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23 Feb 2005

Caponomics Part II: Cap Management Strategies

Guest Column by Bruce Stram

Bring Out Your Dead (Money)

In part one of Caponomics we discussed some basic concepts to help teams maximize the return from their player budget under the salary cap. In this article, I'll discuss specific cap management strategies. I've identified two possible strategies that have been employed with success, which I call "Even Keel" and "Boom and Bust." The names are intended to be pretty descriptive, but before exploring these ideas let's introduce some more real world cap concepts.

Hopefully everyone understands the idea of "dead money" as applied to salary cap calculations. Briefly stated, these are already paid out bonus dollars that were not amortized over the life of the player contract because the player is no longer with the team either through retirement, him being cut or traded. These dollars count against the cap in the year a player leaves or are split between that year and the next year (depending on when he leaves). The dollars count against the cap as if they were paid in salary, but obviously the team has enjoyed whatever benefit it got from its expenditures in the past. Those dollars counting against the cap now limit the team's ability to pay salaries today and therefore acquire talent.

I'd like to introduce another term: "Cap Overhang". These are bonus payments that will not be amortized over the life of the contracts of players currently with the team. We all know that NFL teams sign players to very long contracts that include up front bonuses, and to measure the value of the contract against the salary cap, those bonuses are amortized (evenly spread on an annual basis) over the length of the contract. These contracts typically have very low salary levels in the early years, escalate to "normal" levels in the middle (say the third and fourth years), and then typically include some very high salary years at the end. These last years are not intended to be paid -- the players are usually cut instead -- but exist in order to extend the amortization period to lower the immediate cap impact.

This is really a pretty efficient form for a contract in the NFL. It gives the player what he needs most, guaranteed cash, and gives the team a high degree of flexibility to cut the player rather than pay him if his skills decline through age or injury. Of course they're left with dead cap money, but at least they're not forced to throw good money after bad as per baseball contracts.

Teams also gain a degree of flexibility from the contract length and the early cheap years. This means that a player who in effect is being paid five or six million per year has less of an impact on the salary cap his first couple of seasons than in the outyears. Of course eventually you have to pay the piper. Often the length of the contract extends beyond the likely career of a given player, or the latter year salary levels are so high its obvious the player will be cut rather retained.

Such contracts are virtually certain to lead to "dead money" at some future date. Obviously we can only estimate what that will be for a given contract, but it's still very real. This is what I mean by "cap overhang": unamortized bonus money likely to become dead money in the future. In effect, teams are trading off the future for the present.

Is it possible that team managements are so improvident as to do this? Indeed yes, virtually every team appears to have significant cap overhang. The NFL Players Association keeps track of total team payments to players, and every team has paid more in player compensation than would have been allowed if they had only spent their allotted cap dollars: they've all paid significant bonuses, and have significant unamortized bonus dollars on their books.

Before anyone gets too excited about this, remember a key lesson of Caponomics is relativity: its not how a team is doing absolutely, its how they are doing relative to everyone else. Thus if one wants to judge whether a team has "over indulged" in bonus spending, the real factor that matters is how a team compares to others.

Even Keel, Boom and Bust

One strategy for cap management is to maintain a more or less constant cap overhang so that the team can attain and maintain a certain level of quality, that is, "Even Keel". At least in my concept of this strategy it's a bit more complicated than simple financial management. Basically team management has to view players as replaceable parts and manage the roster so that replacements are in the wings and also use free agency as necessary for a "just in time" inventory of spare parts. From this point of view, a worst case is getting trapped with an "irreplaceable" high value player reaching FA status and having little alternative but to meet whatever is bid. This strategy sounds like it's the one everyone should follow, but there is a problem: to get to the Super Bowl with this strategy, you have to be the best or nearly the best in terms of player evaluation and acquisition and coaching. Unless viable replacement parts keep showing up, you've got big trouble. I would deem New England under Belichick to be the prime example of this approach.

Alternatively, one could willfully and substantially exceed the normal cap overhang in order to build a more talented team than others pursuing more conservative strategies. Of course any GM knows there will be a price to pay in the long run, but he could conclude it's worth it. What's better, five years of 11-5, routine seeding in the playoffs, and losing in the conference championship or four years of 8-8 and a Super Bowl? The former outcome, at least in my simple model, probably represents an overall higher level of coaching and management than the second. But I'm guessing most NFL fans would prefer the second option. So would some owners. That's why "Boom and Bust" makes sense. (A note for economists: we call this an asymmetric value function.)

Like Even Keel, this strategy isn't just simply spending more money. Basically you've got to identify a highly skilled core of players, pay what it takes to keep them, and then try to figure out what else you need and go get that at the cheapest price you can, but the big constraint is time, while the core is still healthy. I think teams that have done this in the past include the Cowboys under Johnson and the other guy, San Francisco under Walsh and Siefert, (For Dallas and San Francisco, this mainly meant paying big bucks to keep a pre salary cap team intact) and the Raiders two years ago. Today I think the Colts are clearly following this strategy: the core is Manning, Harrison, and maybe James.

This course of action is not without risk. The core players must really be extraordinary, and you do have to acquire skilled players elsewhere. Oakland obviously fell just a bit short and is now paying the price.

The Boom and Bust strategy is closely but not absolutely tied to the notion of the franchise player. In one sense it's just arithmetic: a superstar can himself absorb 15% of a team's total cap dollars himself (as Favre does in Green Bay). It's hard to get quality elsewhere without creating significant cap overhang if you're paying that much to a franchise player. In a more fundamental sense, since the team is in part structured around the franchise player anyway, the team is going to take a big performance hit when the franchise player declines in ability. Unless you're very good or very lucky another franchise type isn't going to step right in. Therefore, the team has a strong imperative to succeed while the franchise player is in his prime, and since the team is going to decline anyway when he's gone, why not take a cap bath at the same time? Is 4-12 or worse really all that inferior to 8-8?

This strategy also requires a higher degree of attention to cap management: the team does have to stay under the cap while spending significantly more on personnel than the cap level, and then, over an indefinite number of years, manage the cap overhang and still keep the core and skilled players acquired. Past practice has been to renegotiate high core player salaries into bonuses and turn current cap issues into cap overhang issues.

The Colts recently seem to have done this one better with the Marvin Harrison contract. This is a seven-year contract worth $67 million with $23 million of "guaranteed money". As is typical the contract extends beyond any reasonable estimate of Harrison's life as a high value player (he's now 32). The more novel feature of the contract is that the guaranteed money consists of a relatively modest signing bonus, $6 million, and then bonuses of $7 million and $10 million in 2005 and 2006. These are unusually large and extended future guaranteed bonuses. The contract accomplishes a number of things for the Colts. First, Harrison's cap number for the current season is actually reduced, allowing more flexibility to extend other players during the upcoming offseason (remember the Harrison extension was signed in December). Furthermore, the future-year bonuses "get around" the time limits for bonus amortization. Had Harrison signed for a $23 million bonus up front, the whole bonus would immediately start counting against the salary cap (amortized of course over the lesser of the contract length or league limitation on such things). Now, $7 million doesn't start being amortized until next year and another $10 million the following. (I think I've got this right: that's what the Players contract seems to say, but like all contracts it's a bit convoluted.)

In effect, the Colts have renegotiated Harrison's contract up front. Of course this gives them more cap room in 2005 and 2006 than if they had given the signing bonus up front. But what advantage does it give them over simply renegotiating other contracts to obtain that same room? First of all, if a player's agent is doing his job, any player restructuring his contract to suit the team's convenience will get some extra pay. Second, it's possible there may not be enough restructuring available to accomplish want the team wants to do. In any case, it takes a lot of time that might be usefully spent doing more constructive work, and it gives Indy somewhat better options in terms of taking a cap bath (i.e. going below the salary cap for one or more years to clear out dead money).

At some point Indy has to make a decision that their current run is over. Then their tactics should switch from trying to defer cap hits to trying to accelerate cap hits. Make the cap bath as big and short in time as possible so as to start reloading for a second run with Manning. Harrison's contract gives the Colts the option of taking almost the entire Harrison overhang hit in a single year (say, 2006). Of course, performance occurs on the field, and Indy now faces hard decisions as to whether the current crew with possible additions can get them to the promised land soon. Their maneuvers with Harrison no doubt give them more operating room than would otherwise be the case, but is it enough?

Or, Circle the Wagons

Either of these strategies requires the GM (presumably in collaboration with the head coach) to aggressively take their fate in their own hands rather than let problems come to them. An example of this latter failure is, I think, the recent Packers. They've certainly performed well in the regular season though they've had serious playoff problems. They've had some bad outcomes with free agents (Joe Johnson) and draft choices (Reynolds) that have cost a good deal in salary cap. But some of the worst mistakes have come from the fact that they have often had little in the way of alternatives to replace second rung players (Hunt, KBG, and Diggs, for example) and were forced to match other offers. I don't know this could actually be thought of as a stratagy, but I call this pattern of behavior "Circle the Wagons." (These mistakes presumably didn't occur because of miscommunication between the Coach and GM, since they have been one and the same, but you never know.) They face a similar choice this year with Wahle and Rivera. Here's betting the new GM will make the decision to let these guys go to the market.

What I've provided here is some logic that has to underlie rational thinking about how to use a fixed budget to achieve results. Obviously good cap management doesn't overcome bad coaching and bad player selection. If I had to bet which skill mattered more, I'd probably put cap management as last among these three, but still maybe 25 percent, and of course all of this is properly linked together in an overall package.

The logic I've outlined is mostly an adaptation of fundamental economic theory, not something I've just thought up; I've simply applied it to team management issues. Obviously there may be some errors in my application, and I may exaggerate the importance of these issues. And I've often inferred results rather than explaining logic in detail. (Hopefully grist for interesting discussion.) But, I have to offer that I began thinking about this a couple of years ago, and the team that best follows this logic is the New England Patriots. I don't think I'm jumping on the bandwagon here; the logic can't be changed to suit the vagaries of season outcomes. By the way, in case you didn't notice, Bill Belichick has a degree in economics.

IN TWO WEEKS, PART THREE: Responding to some of the issues from the comments on parts one and two, and breaking down a team's salary budget by position.

Bruce Stram has a PhD in economics from the University of Maryland, was an executive for a major U.S. corporation for a number of years, and now works in business development. He's been a Packer fan since birth in Green Bay, where his mother rocked his cradle while whispering of the long ago glory days of Vince Lombardi. Bruce can be reached at Bruce_Stram@sbcglobal.net. If you have an idea for a guest column, something that analyzes the NFL from a distinctive point of view, please email us at info@footballoutsiders.com.

Posted by: Guest on 23 Feb 2005