The Case for Descending Contracts
NBA General Managers have many goals. While goals like winning a Championship are big and lofty, others like not getting fired are small and specific. The successful pursuit of these goals often comes down to the contracts a GM hands out over the course of his tenure. This clearly is not news to anyone reading this column but it warrants mentioning at the outset nonetheless.
In the NBA, it has consistently been true that one bad contract can ruin a team’s financial and on-court fortunes. Interestingly, this fact is even more true now in 2014 than ever before. While it may seem as though the restrictiveness of the CBA heightens this danger, the reality is just the opposite. With the salary cap increasing and the league’s new TV deal rumored to be very rich, the NBA is in an economic growth phase. Teams are going to have more money to spend over the next half decade. (Let’s pretend, for the moment, as though another lockout is not coming.) More money to throw around increases the propensity for player movement and more player movement increases any one team’s chances of landing impact free agents and making a title run. In the next five years, a title might be just around the proverbial corner for more teams than during any other stretch in the NBA’s history. That reality means that teams cannot afford a bad contract because one ill-conceived deal could blow the chance at a title shot they could have had if they maintained the necessary payroll flexibility.
Keeping that in mind, how do we define a bad contract? In the simplest terms, a bad contract is any deal that pays a player more than the market value of his production. That is production rather than potential or expectation. Multi-year contracts can be both good and bad over their life. The $23 million the Lakers paid Kobe Bryant in 2009-10? Well worth it. The $30 million they paid him in 2013-14? Not so much. While Kobe is obviously an extreme example with lots of complicating factors, the point remains the same. To quote the philosopher Jalen, Father Time is undefeated. The older players get the more likely they are to decline. To press that point further, a veteran signing a new deal is more likely to be worth the money in the first year of that deal than in each subsequent year. So why not structure his deal to match the predictable trend in production? This is the beauty of descending contracts.
Pretend you are a GM looking to add a veteran free agent. Your franchise is at least one year away from serious contention and you are building around a young core. (This describes at least 12 NBA teams right now.) You have identified a veteran free agent to acquire who is entering his 10th year and will turn 32 in April. You are well aware that his current level of production will drop as his contract wears on and also understand that it will take a 4-year deal to get him in the door. If your highest concern is preserving future cap space, why not sign him to a descending contract? It costs the same amount of money over the life of the deal but your expense matches production more efficiently. The team pays slightly more when the player is more likely to produce and your team is still rebuilding while paying less when the player’s production falls off a bit and you need to spend on additional pieces for a playoff run.
For teams signing free agents, the maximum decline from year to year is 4.5% of the Year 1 salary. With that rate of decline, teams can save 7.5% of the average annual value in Year 4. However, teams re-signing a player with Bird rights can use a maximum decline of 7.5% which yields 12.7% savings in Year 4. Now to be clear, we are talking about hundreds of thousands in cap savings rather than tens of millions. However, anyone who followed this free agency period knows that small salary issues can stop big deals dead in their tracks.
Despite the readily apparent advantages of descending contracts for both sides, they happen so rarely in the NBA. For teams, they preserve future cap space and help insure that spending matches production while also making the contracts easier to move later in the deal than they would be otherwise. For players, descending contracts mean more money sooner. Finance 101: It is better to have money now than money later. The sooner money is received, the sooner it can be invested and the larger return it can generate over time. We see players acting on this truth when superstars like Carmelo and Kobe take lump sum payouts at the beginning of the league year. They can make extra millions by investing that money earlier.
Considering the mutual benefit, it is no surprise that teams have signed at least eight contracts with descending salaries in the last two off-seasons. Organizations like the Rockets, Spurs and Warriors have seen the value of these types of deals and shorter tenured front offices like those in Phoenix, Orlando and Atlanta have followed suit. Below is a chart of the players currently signed to a descending contract.
Note: Andrew Bogut signed in the summer of 2013, but his descending extension does not begin until the 2014-15 season. Boris Diaw’s contract descends $500,000 in the first two years before increasing $500,000 in the final year.
As you can see from the chart, this type of contract has been used by both teams currently in contention and teams firmly in the rebuilding phase. Financial flexibility is paramount in today’s NBA and its importance will only grow between now and the next CBA.
Speaking of the next CBA, the value of descending contracts could certainly play a role if the players and owners decide to tear up their existing agreement and haggle it out for the second time this decade. Currently, the maximum allowable annual declines – 4.5% and 7.5% – mirror the maximum allowable raises. The necessity of maximum raises makes total sense because they cap the value of a maximum contract and ensure cost certainty for teams. However, the same case cannot be made for annual declines. There is value to players and teams alike in allowing for front-loaded contracts with large declines in the next CBA. Take the case of Nick Collison.
In November 2010, Collison signed a unique extension that paid him $24 million over five years. Instead of having that salary evenly distributed across the five year span, the Thunder paid Collison more than half of the contract’s total value in the first year ($13,250,000) and the rest in descending amounts over the next four seasons. Why did they do it this way? That’s simple. Oklahoma City had Kevin Durant and Russell Westbrook on rookie contracts in 2010 and flexibility in terms of the salary cap and pure finances. The understanding that their young core of Durant, Westbrook, Serge Ibaka, and James Harden would all need pay raises in the near future made sure Sam Presti and company maintained their future flexibility. The Thunder recognized Collison’s value as a near mid-level player and vital cog in their rotation and the flexibility in the old CBA allowed them to structure his deal and their own payroll in a way that allowed them to retain their key players. Collison was obviously more than happy to get the money he would have been paid eventually up front.
The provision that allowed for this sort of contract structure went away in the 2011 CBA, presumably in conjunction with changes to annual raises. It would be very interesting and not totally unexpected if that same provision made a return to the league some time this decade. The ability to build large declines into contracts enhances teams’ financial flexibility as well as the depth of fan interest in the financial, team-building side of the league, which cannot be overlooked. We have seen over the last few summers that the off-court, front office happenings in the NBA can draw fan interest like the on-court performances and results. Consider the fact that you are reading an article about NBA contract structure in August as proof of that. Anything the league can do which benefits players and teams as well increasing fan interest in the lesser aspects of the game is a no-brainer.
Just like paying a player less when he is 33 than when he is 29.
