With all the big numbers being thrown around this offseason, there have been articles suggesting that teams are unwise to backload contracts. The basis for this opinion is the belief that teams will not have the money to pay the escalating costs, so would be better off paying the upfront fees. For individuals who lack fiscal discipline, it might be better to pay more upfront (kind of like withholding too much from your paycheck so you don’t get stuck with a tax bill in April), but presumably, major league franchises are employing cash management procedures to ensure they can meet future obligations (although the Dodgers and Mets may be teams who disprove that notion).
When a team backloads a contract, the money “saved” doesn’t disappear. If the organization is being run as a healthy business, the additional cash on hand is either invested or put to use in other ventures expected to earn an attractive return. Although these approaches can be risky, strong companies develop plans to ensure cash flow can meet near-term obligations. Tied up in this approach is something known as the time value of money.
Without going into the financial details, a dollar today is usually worth more than a dollar tomorrow (kind of like a bird in the hand is worth two in the bush). So, absent mitigating circumstances, such as the luxury tax threshold, teams are always better off delaying the payments owed to the players they sign. Listed below as an illustration is a present value comparison of Jose Reyes’ contract with the Marlins versus what would be owed if he was paid the average annual value each season. Based on included assumptions, the Marlins are saving $3.3 million by backloading Jose Reyes’ contract. Although that may not seem like a lot, especially in relation to the size of the contract, it is a savings nonetheless.
Jose Reyes’ Present Value Comparison
Note: Based on a nominal interest rate of 6% compounded monthly. Assumes salary paid in full each year (which favors shorter-term deal). Backloaded contract includes payment of $4 million buyout in 2018.
Another argument that has been made is that by backloading a deal, contracts become harder to trade. Again, that is only true if the team wastes the savings it incurs at the beginning of the contract. Let’s look at the Reyes contract once again. If the Marlines decide they want to trade their short stop after the 2013 season, the acquiring team would owe $86 million, or $21.5 million per year, compared to the $17.67 million that would be owed if the contract was evenly distributed. At face value, it would seem as if Reyes would be much harder to trade. However, we can’t forget the over $15 million the Marlins haven’t paid Reyes over the first two years. If that money was invested at 6% and compounded monthly, it would grow to approximately $16.8 million. Assuming the Marlins were desperate to dump the Reyes contract, they could eat $17 million of the existing contract, which would turn the AAV for the acquiring team into $17.3 million, or less than the amount that would be owed under an evenly distributed contract.
Theoretical Cost Comparison for a Team Acquiring Jose Reyes
*Half compounded for 12 months and the other half for 24 months.
In addition to the scenario outlined above, it’s also possible that a team anxious to acquire Reyes would be willing to take on more of his contract. In that case, the Marlins would pocket their invested savings. Either way, they would be in a better position to make a deal because they backloaded Reyes’ contract.
It seems a little perverse to be discussing the Marlins’ exit strategy, but unfortunately, there is a history to consider. Because the team is banking on future revenues being much higher, it makes sense for the Marlins to structure its contracts in a way that would allow the team to shed them if revenue projections fall short, which is precisely why the team seems intent on excluding no-trades and backloading the payouts. For the sake of baseball’s future in South Florida, let’s hope the Marlins don’t have to use the parachutes they are building into each deal.