Professional Sports and Business Expenses

Professional Sports and Business Expenses

by David Sanchez, MBA1

jdsanche@umich.edu

We've spent the last few weeks talking about revenue generation, now we'll look at where it goes. At last, what we all hear about daily: players and their millions. Player salaries are any team's most important operating expense, but there is much more involved. The average major league baseball team has about 60% of its operating expenses tied up in player costs, the average NBA team 58%, and the average NFL team a whopping 72%.

True, no number in sports is more inflationary than athlete salaries. This is not just the case for superstars--they have always made top dollar--but all athletes. It is still the case that superstars make much more and they are being rewarded not just for being a great athlete, but being exciting. This is what draws people and helps them rise above the level of stars to superstars.

Baseball reached the million-dollar average player salary plateau in 1992. The big stars now regularly make over $5 million a year. But to understand how potentially out of whack the system was, say in 1992, you only need to check out second-tier players and what they are being paid for basically being mediocre. In 1992, guys were making the big bucks without having the numbers to support it. These were players like Craig Lefferts, who had a salary of over $2 million and Charlie Liebrandt, a spot starter, who was the highest paid player for Atlanta at over $3 million a year. This trend continues and seems to affect all professional sports.

All of the sports have had their battles between players and management. Individual disputes are as old as sports itself. Little NFL strikes in 1968 and 1974 lost days during the pre-season; bigger strikes interrupted the regular season in 1982 and 1988. Player "holdouts" during the pre-season are also famous across sports.

Baseball's history with players and salaries

But no sport's history has as many examples as baseball's with conflicts over player control, money, and the game. Players as far back as 1885 joined forces for better conditions and pay. But mainly, the efforts resulted in 90 years of frustration and the power remained with owners.

There was no logical reason for the owners to have all the power. It seemed that baseball simply told America it was different from other businesses and America agreed. Players slowly were able to grab some gains in those years--more money, better conditions, and especially contributions from owners toward pension funds--but the main rules never changed. Athletes remained property, to be bought and sold at the discretion of owners. Of course, they could retire if they liked, but if a player wanted to play, it had to be at the owners' pleasure.

This was validated repeatedly on the national level. The Supreme Court ruled in 1922 and again in 1953 that baseball was exempt from antitrust laws. That position was re-affirmed in 1970 when Curt Flood sued baseball. He claimed that in trading him to the Phillies without his knowledge or approval, the St. Louis Cardinals had violated antitrust law. He lost, but this set in motion the forces that would change baseball.

Not long after, players had baseball's first general strike in 1972 over the pension fund. It was 13 days long and forced the playoffs and World Series to start late. There would have been another strike in 1973, but the owners agreed to arbitration of salary negotiations. Arbitration was a key loss of power and control for the owners. As the power continued to erode, salaries climbed.

Then in 1975, two pitchers, Dave McNally of Montreal

and Andy Messersmith of the Dodgers, maintained that their contracts did not pay them adequately for their skills and refused to sign them. At the time, baseball's standard contract provided for automatic renewal for one year at the club's discretion. But after playing in 1975, both pitchers declared themselves free agents; this was not how it was supposed to work. The matter went to arbitration, and the players won.

Baseball's contract structure was crumbling. So, owners reacted and, in 1977, locked out the players from spring training. Later a 50-day players strike split the 1981 season, and a two-day strike hit in 1985. Each occurred while hammering out successive basic agreements between baseball and the Players Union. Details changed from contract to contract. Teams losing players to free agency were first compensated with picks in the amateur draft, then a draft pick and a player from a pool of professionals. The latest strike caused the end of the 1994 season and cancellation of the playoffs and World Series, possibly damaging baseball permanently. It is still unclear when baseball and players will have a long-term working agreement.

All along, the price of players rose. Present-day salaries include many more things like cost of living adjustments. Why do salaries continue to rise today? Free agency. The supply of players seems to be too tempting for the demand by owners to pass. Fearful that players will leave, owners are coaxed to sign them to longer-term, high salary contracts. And there is always that big slugger or healthy arm out there that appears to be the difference between an average team and a contender. On the player side, longer contracts with cash flows well into the future can be troubling so they add ever-increasing signing bonuses, which guarantee cash flows on the front end.

Why don't clubs just get together and not sign any free agents to control costs. Because it is considered collusion and illegal. Not that owners didn't try--in 1985, lack of options caused 28 of 32 free agents to resign their clubs (the four who went elsewhere had been declared "unwanted"). This continued for two more years and the Players Association filed a grievance each year. Finally, the courts decided. In cases known as Collusion I, II and III, owners were found guilty and Major League Baseball owed the players $280 million.

Basketball: A better example?

The healthiest sport today, when it comes to salaries, is basketball. But in 1980, this league was in the trouble. Most teams were losing money, player salaries were already high as a result of bidding between the ABA and NBA for players, and broadcasting revenues were low. In fact, many forget that in 1980, the sixth and deciding championship game between the Los Angeles Lakers and Philadelphia Seventy-Sixers was not shown live but on tape delay! The man credited with the turn-around is David Stern, who took over as commissioner in 1984. He instituted a drug policy, and as important, the salary cap. The NBA was the first major sports league to limit its teams' payroll while guaranteeing its players a share of league revenue.

In 1988, players and the league agreed on unrestricted free agency for any player who had concluded two contracts and five years in the NBA. These players could now sign with any team, but their existing team had the right to match any offer. But, once the player is gone, the team received no compensation. The draft was also shortened from ten rounds to two, and the rules indicate that any player not drafted, becomes a free agent.

Basketball's salary cap

Prior to the start of each season, the NBA and the Players Association meet to determine the salary cap for the upcoming season. Roughly speaking, the cap is calculated by projecting the upcoming season's gross revenue, multiplying it by 53%, deducting an amount for various player benefits, and dividing the remainder by the number of teams in the league. To ensure that players will receive 53% of projected gross revenue, NBA teams are also subject to a minimum salary restriction.

One of the purposes behind the cap is to keep teams intact. So, the NBA has made it possible for teams to exceed the cap to sign their own free agents or to extend contracts. Teams that exceed the cap by re-signing, are subject to a series of rules. An example of these rules is when a player of a team that is over the limit, is put on waivers. The maximum salary the team can pay the player that fills his spot is 50% of the departing player's salary. In addition, guaranteed salaries of waived or cut players must remain in the team's cap.

Some of the other situations that have come up are best handled by example. The Lakers once signed Magic Johnson to a $25 million dollar, 25 year contract in order to annualize it and keep them under the cap. The league and Players Association agreed to curb this by not counting years after a players' 35 birthday. So, if Magic was 30 at the time, the contract could only be annualized over 5 years (at $5 million a year and not $1 million).

Another situation that has been used to manipulate the cap is what are called "backloaded" contracts. These contracts pay a player a small amount in the first year--to remain within the cap--and then large increases the following years. But this too has been regulated. Player salaries can now only increase or decrease by a maximum of 30% from year to year.

So despite all of the restrictions, teams still find ways to sign players. Our example will be Kenny Anderson, who was the second pick in the 1991 NBA draft. His asking price was $3 million a year. The New Jersey Nets were only about $500,000 under the cap so there was work to do. They let one player leave for Italy, two others go without a fight via free agency, and waived two more. Salary savings from this put them $1.8 million under the cap. They then structured the contract with "backloaded" raises of $540,000 (30% of $1.8 million) so that the contract offer added up to $14.5 million over 5 years (average of $2.9 million a year). Anderson had already missed games in the hold-out and fortunately for the Nets, he signed. How fortunate they were, based on wins, is hard to tell. Mr. Anderson is now with Boston.

The NFL and free agency

The NFL also operates with a salary cap, which is at 67% of a team's gross revenues. But it too had to go through growing pains to get where it is now. The issues, as we have seen with baseball, were also around player control. Now, the current situation is similar to basketball, but with some NFL-specific quirks.

In the NFL, salaries were relatively consistent for a long time with only "star" players (mainly quarterbacks) getting the real money. But, when the old labor agreement expired in 1987 and lead to a strike, this helped to start the loosening of restrictions on player movements. If you remember, this was the Plan B stuff under which a team could protect up to 37 players on its roster, leaving the other 10 or so free to negotiate. The quality of the players left unprotected was generally not the starting point for building a franchise. Then, in April of 1990, New York Jets running back Freeman McNeil and seven other players filed an antitrust lawsuit against the NFL. They won. It took some time, but by the end of 1992, the NFL had its own collective bargaining agreement and unrestricted free agency.

This agreement immediately declared free agency status to players in the league for at least five years (since reduced to four years), and these players who were in the final season of their contracts. Of course, certain restrictions were put in place to alleviate owner concerns. Each team had the right to select if it wished one man as a "franchise players" who was not free to negotiate with other teams. In exchange for giving up that freedom, the salary of that player had to be one of the five best at his position. In addition, two others in the first year of contracts and one in the second year could be protected, They also had to be offered the average of at least the top 10 salaries at their relative positions or 110 % of the previous year.

Another NFL restriction is the amount that can be spent on all draft choices. This second cap is set a total of $2 million a year or 3.5% of league revenues, whichever is greater. Judging by recent rookie pay, league revenues must be much greater and there must be some interesting cap maneuvers happening.

Hockey: Still developing

Hockey does not have a salary cap, and does have free agency. The impact of this has been seen from time to time in situations like the Gretzky move to Los Angeles and the recent ordeal between Carolina, the Detroit Red Wings, and Sergei Federov. Overall, the system does try to protect teams in smaller markets through compensations (draft picks, players) and allowing for matching offers. Some of the hotter issues in this sport involve Canadian teams. There has been talk of subsidies from the Canadian government, or the NHL, for teams in Canada because of the recent weakness of the Canadian dollar and high tax rates in Canada.

Conclusion

Even with all the protections and restrictions for teams to protect players, the word "free agency" must still cause many sleepless nights for front office personnel and also burn a hole in the owners' pockets.

In the large picture, it is still undetermined whether free agency has changed more than the pattern of salary distribution. Top players, for the most part, still get the

most money, and mediocre players still try to survive in the leagues. And the rich teams may or may not have been prevented from buying championships. Although no one has created a dynasty like the Boston Celtics or the New York Yankees, smaller market teams have lost big time players to large market teams. Look at Pittsburgh who lost Bobby Bonilla (to the New York Mets), Barry Bonds (to San Francisco), Doug Drabek (to the Chicago White Sox) and even their coach Jim Leyland (to Florida) to free agency. It used to be remarked that it wasn't proven that buying superstars could bring a championship, but the Florida Marlins may have proven it last year with a "rented" team.

Still, when it comes to star athletes winning is only a part of the return. Hockey's Los Angeles Kings were a below average team when they bought Wayne Gretzky. As it turned out, not only would Wayne make them a better team, but he would also prove to be a great investment. The Kings went from last to second in the division and once made it to the Stanley Cup Finals. Off the ice, the front office saw much more: per-game fees for cable, rose 50% and the number of games carried went from 37 to 60. The average ticket price went from $18.50 to $22 and attendance jumped from 427,721 to 547,952 (an increase of 3,360 a game). Finally, the number of sellouts went from 5 to 22. Bruce McNall, the man who made this happen, originally had paid $16 million for the controlling interest in the Kings, after the Gretzky acquisition, he was turning down offers of $90 million.

The point is that winning is only element in the complex business of sports. Things like revenue sharing in the NFL means that winning or losing does not have the impact on revenues that fans think they might. Salaries are rising because free agency has made it possible for all positions (not just the visible ones like quarterback) to be better evaluated for their true value.

Deciding the value of a player, especially a star, is a tough question. Is professional sports entertainment or competition. This is important because having a good show is not necessarily the same as winning. This can affect whether to bench a superstar for the good of the team or to let him play and attract the fans for the good of the organization. This depends on the values in place in the organization, but is nevertheless an issue.

Finally, teams must also consider the value of stars to the organization. A hockey franchise in Los Angeles needs a Wayne Gretzky more than a Montreal. Teams outside major markets may need to shell out for that name player, like the NBA Phoenix Suns did for Charles Barkley, to be financially successful and have "drawing" power. Owners want something that gives the franchise a passionate appeal to the fans. Normally, this is developed with true fans over time, but it can also be created more quickly with a star. Another part of the puzzle is matching the right player and the right place, we're talking about chemistry, like Larry Bird in Boston or Magic Johnson in Los Angeles

Just remember when you hear about Kevin Garnett's $120 million salary, more is at work than service during competition. Many things impact what teams are doing and trying to accomplish. Nevertheless, the impact of salaries on professional sports, its future, fan loyalty and other factors, is still being determined.