Why teams and players like opt outs

Masahiro Tanaka has finally signed. He reached agreement with the Yankees on a seven-year, $155 million contract. The deal should dominate the news cycle for the next few days and start the wheels rolling on other free agents who have been waiting on Tanaka.

The deal includes an opt out after the fourth season, which gives Tanaka the chance to hit free agency prior to his age-29 season. As Jeff Sullivan pointed out at FanGraphs, if Tanaka is anywhere near as good as we expect and remains healthy, he’ll opt out. In doing so, he’ll probably sign another long-term contract worth a LOT more than the $67 million remaining on his first deal.

Tanaka’s agent is Casey Close, who has a history of securing these opt out clauses. Just last week, Clayton Kershaw inked a deal with an opt out after five seasons, and Zack Greinke has an opt out in place just three seasons into his current contract. Which prompts a few questions. Why are opt outs becoming more common in large contracts and what are the inherent risks related to them?

Fundamentally, opt outs are just like their cousin, the player option. Instead of the player deciding if he wants to return for one season at a set rate, it’s a multi-season proposition. We don’t see player options very often because they are pure risk to the team. With the exception of late career veterans, a player will only activate an option if they are hurt or performed poorly in the previous season.

Take the example of Adrian Beltre, whose player option was part of a carefully structured contract. When the Red Sox signed him in 2010, Beltre was given a one-year, $9 million salary with a $5 million player option and $1 million buyout. In this case, Beltre was frustrated with the free agent market and wanted to reestablish his value — which he did. Had he turned in a very poor season, he would have taken the $5 million option and the Red Sox would have been stuck with a sunk cost. In Beltre’s case, the option was a little insurance plan that made it easier to turn down the two-year offers he received.

With Tanaka, Kershaw, or Greinke, the Dodgers and Yankees are taking on a greater chunk of risk than the standard player option. If those players are even relatively decent, they will find more money and years waiting for them in free agency. If the worst happens, then the club is stuck holding a broken asset. Since it is a multi-year commitment, there is a chance that the player helps the club with a comeback player of the year award somewhere down the road. Put simply, the Yankees will only pay Tanaka that last $67 million if they don’t want to.

These opt outs acknowledge that the player is being underpaid despite the massive payroll commitment. By offering non-monetary pay, the clubs get to keep their payroll commitments lower. In the cases of the Dodgers and Yankees, that means fewer dollars being taxed. It’s still a risky tactic, any player can go from star to broken in a single play and that’s especially true of pitchers.

We can view Tanaka’s contract another way. The Yankees think Tanaka is worth closer to $40 million dollars per season over four years ($155 million divided by four).* They’re probably very unwilling to set that precedent, as are all other teams, which is why we’ve seen so many very long contracts. The opt out guarantees Tanaka that money. If he opts out and the Yankees don’t re-sign him, then the club actually saves money.

*That’s just a first order estimate. Luxury taxes, other taxes, the time value of money, and a whole slew of other factors affect the actual total. The point is, the Yankees think he’s worth a lot more than $22 million per season.

The takeaway is that opt outs offer both risk and reward for clubs. The reward is a little sneakier to see, but it’s there in the form of a lower annual payment, a reduced tax burden, and a chance to save a big chunk of money.

The player’s perspective is easier to understand. Inflation, higher revenues, and a possible labor showdown mean that even larger contracts will be available three to four years from now. The opt out gives the player a chance to sign one of these massive deals so long as he stays healthy and performs. And if he doesn’t, he can keep his original contract.

One might wonder why the player doesn’t trade the opt out for more guaranteed money. At this point in the sport and with the luxury tax threshold where it stands, it probably simply isn’t possible. Kershaw received the highest average annual value in history with his recent contract. Close probably had no issue getting the Dodgers to agree that Kershaw was worth more annually (well, probably not out loud), but the club was unwilling to go any farther.

So there we have it, opt outs in a nutshell. Clubs can use them as a way to manipulate payroll and sign players with excessive talent. Players use them as a pseudo-insurance policy in case they fall apart earlier than expected. It works out for both parties and is especially useful for teams who are already paying a luxury tax.