Baseball BeatJanuary 14, 2005
The Art of a Bad Deal
By Rich Lederer

The Los Angeles Dodgers of Los Angeles signed free agent J.D. Drew to a five-year, $55 million contract late last month. He received a $2 million signing bonus and will earn $9 million in 2005 and $11 million in each of the following four seasons.

Dodger Executive Vice President and General Manager Paul DePodesta made the following comments at the press conference:

J.D. is a bona fide offensive force in the prime of his career. He's one of the most complete players in the majors and we expect him to be a cornerstone of the Dodgers for years to come.

"...we expect him to be a cornerstone of the Dodgers for years to come." Well, let's hope so for the sake of Dodger fans but there is no guarantee that Drew will stay more than a couple of years as he has a clause in his contract that would allow him to opt out after the 2006 season.

In defense of DePodesta, he said "years" and there is no mistaking the fact that two is plural. As such, he is technically correct. However, it is the Dodgers -- and not their new star -- who are taking all the risk here. The only reason why Drew would opt out is if his market value has grown to where he can get an even more lucrative deal elsewhere. If he plays poorly or gets hurts, then the Dodgers will be stuck with him for the duration of the five years.

I've heard the argument that the Dodgers would be obligated to pay Drew for years three through five even if they didn't give him the option to leave after two so what's the big deal? First of all, it is a big deal -- and that is precisely the point. In fact, there are 55 million reasons why it's a big deal. In any sizable transaction, you don't give the other side the right to put it back or call it away unless you get something in return.

In other words, the Dodgers should have received some type of consideration for giving Drew the ability to walk after just two years. DePo should have insisted that the Dodgers also have the right to terminate the contract at that point -- essentially making the final three years a mutual option -- or reduced the average annual value of the contract to less than the going rate.

With respect to the last point, perhaps the Dodgers got Drew at a discount. My instincts tell me not, but I am not privy to such information. The only thing I do know is that the Atlanta Braves reportedly offered him a three-year, $25 million deal (which Drew turned down).

In the investment world, investors have the option of purchasing five-year, non-callable notes from government agencies such as Fannie Mae, Freddie Mac, Federal Home Loan Bank, and Federal Farm Credit at approximately 4.00%. If the agency puts an option in there to call the notes in two years, the seller has to offer a higher yield of around 4.375%. In other words, the buyer gets more if the seller asks for the right to opt out early.

In the case of the Dodgers and Drew, the former would be the buyer and the latter the seller. Just as the government agency has to accept terms that are less favorable if they choose to issue a bond that can be called before its stated maturity, Drew should have to do the same.

Instead, Drew is holding all the cards here -- and not just the St. Louis variety. His contract is a one-sided transaction. The fact that J.D., who played in a career-high 145 games last year, has been prone to getting hurt is another reason why he got the best of his new employers. Even DePodesta sounds cautious. "If he can remain consistently healthy, he has a chance to put up some pretty gaudy numbers over the length of the contract.''

"If he can remain consistently healthy...?" That's a lot of money the Dodgers have guaranteed a player they are hoping will stay healthy. At $11 million per year for five seasons, he had better "put up some pretty gaudy numbers," let me tell you.

I have also heard the line of reasoning that if Drew opts out in two years, that could be perfect because he could be entering the decline phase of his career. The team that signs him next would then be the ones on the hook rather than the Dodgers. Well, maybe. But doesn't that presuppose that everyone else is a sucker? That doesn't make sense to me.

Mitchel Lichtman, in a recent interview with Jon Weisman on Dodger Thoughts, had this to say about Drew and his contract:

Drew is one of the few high profile players who are worth their contracts. He is a top 10 player and only a top 10 player is worth 10 mil a year or more. I think the health concerns with Drew have been overstated. I dont particularly like long-term contracts, but one, sometimes you have no choice, and two, people forget that salaries in baseball have risen 12% a year for the last 16 years, and I see no reason why that should not continue.

Well, MGL, nothing grows 12% per year forever. I've got the unders on that forecast. You see, trees don't grow to the sky. Baseball salaries started well below what a free market would bear at the time of free agency and have been playing catch-up ever since. To think that they are going to continue to grow at such enormous rates flies in the face of economic reality.

Asset and business values can grow at a 12% or better clip for years, sometimes even decades, but not indefinitely. Baseball salaries have caught up with the economics of the game. Unless the revenues of the sport itself can grow at 12% or more per year, baseball salaries will not be able to sustain the same level of advancement as they have in the past.

At a 12% growth rate, here is what a player of Drew's ability would be worth down the road:

2005: $11,000,000
2006: $12,320,000
2007: $13,798,400
2008: $15,454,208
2009: $17,308,713
2010: $19,385,759
2011: $21,712,050
2012: $24,317,495
2013: $27,235,595
2014: $30,503,866
2015: $34,164,330
2016: $38,264,050
2017: $42,855,736
2018: $47,998,424
2019: $53,758,235
2020: $60,209,223
2021: $67,434,330

Is there anybody out there who thinks players of Drew's caliber will be making $67 million per season 16 years from now? I didn't think so. Looked at it another way, at a 12% growth rate, the Yankees' payroll would equal almost a billion dollars in 15 years. A billion dollar payroll means each player would have an average salary of $40 million per year!

I would contend that the idea of locking up a player now so as to keep from having to pay escalating salaries down the road is nonsensical. The irony of it all is that the owners are responsible for outbidding one another, forcing salaries ever higher. Even DePo, who I defended when he was hired a year ago, admitted as much when explaining the rationale for signing Drew and not Beltre. "It's a matter of timing."

I won't mention what happened the last time the Dodgers gave a player with questionable health a $55 million, five-year deal. Scott Boras played the Dodgers like a fiddle back then and has once again gotten the upper hand in his most recent dealings with the club. A good deal for Drew. A bad deal for the Dodgers.

Comments

Sixteen years isn't exactly forever -- and who's to say that the owners are going to control their spending by then?

According to Baseball-Reference.com, Kevin Mitchell and J.D. Drew have similarity scores of 939 at age 28 (Mitchell is #8 on Drews list, Drew #6 on Mitchells list). In 1989 Mitchells salary was $610,000. As a 28-year-old, he made $2,083,000 in 1990 and $3,750,000 in 1991.

In 1991, did anyone think a player of Kevin Mitchells ability would be making $11,000,000 in 2005? Me neither.

So if Drew sucks the Dodgers are on the hook for $55 million. If he plays great (and stays healthy) for the next two years then he can go looking for a bigger idiot. It is stupid deals like this that throws the salary structure out of whack. On each free agent the losing team doesn't have to pay the prevaling rate to keep their guy. No, you have to out bid whichever owner is the dumbest at that time. Couple years ago it was Philly giving Thome the 6th year guaranteed. Before that it was Boston upping the ante on Ramirez. Go a couple years earlier and it was Texas bidding against themselves for A-Rod.

Given 12% growth rate:

>>> print 2.083 * math.pow(1.12,15)
11.401

Tom, I'm not sure if I'm agreeing with you or disagreeing, but there it is.

here's another perspective.

the only reason drew would opt out is if he thinks he can get a better deal elsewhere. the only way he could get a better deal elsewhere is if he has really great years. while it would be a shame to lose a player that just had two really great seasons, the heavy odds are on a decline, perhaps a decline that would make his 11 mil salary overpaid. therefore, the dodgers aren't so horribly screwed if drew leaves, because it means they already got two great years at i guess what could be called a bargain price, and are spared the fate of overpaying him for his decline years (maybe).

I agree, salaries have had an incredible escalation during the past 16 years. However, I don't think you can necessarily extrapolate that for the next 16 years.

The pendulum rarely is at equilibrium. It swings too far in both directions. I think baseball has gone from a period where players were grossly underpaid to a period in which they are now amply compensated.

Revenues have also skyrocketed owing to increased attendance and higher ticket prices plus newer sources of revenues, including cable and satellite contracts, corporate sponsorships, stadium naming rights, signage, luxury suites, and more.

Salaries, therefore, have benefited greatly for two reasons:

1. Going from below market to market.
2. The market moving up owing to new and higher sources of revenues.

The rate of growth that has persisted in the past is unlikely to continue for the next 16 years. That is what I was getting at. The past decade or two has been nirvana for players. I don't think it gets much better than that.

Absolute salary levels will probably continue to increase but not necessarily at such a robust rate. One could even make the argument that they may have already peaked. Witness the contracts that were signed in and around 2001 -- ARod, Jeter, Brown, Ramirez, Piazza, Green, Delgado, Vaughn, etc., not to mention the players who fizzled like Dreifort, Park, Appier, Sele, etc.

In any event, I think the more germane point of my argument is that the Dodgers should have gotten something in return for giving Drew the right to opt out after two years. I don't see how that is the case and believe the deal is one-sided and fraught with risk from the Dodgers' perspective.

I addressed that point in the article, Greg.

"I have also heard the line of reasoning that if Drew opts out in two years, that could be perfect because he could be entering the decline phase of his career. The team that signs him next would then be the ones on the hook rather than the Dodgers. Well, maybe. But doesnt that presuppose that everyone else is a sucker? That doesnt make sense to me."

If you believe DePodesta, and I'm not sure why you wouldn't, the Dodgers did get something for including the opt out clause: They got Drew to sign a contract with them. DePodesta has stated that they needed to include the clause in order to get him to sign. It still may be a bad contract but I don't think you can say they didn't get anything for including the clause.

I think what the Dodgers got in exchange for the opt-out is: a) Drew; and b) a flat contract.

Presumably the Dodgers offered 5/$55, and Boras said well, we're fine starting at $11, but feel like our guy should see his salary escalate over the next few years. How about a contract that goes $11, $12, $13, $14, $15 million, or something like that.

DePo was then left with a choice: a) go with Boras's deal; b) tell Boras to go find his deal with another team; and c) offer something else that wouldn't cost him the extra money he didn't want to pay. He chose option C, and it seems fairly smart to me. Obviously he'd prefer to have the option himself, and not leave it up to Drew--who wouldn't. But the question is not whether Drew got something extra from DePo, since of course he did, but whether what DePo gave was better than what he could have given.

Rich -- regarding this passage:

>>I have also heard the line of reasoning that if Drew opts out in two years, that could be perfect because he could be entering the decline phase of his career. The team that signs him next would then be the ones on the hook rather than the Dodgers. Well, maybe. But doesnt that presuppose that everyone else is a sucker? That doesnt make sense to me.<<

Not *everyone*, Rich. All that needs to happen is for there to be one or two teams out there dumb enough to pull the trigger on such a deal. You know: the Mets. The Diamondbacks. I bet before this offseason you would have been shocked to see Lowe (a) signed by the Dodgers, and (b) for 4 years and $36M. Why did DePo pay so much? Easy answer: because others were taking the other pitching off the market early and at exaggerated prices. How does Russ Ortiz get the contract he has? One dumb club. Suddenly, teams start looking at the delta between Ortiz and Pedro Martinez and figuring the premium.

I don't think the Drew signing is a great one by any means, and if I've made it sound like it is, that's my fault. But you have to admit, any contract where the team can get off scot free in the middle -- even if the team can't initiate the divorce -- is a better deal than if there's clearly no way out for either party.

Furthermore: what would you have done instead, Rich? If not Drew, then who?

Rob, Rich isn't playing GM. He's not saying it's a bad signing. What he's saying that it's a bad contract. Big difference.

Picky, picky. The Drew contract, then.

Joe -- one other point. I've gotten a couple roundhouse punches from Tom Meagher about failing to consider contracts in context -- which isn't a bad idea, actually. That's my point here: I think Rich has failed to look at this contract in context of the Dodgers' needs. You can't have an infinitely cheap team.

Once again, Rob, Rich isn't saying he would or wouldn't sign Drew. He's doesn't even say whether $11M is too much for Drew. That's not the point of his article.

But he does make the case that the contract (the escape clause was the whole point of the story) is nothing but bad for the Dodgers, good for Drew.

And speaking of "infinite cheap", aren't you the one who refuses to pay Jered Weaver $2M/yr? You can't have it both ways.

Not to nitpick here, but I think the contract is more like a put-option, where the Dodgers have sold the option to Drew, who then decides whether or not to exercise the option in 2yrs time. Looking at it this way, he has a 2 for 22 contract and the option to continue at 11/per. Should he exceed 11mm value as deemed by the market, he'll exercise his option and re-sign for more. I think 22mm for 2yrs is slightly below market in this context, offset by what insurance premium there would be to hedge injury risk over this period. JMO. I like the article.

I guess I am the lone voice in the wilderness on the Drew contract. Among others, All-Baseball colleague Jon Weisman and friend of A-B and RWBB Jay Jaffe, in an exchange that can be read on Dodger Thoughts and The Futility Infielder, are not bothered by Drew's escape clause.

Oh well, maybe it's just my investment background and how I view deals through the prism of risk/reward. If Drew leaves after two years, "so what?" seems to be the mantra. I say, "fine, give him a two-year deal." The point lost on others is that I just don't want to be stuck with the guy for the final three years if he doesn't exercise his option. That's the risk in the deal.

The reward, I guess, is that if Drew puts together two good years, you enjoyed those but at $11 million per season I would hope he would put up something close to the .300/.400/.500 rate stats I've seen mentioned. Given the risk in extending him a five-year guaranteed deal, I would want the reward to be much more than that. I would want to sign him for either less money to begin with or have the option of keeping him for the final three years if he is producing at such levels.

Or, if I can't get that reward, I would want to reduce my risk by either having the right to terminate the deal after two years (just as Drew has) or have a built-in reduction in his salary for the final three years.

Rich, great article. You're exactly right, of course. JD Drew has been given an option on his contract, and, as you well know, that's a very valuable thing. The one good example I know of recently was with Frank Thomas in Chicago, who opted to stay with the Sox because the deal he had was better than what he probably would have gotten on the "market."

The key that everyone should remember is that Drew's contract is worth MORE than $11M a year -- and maybe a lot more. The club has all the risk but, potentially, not all of the reward.

You can argue pretty persuasively that Drew is worth more than $11 million if he stays healthy and produces like he did in Atlanta. But he's still a big injury risk. I guess what I'm saying is that I think the dollars and the clause together make a lot of sense in this situation. But people shouldn't overlook it or minimize it. It was probably the key to the deal.

So the next question is: how do we value his option?

That's an interesting question, studes, and perhaps a worthwhile project to explore.

The idea of options is certainly not new. Ancient Romans, Grecians, and Phoenicians traded options against outgoing cargoes from their local seaports.

As most of us know, an option is nothing more than a contract between two parties in which one party has the right but not the obligation to do something, usually to buy or sell some underlying asset. Such rights have financial value.

When you buy an option in the financial markets, you pay a premium for that right. Conversely, when you sell an option, you receive a premium for doing so.

Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model in 1973. The Black-Scholes model prices the "fair value" of an option. The basic formula is as follows:

Call Premium = Expected Future Stock Price - Expected Cost of Exercising Option

Without getting too deeply into stochastic calculus here, it seems to me that we should be able to develop a model that could determine the expected value of an option in a contract such as the one signed by Drew.

My sense--and the sole purpose of the article--is that Drew's option is worth more than people currently realize.

"Well, MGL, nothing grows 12% per year forever."

Except the stock market. Unless that doesn't count because it's 11%.

The problem with your piece here, Rich, is that you assume or determine as a given that $11/yr is Drew's fair market value. Well, like any other player, its not a given. It is determined by a player's probability of putting out a certain performance given past performance, age, health, work ethic, etc., not to mention misperceptions on the parts of management and fans. Now, there are varying opinions on Drew's real injury risk and toughness to go with the pretty wide consensus that he's a hell of a baseball player. Personally, I'd say a healthy Drew is comparable to Beltran, at $17/yr. Now, unlike Beltran, Drew is a little older and has more injury risk. But I doubt very much he has $6mln/yr more in injury risk and would avow that a noncallable contract would probably work out to between 12-13/yr. I think what actually happened is not that DePo couldn't afford the 12-13/yr or whatever it would be, but that he's gotten plenty of heat already for not signing Beltre without paying Drew the same as Beltre got from the M's.

Comparing those two, Drew has significantly more consistency of performance, I believe more than compensating for his age and somewhat higher injury risk. If the Dodgers were as stacked in outfield prospects as they are at 3b, I've got no doubt Beltre and not Drew would be a Dodger now.

Johnny: The compound average annual return from the stock market, as measured by the Standard & Poor's 500, has been 10.4% since the index's inception in 1926 through 2004.

*****

Lloyd: I'm not assuming anything. Here is what I wrote:

"With respect to the last point, perhaps the Dodgers got Drew at a discount. My instincts tell me not, but I am not privy to such information. The only thing I do know is that the Atlanta Braves reportedly offered him a three-year, $25 million deal (which Drew turned down)."

As far as fair market value goes, it is the price that an interested but not desperate buyer would be willing to pay and an interested but not desperate seller would be willing to accept on the open market when they are acting freely, carefully, and with complete knowledge of the situation.

I would contend that the Dodgers were perhaps acting somewhat desperately after Beltre signed with the Mariners so I believe it is reasonable to think that they may have paid more than fair market value for Drew's services.

As to Drew and Beltran, the former has only played in more than 135 games once and has averaged just 121 games per year (excluding 1998 when he was called up in September). The latter, on the other hand, has played in 155 or more games four times during this same period.

Here is how they stack up in terms of Win Shares (going from, left to right, 2004 to 2001):

Beltran 31-28-22-27
Drew 34-13-15-22

Although Drew had three more WS in 2004, Beltran has averaged six more per year over the past four years. Carlos is also younger by 1 1/2 years.

Don't get me wrong, Drew is a premier player. I said as much when the Dodgers signed him (http://www.all-baseball.com/richbeat/archives/016879.html). Eleven million dollars per year sounds reasonable to me. However, the five years sounds less reasonable and coupling it with a one-sided escape clause after two years means the Dodgers are taking even more risk than a straight five-year, $55 million deal.

OK, fair point on "Fair Market Value". However, on the injury front, I think its mostly absurd to sabermetrically project past injuries onto "value" without looking at the specifics involved. In Drew's case he lost considerable time to a freekish, not likely to be repeated wrist injury now fully healed. He also lost good parts of two years to a knee injury which apparently caused related maladies while he tried to come back too early. After strenuous off season conditioning last year, this was not a problem and he states he continues to strengthen it and that it feels great. Knock on wood. In any case, if Drew's callable contract is worth 11/yr, what would a noncallable contract be worth to the Dodgers? And who's the better deal, Beltre, Beltran, or Drew? I say Drew, by a nose over Beltre. By more than a nose given the alternatives to the Dodgers in RF/CF. Finally, a question- can Drew call in his contract each year after the second or is this a one time option?

My understanding is that Drew does not have the right to opt out after the third or fourth years. He only has the right to do so after the second year.

It's clear the option is worth a lot to Drew, but it's not clear that it costs the Dodgers all that much. They risk losing him if some combination of increase in market value and performance cause Drew to excercise the option in two years. The other risk of the contract is pretty much the opposite -- a reduction of his value on the market over the next five years.

The Dodgers might not be concerned about Drew walking away after two years if they got good value for the first two years and can replace him with someone cheaper. Like someone who is not yet eligable for free-agency. In a sense, the option doesn't hurt the team as much because Drew's services are potentially replacable.

Giving Drew five years is a potentially bigger risk in the case of an injury or sever loss of production. If some freak accident happens, the Dodgers might loose all of the contract value. A mutual option would be a clear hedge against the possibility, but even the player option is a partial hedge. That's because the potential contract length is 5yrs - 3yr*P where P is the probablity that the option is excercised. (For instance, if the option is excersised a third of the time, the total contract would average 4 years.)

Drew's contract is not about its average length. Instead, its all about who gets to decide the length. The Dodgers are obligated for five years if Drew doesn't exercise his option whereas Drew is only obligated for two years.

If Drew leaves, it's because his market value and presumably the market value for equivalent players has gone up. The Dodgers will be required to give Drew or his equivalent an even better contract. That means the cost of the contract will turn out to be higher than the advertised price of 5/$55m.

If Drew doesn't leave, that means his market value isn't worth $11 million anymore, yet the Dodgers will be stuck with him for three more years. That means they will have overpaid at 5/$55m.

Drew can't lose but the Dodgers sure can.

The contract is a put option.
Inputs
Writer of Option = Dodgers
Holder of Option = Drew
Definition
Put: A contract that gives the holder the right to sell to the writer of the option a specified amount of commodities or securities at a stated price.

In context: A contract that gives Drew the right to sell to the Dodgers a 33mm, 3yr contract, which is in the money if his market value is deemed to be less than 11mm per year.

In its simplicity for baseball/bond talk, a call option basically gives a team/borrower the right to terminate a contract early, wheras a put option gives a player/investor the ability to extend the contract.
Traditionally, the team option is represented by a buyout amount, so the player contracts are not effected by an embedded option. In Drew's contract, however, the Dodgers are not going to receive a buyout from Drew if he turns and signs a more valuable contract elsewhere, so the value of the option has to be embedded by his taking marginally fewer dollars. I think this is key if you are going to analyze this contract in depth. My 2 cents after blabbering about options? A short contract for a highly valuable player is tough to do. I believe DePo has a preference for shorter duration contracts, but clearly the downside risk here is ugly. Is Drew going to have an arthritic knee in 2yrs though? Will insurance cover that? I don't think 11mm for 2 seasons is enough of a discount to cover the risk that he drops from a top tier outfielder to a middle tier outfielder (who I'm guessing would make approx 7mm or so per season).

>>And speaking of "infinite cheap", aren't you the one who refuses to pay Jered Weaver $2M/yr? You can't have it both ways.<<

Joe -- wake me when Jered Weaver has played ONE SINGLE PROFESSIONAL GAME. That is all.

George is absolutely correct that the Dodgers have given Drew a put option. He has the option to "put" the contract back to the Dodgers at the end of two years. If he doesn't exercise his "put," then the contract extends to five years. His analysis is spot on.

Wake me when JD Drew plays 150 games...

Joe -- Jered Weaver and J.D. Drew are not the same thing. One is a flawed player with a track record of effectiveness when healthy. The other is an untested college player who may never reach the major leagues. It's that simple. Or, shall we start handing out guaranteed contracts to every untested high school phenom who shows some promise? Because that's the road you'd point the Angels -- and major league baseball, by extension -- toward.

One question: Did LeBron James deserve the contract he got?

The LeBron comparison MIGHT make sense if Weaver did what he did, had a 98 MPH fastball, a plus plus slider and the makings of a solid third pitch. LeBron was the #1 player in terms of both production and tools that scouts had seen since probably Magic Johnson. Weaver did well on the production side, but doesn't exactly have the tools, and even those that love his production acknowledge that his max upside is of a #2 starter, most likely a #3. LeBron came in looking like he was going to be an all-time great to just about everyone.

Besides, for every LeBron, Kobe or Garnett, there's a McGrady or Jermaine O'Neal (didn't get good until after their initial contracts expired) and two Dasagna Diops / DeShawn Stevensons. If baseball can somehow get away with it, that's probably not a road they can afford to go down, especially considering how many more players a baseball club needs to sign as opposed to an NBA team.

Not that I would defend not paying a half mil for Weaver, but if his rumored price is true, I think Anaheim can avoid signing him since they already signed the equivalent of a high first-rounder in Kendry Morales.

On the article, good article, but there definately was something in exchange for the opt-out. As a transactional lawyer, I can definately tell you that a party won't get something that big without giving up something significant in return. My best guess is that getting that clause shaved off a few million from the deal, allowed the flat structure, and allowed there to be no no-trade clause.

Congratulations to all the commenters. That was a good discussion. Thank you for participating.