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April 18, 2002

Prospectus Feature

Sensible Revenue Sharing: One Man's Plan

by Keith Woolner

One of the most complex and bedeviling problems in baseball today is understanding to what extent large-market teams have an competitive advantage over small-market teams. Many people have proffered solutions despite not analyzing the problem thoroughly, with most of the plans featuring some sharing of revenues between large- and small-market teams. These plans have generally suffered from one or more problems:

  • Revenue sharing that simply puts money into a small-market owner's pocket without a guarantee that the money will be used to field a more competitive team.
  • Revenue contributions that are tied solely to expenditures, not actual inherent market advantages.
  • Revenue sharing designed simply to put a drag on salary inflation.
  • Confusing on-field success and off-field marketing savvy with market size.

I've attempted to define what "large" and "small" markets should mean, to understand how a large-market team might have a systematic advantage over small-market teams, and to construct an alternate revenue sharing plan that addresses these issues.

Assessing Market Size

To begin, we need a clear understanding of what we mean when we discuss market size. Market size is not attendance, winning percentage, or payroll. Those are all variables that are intertwined, and are heavily dependent on the decisions of management. A revenue-sharing plan shouldn't insure against having a poorly run team. It should instead compensate for the inherent factors that result from operating a team in a given location.

Markets should be measured by their revenue potential. How well a team does in marketing their product and extracting that potential should not play into the evaluation of a market. Clearly, population will be one major factor in determining market size. In addition to having a larger pool from which to draw attendance, more people means more TV viewers, greater reach for commercials aired during televised games, and thus correspondingly higher valuations for TV packages.

The average affluence, or wealth distribution, in the area may also have an effect on revenue potential. A city heavily reliant on a declining industry may have the same population as a city with a broader economic base, but the revenue potential of the two are not the same, and that's not a function of team's management.

A more controversial idea is that certain areas of the country may have a greater cultural affinity for baseball than others. Does a team with a hundred-year history of rabid fandom (say, Boston) have an advantage in being more culturally invested in baseball than a city of comparable size with a team of more recent vintage and less history (Anaheim)? This is a dangerous area to draw conclusions, however, because there is a strong interaction between the long-term success and competitiveness of a franchise and how much support they draw even in down years. Because competitiveness is controlled to a large degree by the team's decision-makers and managers, the team exerts an influence on the market affinity for baseball. Separating background cultural affinity from the team's influence may be nearly impossible.

Dividing markets that have multiple teams also presents a possible problem. On one hand, the simplest approach is to divide the market equally. However, it's possible that the presence of more than one team causes a higher consumption of baseball per fan than in single-team markets, which makes those markets even larger by virtue of having multiple baseball options.

Another problem is that teams within the same market have different local competitive advantages and disadvantages. The age of a ballpark, cultural identification, attractiveness of the location where they play, and differences in wealth distribution in the area around the park can cause an uneven division of the market between the two teams in ways that are difficult or impossible to counteract in the short term.

Ultimately, the entire issue of assessing market size is something that would have to be negotiated among the teams as part of an overall revenue-sharing agreement. (Sadly, this would probably end up being something as illogical as the free-agent rating system.) Factors that could be counted in such a system include market size, affinity, presence of a public/privately funded stadium, and so on. The key is to get it away from associating current revenues or team success with market size.

Potential Competitive Problems Resulting From Market Size

One of the assumptions in the debate is that some revenue sharing is required to level the field. There's a sizable contingent in the sabermetric community, including a large portion of the Baseball Prospectus staff, who do not think that there is a problem here to be solved, or certainly not one of the magnitude that is it is believed to be.

It seems relatively clear that in the current game, there's enough variation in the quality of team management and player-development programs to overcome any actual market advantage. Neither the Athletics nor Mariners are large-market teams, yet both are enjoying extraordinary success. Therefore, I do not believe that there is a critical need for revenue sharing.

However, that's a far cry from saying there's no possibility for market size to become a significant issue, and I think it's worth exploring what market-related advantages could exist. One real and under-explored possibility is that rational differences exist in risk tolerance according to the revenue potential of the market. In other words, large-market teams have a cushion of profitability that allows them to take more high-cost, high-upside risks than small-market teams can.

For example, consider two teams, one large-market (L), the other small-market (S). At the moment, L is operating at a $20 million profit, and S is operating at a $3 million profit. We'll assume, for simplicity's sake, that those profits are certain.

Each team faces the same possible investment in a development program. The program has risks, and carries a 50% chance of making a $20 million profit, and a 50% chance of a $10 million loss. Team L then has a 50/50 chance of either a $40MM or a $10MM profit outcome. Team S, in contrast is looking at an equal shot at a $23MM profit or a $7MM loss. These teams are not in the same situation, even though the expected value of gambling on the development program in both cases is $5MM larger than the guaranteed value of operating the club without it.

Teams in markets with high-revenue potential have greater flexibility to bounce back from high-cost errors. This is a competitive advantage, though how large this is in practice in unclear. This phenomenon is not limited to baseball. Larger-revenue entities in any industry can generally afford more risk tolerance than smaller firms can in the same business. The financial flexibility to bounce back from poor outcomes on an investment is an ongoing advantage in high-revenue-potential markets.

This leads into the concept of a baseball team as an investment, and brings up the issue of capitalization. There's no reason, a priori, why owners worth hundreds of millions or billions of dollars (such as Carl Pohlad) can't invest capital in the product during periods in which revenue is expected to be lower, in the hopes of gaining revenue down the road. Having well-capitalized ownership is important because it relieves some of the short-term cash-flow pressures that would otherwise exist, ones that could cause the team to make less desirable competitive decisions based on short-term financial necessities. Capitalization allows ownership to ride out the inevitable down cycles and economic recessions to retain and fund a long-term profitable investment in the team.

That suggests that conglomerate ownership has advantages over a hypothetical owner who relies on the team to operate as a standalone business. Conglomerates that have a baseball component should be less risk-averse than a standalone owner with less overall wealth. But unless all conglomerates have the same risk preference, or if the range of differences is sufficiently small over the range of possible baseball-related cash flows, risk preferences do not go away as a potential issue, though they can offset some of the market-specific risk. If the conglomerate is run such that each sub-entity is evaluated as a standalone business, then we're back to square one, as business decisions for the baseball team will be made as if it must be self-funding in the short term.

Provided that the expected cash flow over time turns out to be positive, it's an entirely reasonable thing to expect that well-capitalized owners will ride out the fluctuations in business. However, financing a baseball operation through personal wealth or redirected revenues from other businesses without an expected net financial gain over some reasonable time horizon (including tax benefits to other holdings) shouldn't be a requirement or expectation of ownership. This is not to say that a one-year cash-flow deficit should be seen as a disaster. Rather, as long as teams do not freely enter and leave the market, I think it's reasonable to expect a decently-run team to be profitable and self-funding over the long haul, while fielding a competitive product with some reasonable frequency.

Competitive Ecology

Another important aspect to evaluating the appropriateness of a revenue-sharing plan is an issue that I refer to as the "competitive ecology" of the game. These are issues facing game as a whole, rather than a specific team. For example, how often does a franchise have to be competitive to be self-sustaining in the long term? Is once every five years the minimum? Every three years? Every ten years? Does a streak of five playoff appearances have a lasting effect on marketability that five years with the same number of wins, but failing to reach the post-season a couple of times doesn't? How long does the bump in demand last following a World Series win? Is any of this dependent on market size? If the Dodgers can afford to compete in 80% of seasons over the long term, and the Royals can afford to compete only 20% of the time, can they be equally healthy businesses? Does it matter if they are?

Suppose a small market has a maximum revenue potential of $100 million, and a large market has a maximum revenue potential of $180 million. The latter is going to be willing to invest more to tap the market to the greatest possible extent, assuming that it continues to be marginally profitable to do so as costs increase.

If this investment is directed to payroll (as opposed to marketing, promotion, stadium renovations, or other items that improve the team's marketability without impacting the caliber of the on-field product) then it improves the caliber of team the large-market franchise can field on an ongoing basis. Because baseball is a zero-sum game, if one team wins more, other teams must lose more.

A sustainable payroll advantage given to a smart management team allows them to field a better team than if they had a smaller budget. This then lowers the expectations of competitiveness for markets with lower revenue potential, which makes it even harder to extract the revenue they could get, since competitiveness is recognized as a key requirement for maximizing market revenues. Sustained success in one (or a few) markets drives down interest in other markets if the local team is perceived as not being competitive (such as the effect the Yankees/Dodgers dominance in the 1950s had on the rest of the sport).

The Fatal Flaw

The single largest problem with most of the revenue-sharing plans that have been put forth to date is that they have failed to address the basic fact the best way to encourage a desired behavior is to create incentives that reward it. Teams are governed primarily by self-interest, and management makes decisions according to expected risks and rewards. If true small-market teams aren't investing in a competitive on-field product, it is likely because they do not receive the benefits proportional to the risks they take (at least in their own minds), whether that be from lack of revenue, or risk aversion.

Revenue sharing that simply puts money to a small-market owner's pocket is a handout that may help increase the capitalization and cash position from which he can operate a team, but does not create any direct incentive to actually invest the money to field a more competitive team. Revenue sharing that is tied solely to expenditures (i.e., payroll) taxes large- and small-market teams at the same expenditure level equally, despite the fact that the small-market team is likely incurring greater risks with their investments. Lastly, tying revenue sharing to actual revenues generated confuses on-field success and off-field marketing savvy with the actual revenue potential of the market.

The Solution

All of this would be just so much hot air unless there's something substantive proposed to solve the problems I've raised. Therefore, I've attempted to construct an alternate revenue-sharing plan that addresses these issues. If revenue sharing is going to happen, it's important that it be done well.

The basic idea is to create a revenue-sharing plan that would actually give incentives to the small-market teams to field more competitive teams. At the plan's core is an incentive pool into which teams would contribute a fraction of their payroll, where that fraction is determined by market size. Teams in larger markets would be taxed at a higher rate.

The pool would be divided among small-market teams who compete with each other for a share of the pool. The competition for the dollars available is among fewer teams, with a narrower gap in market size separating them, giving each a legitimate shot to earn additional revenue and ensuring that all of the money will go to small-market teams. In addition, one of the criteria to be used will be the team competing against its own record, meaning that any small-market team can earn revenue sharing dollars simply by improving from year to year. This accomplishes a few things:

  • Large-market teams contribute proportionally more, but can still control how much they have to pay according to their total payroll.
  • Small market teams can win a substantial amount of additional money, but only by either improving their own team, or by competing successfully against other small-market teams.
  • Small-market teams that continue to do poorly do not get much, if any, of the shared pool.
  • Thus, there is increased financial incentive for the small-market teams to field a competitive team.

The Plan

I will illustrate how such a plan might be structured, and how it would have been implemented for the 2001 season.

Market size will be determined by a combination of two factors. One is the relative market size based on Nielsen TV markets, as determined by a study by Mike Jones. The other factor is market affinity for baseball, though I reiterate the caveats about using this as an inherent attribute of a market. The source for this factor is a study by Scarborough Research showing the affinity for baseball in each market. In particular, they measured the percentage of total adults who are avid fans (defined as "very interested in major league baseball") in the designated market area.

The sample plan has the following characteristics:

  • The teams in the bottom 40% by market size are eligible for a piece of the pool.
  • Small-market teams are exempt from payroll contributions to the pool.
  • The team in a market equal to the average market size of all taxed teams (thus excluding the small markets from the average) will contribute 5% of payroll to the pool.
  • The minimum a contributing team will be taxed is 1% of payroll.
  • The revenue sharing percentage is determined by the formula:

    Contribution % = 1% + 4% * SQRT[ (S-MinS)/(AvgS-MinS) ]

    --where S is the team's market size

    --the average market size of all contributing teams is AvgS

    --the market size of the smallest contributing team is MinS

  • The bottom 40% of teams will compete for the shared revenue pool. Each team can earn shares according to the following schedule:
    • Team earns one share for every game of improvement from the prior year. For example, in 2001 the Padres improved from 76 wins to 79 wins, and earn three shares.
    • A team gets shares for the number of total wins in the most recently completed season, rewarding overall excellence.
      Wins    Shares
      

      90+ 10 85-89 8 80-84 6 75-79 4 70-74 2

    • 15 shares for having the best three-year record among the small-market teams.
    • ten shares for having the second-best three-year record.
    • five shares for having the third-best three-year record.
    • five shares for winning the division.
    • three shares for finishing second in the division.
    • one share for winning the wild card.
  • Each small-market team gets a percentage of the shared pool equal to the percentage of shares it has of the total shares earned by all small-market teams that season.

The shares for winning the division/wildcard or finishing second may seem small compare do the other rewards, but consider that those teams have already earned shares for the number of overall wins, have likely improved from year to year, and probably rank well among all small-market teams.

An Example

Using 2001 as an example, I used the 2001 total payroll figures found on ESPN.com. Calculating each team's market size, 12 teams qualify as small markets. The market sizes and contributions are in the following table:

                    Market   Small   Contribution   Total
Team                  Size   Market?     Rate      Payroll Contribution

New York Yankees 342 No 8.92% 109,791,893 9,798,427
New York Mets 318 No 8.57% 93,174,428 7,985,902
Cleveland Indians 188 No 6.18% 91,974,979 5,687,952
Los Angeles Dodgers 163 No 5.59% 108,980,952 6,094,903
Atlanta Braves 158 No 5.47% 91,851,587 5,026,761
Boston Red Sox 154 No 5.36% 109,558,908 5,869,930
Baltimore Orioles 146 No 5.15% 72,426,328 3,727,357
Anaheim Angels 137 No 4.87% 46,568,180 2,269,487
Seattle Mariners 125 No 4.50% 75,652,500 3,405,870
Philadelphia Phillies 113 No 4.07% 41,664,167 1,695,580
St. Louis Cardinals 108 No 3.86% 77,270,855 2,986,079
Florida Marlins 94 No 3.25% 35,504,167 1,154,772
Texas Rangers 90 No 2.99% 88,504,421 2,642,480
Toronto Blue Jays 89 No 2.98% 75,798,500 2,257,575
Houston Astros 85 No 2.73% 60,382,667 1,647,287
Chicago Cubs 85 No 2.68% 64,015,833 1,716,462
San Francisco Giants 73 No 1.29% 63,332,667 820,108
Chicago White Sox 73 No 1.00% 62,363,000 623,630
Tampa Bay Devil Rays 70 Yes 0.00% 54,951,602 0
San Diego Padres 67 Yes 0.00% 38,333,117 0
Arizona Diamondbacks 64 Yes 0.00% 81,206,513 0
Colorado Rockies 62 Yes 0.00% 71,068,000 0
Cincinnati Reds 56 Yes 0.00% 45,227,882 0
Oakland Athletics 53 Yes 0.00% 33,810,750 0
Montreal Expos 44 Yes 0.00% 34,774,500 0
Detroit Tigers 35 Yes 0.00% 49,831,167 0
Minnesota Twins 34 Yes 0.00% 24,350,000 0
Pittsburgh Pirates 34 Yes 0.00% 52,698,333 0
Milwaukee Brewers 29 Yes 0.00% 43,089,333 0
Kansas City Royals 21 Yes 0.00% 35,643,000 0

A total of $65,410,561 in incentive revenue would have been collected last year.

How many shares did each small market team earn in 2001?

             ARI  CIN  COL  DET  KCA  MIL  MIN  MON  OAK  PIT  SDN  TBA
Wins, 2001:   92   66   73   66   65   68   85   68  102   62   79   62
Wins, 2000:   85   85   82   79   77   73   69   67   91   69   76   69
Wins, 1999:  100   96   72   69   64   74   63   68   87   78   74   69

Win Division 1 0 0 0 0 0 0 0 0 0 0 0 Finish 2nd     0 0 0 0 0 0 1 0 1 0 0 0 Wild card 0 0 0 0 0 0 0 0 1 0 0 0

3Yr Avg Wins* 92 82 76 71 69 72 72 68 93 70 76 67 3-Year Rank 2 3 5 8 10 7 6 11 1 9 4 12 *rounded for display

Improvement 7 0 0 0 0 0 16 1 11 0 3 0 70-74 Wins 0 0 1 0 0 0 0 0 0 0 0 0 75-79 Wins 0 0 0 0 0 0 0 0 0 0 1 0 80-84 Wins 0 0 0 0 0 0 0 0 0 0 0 0 85-89 Wins 0 0 0 0 0 0 1 0 0 0 0 0 90+ Wins 1 0 0 0 0 0 0 0 1 0 0 0

Total Shares 32 5 2 0 0 0 27 1 40 0 7 0

Lastly, how much do those shares amount to?

Team    Incentive Share

TBA $0 SDN          $4,016,438 ARI $18,360,859 COL $1,147,554 CIN          $2,868,884 OAK $22,951,074 MON $573,777 DET                  $0 MIN $15,491,975 PIT $0 MIL $0 KCA                  $0

Here we have a system that rewards small-market teams for being successful, with Oakland, Arizona, and Minnesota earning the lion's share of the incentive pool. A modestly improving team like the Padres would have earned over $4 million in incentives. Even the Expos earned almost $600,000. A team can always earn money by competing against itself, but can do even better by outdoing other small-market teams.

Teams that refuse to invest in talent or player development won't share in the benefits, as they will continue to be outplayed even by their small-market brethren. The Pirates, Devil Rays, Tigers, Brewers, and Royals failed to earn any incentives based on their three-year track record. Yet, the money is clearly there to make it worth their while to improve. Given these kinds of financial incentives, teams who otherwise believe they can't compete will still be driven to maximize their rewards.

Objections

The biggest objection to a plan like this is that, as a tax on payroll, it's an external salary restraint, and anathema to the MLBPA. Still, the union has previously agreed to a luxury tax, and there is no salary cap (or floor, for that matter). Nor is there a punitive large tax rate for exceeding an arbitrary payroll level, so if some form of plan is to be accepted, this one may be a more attractive option.

It is possible to construct a contribution model that is based totally on market size, without tying it to payroll. The one problem is that to a large-market team, it would be treated as a fixed cost (i.e., the Yankees contribute $15MM/year to revenue sharing regardless of payroll). This has no impact on whether the Yankees maximize profit at a $90MM payroll or a $120MM payroll, since the marginal cost of talent is the same. With a system that includes both payroll and market size, you are affecting the marginal cost of winning. This method would, it must be said, be a drag on salaries.

Another objection takes the exact opposite tack, which is that this "solves" a problem that only the Yankees have created, and as such is basically targeting them for being successful. This gets back to a common sabermetric position that there is no economic problem here to solve. To be sure, the Yankees play in a large market, but they also combine that with a smart management team that knows how to exploit it. I have an underlying belief that the Yankees have shown the way for other large markets to follow, if they get the right management and marketing teams in place.

The rest of the teams are capable of addressing one of those advantages directly--quality of management--but that doesn't eliminate the other. I don't want to rely on continued poor management from other large-market clubs to keep a semblance of competitive balance. The Yankees have shown that smart management can exploit market advantages. Addressing half the problem is better than addressing none of it.

Another response is that the plan ignores costs. To use the example presented earlier, if a small market has a maximum revenue potential of $100 million, and a large market has a maximum revenue potential of $180 million, the latter is going to be willing to invest more to tap the market to the greatest possible extent. It will also have a larger initial investment, and possibly larger operating costs, hampering its ability to do these things, which will level the playing field so that a larger-revenue potential market presents less of an advantage.

However, once the initial investment is made, it's a sunk cost as far as future decisions, unless there is debt service or some other ongoing cost related to the purchase price. It's not obvious that operating costs would be higher in a large market, and it is likely more related to the stadium deal the team negotiated (or whether the team owns the stadium), and the age of the venue itself. Some labor costs might be higher for staffing, and in some cases there may be city taxes to deal with, but in lieu of actual numbers (perhaps Doug Pappas or the Forbes study will shed some light on this subject), I'm inclined to think this is a small effect.

There is a public-relations angle to this plan as well. The "outrage" among baseball fans is mostly about large-market teams--usually the Yankees--being able to afford payroll expenditures that other teams can't. Tying the contribution to both market size and payroll causes the revenue-sharing contribution to be levied in greater amounts when a large-market team exploits its inherent market advantage. When your product's marketability is based on the perception of competitiveness, I can certainly believe that an owner would be motivated to fix a perception problem. However, it would help if the owners weren't demeaning their own product so loudly in public. It's a most peculiar marketing strategy--telling everyone what bad shape your product is in.

The all-or-nothing threshold of the bottom 12 teams in market size qualifying for incentives could easily create an incentive for teams that are just outside the revenue-sharing pool to relocate to a bottom 12 market, or to game the system by lobbying for a particular market-sizing scheme. I tried to address this by having the amount of revenue sharing start at a very low percentage for those just above the threshold, but there's still a discontinuity: If the cutoff is the smallest ten teams get to participate in the shared pool, then the #10 team could get millions of dollars in reward for a good season, while the #11 team isn't eligible for anything, and in fact pays a small amount to the pool.

A modification of the system that included some kind of scaled reward system, rather than an absolute cutoff where you're either a small-market team or not, would help. I strongly believe that a cutoff or a tapering to zero at some point should be part of the plan, because I don't think the Yankees, Mets, Dodgers, et al should be eligible for a fund set up to help small-market teams.

Conclusions

If revenue sharing is to be implemented correctly, teams that receive the money must have incentives to use it to field a more competitive team, or else the exercise is futile. By linking on-field success to their share of the available pool of money, yet guaranteeing that all of it will go to small-market teams, a secondary competition within the overall structure of MLB is created. This structure will motivate decision-makers for small-market teams to make the investments in free agents and player development because the risk/reward balance has shifted.

The plan I've presented may not be the best one, or even agreeable to all of the parties, who would certainly have to negotiate the specifics. But it demonstrates how such a plan might be constructed, how much each team would be affected by it, and how the money can be distributed in a way that rewards success among small-market teams.

Keith Woolner is an author of Baseball Prospectus. 
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