Pro/Rel talk: How much would promotion relegation cost MLS owners?

Jürgen Klinsmann recently re-stated his thoughts on promotion and relegation when he said that the U.S. would benefit from the system the rest of the world knows and loves.

Here's an excerpt of what Klinsmann had to say on the topic:

"This thrill of the relegation battle is non-existent in the U.S. league. The risk for club investors to all of a sudden play in the second league would be too high. But the sporting side would benefit from it. Our players from Europe know that. That furthers our national team. Something is at stake week in, week out. Be it at the top or at the bottom, you always have to perform."

A few months back MLS commissioner Don Garber said that a promotion relegation system was not going to happen for a long time:

"It makes absolutely no sense. There is not a developed secondary division. We have union agreements. We have national television deals. We have investors that have put in billions of dollars. It is not going to be something that could be managed in anytime soon."

Promotion and relegation is the common system globally but MLS has chosen the system that mirrors the major sports in the U.S., a single top league with playoffs that crown the season's champion. Pundits that are for promotion and relegation claim that it will help the popularity of soccer grow in America. There would be more meaningful games and the structure gives hope, and presumably more revenue, for clubs in smaller cities based on the fact that they could someday be competing with top clubs.

The most significant issue lies with the owners of the current Division 1 clubs, or in the case of American soccer, the single entity that is Major League Soccer and its franchise owners and operators. The issue for the owners is that the risk of being relegated will directly impact the revenues of the club and therefore the value of their asset. Or in the case of MLS, their piece of the asset. Klinsmann acknowledged the issue directly in his quote and Garber implied it in his. Some owners stand to lose too much money, but how much?

The owners have a stable and growing cash flow from the current design. The current value of that future cash flow is summarized by what can be called the franchise value. If you introduce a probability that the cash flow might some day shrink, then the franchise value also shrinks. Therefore, for most of the clubs in MLS, a promotion and relegation system would immediately shrink the value of their franchises.

That's not true for all franchises. Some of them might see a franchise value increase. Some clubs like the LA Galaxy or Seattle Sounders would have a very low probability of being relegated. They would probably get an increase in value given the higher profile of being a top club in the top league consistently. Think about the top four clubs in the Premier League: Manchester United, Manchester City, Chelsea and Arsenal. It's hard to imagine any of those clubs ever moving down to the Championship given the amount of money that is invested in quality players. Yet teams like Sunderland or Aston Villa need to sweat out their rite to play in the Premier League each season. Those clubs have lower values due to this increased risk of moving down.

But just how much would relegation cost some owners of Major League Soccer? We already know it will be different for different clubs. But let's understand just how much value they could potentially lose. To do this we can look at the data of some recent transactions in the Premier League. Consider the following chart.

Four clubs have been sold since 2010: Liverpool, Blackburn Rovers, Queens Park Rangers and Fulham FC. The chart shows the self-reported revenues of those clubs and the ratio of the sale price to the prior year's revenues. In the case of QPR, the club was sold after they had achieved promotion to the Premier League so the ratio based on next year's revenues, the projected value of which would have been factored into the value of the franchise.

Liverpool was sold at 1.7 times revenue in 2010. Blackburn was sold at .8 times revenues in the same year. QPR was sold at 1.1 times forward looking revenue in 2012 and Fulham was sold at 2.7 times revenue in 2013.

Forbes has consistently attempted to value the largest soccer franchises in Europe. Here is the trend of their projection of the value to revenue ratio of the top five teams in the Premier League. These are teams that have virtually no chance of being relegated and their valuation to revenue ratio reflects that.

From this history we can observe that Shahid Khan bought Fulham at a price that assumes the club stays in the Premier League, or close to it. The Fenway Sports Group it appears got a pretty good rate on their purchase of Liverpool, given the team is very unlikely to be relegated.

The valuation of QPR was just 1.1 times revenue, factoring in the potential for revenues to decline if the team were relegated.  The same can be said of Blackburn's ration of 0.8. And it is from the sale of both Blackburn and QPR that we can get a sense of what a promotion relegation system might cost an owner.

And now time for the disclosure paragraph. It needs to be noted that focusing on the value per revenue ratio, while common, is an overly simplified method of valuing a company. I believe in this case that the majority of the difference between the ratios lies in the relegation reality but certainly other aspects of a club's situation could factor in. Teams at the bottom of the Premier League may have a more difficult time making a profit compared to the top teams. They may also have lower potential for revenue and therefore profit growth. This could factor into the value to revenue ratios. Also, there are only two teams in the sample that are used to assess teams with a higher risk of relegation. There may be unique situations with teams that kept their valuations lower than those of top clubs. All of that said, let's assume for sake of argument that the ratio difference between the low-risk teams and high-risk teams is a function of risk of relegation. Many of the other issues could go in either direction, but the risk of relegation is a hard reality.

Because of the unknown, let's look at a range of ratios. I'll use Liverpool's sale and the average of the top Premier League teams from Forbes. The range of declines in value based on the valuation per revenue is between 46% and 70%. To calculate that range I took the average sale price to revenue ratio for Blackburn and QPR and divided them by both the Liverpool ratio and the Forbes average ratio over the last 5 seasons.

This range doesn't immediately translate to the impact that relegation would have on some MLS owners. For one, the television revenues in the U.S. are a much smaller percentage of overall revenues than in the Premier League. The growth in revenue when entering the Premier League for teams like QPR is tremendous. Consider the three teams that entered the Premier League in 2013/14: Crystal Palace, Cardiff and Hull City. Here is a chart that shows their growth in revenue year over year. Between 60 and 70 million pounds are earned incrementally by each team in the Premier League following in the latest deal.

Promotion to MLS would not grant the same fortune. The stateside deal is worth just $90M in total per year and divided amongst the 20 teams (and beyond) will give teams between $4M to $4.5M at the maximum level (which likely does not entirely go to the franchises anyway). Television revenues can be as much as 80% of team revenues in the Premier League whereas, if you trust Forbes' MLS revenue numbers from 2013, television revenues would be as much at 30% of revenues.

The lower television revenues would keep the bottom MLS teams from having their value impacted as much as QPR's or Blackburn's. However, the U.S. is far less stable from a cultural perspective and a relegated team might suffer a higher drop in ticket and merchandise sales as well.

In the end we can only imagine a range of financial outcomes for higher risk owners. If we do some non-financial but simple ratio math with the numbers above, the mere threat of relegation could lower the value of the franchise immediately between 17% and 27%. It could be better. It could be worse. In 2013, Forbes gave the Philadelphia Union, who would be at high risk of relegation if it existed, a $90M valuation. The introduction of promotion and relegation could reasonably cost Jay Sugarman and his group roughly between $15M and $25M in value. That is substantial, I don't care how rich you are. The lowest-valued franchise in 2012 was DC United at $71M according to Forbes. The value has probably substantially increased the last three years, but even back then relegation would cost the owners between $12M and $20M.

Other owners would have their value increase certainly. If a new system included the lower leagues, which if MLS gets large enough might not be the case, the value of the teams in those leagues would increase due to the increased probability of promotion. Teams at the top of MLS with low likelihood of relegation would likely see an increase due to the shrinking and increased stature of the top league. This makes sense as proponents of the system believe that overall more financial value will be created due to a broader interest in the sport. The issue is evenly distributing that new wealth.

The key to bringing promotion and relegation to America then is to come up with a system that compensates the owners that stand to lose value. Given the single-entity status of MLS this is certainly something that could be done behind the scenes, if the owners believed that promotion and relegation would ultimately add value to the league. But such a system would take a lot of work, and there are many owners with little financial incentive to open their minds to the idea.

This is where fans of the promotion and relegation system need to start their thinking. They have to answer the question, how do I compensate the owners who stand to lose money? Jürgen Klinsmann acknowledged the issue, but he also knows that business issues are solvable. He believes that ultimately promotion and relegation would be good for business and good for the development of soccer players in the U.S. There's just one big problem to solve: those pesky owners.

Sources for the revenue numbers in this report were many: The Swiss Ramble, The Guardian, The BRFC Action Group, Just Football, The Tomkins Times.