Reprint: Playing GM - A primer on salary cap management

I wrote this article two years ago and it was published on Hogs Haven in January 2017, and again in January 2018. Now, in January of 2019, I thought I’d publish it a third time.

This article is designed to explain the basics of how salary cap is calculated.

The article is a bit dated. There are contract examples in this article that show Pierre Garcon playing for the Redskins and Jay Cutler playing for the Bears. I think that the examples are still recent enough that the article can be posted and readable. If I try to use it again next off season then I’ll probably invest the time to update the examples.

I’m posting another salary cap related article this morning:

• The difficulties that can arise in understanding salary cap in unusual contract structures

Feel free to read any that you think may interest you.

Managing the NFL Salary Cap

Salary cap management in the NFL is a game played by rules that few people really understand.

It is a game for lawyers and accountants that relies on rules seemingly written by a room full of lunatics driven to create a system for a monopoly business that remains legal only due to its negotiation with a player’s union representing a few thousand 20-year-olds, each likely to earn anywhere from one to several million dollars in a career that may last from a few weeks to more than a decade.

It’s a system that is intended to protect the lowest tier players while providing massive upside potential to superstars; to encourage teams to retain aging players at the same time that the franchises are fighting to infuse the teams with young talent; to protect franchises from overspending, and the league’s players from teams’ under spending; and — in conjunction with the draft, free agency, and targeted scheduling — aims to maintain parity and competitiveness across the league.

It ain’t common sense

In short, the salary cap is a system that — much like the U.S. Tax Code — is built, not on common sense, but on a set of detailed rules, methods and loopholes designed to achieve a specific result. Trying to apply common sense to the salary cap is like trying to figure out how the country had to choose between Donald and Hillary... common sense doesn’t really come into it. The professionals play the game, and everyone else looks on rather stupefied.

Gaming the system

I spent about a decade of my life advising people in Australia how to pay less money in tax by following the specific rules that the government wrote — even when those rules didn’t make a lot of common sense.

For example, at the time I lived in Australia, in most cases if a man retired on, let’s say, Tuesday and converted his entire retirement fund into a pension, that pension was fully taxed in retirement.

However, if that same man retired on the same day, but withdrew several hundred thousand dollars from his pension fund as a lump sum, then re-deposited it into his retirement fund the following morning (in this case, on Wednesday), some or all of his pension income could be paid out to him tax-free for the rest of his life. The amount of tax he saved could pay for an annual vacation to Europe.

No person in their right mind would ever think to do such a thing with his pension, but the professionals who studied the law figured out that it was a strategy that worked, and so it became a common (and perfectly legal) practice.

Managing the salary cap is often the same sort of exercise.

When 2 + 2 = 5

A man reads that his favorite team has available salary cap space of $30m this off-season.

He then reads that the team signed 5 new players for a total of $22m per year, and his common sense tells him that the team has $8m left of salary cap.

The next day he reads a tweet that says the team has $19m of salary cap space remaining and thinks that something has been reported wrongly somewhere. There’s no way that the team signed 5 contracts at $22m per year, yet only used $11m in salary cap space.

Welcome to the world where 30 - 22 = 19! You’ve just gone down the rabbit hole (or through the looking glass) to a place where common sense doesn’t apply.

Accrual accounting

Definition: Accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged.

The first thing to understand about the salary cap is that it uses accruals.

Cash flow makes sense to me

Like most average households, I run my affairs on a cash-basis. I have a bank account. I get paid twice a month, which adds money to my account, increasing my balance. I pay my bills and pull money from the ATM for daily expenses, which takes money out of my account. As long as my balance is above “zero”, I’m solvent.

Accruals are harder

Most medium-to-large businesses use accrual accounting, which aims to match income and expenses to the period in which they are earned or spent. For example — let’s say an order for $26,000 is received in May. The order is processed and shipped in May, but the customer pays for the product in June.

In a cash-based method, like my household expenses, I would count the income in June (when I receive the cash). That’s my “payday”.

In accrual-based accounting, the business will count the income in May, when the sale was recorded and processed.

Most people understand that idea fairly well.

It extends to expenses, too. If my company is the customer, and I buy office supplies in February but send payment to the supplier in March, my accountant will put the expense in February, when I bought the pens and paper clips.

The tricky part

The tricky part comes when you start buying things that have a useful life of several months or years.

Let’s say you buy computers for your office, spending $3,600 in total for the equipment. All the cash goes out in January this year, but you expect the computers to last for a long time. Your accountant will estimate a useful life for the equipment (say, 3 years) and charge the expense off at a rate of $1,200 per year (or $100 per month) for the next 36 months.

So, the cash was all spent in Jan 2018, but the computer equipment will be charged as an expense on the company income statement month-by-month and year-by-year across three years (2018 to 2020).

If you bought some furniture for $3,500 to go along with your new computers, the accountant might estimate the useful life of the furniture at 7 years. In this case, the cash spent in January of 2018 would still be showing up as an expense until 2024. The furniture would be charged to the income statement at a rate of $500 per year ($3,500 / 7 years).

The NFL salary cap uses the concept of accrual accounting, meaning that the cash paid to players is not the same as the salary cap charge. Often the difference between cash flow and cap charges is so great that it seems impossible to achieve, and the difference between cash-based and accrual-based accounting used in the salary cap calculations leads us into the world where 30-22=19.

Signing bonuses and accruals

The main culprit in creating this rift between cash-flow and accruals is signing bonus.

While player salaries are considered to be like office supplies, and charged as a salary cap expense in the year that they are paid, signing bonuses — paid out in cash at the beginning of the contract — are treated like the computers and furniture in the example above; that is, they are spread out over the life of the contract, up to a maximum of five years.

So, if a player signs a 3-year deal, with a $9m signing bonus, he will receive the cash in a lump sum (or near enough as to make no difference to our example), but the $9m will not be charged to the salary cap all in the year it was paid. Instead, $3m will be charged to the salary cap in each year of the contract.

If a player signs a 5-year deal with a $20m signing bonus, that bonus will be charged off at a rate of $4m per year for the 5-year life of the contract. If you add a 6th year to the contract, that accrual rate doesn’t change, because the player’s “useful life” is limited to five years. In year 6 of the contract, there would be no pro-rated bonus charged, and (assuming no guaranteed money in year 6) there would be no dead-cap hit.

Non-guaranteed money

My mother and father taught me that a contract is a solemn promise, and that every contract must be fulfilled.

When I was in my mid-20s I bought a house using money borrowed from a bank. Having signed the contract, I never considered the possibility that the owner wouldn’t transfer title to me; likewise, I never thought that the bank would be okay if I only mailed them half of the payments I agreed to make.

At the university where I work now, I sign a one-year contract every October. I have never been concerned that, sometime late in the year, the university administration might call me in the office, tell me that they didn’t want me to teach any more classes this semester, and stop paying me. I trust that they will pay me for the full year because my contract says they will.

The contracts I signed to buy a house, take a mortgage, and work at the university were signed in good faith, and I expected the seller to give me title to the house, I expected to make all the payments on my mortgage loan, and I expect to go to work for 12 months and get 12 months’ worth of paychecks in return.

NFL contracts are — for the most part — completely different

Under the rules of the NFL collective bargaining agreement (CBA), a college player selected in the first round of the draft gets a 4-year, fully guaranteed contract. Once the contract is signed by the team and the player, almost no matter what happens, the player will get paid the full value of the contract. If the player is cut, injured, or traded he will get every paycheck, to the full value of the contract.

These 32 first-round rookie contracts are fairly unique in the NFL. Most player contracts are written in a way that protects the team from poor play or bad player-evaluation by the front office. Most contracts allow the team to cut the player in the later years of the contract without having to pay the player the remainder of his agreed salary.

I like to say that NFL contracts are signed knowing that the player will never receive all the money promised.

Of course, that’s not really true. Many players actually do play to the end of their contracts. But, because the later years of most NFL contracts are not guaranteed, the team is in a position to cut the player whenever his salary is not matched by his production.

Let’s look at the 5-year contract signed by Pierre Garcon ahead of RG3’s rookie season of 2012:

You can see that Garcon’s cap hit in the first year of his contract was only $4.7 million, while the cap hits in the final two years of his contract were $9.7m and $10.2m.

If the Redskins had cut Garcon at the end of 2014, they would have avoided paying 2 years of base salary, roster bonuses and workout bonuses totaling $15.5 million.

Most NFL contracts are designed this way. Unlike contracts to sell a house, take out a mortgage or teach at a university, NFL contracts are designed to be terminated early by the team if the player’s production no longer warrants the expense.

This is a form of risk reduction that most fans don’t think about when they read on twitter about the latest mega-contract signed by a free agent.

The money that’s not guaranteed gets counted in the contract, but may never reach the player’s bank account.

A bit more about Garcon’s contract

The Redskins could have cut Pierre after 2014 because Garcon’s salary, roster & workout bonuses were not guaranteed. Although it never happened, many fans and some media analysts argued that cutting Garcon was exactly the right move. If they had cut Pierre at the end of 2014, he would have been paid $27m over 3 years — only about 63.5% of the total contract value.

And while Pierre’s cap hit was only $4.7 million in 2012, his cash received that year would have been around $13.5 million, because his contract included an $11m signing bonus. That’s the magic of signing bonuses and accrual accounting at work.

A quick look at Jay Cutler

Jay Cutler signed a 7 year contract with the Chicago Bears worth $126.7 million on January 2, 2013. Let’s look at his contract.

The Bears were able to release Jay Cutler in the 2017 off season and avoid paying out $72.7 million because none of Cutler’s remaining contract was guaranteed.

Cutler’s 7-year, $126.7m contract reported on twitter turned out to be a 3-year, $54m contract.

In other words, Cutler’s 2013 mega-deal ended up paying him less than Brock Osweiler’s deal with the Texans. I mean, it’s still a lot of money, but it’s only 42% of the total contract value. Those headline twitter numbers that seemed so Earth-shaking at the time turned out to be only a minor tremor.

When the Bears released Jay Cutler last off-season, the Bears had paid out $18m per year to their starting quarterback for those three years, but they weren’t stuck with an under-performing player beyond 2016 (when he had a fully guaranteed base salary of $16m).

The effect of signing bonus on an NFL contract

When the average NFL fan reads that a player just signed a 3-year, $24m contract, their mind naturally imagines something like this:

2017 - $8m 2018 - $8m 2019 - $8m

Knowing that a degree of back-loading is common, some fans might imagine the contract to be more like this:

2017 - $7m 2018 - $8m 2019 - $9m

In fact, the most common practice in the NFL is to add some bells & whistles to the contract with roster bonuses, workout bonuses, performance incentives, injury guarantees, and other conditions.

But the four most significant elements of the contract are:

1. Length of contract
2. Base salary in each year of the contract
3. Amount of base salary guaranteed in each year
4. Amount of the signing bonus

The most significant structuring tool in salary cap manipulation is the signing bonus, because it is the one element of an NFL player contract that is accrued, then charged off over the life of the contract, in a manner similar to the computer or office furniture discussed above.

Let’s look at how the salary cap hits can be manipulated in my hypothetical 3-yr, $24m contract example above, and how the risk can be minimized by structuring the guaranteed money.

You can see that while the cash flows for the player are fairly even (8, 7, 9m) the cap hits are dramatically different at $4m, $9m, $11m.

This structuring allows the team to fit a fairly large contract with an Average Per Year (APY) of $8m into this year’s available cap space at a cost of just $4m.

By pushing a large proportion of the contract ($11m) into the final year without any guarantee on that money the team accomplishes two things:

i. The team controls the player in 2019, so if he is playing at a high level, they can keep him on the team, albeit at a high salary (think Pierre Garcon).

ii. If the player’s performance doesn’t justify his salary, the team can cut him after Year 2, and avoid paying him the $9m salary due in Year 3 (think Jay Cutler)

If the player is cut after Year 2, this becomes a 2-year, $15m contract with an APY of $7.5m.

If the player makes the team for all three seasons, the contract has an APY of $8m.

The combination of contract length, base salary per year, guaranteed money, and signing bonus are used to create a structure that:

• pays the player a lot of cash each year
• reduces the first year cap hit for the team
• gives the player an incentive to continue to perform well in the latter year(s) of the contract (to avoid being cut); and
• gives the team flexibility to get out of the contract early with only moderate salary cap damage if the player fails to perform as expected

A word about “back loading”

Because the salary cap charge in this example goes from $4m in Year 1 to $11m in Year 3, most fans tend to view this contract as heavily back-loaded, and see this as a big risk to the team.

“Back loading” is a dirty word to many fans.

But back-loading is a tool, and like most tools, it can be used productively in the hands of a craftsman, or it can be used to cause a lot of damage in the hands of someone who doesn’t understand it.

When a contract is back loaded with guaranteed salary, then it creates a lot of pressure on the salary cap that can’t be released. Tony Romo is a recent example of a player who carried such a large dead money hit that he couldn’t be released — until there just wasn’t any choice.

In Romo’s case, the back-loading resulted — not from the original contract structure -- but from Jerry Jones repeatedly re-structuring Romo’s contract by converting salary to signing bonus in an effort to make cap room to sign other players. With fewer and fewer years of ‘useful life’ remaining on Tony’s contract, he accumulated larger and larger dead cap money. When the Cowboys released Romo going into the 2017 season, the Cowboys had to eat a charge of $19.6 million. In fact, The Cowboys -- 2 years after Romo actually retired — are still carrying a cap charge for him while he sits in a booth as a TV analyst.

In other words, the Cowboys took pretty much the same salary cap hit on Romo not to play as the Redskins took to have Cousins start 16 games in 2016. That’s a badly back-loaded contract, created by a short-sighted front office. That’s bad cap management.

But when the final year(s) of the contract are not guaranteed, then the pressure on the team’s salary cap can be released by simply cutting the player (again, Jay Cutler).

For a prudent front office, shifting the salary cap hit from Year 1 to Year 3, in the end, has no real effect because any salary cap not spent each year can be rolled over and used the following year.

Unused salary cap can be rolled over indefinitely, as long as the minimum salary spending limits are met. By shifting the salary cap hit to later contract years, the available salary cap now is maximized, allowing for greater flexibility. This is how the Redskins were able to afford the Josh Norman contract when he unexpectedly became available in 2016.

Salary cap isn’t a credit card

At times, some analysts are tempted to describe salary cap space as a ‘credit card’ that can lead to trouble if not managed properly.

In fact, the salary cap room is more analogous to a savings account; it’s there to spend, and you can’t take the balance below zero, but if you don’t spend it you don’t lose it. It stays in the ‘bank’ and can be spent next year or the year after.

By being prudent with the account, the money needed is always available, and the team never runs into trouble. The key lies in good projection and understanding of the cap.

And there are advantages to back-loading non-guaranteed money into an NFL contract

A contract that is back loaded with non - guaranteed money has the following advantages for the team, the player, and the player’s agent:

1. The team is able to guarantee a smaller portion of the total contract value. If the player performs below expectation, the team can cut him, saving a large percentage of the total contract value.
2. The player’s guaranteed money is focused on the early part of the contract, when he is likely adapting to the new team or situation. He can relax and play, knowing that his income is safe for a year or two.
3. The player is motivated to play up to his salary in the final year or two, since he runs the risk of being cut if his performance doesn’t match his contribution.
4. If a player isn’t playing up to his salary, the backloading allows for (and encourages) renegotiation. Think about the recent example of D’Angelo Hall being cut in the final (expensive) year of his contract, then being re-signed to a much less lucrative contract just a short time later.
5. Because the final year or two is non-guaranteed, the team can afford (from a risk standpoint) to put very high salary figures in the contract, knowing that the player is unlikely to earn them. This gives the player and agent a “win”, since they can use the final year or two to boost the APY (average per year) and total value of the contract and grab the twitter headlines with gaudy numbers.
6. If the team retains the player in the final non-guaranteed year(s), it does so because the player is performing at a very high level that justifies the salary he is being paid.
7. Shifting salary cap hits to later years provides greater flexibility in early years for the front office to use the money to sign other players. If the money is not used, it can simply be rolled over and added to next year’s cap.

In reality, back loading — if it is done the right way, with non-guaranteed money — does not increase the salary cap risk and reduce the team’s flexibility; instead, because the player can be cut at any time (Jay Cutler), it actually reduces risk and increases flexibility for the franchise.

It’s not really that simple

The penultimate word here is that NFL contracts are both simple and complex.

Andrew Luck signed a new contract in the 2016 off-season that had so many conditional guarantees that it’s almost impossible to describe in an accurate and meaningful way in an article of less than 2,000 words.

Colin Kaepernick’s 2014 contract with the 49ers was similarly complex, but with a very different structure than Luck’s.

The Luck contract with the Colts demonstrated a franchise that was ready to make a large financial commitment to its franchise quarterback, while offering a certain level of protection for the franchise against poor play or significant injury affecting Andrew Luck. If Luck doesn’t get healthy and play this season, the Colts can pretty much just walk away from the contract a year from now.

The Kaepernick contract, on the other hand, was put together by a franchise that wanted the option to keep their quarterback around if he achieved his upper-limit potential, but the structure indicated that the front office wasn’t really “sold” on Colin. We saw last off-season the flexibility. In effect, the 49ers created a set of 1-year options that they controlled, and they cut Kaep after just 3 years.

Meanwhile, the Luck contract gave the QB the highest APY in history, but vested the guarantees in stages.

These contracts are the exceptions, however. Most NFL contracts follow standard patterns that can be shown in simple charts like the one for Pierre Garcon above. By understanding the contract length, year-by-year base salary and guarantees, roster & workout bonuses and pro-rated signing bonus, the average fan can understand 95+% of a player’s contract structure. There will likely be other details in the contract, but they will usually be incidental to the salary cap.

Only the big ones have room for much structuring

Finally, the kind of structuring discussed in this article really only matters with contracts of significant size. The larger the contract, the more room there is for manipulating the salary cap impact.

In other words, the front office will likely need to spend a lot of time structuring the contract for the team’s franchise quarterback. The structure of that contract will have a huge effect on what is possible under the salary cap each year in terms of building the rest of the team.

At the other end of the spectrum are UDFA and veteran minimum contracts. From a salary cap management standpoint, there’s actually no meaningful room for manipulation in a vet minimum contract. It is what it is. The cash flow usually is the same as the cap hit, and cutting one vet minimum player and replacing him with another doesn’t affect the salary cap.

Even when players earn slightly more than the minimum contract (say $1 - $1.5m per year) any “structuring” of the contract has such an insignificant effect on the salary cap that it’s typically not worth discussing.

For a fan trying to assess his team’s salary cap position, and how it will be affected by free agent signings, there’s usually only a handful of contracts to consider.