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August 12, 2009

The Biz Beat

A Revenue-Sharing Re-Think

by Shawn Hoffman

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"We've gone as far as we can go with revenue sharing at this point."
-Red Sox owner John Henry (SI.com)

"If everyone's revenue grows ten percent with the current system, we're screwed."
-Anonymous small-market executive

If you were John Henry, you would hate revenue sharing too-imagine having to give your competitors tens of millions of dollars every year, just so they can have a better shot at beating you. But while the Red Sox and Yankees politic for a lower rate-currently at 48 percent, counting both the "straight pool" and the "fixed pool"-small-market teams are terrified that the system may just stay the same. You'll probably start hearing the "if-everyone-grows-ten-percent" line a lot as we get closer to a new CBA, and it's a legitimate concern; in terms of absolute dollars, 10 percent for the Marlins is Braden Looper, while ten percent for the Yankees is A-Rod and a new fleet of corporate jets.

You'd be hard-pressed to find a solid subset of franchises that's fully satisfied with the status quo going forward. But the thing is, baseball's current revenue sharing system has actually worked pretty well-the goal is to balance competition and profitability, and MLB has had a pretty good share of both over the past few years. If the owners were to completely reinvent the wheel for the next CBA, they would be taking on a significant amount of risk, which really isn't necessary given how well the current system has worked.

Instead, it just needs a couple tweaks-significant tweaks, but tweaks nonetheless. The key is to give every team, no matter what market they play in, significant upside potential, along with some downside protection if the fundamentals of baseball's economy change. The current system is very inflexible and could outlive its usefulness, much like the NFL's has in recent years. Also, anything that improves the implicit incentive structure would be a major step in the right direction. The existing system is far better than its predecessor, but it still taxes new revenue at a pretty high rate (31 percent), and it does nothing to encourage national revenue growth.

So what to do? Here's one way to fix it: tie the revenue-sharing rate (which is now 48 percent) to the percentage of total revenue that comes from national sources.

Let me explain that a bit. National revenue, which comes from television deals, licensing, MLB Advanced Media dividends, and so on, is shared equally amongst the thirty teams. When that revenue increases, small-market teams benefit more, on a relative basis, than large market teams. Let's say Fox and ESPN get a little spend-happy and all of a sudden that pool doubles, while all of the teams' local revenue stays the same. The small-market teams would obviously be starting from a much better competitive position, and less money would need to be shared in order to get back to the same place. Logically, this should also be true on a less extreme level-if national revenue went up even one percent relative to local revenue, the amount that would need to be shared would go down.

We can run through an example. The teams brought in about $6 billion in revenue last year, and will probably be right around that figure again in 2009. (I'm not counting the half-billion or so that flows into MLB Advanced Media and MLB Network, but doesn't reach the teams themselves.) Let's assume that about 20 percent, or $1.2 billion, came from national sources. That means each team would collect about $40 million.

Now what if that figure went up to $44 million and local revenue stayed the same? That means national revenue would grow from 20 percent of the total intake, to 21.6 percent. If we had the simplest possible system, we would decrease the revenue-sharing rate the same 1.6 percent, to 46.4 percent.

Before Mark Attanasio throws his computer out the window, let's see how this would actually impact small-market teams' top lines. According to Maury Brown, somewhere around $390 million was transferred from high-revenue teams to low-revenue teams in 2008. If the revenue-sharing rate drops by 1.6 percent, or one-thirtieth of the original 48 percent, we can guesstimate that the total amount shared would drop to about $375 million. In other words, the bottom 10-15 teams would be losing $15 million, or about $1 million per team-but only after gaining several times that in national revenue.

Now, there's obviously a big difference between getting an evenly distributed share of one pool, as opposed to receiving a check directly from the other teams in your division. But I'd still say that small-market teams would be in a better competitive position-not to mention a much more self-reliant position-under this system than the current one, even with a pretty significant drop in the revenue-sharing rate.

There's also the other side to this, of course: if local revenue outpaces national revenue, the rate would go up. That's the last thing that big-market teams want, but there's actually some downside protection built in for them too: since national revenue currently holds a relatively small share of the total and is unlikely to decrease in absolute terms, there's a far greater chance of it rising 10 percent (and therefore lowering the revenue sharing rate by that amount) than falling 10 percent. While that still seems like a gamble, remember this: if the revenue-sharing rate did go up, it would almost certainly be because the biggest teams had seen significant increases in their local markets, so they would still be somewhat farther ahead than where they are now.

There are a bunch of side benefits that would come from this setup, the most important of which is that it aligns all thirty teams on national revenue. Small-market teams have always relied heavily on this money, not just to finance operations, but also to raise their franchise values. Since TV contracts and the like are far more stable than, say, ticket sales, national revenue will usually have a disproportionate effect on a team's potential sale price. Also, if the owners-particularly those from the biggest and most powerful teams-were to spend more bandwidth on innovating nationally, and the tax rate did decrease, teams would be more incentivized to grow their local revenue as well. Eventually, that could actually lead to more money being shared, even with a figure below 48 percent.

There may not be a perfectly elegant solution, but this is one that passes the laugh test, and it's a way to avoid the inevitable tug-of-war over the top rate. In all likelihood, it'll be politics as usual, with competing camps trying to win as many votes as they can. But if the owners want to come together on a divisive issue, and spend more of their energy fighting the common opponent (the union), this could be one way to do so.

Shawn Hoffman is an author of Baseball Prospectus. 
Click here to see Shawn's other articles. You can contact Shawn by clicking here

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