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NBA Free Agency Extravaganza: How the NBA Salary Cap Works and Impacts Free Agency

Note: This is the second installment of The Sixth Man’s Free Agency Extravaganza. As a part of this Extravaganza, we will provide updates on all the latest signings and acquisitions. We’ll also offer analysis and exclusive content over the next few days about free agency and what it means for the landscape of the NBA.

Decisions made during the summer free agency period can make or break the future of an NBA franchise. Free agency is a crucial time for general managers to try to improve their teams by signing players who are no longer under contract.

Various rules and regulations govern how (and on whom) general managers can spend their money. The system is set up in such a way that having the most money doesn’t guarantee you’ll land the best available players—just ask the Knicks and Lakers.

This article will explore and attempt to clarify the major force behind NBA free agency: the salary cap. Breaking down the cap—which is confusing and complex—will help us gain a better understanding of how the free agency process works. What must general managers and owners consider before signing a player? How much freedom do they have? How are they restricted?

Let’s begin our investigation.

The New Deal

This free agency has been unusual given the extraordinarily large amounts of money teams are paying to free agents. Khris Middleton and Brandon Knight each received five-year, $70 million deals. DeMarre Carroll will make $60 million over four years. While each of these guys are above average players, they’re certainly not stars (yet they seem to be earning star money).

Even mediocre (and that’s putting it nicely) players are making bank. Al-Farouq Aminu signed a four-year deal with Portland worth $40 million. He averaged 5.6 ppg and 4.6 rpg last season—numbers that don’t really scream $40 million. If this were three years ago, Aminu would be lucky to get $15 million for four years.

What the heck is happening? Where is all this money coming from?

In 2014, the NBA announced a new nine-year, $24 billion television deal with ESPN and Turner. Talk about a big signing! The deal, which is slated to take effect after next season, will raise the annual salary cap from $67 million (in 2015-2016) to about $89 million (in 2016-2017), and then up to $108 million the following year (in 2017-2018).

The impending salary cap increase means that teams will be allowed to spend more on signing players than they have in the past. In turn, GM’s realize they can afford to offer contracts containing higher salary figures than usual.

Let’s examine Iman Shumpert’s recent contract extension for a moment.

The Cavs signed Shump to a four-year, $40 million deal. He now makes $10 million per year, which accounts for 15% of the projected 2015-2016 salary cap number. However, that percentage will decline when the cap goes up. $10 million represents 11.2% of the estimated 2016-2017 salary cap number and only 9.2% of the estimated 2017-2018 cap number.

Although Shump is making a lot of money, his salary will actually represent a lower percentage of the overall annual salary cap. Since they have the money to spend, the Cavs are actually getting a good deal by paying Shump only $10 million per season.

Why Have a Salary Cap?

The NBA and other professional sports leagues institute a salary cap in order to limit how much a team can spend on players. In principle, this restricts big market teams—who have more money at their disposal—from throwing gargantuan wads of cash at free agent targets. Big market teams are only allowed to offer a certain amount of money, providing smaller market teams (who have less financial resources at their disposal) with a nearly equal chance of reeling in a free agent.

In short, the salary cap seeks to level the playing field and keep the NBA competitive.

This off-season, free agent big man Greg Monroe drew interest from many teams. The New York Knicks and Los Angeles Lakers, who represent two of the biggest markets in the league, pushed hard to sign the double-double machine but came up empty. In a surprising turn of events, Monroe joined the Milwaukee Bucks.

Despite being a small market team, the Bucks were able to offer as much money to Monroe as the Knicks and Lakers for two reasons: 1) He signed a maximum contract with a new team. Under current CBA regulations, the Pistons (who he played for last season) could have offered him more money than the twenty-nine other NBA teams. The Knicks, Lakers, and Bucks were able to offer Monroe the same maximum amount of money as each other.

Aside: The CBA, or Collective Bargaining Agreement, is the official agreement between the NBA and the NBA Players Association that details many of the existing rules. Specifically, it lays out the guidelines for how things like revenue distribution and the salary cap function.

And 2) The NBA salary cap restricts how much teams can spend on a free agent. Although the Knicks and Lakers surely have more money to work with than the Bucks, they are prevented from emptying the bank. They can only offer a certain price—a price determined by the CBA that is theoretically affordable for every team.

Therefore, the Bucks (a small market team) have as good of a chance to sign a major free agent like Greg Monroe as the Knicks and Lakers (two big market teams).

Monroe’s decision demonstrates that big market cities are not necessarily the most desirable destinations. Similar money and marketing opportunities now exist around the country. This has resulted in players considering another factor when determining where to take their talents: championship potential. Free agents want to join teams that have a better chance of winning.

Exceptions to the Salary Cap Rules

What’s a good rule if you can’t bend it a little? Actually, the NBA has established a system that allows for significant bending.

The league has what’s called a “soft cap,” which lets teams exceed the annual salary cap number. Its purpose is to make it easier for organizations to re-sign players they currently have under contract. The soft cap is beneficial to players since it creates financial and geographical stability.

Conversely, leagues like the NFL and NHL have a hard cap, which prevents teams from ever exceeding the salary cap number. Although it does a nice job of leveling the playing field, the hard cap makes it difficult for NFL organizations to maintain rosters for long periods of time. This can make team building very tricky. The NBA is much more flexible than the NFL, as assembling a championship team is surely met with less contractual obstacles.

One of the major exceptions to the salary cap (made possible by the soft cap) is called “The Larry Bird Exception” (a.k.a. “Bird rights”). The provision permits teams to break the salary cap line in order to re-sign free agents who played for their team the prior season. This is why it was so important that the Miami Heat traded for point guard Goran Dragic mid-season (in 2015) instead of waiting to sign him during the offseason.

Dragic’s Bird rights transferred to the Heat when he joined the team, which wouldn’t have happened had he remained with the Suns for the entire year. Because the Heat control his Bird rights, they can offer him the most money.

Next season, Bosh is set to make $22 million; Wade, $20 million; Dragic, $16 million; Deng, $10 million; and McRoberts, $5 million. The total amount of money due to these players already exceeds the salary cap number. Lucky for the Heat, Wade and Dragic have their Bird rights (since they played for the Heat last season). Therefore, the Heat can legally go over the salary cap in their expenditures.

Many other similar exceptions exist that can be used to circumvent the salary cap rules. For example, teams have one “mid-level exception” per season, which sanctions them to sign free agents for a specified amount of money and time (depending on the team’s salary cap status). This stipulation holds true even if teams exceed the salary cap figure in the process.

The Not-So-Luxurious Luxury Tax

Although there are exceptions and conditions that allow teams to surpass the salary cap figure, there is still a limit to how much money organizations can dish out in one year. This limit is called the luxury tax threshold.

The luxury tax, which is typically $10-$15 million more than the salary cap figure, was established to prevent teams with exorbitant amounts of money (i.e. big market teams) from spending with reckless abandon. The tax essentially authorizes teams to go over the salary cap, but not too far over. It is meant, once again, as a way to level the playing field and to keep the league competitive.

The MLB does things a bit differently. In place of a salary cap, the MLB has a luxury tax cap (a.k.a. the “Competitive Balance Cap”). It’s an arrangement that calls for substantial taxation for teams that exceed a certain annual payroll. The NBA and MLB basically work the same way, minus the salary cap in the MLB. There is one line to cross, which is the luxury tax line.

The Yankees are no strangers to getting hit with a luxury tax bill. According to ESPN, they’ve paid more than $250 million in luxury tax fees since 2003. That’s a quarter of a billion dollars. Damn.

In baseball, there exists an enormous spending gap, despite the luxury tax cap. Only select teams can have a $100 million payroll, for example (i.e. the Yankees, Red Sox, Giants, Dodgers, etc.), and they are the ones who tend to win the World Series. Seven out of the last nine World Series winners had a payroll of over $100 million.

Why is this significant? Because teams with the most money can offer players the most lucrative contracts. Free agents will join organizations that them pay more. For this reason, the Yankees, Red Sox, and Giants have enjoyed much success as of late.

Should the MLB introduce some form of a salary cap to try to make the free agency process fairer? This debate deserves to be addressed fully in another article.

Back to the Association.

Many NBA teams have dipped (and continue to dip) into luxury tax land. The Knicks, Nets, Heat, and Lakers do it seemingly every year. How shocking that big market teams are the most consistent offenders.

Smaller market teams, like the Charlotte Hornets and Memphis Grizzlies, are hesitant to breach the luxury tax threshold. Punishments for doing so are severe.

If a team is $5 million or less over luxury tax, they must pay a penalty of $1.50 per excess dollars spent. If a team is $5-$10 million over, it owes $1.75 per excess dollars spent. $10-$15 million over means $2.50 per excess dollar, and so on. The rates double for repeat offenders.

Due to the incredibly harsh penalties awarded by the NBA, teams try desperately to keep their annual salaries below the luxury tax line.

In 2013-2014, the Nets paid a record $90.57 million in luxury taxes. That’s more than the luxury tax threshold itself!

Breaking Up is Hard to Do: The Oklahoma City Sob Story

After a disappointing loss to the Miami Heat in the 2012 NBA Finals, the Oklahoma City Thunder were forced to make difficult decisions regarding their young talent. They signed blossoming superstars Kevin Durant and Russell Westbrook to max contracts and power forward Serge Ibaka to an extension. This left the Thunder with hardly any money to try to retain one of their key pieces: James Harden.

If OKC were to re-sign Sixth Man of the Year Award winner James Harden, it would require them to pay max money to do so. However, with the signing of Durant, Westbrook, and Ibaka, the Thunder’s hands were tied.

Had they chosen to cough up max money for Harden, OKC would’ve been forced to cross over the luxury tax threshold—very dangerous territory for a small market team. Refusing to bite the bullet, OKC offered Harden a four-year, $55.5 million contract ($5 million less than what he would have received for in a max deal).

Harden rejected the deal, forcing the Thunder to trade him to the Rockets. This year, Harden finished second in MVP voting and has become arguably the best player in the league.

OKC knew they had something special with Harden. He showed glimpses of the superstar he’s grown into today, most notably in the 2012 Western Conference Finals series against the San Antonio Spurs. But the Thunder front office wasn’t willing to pay hefty luxury tax fines. Signing Harden would hit their pockets far too hard.

The decision not to re-up Harden may have legitimately cost OKC an NBA championship, but it was a decision they felt a lot of pressure to make. Had the Knicks, Lakers, or Celtics been in a similar position, they would have definitely signed Harden to a max deal and accepted the luxury tax penalties.

The unfortunate OKC-Harden divorce demonstrates that big market teams still have some advantages in free agency over smaller market teams. Does that mean things should change? Not necessarily. The hard and soft caps each have their benefits and downturns. Out of all the major professional sports leagues, the NBA actually seems to have one of the best (if not, the best) systems in place.

Look out for the next article in our Free Agency Extravaganza series! It will provide reaction to and analysis of this past week’s free agency signings.

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