Wednesday, May 25, 2011

Change the Model- A Proposal to Make the NHL and Its Teams More Profitable

Part 2 of a series

In the first part of this series, which is here, the question was raised, "Does the NHL's Business Model Work?"

There are no simple answers to that question, but it is a question that merits examination.

Looking at the revenue components, it is a given to say that different markets will allow a team to command different ticket prices. The demand in a market like Toronto will allow the Leafs to continue to support the highest average ticket price in the League. This is simply an economic function: demand is greater than the supply of available seats, which allows the team to price their tickets higher than a market that does not enjoy that level of demand. It is this high level of demand that allows the Leafs to command the highest ticket prices in the NHL and to be the League's most profitable franchise.

Venue revenues are negotiable from franchise to franchise and it is incumbent on each team to attempt to negotiate the most favorable revenue arrangement possible. The lack of revenue from the Nationwide Arena in Columbus is an prime example of a franchise that is starved for revenue from their facility. Each franchise is responsible for negotiating their lease and the accompanying revenue split from non-hockey events. One can examine the situation in Columbus, where they get no naming rights revenue or suite revenue to see how a poor lease can cripple a vital source of team revenues.

The broadcast revenue stream is also a function of market size and the ability of a team to negotiate favorably. Large market teams hold a distinct advantage in this area, and this disparity will remain in place simply because of demographic factors. Teams in a larger media market will command higher broadcast rights fees than those in smaller media markets.

The revenue from merchandise sales will vary according to the longevity of a franchise, the size of the fan base, and the on ice performance. Again, these factors vary from market to market, with newer franchises and smaller market teams at a disadvantage.

Which brings us to revenue sharing. The current revenue sharing arrangement is complicated, to say the least, and attempts at re-vamping the revenue sharing arrangement will be complex and have lasting ramifications for the League and its franchises. Fundamentally, the question is "Should the revenue sharing arrangement be re-worked, and if so, how?"

So should the League change its business model to make its franchises financially healthier? If the business model is changed, what modifications are needed?

The answer to that question is provided by looking at the numbers. When more than 50% of your franchises are losing money, it is safe to say that something should change.

Foremost in considering a change to the business model is the necessity to keep costs contained. The primary driver of franchise costs is player salaries. Obviously, the players do not want to see limitations to their salaries, but the advisability of a League that has numerous money losing franchises spending near or up to a consistently rising salary cap is questionable.

The first change to the business model that should be considered is the removal of the salary floor. The cap should remain, but the floor should be removed. As League revenues rise, the salary cap rises and teams are forced to spend more money on player salaries to meet the League mandated minimum. This is problematic for teams in smaller markets that derive lower revenue streams from all sources due to demographic and market limitations. Removing the salary floor will allow smaller market franchises more flexibility in tailoring their payroll to the demands of their market will having no impact on teams in larger markets. While this would not have an impact on players currently under contract, it allows more leeway to a team in filling out their roster. This "wiggle room" will become even more important to small market franchises if League revenues continue to rise.

As for that cap, the calculation should be changed. Rather than calculate a cap based on League revenues, which take into account television rights and revenue streams from other sources including gate receipts, the cap should be a function of gate receipts only. Revenue collected at the League level would be distributed under a new revenue sharing arrangement. This change in calculation ties the salaries of the players to the product on the ice and is a more equitable arrangement for each club and for the players. Their salary level is directly related to the product on the ice on a league wide basis.

There is an obvious problem with this change in the way the cap is calculated. Franchises that struggle on the ice, such as the Islanders, Thrashers, Blue Jackets, and Coyotes have done recently, have a direct impact on the total gate receipts for the League. Players have benefited from rising League wide revenues regardless of the quality of the product that is put on the ice. This disconnect is unfavorable for individual franchises and for the League. Using this method of calculation will put more pressure on franchises that have not put a quality product on the ice to improve their play and their fan experience to drive traffic into their barn. It also could result in a lower cap than is presently enjoyed by the players, which would be a point of serious contention with the negotiation of a new Collective Bargaining Agreement.

Currently, teams keep 54% of their hockey related revenue, with the balance being remitted to the League. Under this proposal, each team will keep 100% of their hockey related revenue.

A more complex change in the business model should be a change in revenue sharing. Revenue sharing has a disincentive that is built into the system in that teams that want to participate in the program are voluntarily constraining their spending to the mid-point of the salary cap. This can impact the League's stated goal of competitive balance because team's that desire to receive their shared revenue are not going out and signing high priced free agents or retaining unrestricted free agents on their roster that accept higher contracts from a competitor.

There is no doubt that revenue sharing has to be part of the NHL. So how should it be modified?

The NHL was the last major professional sports league to begin revenue sharing. The program used in the NHL is a complex process. As mentioned, the three criteria are average attendance above 14,000;  a team must be in the bottom 15 clubs in total revenue; and the team must spend no more than the mid-point of the salary cap. By contrast, the NFL splits locally earned television revenues and gate receipts between the home and visiting team with the home team receiving 64% of this revenue and the visiting team 36%. The NBA has a similar arrangement, but the home team keeps 95% of the revenue and the visiting team receives 5%. Major League Baseball puts 20% of all revenue into a pool with 75% of that pool shared among all 30 teams and the remaining 25% split among the lowest revenue producing teams based on how far below the mean revenue number they may fall.

The distribution of revenue for the NHL, provided that the initial criteria are met, is determined by a complex formula that is as follows:

Description of the Sources of Funding for the Shared Revenue Pool

Funding Phase                  Percentage of Pool            
League Revenue
Phase                               Up to 25% of minimum

Distribution requirement:     League may use up to half
                                          of any centrally generated
                                          league revenues (NHL Enterprises,
                                          television, sponsors, etc) in
                                          excess of $300 million to fund,
                                          at most, one fourth of the minimum
                                          redistribution requirement.

Escrow Funding Phase      Up to 33% of remaining
                                         balance (25-33% of total)

Distribution requirement:   At the end of the season,
                                        money accrued in the escrow
                                        accounts of the top ten teams
                                        in terms of revenue will be
                                        committed to covering up to
                                        one third of the remaining
                                        balance after Phase 1.

Playoffs Funding
Phase*                            50% of remaining balance
                                       after phase 2 (25-50% of
                                       total).

Distribution requirement:  Each playoff team will be
                                       taxed a certain percentage of every
                                       playoff ticket sold. Teams in the
                                       top third of the league in terms of
                                       revenue will pay 50%, second third,
                                       40%, and bottom third, 30% of each
                                       ticket.

Supplemental Funding      50% off remaining balance after phase 2 (25-50%)
                                        total.

Distribution requirement:  Supplemental funding phase will be
                                       funded by the top ten revenue teams,
                                       with each paying a proportion of the
                                       total based on how much higher their
                                       revenues are from the 11th ranked team.

Understand all that?

One factor that stands out is that the League only distributes a portion of  Phase 1 net revenues above $300 million. The aspect of the Phase 1 distribution that stands out is that until recently, the League has struggled to hit the $300 million net revenue mark

There are numerous inequities in the revenue sharing model the NHL uses. It was mentioned earlier that the current revenue sharing model provides incentives for teams in the bottom half of the salary scale not to spend money in order to achieve revenue sharing qualifying status. Teams in larger television markets are ineligible for revenue sharing, even if they are in the bottom half of the League in terms of spending. The current system is disproportionately  subsidized by teams in strong markets.

So what should be done?

Revenue sharing should continue. The continuation of the program should be simplified radically to provide more equity among the thirty teams. Here is how:

Keep the attendance metric.This ties revenue sharing to the on-ice product and the fan experience in each market and will keep teams focused on icing a competitive squad and providing the paying customers a quality experience.

Secondly, remove the escrow clause. Instead, set profit goals for the League and allow the players to share in the League's profitability as a component of their compensation. Essentially, this is a form of escrow, but escrow has been a burr under the saddle of the players. Re-framing escrow as profit sharing ties the players to the profitability of the League and removes the onus of the "give back" that escrow creates. The calculation of the profit sharing pool could be the same as the current escrow arrangement or a similar arrangement that was agreed upon between players and management.

If you understand that complex revenue sharing formula that was presented above, you have a job awaiting at NASA. Simplify the formula, and include all 30 teams in the profit sharing. First lower the threshold for profit sharing. More realistically, Phase 1 distribution targets should be in the neighborhood of $150-200 million. Once that threshold has been surpassed, all thirty teams should participate.

The distribution formula should be simplified significantly. Adopting an NFL type of revenue sharing would fit that criteria and would work as follows:

Once the agreed upon target is surpassed, 60% of all revenue above that number is deposited into a pool to be shared by all thirty teams. The remaining 40% would be divided among the bottom 15 teams in terms of revenue and the demographics of each team's market. Demographics would carry a heavier weight in the final formula with teams in smaller markets receiving a greater share of the remaining 40%.

For instance, a team in a market with 2.5 million people or less would have a higher weighting  in the final calculation of the revenue sharing. Presumably, teams in larger demographic markets will have higher media revenues than those in smaller markets, and weighting the final distribution more heavily to those smaller markets will allow a balancing effect.

Each team should be allowed to retain 100% of the revenue that their venue generates. This causes teams to evaluate the most cost effective manner in which to deliver a quality fan experience on game nights, from concessions to ushers to security. This also provides added impetus to negotiate a favorable lease with the owner of their barn as well as increasing the utilization of their facility for non-hockey events. Most teams have a revenue sharing arrangement with an arena management company, and non-hockey utilization will increase the revenue flowing back to the team.

Each team would be allowed, as they are now, to keep 100% of their regional broadcasting income.

Merchandise sales should be pooled and distributed evenly among the teams with the League receiving a portion to cover licensing and administration. It becomes critical for the League to effectively market merchandise much like the NHL has done. Centralizing the marketing for all teams gives the League leverage to negotiate more favorable contracts for merchandise and is more cost efficient. The League does some of this now at their shop.NHL.com site, but their is great room for improvement in this area.

Is this proposal perfect?

Absolutely not.

Is it simpler and more equitable than the current system.

Definitely.

Regardless of how the system is modified, it is essential that the business model of the League be critically examined and made more workable so that teams move toward sound financial footing.

Fail to do so, and the presence of financially troubled franchises will continue to be a fact of life for the NHL.

And that is a business model that doesn't work.

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