Tuesday, February 23, 2010

Backloaded Contracts

Toronto Blue Jays starting pitcher Ricky Romero throws a pitch against the New York Yankees at Yankee Stadium in New York

by jw
I feel it my duty to point out a major flaw in conventional views of contracts: namely, the opposition to backloaded contracts by fans.  I have seen one too many shots against backloaded contracts for players for me to stay silent anymore.  Let me put it as plain as possible: backloading contracts is beneficial to the club, not to the player.

Take Vernon Wells, for example.  He has a vast contract for 7 years and $126M, which is an average annual value of $18M.  According to Cot's Baseball Contracts, this breaks down to: 08:$9M, 09:$10M, 10:$21M, 11:$23M, 12:$21M, 13:$21M, 14:$21M (I factored in his signing bonus).  Without considering whether or not the contract is good value, we'll take it like the club valued his performance to the tune of $18M a year, the average annual value of his contract.

Subtract the average value from the earned value and you get: 08:$-9M, 09:$-8M, 10:$3M, 11:$5M, 12:$3M, 13:$3M, 14:$3M.  From where they valued him, the Blue Jays saved $17M in the first two years and lose $17M over the last five years of his contract, given his contract worth of $18M a year.  Obviously, due to the time value of money, you would far rather have money now than money later.  Money now can be invested for a return, so the 7/$126M contract that Vernon has is better value to the club than a 7/$126M contract paying the $18M a year.

It goes further, though.  Players tend to decline over the length of their long-term contracts once their past their peak, conventionally to the tune of a half win above average a year, which is valued at about $2M in the current market.  So, if Vernon is worth 7/$126M, his seasonal value should be about: 08:$24M, 09:$22M, 10:$20M, 11:$18M, 12:$16M, 13:$14M, 14:$12M.  So, in fact, the Jays save $27M in the first two years of the contract compared to the $27M they lose in the final five.  That's a significant amount

So, between the time value of money and the expected decline in player performance over the length of a contract, backloading a contract is substantially beneficial to the club.  Obviously Vernon was never worth the amount of money to begin with, but the problem with the contract is the length and the amount, not the structure.

1 comment:

  1. EXCELLENT breakdown. Well stated