On Opt-Outs and Risk Mitigation

On Tuesday, David Price signed the largest contract for a pitcher in baseball history, getting $217 million over seven years to join the Red Sox. But the value of his deal isn’t just the $217 million dollars he’s now guaranteed; he also obtained an opt-out which gives him the right to hit the free agent market again in three years, if he believes he’ll be able to get a raise at that point. If he pitches well over the next few seasons and opt-outs, he may very well be able to replace the final $127 million of this deal with another $175 to $200 million commitment, pushing the total he’d collect between the two contracts close to $300 million.

Yesterday, Eno Sarris looked at the opt-out from a few different angles, estimating that it added something like $10 to $15 million in value to Price’s deal. Clearly, the opt-out is a perk to the player, as it allows them to reset their salaries if they play well and the market inflates, but doesn’t give the team the same option if they struggle or get injured. The team assumes the full risk of the guaranteed money, but does not get the same potential return if the investment goes well, as the opt-out reduces the upside for the team.

But could an opt-out clause also reduce a team’s risk? Over the last few days, both on Twitter and in (and after) my chat yesterday, a significant number of people have argued that including the opt-out increases the odds that the Red Sox avoid the riskiest years of this deal, and that the opt-out could help the team if they’re willing to let him leave after he opts out. After all, at that point, they’d have signed the best pitcher on the market for $90 million over three years, which is obviously a pretty great outcome for the team.

This assertion often conflates correlation and causation, though. While it’s true that getting three years of Price at $90 million without carrying the longer-term risk is a good outcome for the Red Sox, Price only opts out in situations where his market value is greater than the remaining $127 million left on his contract. In other words, at that point, the Red Sox wouldn’t be able to replace Price’s expected future performance by spending $127 million; they’d either have to pay more to keep him in Boston, or pay a lesser player (or players) that amount in order to fill the hole that the opt-out created. The opt-out occurs at a point when the original contract has turned out well for the Red Sox, but the opt-out is not the cause of the contract turning out well, and it does not improve the team’s situation at the point the opt-out is exercised.

From a purely accounting standpoint, the only way including an opt-out can be a positive for the team is if the player takes a larger discount in guaranteed money than the value of the opt-out is expected to provide. For instance, if Price would have demanded $250 million without the opt-out, then signing him for $217 million and including an opt-out is very likely a better decision for the Red Sox, since the math suggests the value of the opt-out is less than $33 million. For a team, whether to include an opt-out should mostly be a calculation based on the difference in guaranteed money the player is willing to leave on the table in order to have the opt-out included.

But while I’ll disagree with the sentiment that including the opt-out without getting a financial offset can ever be a net positive for a team, I do think a few interesting counterpoints were raised about the difference in expected long-term outcomes for a team when an opt-out is included. In particular, this comment from Josh yesterday explained a somewhat different perspective pretty well.

Certainly, if Price opts out, it’s because there’s a market for his services that may or may not include the Red Sox. In theory, if he had positive value, the Red Sox could trade him to one of those other teams interested in picking up the back end of his deal, no doubt.

The problem is that the market doesn’t work that perfectly. There are relatively few teams that can absorb a $32M pitcher and it’s possible that they are undesirable trade partners (division rivals, poor relationship between front offices, etc). If there is a trade partner, there’s no guarantee that the available return is greater than the value of a qualifying offer. There’s also a chance teams would be less than excited to acquire an asset at full price that’s only being dealt because of the risk he’s about to decline. If he opted out, it’s likely more teams would get involved at a sub-32M AAV in exchange for years. Perhaps he’d take 6/150 rather than 4/128.

I tend to think along the same lines as Dave on this — that the opt out is obviously player friendly — but the argument that there is no conceivable benefit to the team is a little too black and white for me. They definitely won’t be able to acquire a package of players from an interested trade partner this way(versus “might have been able, otherwise) but I’m sure the Red Sox would get over the grief of being out from under pricy decline years and their newfound payroll flexibility and draft pick quickly enough.

In the scenario where Price opts out, it is a given that there’s a market for his services that would result in a larger payday awaiting him in some other city. I’m not particularly convinced by the annual average value argument, as if a team was willing to pay him 6/$150M, they’d likely be willing to trade for Price at 4/$127M and then sign him to an extension that pushed some of the present money back into the new years of the deal; Price doesn’t have to be a free agent for an acquiring team to re-work his contract, after all, and plenty of trades are made contingent upon a player agreeing to a contract with their new team as part of the deal.

But I think Josh raises a point about the potential frictional costs of making a deal that are worth considering. In the scenario where Price has positive value in three years, he’s clearly pitched well to that point, and teams are often reluctant to trade star players who are performing at a high level, even if you could argue that there are signs that point to it being a rational decision in order to do so. The opt-out could force a rational decision upon the Red Sox where irrationality would prevail otherwise. While a team owning a positive-value contract without an opt-out always has the option of essentially forcing an a similar outcome if they so choose — MLB has the waiver system, and any player claimed on waivers could always be given away at any point, so a team is never really stuck with a long-term contract that has positive value relative to the market rate — often contracts at this valuation come with no-trade clauses, which complicates the ease of making a trade, even if a team decided they wanted to do so.

There are frictional costs to trying to trade highly paid star players, and regularly, teams end up hanging onto expensive aging players beyond their sell-by date because of the perception backlash that comes with trading a face-of-the-franchise type of talent. So, perhaps the theoretical upside of the potential trade value is overstated, if a team isn’t willing to act on that trade value. And the point about the qualifying offer is completely correct; even though a team doesn’t get to trade a player who opted out, in the current form, they are compensated with an asset valued at roughly $10 million in exchange for the player leaving for another organization.

We don’t know that the qualifying offer system will survive the next round of CBA negotiations, so a team signing a player to a deal with an opt-out this winter shouldn’t count on the fact that they will get draft pick compensation if the player outs out, but it is a potential benefit that could be realized by a team that has a star player opt-out in the future. The draft pick isn’t going to wholly compensate a team for the entirety of a player’s positive trade value in most cases, but we shouldn’t also assume that a team who has a player opt-out gets nothing in return; it’s the marginal gap between the potential crop of prospects and the draft pick that matters.

But beyond that, the increased likelihood of the team’s ability to walk away from an extension versus choosing to trade the final years of a deal also have to be factored in. And when we look at how irregularly teams choose to trade these types of players, it’s a fair point to suggest that the opt-out may force them into a good decision more frequently.

Overall, the opt-out is still always going to be a player-friendly perk, and one that benefits the player more than it benefits the team. But given the frictional costs involved with actualizing the trade value of a star player versus receiving compensation if the player forces the team into walking away from the risk of the longer-term commitment, the marginal cost of an opt-out to a team may be diminished somewhat. And if a team can get a player to leave $15 or $20 million in guaranteed money on the table — especially by taking a lower annual salary up front, and pushing more of their compensation to the end of the deal, after the opt-out decision has to be made — in order to obtain the opt-out, then it can be a perfectly rational decision to include one in a contract.