### The Problem With APY-Based Contract Analysis

On Thursday, Allen Hurns and the Jaguars reached an agreement on a four-year contract extension that covers Hurns’ restricted free agent season (2017) and buys out three potential unrestricted free agent seasons (2018-2020). While the contract details have not yet been published, the extension was initially reported as worth \$10 million per year on the basis of \$40 million worth of new money and 4 extension seasons. One other way to look at this report is that the contract is worth \$8.12 million per year on the basis of \$40.6 million worth of total money over 5 total contract seasons. Jason has pointed out that the extension is worth \$12.4 million per year over just three extension seasons once the potential 2017 RFA tag is taken into consideration when determining new money and new years.  I think it does not matter which view of APY one takes, because APY-based contract analysis is based on a flawed premise.

NFL salary cap commentators are in agreement that the total face value of a contract is not determinative of the amount of money the player will ultimately receive, and therefore not particularly relevant in analyzing the contract. As Andrew Brandt notes, “Reports of extension for Allen Hurns of \$40M which, in NFL terms, means Jags will pay him about \$20M over next two years, then “we’ll see.”” This is why Expected Contract Value assigns a probability to each contract dollar on the basis of contract characteristics.  If the total face value of the contract does not matter, then the nuances of the contract must contain the pertinent information.

However, each time that a new contract is signed, the initial disclaimers regarding the total face value are quickly followed by commentary as to how the APY of the contract will affect future contracts, and what those implications say about the advisability of the contract from the team’s perspective. The problem with such analysis is that the numerator of an APY calculation is the total face value of the contract – the same number that is unanimously regarded as misleading or irrelevant. Even more problematic, in the case of an extension the denominator of an APY calculation is not even the total length of the contract, but rather only the seasons for which the player was not previously signed under contract. The smaller of a denominator that is used, the more that the resulting APY metric highlights contract amounts that are less likely to be earned.

Imagine that the final season of the Hurns extension consists of a non-guaranteed base salary of \$15 million. If Hurns is released prior to this 2020 season, then he would have only earned \$25 million worth of the new money, and \$25.6 million in total. Based on the different methods of viewing APY highlighted above, this would mean that his APY was retroactively \$6.4 million (instead of \$8.12 million), \$8.33 million (instead of \$10 million) or \$11.1 million (instead of \$12.4 million). If APY can change retroactively based on the outcome of the contract, then it does not make much sense to analyze the contract on such basis prospectively.

Each contract should instead be analyzed in terms of its fundamental characteristics: the quantity of risk actually incurred by the team (i.e. fully guaranteed money), the potential (or lack thereof) for upside (i.e. surplus value) and the degree of optionality (i.e. value of nonguaranteed seasons and tradability). Every characteristic of a contract – the type of payments, the amount of the payments, the timing of the payments, etc. – ultimately affects one or more of risk, upside or optionality.

Because the details of the Hurns extension have not yet been published, I will use Jordan Reed’s contract as a brief example of this type of analysis. I strongly suspect that the structure of the Hurns extension will look similar to the structure of the Reed extension.

Washington incurred \$12.339 million worth of risk, which is equal to the \$14 million worth of fully guaranteed money, subtracted by the \$1.661 previously scheduled 2016 base salary that we can assume Reed would have otherwise earned. If we add in the \$500K worth of per-game roster bonuses in 2016 and 2017 that are associated with seasons in which the base salary is fully guaranteed, then the amount of risk can be considered \$12.889 million.

In exchange for incurring this risk, the team bought out one year of free agency (2017) and secured the option to buy out four additional years of free agency (2018-2021). Reed’s salary cap number in 2017 will be \$5.8 million. The amount of upside/surplus value associated with this contract season depends on how much one thinks that Reed would be worth on a one-year contract in 2017. If that deemed worth is \$9 million, then Washington secured \$3.2 million worth of surplus value. If the deemed worth was only \$6 million, then the surplus value would be an immaterial amount.

It almost certainly would not make sense to incur \$12.889 million worth of risk to secure surplus value of only a few million, but that is why the team also demands option years in order to justify the initial guarantee. In 2018, Reed’s cap number will be \$10.3 million. There may not be any surplus value associated with this cap number; on a one-year deal Reed might be worth roughly \$10-\$11 million in 2018. However, if Reed was a free agent in 2018, the team would certainly need to provide a large guarantee in order to re-sign him. So even if the team does not realize any surplus value with a \$10.3 million cap number in 2018, the team will be in a better position in February/March 2018 than if they had not previously bought out his free agency for that season. There is value in having a risk-free option, which helps justify the initial risk of \$12.889 million.

This type of analysis would continue for each year of the contract, and the conclusion would depend on whether the initial risk of \$12.889 million is justified by the cumulative surplus value of all the extension years plus the cumulative value of the team options in comparison to free agency in any given offseason. The value of these options declines over time, as Reed is increasingly unlikely to justify the contract amounts as he gets older. One can imagine this type of analysis become quite sophisticated by incorporating performance projections to estimate surplus value and volatility analysis to quantity the value of the team options.

For Reed, the analysis would work the opposite way. The question would be whether the initial guarantee of \$12.889 million justifies the opportunity cost of being locked into fixed amounts with no guarantees each year 2018-2021, as compared to the amounts he could otherwise have secured as free agent. As Kam Chancellor, Reshad Jones and Eric Weddle have demonstrated in recent years, this opportunity cost is real.

Importantly, under this analysis no consideration is ever given to the total size of the contract, whether directly or through the proxy of APY. The analysis instead focuses prospectively on contract characteristics that cannot change retroactively. As a result, the discussion would shift away from keeping track of who the “highest paid” players are by means of a metric that has little bearing on actual earnings, and instead focus on analyzing the real tradeoffs between risk, upside and optionality made between the players and teams.

Bryce Johnston earned his J.D. from Georgetown University Law Center in May 2014, and currently works as a corporate M&A associate in the New York City office of an AmLaw 50 law firm.  Before becoming a contributor to overthecap.com, Bryce operated eaglescap.com for 10 NFL offseasons, appearing multiple times on 610 WIP Sports Radio in Philadelphia as an NFL salary cap expert. Bryce can be contacted via e-mail at bryce.l.johnston@gmail.com or via Twitter @NFLCapAnalytics.