Is the Price Right?

David Price’s $217 Million contract with the Red Sox surpasses other starting pitcher’s recently signed contracts however, where does the contract’s net present value place it in comparison?

INTRODUCTION

This week David Price signed a seven year $217 million contract with the Boston Red Sox, while Zack Greinke, who optioned out of his contract with the Los Angeles Dodgers, signed a six year deal with the Arizona Diamond Backs for $206 million.  Price and Greike’s contracts have drawn comparisons to that of other recently signed contracts for starting pitchers, specifically Clayton Kershaw’s $215 million contract signed in 2014 with the Los Angeles Dodger and Max Scherzer’s $210 million deal inked with the Washington Nationals last January.

Although it would seem that all four deals are similar in value, unfortunately the monetary amounts reported do not reflect the true value received by the player.  The real question to examine is not which player received the largest gross dollar amount, but rather, who received the greatest true net value?

CONTRACTS IN TERMS OF TRUE NET VALUE

Though media outlets report the terms of player contracts in gross dollars and agents are paid to maximize the overall contract value for their clients, these numbers are not truly indicative of a contracts actual pay-out.   In order to determine the true (or actual) value of a contract, the net present value formula represents the best approach in determining the actual value received by the athlete.

While the gross value of player contracts is easily obtainable, determining the net present value or true value takes considerable analysis.  In order to determine the true value, there are two items which need to be taken into consideration – tax liability and the time value of money.

Tax Liability

While all athletes incur federal tax liability on their earnings, their exposure to state and local taxes will be directly correlated to their team’s home and away schedule.  Therefore, David Price, while pitching for the Red Sox, will not only be taxed in Massachusetts at the resident tax rate of 5.15% – he will also be subject to non-resident tax in each jurisdiction the team plays.  In 2016, the Red Sox and Price will perform services in 18 different jurisdictions. Price will be exposed to non-resident state and city taxes ranging from a low of 1% (Kansas City) to a high of 13.3% (California).

By  analyzing each team’s home and away schedule, a player’s unique tax liability can be determined. As the chart below indicates, Kershaw, who is a resident of California, faces the highest percentage of tax among those being compared, as he retains only 48.95% of his income while Greinke, a resident of Arizona,  retains 53.15%.

CHART I

Tax Liability as a Percentage


Player

Team

Pct of Tax Liability

Clayton Kershaw

Los Angeles Dodgers

51.05%

Max Scherzer

Washington Nationals

48.42%

David Price

Boston Red Sox

47.32%

Zack Greinke

Arizona Diamondbacks

46.85%

Tax Tip

It should be noted that the above chart reflects Scherzer as a resident of the District of Columbia.  The use of tax planning strategies and resident issues can help alleviate some of an athlete’s tax burden.  By establishing Scherzer as a resident outside the District of Columbia, which doesn’t tax non-residents, he can lower his tax burden considerably. To see more on Max Scherzer’s contract please check out my analysis on his contracts “true value”

Time Value of Money

The general principle that states: the value of a dollar received today is more valuable than a dollar received tomorrow – because of the ability to invest that dollar, plays a significant role in analyzing the overall value of a long term contract.

Over the past ten years the S&P 500 has increased at a rate of 7.4% while the consumer price index (CPI) since 2010 has increased by 1.8%.  By averaging the two indexes and using 4.6% as a discount rate, we can convert dollars received in the future back into today’s dollars to compare the current value of each long-term contract.

A good example of how the time value of money affects actual contract values is Max Scherzer’s contract.  Although Scherzer’s gross contract value and tax liability is similar to that of Price and Greinke, $105 million of his contract is deferred to after the expiration of his deal and therefore the present value of his contract is worth considerably less than the others.

ANALYSIS

By taking into consideration each pitcher’s tax liability and the time value of the money received, the following reflects each player’s contracts true value:

CHART II

True Value of Contracts


Player

Team

First Year

Term

Gross Value

Net Value

True Value

AAV

David Price

Boston Red Sox

2016

7

$217,000,000

$114,312,641

$95,640,888

$13,662,984

Zack Greinke

Arizona Diamondbacks

2016

6

$206,500,000

$109,765,075

$94,055,348

$15,675,891

Clayton Kershaw

Los Angeles Dodgers

2014

7

$215,000,000

$101,632,049

$86,989,532

$12,427,076

Max Scherzer

Washington Nationals

2015

7

$210,000,000

$108,316,727

$78,581,695

$11,225,956

Although it may not be a surprise to see that David Price’s contract has the highest true value – It’s noteworthy to see how close Zack Greinke’s true value is to Price’s contract.  It should also be pointed out how negatively affected Clayton Kershaw’s true value is due to California’s high tax rate and how Max Scherzer’s deferred compensation lowers his true value to the lowest amongst the four comparable players.

CONCLUSION

Understanding the true value of a contract is vitally important and would benefit each side of a negotiation.

Teams

Teams need to quantify the monetary leverage that their team’s unique tax situation creates for their players.  Teams in Florida, Texas, Tennessee and the state of Washington have an advantage in that these states collect no income tax.  In contrast, teams in California, Minnesota, New York, Ontario and Quebec need to understand that their high tax rates cause them to have to pay at a premium.

By quantifying either their advantage or disadvantage a team can systematically adjust their contract proposal depending on the individual player and the opposing teams in competition for the player’s services.

Player Representatives

It is important for  individuals who represent athletes to understand the potential tax consequences their clients face. Understanding state residency issues, as well as tax rates and reciprocal agreements will limit the liability that their clients are exposed to.  In the end, the money an agent can save their client is equal to the additional money they have generated for them.

ALAN POGROSZEWSKI is President of AFP Consulting LLC, which specializes in the consulting and preparation of professional athlete’s international, federal and state taxes. Mr. Pogroszewski is also the creator of the Jock Tax Index (JTI) which was presented at the 2015 MIT Annual Sloan Sports Analytics Conference and has also been featured on “Off the Charts” by Scarlet Fu on Bloomberg Television’s Market Crashers.  The JTI was used in determining the calculation in the above article as it measures how much a team’s location dictates the tax burden on an athlete because of the jurisdiction’s income tax policies and allows individuals to compare the net take-home income after tax liabilities and credits of any contract proposal between competing offers from different tax jurisdictions.

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