year 3. Team Y can still avoid the disadvantage of future cap trouble by carrying forward the $2 million in cap space that was saved in Year 1 and then carrying forward $1 million of that cap space from Year 2 to Year 3, thereby negating the extra $1 million cap charge of Player B in both Year 2 and Year 3. However, the Team Y contract is the dominant strategy because Team Y has the option to use the extra $2 million of cap space in Year 1 if an attractive use of such cap room presents itself. Team Y’s contract potentially has the same benefit as Team X’s contract, but it also reserves the flexibility to make a different choice. This dominant strategy is illustrated in the following payout table:

 

Ability to Avoid Future Cap Trouble?Ability to Take Advantage of Attractive Opportunity?
Team X

YES

NO

Team Y

YES

YES

 

Another characteristic of an optimal contract structure is that it would provide the team with the opportunity to completely mitigate dead money that the team would incur upon termination of the contract. When I say, “mitigate,” I am referring to the idea of trading the dead money away. I addressed this concept in my previous piece, and it also derives its importance from the significance flexibility.

Team X structures Player A’s contract in such a way that his dead money is not tradable. If Team X determines that it wants to terminate its contractual relationship with Player A, via release or trade, Team X will incur the dead money associated with that contract on its salary cap. Team Y structures Player B’s contract in such a way that his dead money is tradable. If Team Y determines that it wants to terminate its contractual relationship with Player B, Team Y can choose to incur the dead money associated with that contract on its salary cap, or it can choose to trade that dead money to another team, along with draft pick compensation, and have the other team incur the dead money. Team Y has the ability to decide whether it prefers the cap space or the draft pick compensation. Team Y is never worse off than Team X, and in some cases it is better off, as the following payout table demonstrates:

 

Option to Incur Dead Money on Own Cap?Option to Prefer Cap Space at Expense of Draft Pick?
Team X

YES

NO

Team Y

YES

YES

 

The three prominent contract structure types – the Signing Bonus Contract, Roster Bonus Contract, and Post-2011 Contract – possess back loaded allocation of salary cap charges and tradability of dead money to differing degrees. Each of these contract structure types presents a trade-off between cap charge allocation and dead money mitigation. The following examples demonstrate the effects of choosing one structure type over another in the case of a 5-year contract worth $25 million with $10 million guaranteed and $15 million paid out over the first 3 years.

 

Signing Bonus Contract

Cap Charge

Dead Money

Mitigation?

Year 1

$3,000,000

$10,000,000

No

Year 2

$4,000,000

$8,000,000

No

Year 3

$4,000,000

$6,000,000

No

Year 4

$7,000,000

$4,000,000

No

Year 5

$7,000,000

$2,000,000

No

 

Roster Bonus Contract

Cap Charge

Dead Money

Mitigation?

Year 1

$11,000,000

$10,000,000

No
Year 2

$2,000,000

$0

Yes
Year 3

$2,000,000

$0

Yes
Year 4

$5,000,000

$0

Yes
Year 5

$5,000,000

$0

Yes

 

Post-2011 Contract

Cap Charge

Dead Money

Mitigation?

Year 1

$5,000,000

$5,000,000

Yes

Year 2

$5,000,000

$5,000,000

Yes

Year 3

$5,000,000

$0

Yes

Year 4

$5,000,000

$0

Yes

Year 5

$5,000,000

$0

Yes

 

Keeping in mind the requirement to keep the guaranteed money and three-year payout constant, the Signing Bonus contract offers the best cap charge allocation, but the worst dead money mitigation. The Roster Bonus Contract offers much better dead money mitigation – because there is no dead money after the first year – but this comes at the expense of the worst cap charge allocation. The Post-2011 contract offers the best dead money mitigation, but merely mediocre chap charge allocation. This is an oversimplification because many contracts incorporate aspects of two or more of these structure types, and because subsequent-year option bonuses can add another layer of complexity, but it establishes a viable framework for comparison nonetheless.

The Optimal Contract borrows the advantages of each of these contract structures, while at the same time avoiding the disadvantages. This contract structure type allocates the cap charges of the guaranteed money in the same way as a Signing Bonus Contract, except that the team does not provide a signing bonus. Instead, it fully guarantees – for injury, skill, and cap – amounts of base salary equal to the prorated amounts that would have been present if the team had used a signing bonus. With respect to the contract used above, the team would fully guarantee $2 million worth of base salary in each of the 5 years of the contract. The contract would therefore look as follows:

 

Optimal Contract

Cap Charge

Dead Money

Mitigation

Year 1

$3,000,000

$10,000,000

Yes

Year 2

$6,000,000

$8,000,000

Yes

Year 3

$6,000,000

$6,000,000

Yes

Year 4

$5,000,000

$4,000,000

Yes

Year 5

$5,000,000

$2,000,000

Yes

 

This contract possesses both the allocation flexibility and the mitigation flexibility highlighted earlier as hallmarks of an optimal contract.

First, notice the low first-year cap number that matches that of the Signing Bonus Contract. As was explained in the example earlier in the article, the $2 million in cap space saved relative to the Post-2011 Contract can be carried forward to Year 2 and Year 3 to smooth out the cap numbers. Alternatively, the $2 million in cap space can be used to capitalize on an attractive opportunity. As a result, this contract possesses allocation flexibility.

Second, notice that the dead money can be fully mitigated throughout the contract, unlike in the Signing Bonus Contract or the Roster Bonus Contract. This is because the guaranteed money comes in the form of base salary, which can be traded from team to team.

Article 13, Section 6, (d), (iv) of the Collective Bargaining Agreement states that, “Any portion of Salary guaranteed for any period after a player is released for a reason covered by the guarantee shall be immediately included in Team Salary at the time of his release*….”. Therefore, because these guaranteed portions of the base salaries are fully guaranteed (injury, skill, and cap), they will all accelerate into the present year onto the salary cap of whichever team releases the player.

So if the original team releases the player, the effect is no different than if the team had used a signing bonus. However, as was previously discussed, in this context the team can trade the dead money. The team that trades for the player can then choose to release the player in the current year and absorb the entirety of the dead money, or it can choose to keep the player on the roster and absorb the “dead money” year by year. Both teams have the option. As a result, this contract possesses mitigation flexibility.

The contract structure I am proposing is a fairly radical change in comparison to the historical and current norm in contract structuring (at least with respect to contracts other than those for high 1st round picks). NFL teams have started to move from a model of paying large up-front bonuses and not guaranteeing any of the contract,** to a model of guaranteeing most of the first two, or sometimes three, seasons of a contract. Under my proposed contract structure, the contract would be fully guaranteed – at least to a partial degree – throughout the entire length of the contract.

If teams were to utilize this type of contract structure, NFL contracts would begin to look a lot like contracts in the NBA or MLB. There isn’t really a difference between saying “NFL Player X’s base salary in Year 5 of his contract is fully guaranteed for $2 million out of the $5 million owed” and saying “MLB Team Y has a 5th year club option for MLB Player Z’s contract for $5 million, with a $2 million buyout.” And just as NBA and MLB teams continuously decide whether salary cap or payroll flexibility is worth giving up the assets needed to obtain it, contract structuring trends in the NFL indicate that NFL teams are ultimately headed in this same direction. The contract structure I have proposed here would afford NFL team’s the greatest degree of flexibility in making such decisions.

In my next article I will illustrate how the Optimal Contract structure technique can be used to restructure contracts in the context of a team attempting to create salary cap space.

 

Footnotes

*The provision goes on to say, “at its present value rate calculated using the Discount Rate.” Discount Rate is a defined term in the CBA that is calculated using interest on an annual compounded basis using the one-year Treasury yields at constant maturities as published on February 1 of the relevant League Year. For 2014, the one-year Treasury yield on February 3 (the 1st was a Saturday) was .11. This is an interest rate of 0.11%, or approximately one tenth of one percent. In other words, the present value calculation required by the provision is not material.

**In many cases salaries that are not “guaranteed” are effectively guaranteed due to dead money ramifications, but this is a discussion for another day.

 

Bryce Johnston

E-mail:  eaglescap@yahoo.com

Twitter: @eaglessalarycap

Previous Articles:

Trading Dead Money & The NFL Expiring Contract


 

  • http://www.nyjetscap.com/ Jason Fitzgerald

    Definitely an interesting look at things. There are two issues I think that would think would be good to think further on. One deals with the cash flows of the deal. The contract structure you are proposing does a very good job of giving the player the dead money protection which should drive the overall contract price down from where the all cash model contracts are(i.e. the Bucs who have gone pretty wild with overpaying players to avoid bonuses) and back into a normal range. But my guess is that the actual cash compensation over the first two years might be too low for certain agents. So I would think you may want to consider a small shuffling of money or doing a NPV calc to treat the guarantee as a deferred type bonus and slightly upping the guarantee or first year pay to compensate.

    The other consideration deals with end of CBA ramifications. Its still a few years away from being a factor (2017 would probably be first year for the proposed structures) I think if you want to use guarantees beyond that year you need to guarantee the entire 2020 salary.So its one of those things where you want a contingency plan in place to keep with the strategy over the long haul.