A common-sense approach to contracts

The following is a guest post from our dear friend David Meadvin. David’s a long-time reader, first-time contributor.

If you sell hot dogs for a living, your annual income is tied to the number of hot dogs you sell. If you’re a taxi driver, your income depends on how many rides you can squeeze into each day. On the other hand, if you play Major League Baseball, your salary is only vaguely connected to your on-field performance.

I’ve long dreamed of a salary structure where players are compensated based on their statistics in a given year. Instead of paying Alex Rodriguez a flat $30 million, for example, why not give him a base salary of $15 million and make him earn the other half in performance incentives?

I realize this isn’t likely to happen – the MLBPA would surely object. That’s why I call it my dream scenario. But here’s another proposal that just might work: why not sign free agents to declining-value contracts?

Let’s stick with the Alex Rodriguez example. Here’s what A-Rod’s earned in each year of his current 10 year, $275 million contract, compared with his on-field value for each season:

As Rodriguez continues to age into the twilight years of his career, we can reasonably expect the gap between actual salary and on-field value to grow ever wider.

But what if A-Rod had signed a contract like this:

Year 1: $50 million
Year 2: $45 million
Year 3: $40 million
Year 4: $35 million
Year 5: $30 million
Year 6: $25 million
Year 7: $20 million
Year 8: $15 million
Year 9: $10 million
Year 10: $5 million

Rodriguez should love this deal from a purely economic perspective. He earns the same total amount and gets more of it up-front. And it makes even more sense for the Yankees, who might vastly overpay for his prime years, but in exchange, have far more salary flexibility in his later years to supplement his likely diminished production with younger, more expensive bats.

The sheer size of A-Rod’s monster deal makes this example extreme, and I can see why any team would balk at committing $50 million to a player in one season. And to be fair, his contract does decline somewhat in his last few years, though not nearly to the extent I’m suggesting.

If you follow this logic to all contracts, you create a situation where teams get far better return on their investment – and avoid the problem of aging, unproductive veterans eating up the payroll that the Yanks will have to deal with this offseason and in years to come.

By night, David Meadvin is a diehard Yankees fan and Yankeeist reader. By day, he is president of a Washington, DC speechwriting and communications firm, Inkwell Strategies.

5 thoughts on “A common-sense approach to contracts

  1. Anonymous

    I am a huge Yankee fan and a big AROD fan, but i agree 100% with David's suggestion. It makes perfect business sense and it would take into account the declining production that inevitably comes with aging. There is nothing these players can do to stop the aging process and why not take advantage of them while they are young and in their prime! I wrote a paper about 20 years ago proposing that professional athletes get paid a small base salary with large incentives based on their on-field production, but i also built in significant salary deductions for off-field incidents that embarrass the franchise and ownership. In most jobs you get fired for doing stupid things not in professional sports. These overpaid gazzilionaires just get small fines that they laugh at! Something seriously wrong with the system as it is today. Sadly it's only going to get worse!

  2. Anonymous

    Nice freaking idea…really. Too bad it will never be taken seriously, but i really love it. makes sense.

  3. Not so sure this makes sense if you keep the total contract value the same. From a net present value perspective you'd prefer to pay more in the later years.

    The problem with the ARod deal is the Yankees weren't negotiating against anyone and STILL gave him more years than they should have.

  4. Anonymous

    Michael nailed it…..it's a question of NPV. Rest assured that the same Harvard guys who are running player valuations understand discounted cash flow. The better part of the idea is tying performance closely with actual production (performance bonuses and deductions). Sadly, not something that will ever be taken seriously by the powers-that-be……it makes too much sense to fans.

  5. I have to politely disagree with those arguing for a Net Present Value approach to contracts and defend Davey's essential premise. NPV as a method of evaluating investments puts not restrictions on the goods and services that a company or individual can then go on to purchase with the income those investments generate. A dollar today is therefore worth more than a dollar tomorrow because of interest. However, that interest exists to match inflation, which is a reflection of rising prices but also an appreciation in the relative value of goods and services (ie, next year's TV is slightly better than this year's model, which partially justifies the price increase).

    This premise does not hold true for aging ball players. A-Rod suffers from an accelerated rate of deflation. Even if we adjust the future cash outlays of the contract for the assumed rate of inflation, the team still winds up paying more relative to the output it receives because A-Rod, or any other old ball player, typically gets worse as he ages. Hence, odds are the interest gains from backloading a contract do not outweigh the decline in player performance.

    Jeter's contract is an excellent example. He made $21 million in each of the past three seasons, but only generated a positive return in one of those seasons. From an NPV standpoint the team structured the deal ok, because it paid some of the highest years of the deal at the end of the deal, but on a season-by-season basis it was precisely those later years that were actually a net-negative investment because the item those dollars are required to purchase is non-negotiable – you've got to buy a 36 year-old Derek Jeter.

    NPV only makes sense if you can shuffle the funds as you see fit. In this instance, you are fairly certain that you will be purchasing something with declining value. It makes much more sense to front load the contract of an aging player.

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