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NBA Lockout Appears Inevitable

This Miami Heat team is positively thrilling. And while they don’t enter the playoffs tonight without flaws, they also have a legitimate shot at marching through the Sixers, Celtics, and Bulls all the way to the NBA Finals. Yet thanks to the squabbling of millionaires and billionaires over how to divide a $4 billion industry, this may be the last time for a long time to enjoy it.

Negotiations surrounding a new NBA collective bargaining agreement to replace the current six-year deal that expires on June 30 are not just in a stalemate. They’re turning nasty. A lockout seems inevitable. And it could last a while. It could wipe out the entire 2011-12 season.

The information, misinformation, accusations and counter-accusations are flying so fast and furious that you need an accounting degree and a decade of practical experience under your belt to actually be able to make sense of it all.

The two sides remain deeply divided over what percentage of revenue the players should receive and how owners should share their money.

Players currently receive not less than 57% of every dollar generated by the NBA in salaries and benefits. Players have no costs. Every dollar they make, they get to take home (excluding withholding taxes, of course).

Owners need to net their 43% share of revenues against all the costs of fielding their teams. According to Commissioner David Stern, the NBA will lose roughly $300 million this season. That’s actually better than the $340 million in losses last year and even better than the $370 million in losses the year before that. Stern has also spoken of losses of at least $200 million in each of the first three seasons of the current agreement.

That’s $1.6 billion in losses in six years. That’s huge! And the league has sent both audited financial data and tax returns to the player’s association to substantiate the losses.

The NBA is claiming the business model is broken.

Owners are seeking a complete overhaul of the league’s financial system, and have submitted proposals to the players that feature a hard salary cap, rollbacks to existing player salaries, shorter contract lengths, reduced annual raises, and the reduction of the players’ share of revenues from the current 57% to less than 40%.

But the players disagree with the story the numbers tell.

The players contend that the vast majority of the so-called losses is the result of creative accounting and tax loopholes. They contend that only a small number of teams are suffering, and that their problems can be addressed primarily through enhanced revenue sharing.

There is every reason to view the league’s claims of financial hardship skeptically.

Independent estimates of the NBA financial condition reflect a league that has grown at a slower rate compared to other sports, and which has an uneven distribution of revenues between teams – but which is fundamentally a healthy business.

Forbes data from January suggests that the league is still profitable. League-wide EBITDA (earnings before interest payments, taxes, depreciation and amortization) is estimated to have been $183 million for the 2009-10 season, or about $6.1 million per team.

The Forbes analysis is not infallible. Basketball teams are by-and-large private businesses, and they are not required to make their financial results public. Consequently, the Forbes numbers are just estimates. But they’re intelligent estimates, from a respectable publication. It’s difficult to imagine they’d have no basis in reality.

Could the players be right? Could creative (yet legal) accounting methods and tax loopholes better explain this huge differential?

There are any number of ways to artificially destroy the profitability of a franchise in ways that are perfectly legitimate.

The most prominent example stems from an accounting rule that allows team owners to claim a special expense associated with buying their teams. Basically, owners get to treat their sports franchises like new cars – which lose value as soon as they leave the lot and continue doing so until they become worthless. According to the IRS, a sports franchise becomes almost completely worthless after 15 years of ownership. Teams get to claim this theoretical decrease in value – from the initial purchase price all the way down to zero – as a deduction on their tax returns.

So, for example, suppose you pay $300 million for a sports team that generates $10 million of annual pretax income. You now get to deduct $20 million in amortization expenses ($300 million / 15 years) from pretax income simply because you bought the team. As far as the IRS is concerned, your team is no longer generating $10 million; instead, it’s losing $10 million. But what really happened? The $10 million of pretax profit isn’t really lost; it’s a paper reduction according to allowable IRS rules. So you get to enjoy the $10 million of profit tax free!

But it gets even better. If you’ve structured your team as a pass through entity, the $10 million paper loss from your team goes straight to your personal income tax return and shelters any other income you may have from any other sources. You’ve just saved yourself from having to pay taxes on $20 million of income. Since you’re probably paying taxes at the top marginal tax rate of 35%, it’s basically the equivalent of having the IRS cut you a check for about $7 million every tax day for the next 15 years!

By the time the 15 years are up, you will have collected $105 million. So here’s another way to think about it: You only paid $300 million for your franchise. The government is giving you back $105 million. Essentially, the IRS is funding around 35% of the purchase price for you (in the form of future tax breaks) — all because those that write the tax laws feel that when you buy a sports franchise, your essentially buying a wasting asset that will become nearly worthless in 15 years. Like a car.

Of course, sports franchises aren’t like cars. They don’t lose value. They are more like the best investment you’ve ever made in your life. They’ve gained more value over the years than anyone could have possibly dreamed of.

The amortization shelter is one of the great hidden benefits of owning a sports team. It gives potential owners every incentive to buy one. And when they do, rarely do they pay in cash. Instead, they take out huge loans to offset much of the purchase price. The interest charges on acquisition-related debt have been estimated to account for roughly $150 million of the annual losses claimed by the league. The players association feels these expenses should be netted out, and that acquisition-related expenses are unrelated to the health of the league as an operating entity.

Another common accounting haven for sports franchises involves the use of related-party transactions. Owners often use less than arm’s length transactions with related entities, or allocate expenses to their teams while allocating income to related parties, to lower the apparent profitability of the sports team in favor of improving the situation of the other, related businesses. For example, the Washington Wizards are owned by the same corporate entity that owns the Verizon Center in which they play. By shifting around the Wizards’ rent payments to the arena, the team’s cost structure can be manipulated in arbitrary ways. This is problematic in that the team’s financial outlook is intentionally distorted.

It’s not hard to see the benefits. Owners can utilize these losses in the pursuit of new, publicly-funded arenas or below market leases. They can use them in negotiations for new and more favorable collective bargaining agreements. Most prominently, they can generally pass these book losses directly onto their personal income tax forms. This is a completely distinct profit stream vital to billionaire owners with huge disposable incomes.

Let’s take the example of hypothetical Team A, which is earning a hypothetical $10 million per season in profits, in order to better understand the magnitude of such creative accounting. A $450 million purchase price creates $30 million of amortization expense (with no corresponding cash impact). A 50% leverage ratio creates another $15 million or so of interest expense. And then there’s the honorary management title and accompanying million dollar salary for each of the hypothetical new owner’s two hypothetical sons.

The business hasn’t changed at all. It’s still making $10 million per season. But the new owner can claim a $37 million loss on his tax return, which erases up to $13 million in personal taxes. So… the new owner gets his $10 million in true profits free of tax, gets another $13 million in tax savings, and gets to turn over to the players union financial statements that show a $37 million loss in order to support an argument that the current economic system is unsustainable.

From the players’ perspective, the split of revenues has been at least 53% in their favor for the last 28 years. The two sides agreed to 57% just six years ago, and revenues have grown each season since that time – including through the current economic downturn. And that split doesn’t even contemplate the hundreds of millions of dollars of expense credits that owners take off the top (which, in reality, knocks down the split of true revenues to 50-50). Yet the owners are claiming massive losses. The players would like to understand why.

It is a reasonable question when considering the pay structures in the NFL, MLB, and NHL. Each currently has a system in place that pays its players between 53% and 57% of revenues, and each is currently profitable.

The NHL and its players lost the entire 2004-05 season negotiating a CBA which calls for the players to be paid 57% when league revenues in any year exceed $2.7 billion. According to a press release issued by the league three days ago, the NHL will take in more than $2.9 billion this season.

It certainly bears questioning why a substantially less marketable league with a substantially smaller revenue base like the NHL – a league which plays an identical 82-game schedule in very similar (and in several cases the same) arenas – is able to turn a respectable collective profit paying its players an identical percentage of revenues while the NBA struggles mightily with a lack of profitability.

What are these expenses that have nothing to do with player salaries that no other professional sports league seems to have? Is it private jets and cruise-liners? Is it the massive amortization and interest charges created from the record purchase prices we’ve seen over the last few years? Or is it legitimate operating expenses required to run the teams? The answer would go a long way toward finding an amicable solution to the current stalemate.

Unfortunately, we will never get the answer. It is entirely possible that the owners will not communicate this information even to each other, let alone to the players association, and certainly not to the public. The players simply cannot understand the true profitability of owning an NBA franchise – not even with a pile of audited financial statements and tax returns staring them right in the face.

One thing they do know – there is a massive disparity in the profitability profiles of these franchises.

According to the Forbes data, despite the league-wide profitability, seventeen of the league’s thirty teams were unprofitable in 2009-10, suggesting that a large part of the problem has nothing to do with the players and everything to do with inadequate revenue sharing amongst the owners.

The war, therefore, isn’t only between fought between Stern and the players. Stern’s responsibility is only to find that delicate balance between the fractioned owners he represents. This is as much a vendetta by the hard-line owners against those that refuse to share their revenues as it is an all out war between the league and its players.

The NBA generates $930 million in revenue per season from its national broadcast and network cable television contracts with ESPN/ABC and TNT. With ad sales brokered by Turner Sports, the league-owned NBA TV platform takes in another $50 million or so in sponsor dollars. These funds are distributed equally amongst the teams.

The vast majority of the remaining $3 billion of league-wide revenues are kept almost entirely by the individual teams that generate them, the bulk of which is generated from local broadcast partners… the YES Networks and MSGs and regional Fox Sports channels and NESNs of the world.

The only true revenue sharing program the league currently has in place is the luxury tax. Luxury taxes are paid by high-spending teams and then distributed, in part, to low-spending teams and, in part, to into the league’s team assistance plan, which is designed to subsidize teams that lose money. But the impact of these programs is small because the dollars that underlie them are small. Luxury taxes have re-distributed an average of just $80 million per season over the current CBA. In many cases, however, teams were getting back money they had put into the pool themselves, so the net redistribution of money was much lower than the gross redistribution.

The way the current NBA labor deal is structured, the following very real example is happening right now. The Los Angeles Lakers just struck a 20-year local television rights deal with Time Warner Cable worth a reported $3 billion. That’s an average of $150 million per season. Good news for the Lakers, because they get to pocket all of that money. Bad news for the other teams, because that $150 million counts towards the total league revenue as defined by the CBA, against which the salary cap and salary floor (the minimum amount each team is required to spend on player salaries) are calculated. This means that the salary cap for each team just went up by an additional $2.55 million. And since the salary floor for each team is 75% of the salary cap, it also means that every other team in the league is now required to spend an additional $1.91 million per season on player salaries as the result of a deal from which they get zero revenues.

If you’re a low-revenue team, you don’t like that one little bit, because where the Lakers just made money, your expenses just went way up, and there’s nothing you can do about it.

Contrast that with the other major sports leagues.

The NFL’s revenue-sharing model is universally lauded as the reason pro football continues to thrive in tiny markets like Green Bay, Wisconsin. Approximately 60% of the total $9 billion in revenue generated by the NFL is generated centrally and distributed equally among the 32 teams. The vast majority – about $4 billion – comes from national television contracts with NBC, CBS, Fox, ESPN and DirecTV. Profits from licensed products – everything from jerseys and jackets to helmets and footballs are distributed equally as well. Even ticket revenue is shared. The home team keeps 60% of the gate (excluding luxury boxes) for each game, while the visiting team gets the remaining 40%.

The MLB revenue-sharing model is excessive to the point of controversy. Unlike the NFL but more like the NBA, the majority of revenue is generated locally. Therefore, all 30 MLB teams contribute 31% of their net local revenues – including regional television deals (Comcast SportsNet/Fox Sports Net/YES, etc.), season ticket sales and local sponsorships minus actual stadium expenses – into a general fund. At the end of the year, each team gets 1/30th of the total amount. In addition, the revenues MLB does generate centrally – from sources like national broadcast contracts, licensing, and marketing – are disproportionately allocated to teams based on their relative revenues, so lower-revenue teams get a bigger piece of the pie. . In 2010, 404 million in revenue-sharing dollars moved from high-revenue clubs to low-revenue clubs as a result.

Since the NBA has a distinct lack of effective revenue sharing, the game becomes focused on location. You can make money in Indiana or Milwaukee or Sacramento. But it’s infinitely easier to do in, say, Los Angeles.

Ask Donald Sterling, whose Clippers, according to Forbes, turned a $11 million profit last season despite a 19-63 season. Or James Dolan, whose Knicks rake in tens of millions in profits every season despite not having been competitive since the turn of the millennium.

The Simons and Maloofs and Kohls of the league are demanding improved revenue sharing. But the Sterlings and Dolans and Busses of the league don’t want to give up the cash. The more they resist, the more concessions will be demanded of the players. The more that is demanded of the players, the more contentious things get.

Big market owners are at war with little market owners to keep their revenues. Little market owners are at war with the players to make up the difference. Who we – as fans – believe, who we side with, it all doesn’t matter. It’s a war being fought by multiple parties – each of whom has perfectly valid, if not empathy-worthy, arguments.

Something has to be done. Because if not, we’re going to go without basketball for a long, long time.

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