Capital Allocation and NFL Contracts
The talk of the offseason will be the NFL quarterback carousel. Who is going to be moved? Who won the Rams/Lions trade? Will Watson hold out?
These storylines all began with decisions made by front offices several years ago. Let’s skip over the symptoms and cut straight to the root cause.
Types of Capital
NFL teams accumulate players to form a team each season. They keep one eye on the present and the other on the future. Draft decisions, contract signings, and trades all have ripple effects, and these ripple effects are caused by scarcity.
I recently wrote about how the NFL salary cap is calculated each year. It’s a hard cap, so teams can’t go over it like with the soft cap in other sports. As a result, the opportunity cost of $1 in salary cap is greatest in football.
Let’s take a step back. NFL teams only have 3 buckets of assets at their disposal: (1) cap commitments (2) available cap and (3) draft picks. That’s it. Every transaction involves trade-offs between these three buckets. That’s how we should analyze opportunity cost.
Valuation
How can we use financial analysis strategies to value existing cap commitments? One possibility is a mark to market approach. MTM involves frequently calculating the market value of an asset.
“Mark to market can present a more accurate figure for the current value of a company's assets, based on what the company might receive in exchange for the asset under current market conditions.”
This strategy allows you to factor in variables like salary cap inflation and determine any change value over the life of the contract. It’s important to understand that contract price is not equivalent to contract value. The Chiefs are just guessing what the value of Patrick Mahomes will be several years from now, even though the price is already set in stone.
How should we value cap availability? For the most part it’s going to be spent on players, and a substantial portion of that is spent in free agency. Daryl Morey gives a simple description of how to navigate free agency; analyzing the market forces of supply and demand. The basic tenets of economics will determine what a player gets paid.
For example, an objective analysis can spit out a fair value of $10m per year for a wide receiver, but if he’s the only one on the market, that $10m reference is useless in a bidding war. This ties into the previous point about valuing cap commitments, because contracts are often influenced by forces such as the franchise tag or other clauses.
There is already extensive research on how to value draft picks. Optionality is inherent to draft picks, but that concept has not yet been applied rigorously to contracts.
Optionality
Why don’t we start viewing NFL contracts like options? It’s certainly more feasible than in the NBA or MLB where contracts are guaranteed. In those sports, you’re more likely to find explicit player or teams options. Most NFL contracts are implicitly options:
“Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.”
Think of NFL contracts as a string of 1 year contracts that the team has the option of fulfilling. Once the initial deal is signed we can track the value of the remaining years. We do this by examining key factors in options pricing: underlying price, strike price, time to expiration, and interest rates.
The underlying price is the fair market value of a player’s production, the strike price is salary, time to expiration is self explanatory, and interest rates deal with salary cap inflation.
Case Studies
Here’s the wrinkle. Sometimes teams are the ones holding the option, other times it’s the player, and occasionally it’s neither.
Let’s look at some current examples and see where teams can learn.
Mahomes
Patrick Mahomes recently signed a $500m contract (even though he’s making $10,825,000 cash this season on a $5,346,508 cap hit). After the 2021 season there is no possible way for the Chiefs to part with Mahomes without eating a $100m dead cap hit. You may be thinking “well of course they wouldn’t want to part with Mahomes,” and you’re probably right. How about when a team makes a similar commitment to Carson Wentz?
Wentz
In June of 2019 Carson Wentz signed a 4 year $128 million contract extension with Philadelphia. The nature of the extension gives Wentz the benefit of optionality. Philadelphia put all their eggs in the Wentz basket. It was the equivalent of being long a stock and writing put options with no hedging. Wentz has all the optionality, because working out a trade to another team would likely require him forfeiting some money.
Garoppolo
The 49ers did something most teams don’t do. They chose not to defer cap spending with Jimmy Garoppolo. What most teams do is pay a huge signing bonus that is then prorated over the course of the contract. All this does is kick the can down the road, like running up a credit card bill. The 49ers now have the freedom to move on from Garoppolo if they so choose. It’s similar to buying a call option where the 49ers have the right to keep him around for longer, but if not they’re only losing the premium paid for the option.
Watson
The Texans are in a great position at QB. They have Deshaun Watson under contract for several years. What helps even more are the new CBA terms working against players threatening to hold out. Watson has very little, if any, leverage. Additionally, his contract includes significant base salaries, which would become the responsibility of the new team should he be traded.
Conclusion
We need to track not only who holds implicit options, but the optionality that we create. It’s common knowledge at this point that draft picks represent valuable assets, but we can go further. As previously mentioned, having little to no dead cap is a version of positive optionality. Certain contracts also represent great options for teams, like the Texans and Watson’s contract.
We’re seeing teams pay roughly the same amount of money to quarterbacks, yet the way the deals were structured put them in vastly different scenarios. It’s why Goff was more tradeable than Wentz.
The same thing happened with GameStop. People buying call options and put options both made a lot of money. People buying put options as the stock rose may have been temporarily wrong, but they faced little downside risk and still made money. It was those initially shorting the stock who lost out.
There’s a difference between buying shares, buying call options, and writing put options. They’re all signs you believe a stock will increase in value, but they are vastly different positions in terms of optionality and risk.
In the future we’ll see this play out with more NFL contracts.