The Net Present Value of an NBA Contract

🔖 Patrick Minton on Feb 11th, 2014

Here's a story you often hear: an NBA player opts out of the final year of a huge contract, then signs a long-term deal worth less money per year, but more total money. An example of a player that tried to do this last year was Andre Kirilenko, who opted out of one year and $10 million for the wolves, hoping to get something like 3 years and $20+ million from someone else. Kirilenko ended up signing for much less, but that was his own fault; he reportedly turned down a 3-year, $21 million dollar offer from the Wolves.

But here's the thing: almost anyone who has taken a college-level finance class will tell you that it's a stupid decision. And the reason it is a bad decision is because of the Net Present Value of money, which says that money today is worth more than money tomorrow. And furthermore, this effect is even stronger for the wealthy, because of something called the discount rate, which is generally higher for wealthier people (or corporations).

Here's the premise. Assume that I give you a choice between $1000 today and $1010 next year. If you do not need the $1000 now, then the $1010 is a better deal, right? You get $10 more. But in fact, the $1000 today is better, and not just because of instant gratification. The reason is simple -- since you don't need the money now, you can invest it, and the expected return on your $1000 is higher than $10, which equates to 1%.

And the more money you have, the more true this is. If your savings account isn't very full, then you cannot handle lots of risk (like stocks). The best you can do in guaranteed returns is treasury bonds, CDs, or a Money Market savings account, and that won't be much more than 1%. However, if your savings account has some money in it, then you can afford to court some risk; the average annual return for $1000 invested in an S&P 500 mutual fund since 1970 is around 12%. In other words, if you already have 6 months of expenses saved up, an extra $1000 that you can invest has a much higher expected return for you then if your savings were running low.

This is what the discount rate captures; the interest rate that you could expect to earn (on average, of course) with any given amount of money. And generally speaking, the more money you have, the higher this rate is; someone with $100 million has investment means at his disposal that someone with $1 million could not possibly undertake.

What does this have to do with the NBA? Well, the following tweet sparked my interest:

Rudy Gay has a player option for $19.3 million next year. This is similar to the amount that Kevin Durant and LeBron James earn. And while some debate rages between casual fans and Box Score Geeks about whether Gay is a good player, and he's definitely looked a lot better in Sacramento so far, there is little doubt that the list of teams willing to pay Gay anywhere near twenty million dollars is...well, empty.

But let's assume that Gay could get a contract in the range of Nicolas Batum or Andre Iguodala; something like 4 years, $55 million. $55 million is WAY more than $20 million, so even accounting for Net Present Value, that's a great deal for Gay, right?

Of course not.

The fallacy in that argument is assuming that if Gay were to play one more year, he couldn't still get 4 years and $55 million after that. And since opting out would mean that he'd be leaving about $7 million on the table in 2014/2015, the net present value of any long term deal he signs would have to make up that difference, and that's practically impossible. If we assume a very conservative discount rate of 10% for Mr. Gay, then $7 million now is worth $10.2 million in 4 years. Is he likely to make an extra $10.2 million dollars in year four by opting out? Is he really making a total of $7 million (in present dollars) more over the next four years by opting out? I don't think so! Many NBA players make this mistake; they confuse the total dollars of a new long-term contract when compared to the dollars on that one remaing year, and assume they are making a smart decision by opting out. 

Of course, there's the risk of injury, and that's a valid concern. But let's look at it this way: if hedging against the risk of injury is the main concern, then Rudy Gay would be essentially paying $7 million dollars to mitigate that risk by opting out. That is one hell of an insurance premium! I can only assume that there is a Lloyds of London policy he could buy for far less money than that.

Why do players make these mistakes? Doesn't somebody advise them about money? Sure...thier agents. I am quite sure there are plenty of sports agents out there happily advising players to opt out of final years so that they can sign a new deal.  The agent, of course, makes money at signing, so a new contract is always in the best financial interest of the agent (a similar tale can be told of stock brokers; they make money not by watching you get rich off one or two stocks that you buy and hold, but on commissions for buying and selling stocks). As former player Danny Shaye wrote today at SheridanHoops:

• Athletes, like entertainers, have the biggest disconnect between how much they earn and what they know about money and finance. They are paid like CEOs of billion dollar companies without having a clue about money.
• They are trained from childhood to be coached and managed. They grow up being surrounded by folks telling them what to do and where to go. Their world is sports, and it is consuming mentally and physically, leaving room for little else.
• Once in the pros they are represented by agents who tell them “just play, I’ll take care of everything else”! They have financial dealings with dozens of people who’s job it is to separate them from their money. Like Elvis, they become surrounded by “friends” and advisors who have no incentive to help them become educated.

It seems, however, that athletes aren't the only ones who don't do finances well; most of the mainstream reporters make the same mistakes. Of course, when it's time to negotiate contracts, most journalists will get their information from...you guessed it, the agents.

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