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Shohei Ohtani, corporate finance, and a win-win contract?

This contract is extremely favorable to the Dodgers from a business perspective. It may also be extremely favorable to Ohtani’s tax bill.

MLB: Los Angeles Angels at Philadelphia Phillies Eric Hartline-USA TODAY Sports

The $700 million deal the Dodgers gave Shohei Ohtani contract seems like the largest in sports history by a lot, but in reality this is really a team-friendly deal in many ways. We have never seen a deal structured remotely close to this one. The Dodgers will pay Ohtani just $2 million per year from 2024 to 2033, with interest-free deferrals paying him $68 million from 2034 to 2043. It is a unique deal for a unique player with possibly unique implications for the business of the Dodgers and professional baseball as a whole.

Let’s start with the math that the league is applying from a luxury-tax basis. The league is going to have this contract hit their tax threshold at $46.06 million per year. That is an implied discount rate of 2.82%. If you want to see the math, this link will take you to a Google Doc with the discounted numbers in it. They actually discount only the deferrals, but I am keeping the model simple for comparison. I also included the same math for union value of $437,830,563, which is an implied discount rate of 3.17%. Then I put in the math on Mike Trout’s contract extension in 2019 and inflated that present value to 2024 for comparison.

I inflated Trout’s contract three different ways to show all of the possibilities, and his contract could be comped as being somewhere between $371 million and $399 million in today’s dollars. The $371 million is light because I don’t have average player salaries for 2024 yet, meaning it is missing one year of inflation. Either way, this contract is a 10 to 20% premium over Trout’s extension in real terms, but that is also not a fair comparison. The first year of Trout’s contract was a arbitration year and so he only got $16 million, though the $20 million signing bonus maybe smooths that out. If not, the Ohtani premium would drop into the 4 to 15 percent range if they had to pay the AAV of the rest of the contract in year one.

The point here is that the Ohtani deal is not a crazy expensive contract like it sounded on day one. An eye-watering $70 million per year when back-loaded and paid out over 20 years with those huge deferrals puts it in line with what the last best baseball player in the world got. Is Ohtani worth more than prime Trout was? On the field, maybe. He does take up two spots, DH and a rotation slot, freeing up one more bench spot. Granted, that is risky because if he is hurt that means you have two spots to fill all of a sudden. From a WAR perspective he is similar, putting up 9+ fWAR in the last two seasons. I’m not sure WAR can actually account for him perfectly, but it is probably not giving him enough credit if anything. The Dodgers are getting the best player in baseball for his age 29 through 38 seasons when 9 WAR seasons are worth somewhere in the $70 million range. He is more than worth $460 million in terms of baseball skill, and he is worth more than just what he does on the field.

Where this deal becomes a coup for the Dodgers is off the field. I am not sure any player in baseball history has the pure money generation value that Ohtani has. He drives attendance and merch sales up, and might be enough for them to raise ticket prices more than they would have going into this season. Oh yeah, and there are 125 million people in Japan and a lot of them like baseball. They broadcast every Ohtani game in Japan, and I have no idea what that is worth to the team, but it has to be something. They also get to sell advertisements in the stadium for those extra eyeballs to see, which increases their income by pushing higher demand for their ad spaces. I don’t know how to guess what all of that is worth, but it is definitely going to offset several million dollars a year of his cost. He might generate $100 to 200 million or more in increased revenue over the next 10 years for the team according to LA Times reports on how much the Angles were making off of him.

I was actually surprised that this contract was not more money, in present value not nominal terms. If it was $70 million per year for 10 years, that would probably make more sense based on the fact that the team will cover nearly a third of it with revenue increases. That he is willing to let them wait on paying him the vast majority of it for so long seems crazy. The Dodgers finance people had to have been giddy getting that done. The valuations in the Google Doc above were done purely using inflation or something akin to long-term inflation. Internally, the Dodgers front office would be discounting it closer to the required rate of return for their equity since that is primarily how it will be funded. If you bump that discount rate up to 10 or 12%, the present value goes down substantially to under $200 million in 2024 value. If the Dodgers are generating reasonable returns and able to generate more off of the saved money/ancillary income in the front end of the deal, then they will come out way ahead on this deal. Why would Shohei Ohtani, and his representation, agree to this?

1. The lower luxury tax hit allows the Dodgers some freedom to expand payroll and avoid penalties. The opt out in the first link above talks about front office changes, so it seems Ohtani believes in this group that has consistently put winning teams on the field. Any fan could follow the logic of taking less money and agreeing with the front office that they will spend the money they are saving on more talent to increase the probability of championships. This makes some sense, though I am not entirely buying it. The $2 million a year price tag is deceiving. When a contract has deferrals, the team is required to put money into an escrow account each season in the interim. In this case, the team will be putting about $44 million per season into that account, so on a cash basis he still costs a lot over the first ten seasons. This structure helps, but it may not be the sole reason for this structure.

2. He wants to avoid income taxes

If true, this changes the calculus substantially. There are reports that this will allow Ohtani to retire from baseball after the contract and no longer live in California. That my exempt him from state income tax as well as State Disability payroll tax. If he can avoid 14.4% in taxes on $680 million, that would be $97.92 million (probably too simplistic) in cash savings. That is a huge chunk of change. I do not have enough knowledge of the California tax laws to go figure out how that changes the cash flow models, but it could make this a win for the Dodgers an for Ohtani. That sort of thing could make large contracts in California start looking like this regularly, and also likely lead to changes in their tax codes to close the loophole.

Sorry, I am avoiding talking about the whole picture here because this is getting long. I know there is the risk that Ohtani’s second Tommy John surgery limits him as a pitcher and takes away some of that upside, so it is far from no risk from the Dodgers perspective. Still, it seems like a pretty safe gamble that Ohtani will be one of the best players in baseball, if not the best, for at least the first half of the contract. Even as a right fielder I think Ohtani is worth something close to this contract in terms of baseball value. The business side could all be gravy for the Dodgers. I think it is a win for their organization to get the highest profile, highest skill player locked up for ostensibly the rest of his career. It also seems like for Ohtani it could be a structure that helps him avoid about $100 million in taxes and gives him a huge amount of guaranteed cash flow for a decade after he stops playing baseball. This seems like a clever way to set up a best of both worlds scenario and keep both counterparties happy.