Shohei Ohtani is a Japanese baseball star who just signed a $700MM contract with the Los Angeles Dodgers making him one of the highest paid players in sports history. The full contract hasn’t been made public, and is pending a few details before being finalized. That means Deep Knowledge Investing hasn’t been able to read it, but enough information has been made public that some analysis is possible. We thought it would be fun to dive into a situation where pop culture meets finance and loop in some of the topics we frequently discuss here at DKI!
Ohtani has agreed to play for the Dodgers for the next 10 years and get paid $2MM a year during that time. The other $680MM of the contract will be paid during the following 10 years. That means 97% of his salary will be paid after he is presumably done playing. It’s been reported that Ohtani is the one who proposed the unusual terms. Why would he do this?
Let’s dive in:
Did Ohtani Really Disadvantage Himself
The time value of money matters. We’d all like to be paid today, and Ohtani appears to be agreeing to delay $680MM of compensation by 10 years. At a 5% discount rate, that would cost him a little over $250MM dollars. Does that mean he just gave up a quarter of a billion dollars in value to the Dodgers?
Of course he didn’t. Remember that any value created by the contract structure can be transferred or shared. Another way to think about this is Ohtani really agreed to be paid $450MM in value assuming a more standard contract without deferred payments, but structured the deal in a way that allowed for there to be a $700MM headline number. There are marketing-related reasons on both sides to do this.
Ohtani is rumored to have other income of about $50MM a year so he’ll definitely be able to pay his grocery bill and rent on “only” $2MM a year for those first 10 years. The key point here is Ohtani chose a deal where he gets paid more in later years instead of one where he gets paid less overall, but sooner. This represents rational thinking from both sides.
Note that the current yield on the 10-year Treasury is 4.2% and the 20-year is 4.5%. One could reasonably argue we should be using a higher discount rate here. The objective isn’t to precisely value Ohtani’s contract; but rather, to give you a sense of where the big levers of value are.
Deep Knowledge Investing regularly writes about inflation. If your expenses have gone up considerably in the past few years, you understand why it’s an issue. As the government issues more dollars, the value of the dollars you hold decreases. That decline in purchasing power is felt as inflation, or higher prices. The reason we’re talking about the value of Ohtani’s contract being worth closer to $450MM than the headline $700MM is because when he receives the $680MM of payments 10 years later, his purchasing power will be much lower then than it would be if he were to receive the money while playing instead of deferred by a decade. That loss of purchasing power is one main reason the stated value of the contract is so high.
The “Luxury Tax” as it Relates to Ohtani’s Deal
Major League Baseball has a “Competitive Balance Tax” that’s referred to as the luxury tax. If a team is over the payroll limit for three years in a row, that team has to pay up to 50% of the excess amount to lower-income teams. This was designed to prevent wealthy big market teams like the Dodgers and Yankees from buying championships and relegating small market or less wealthy teams to the bottom of the standings each year. That was the intention. You are invited to draw your own conclusions on the results.
Baseball accounts for deferred contract payments in a complicated way. According to multiple reports, the luxury tax for the Ohtani deal will be $46MM a year. That means the Dodgers are deferring $34MM a year, or $340MM over the 10 years Ohtani will play for them. If the Dodgers end up over the cap in each year, that means the team will save $170MM over the course of the contract. That’s value that can be saved by the team, shared with Ohtani, or used to sign other players.
It’s also reasonable to assume the threshold for the luxury tax will continue to rise meaning when the bill for the Dodgers’ deferred contract obligations comes due, it’s likely to be against a higher luxury tax amount. The overall payments to the small market teams would be lower under this scenario.
Is the Ohtani Deal Legal?
I’ve seen speculation that other Major League Baseball owners should reject this deal as abusive and outside the spirit of the competitive balance tax. I’m not an expert in baseball rules, but I don’t think there’s a limit to the amount of contract dollars that can be deferred. The Dodgers may have found a way to abuse the system while technically complying with it.
That means the deal is likely to be approved. It’s possible some teams will succeed in preventing it. Another potential outcome is to approve this deal as within the letter of the law and then change the rules to prevent future deals that are so blatant in luxury tax avoidance. At this point, it’s too early to know.
The key takeaway is that by deferring payments, the Dodgers give themselves additional financial firepower and can keep or share all or some of that value with their new star.
Competition and Defining Success
Most sports stars like the idea of being very well paid for their skills (as do we all). The best ones have a competitive drive to win championships as well. At some level, a sports star will be willing to trade money for championships. Tom Brady once famously agreed to a below-market-value contract with the New England Patriots to give the team more room under the salary cap to sign other great players. That was a contributor to more Super Bowl wins and enhanced Brady’s reputation as a team-first winner.
If you were Ohtani, would you rather have $700MM and no championships or $500MM and 5 World Series wins? I’m not saying that’s an exact calculation, and I have no idea who’s going to win the World Series for the next 10 years. (This is neither financial nor betting advice!) However, Ohtani is going to have more money than any reasonable person could ever spend. It’s not crazy to think he would give up some current compensation to make his new team stronger and potentially enhance his legacy as a champion.
Taxes and Tax Avoidance for Consideration
The Los Angeles Dodgers have the good fortune of playing in a wealthy large market. They have the disadvantage of that market being located in California where State taxes of more than 13% are unusually high. Ohtani will have the option of moving out of the State and to a jurisdiction where his income taxes on the deferred $680MM of income will be somewhere between lower and zero. Remember, he has to live in California to play for the Dodgers. He can live anywhere he wants once he is done playing baseball. By structuring the deal in this unusual way, he gets to choose his tax jurisdiction when he receives the majority of his baseball salary.
Marketing Value of Ohtani’s Deal:
The massive sticker shock of being the $700MM man is a benefit to both Ohtani and the Dodgers. Sports stars are often judged on their earnings and this big number both elevates Ohtani and confirms his position as the biggest name in the game.
There are benefits to the Dodgers as well. If you’re a fan of the team, you just saw headlines that management is paying $700MM to bring you the best player available. The move confirms that the Dodgers are committed to winning and takes your fandom seriously. I’m not the only one predicting increasing sales of season tickets, jerseys, and other Dodgers’ merchandise.
Structuring the deal in a way that allows for the maximum headline compensation number while deferring payments to a time when they have lesser value is smart marketing by both the Dodgers and Ohtani.
It’s a weird and exciting deal with a huge headline number and lots of quieter clauses that reduce the value to something below the stated $700MM. It will be fascinating to see what additional detail becomes available in the upcoming weeks and if Major League Baseball either approves the contract and/or changes the rules for future deals.
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I grew up a fan of the Detroit Tigers and the New York Yankees so any accusations of favoritism towards the Dodgers will be rejected. Robb Fahrion of the fantastic Flying V Group was a meaningful contributor to this report and is, unfortunately, an Angels fan. Please direct any irritation at the Angels to him and please don’t remind him that Ohtani signed with the Angels’ crosstown rivals. Plus, if you’re reading this article, it’s because of Robb, so if you’d like some marketing help for your business, consider reaching out to him.
I just handle the finance end of things and help people get better returns in the stock market at Deep Knowledge Investing. You can reach out to us if you’d like to make more money, or to better protect your portfolio, but we can’t help your baseball team win the World Series.
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