The Houston Rockets' poisonous play for Jeremy Lin

July 17, 2012: 10:51 AM ET

Will the NBA's 'poison pill' contract force rich teams to choose between large payrolls and young players?

By Chip Lebovitz, reporter

FORTUNE -- Last week New York Knicks rookie phenom Jeremy Lin stormed back into the spotlight, reviving Linsanity and highlighting a new form of NBA contract that could change the way that teams compete for talent.

Now a restricted free agent after a career-making season with the Knicks, Lin signed a three-year, $25 million offer with the Houston Rockets, which cut him last year. The deal includes a third-year balloon payment -- a so-called "poison pill" -- that Rockets general manager Daryl Morey designed to thwart the Knicks, one of the richest teams in the league.

New York can't match Lin's proposed third-year salary without exceeding its league-mandated payroll cap for the year, and as punishment, paying up to $45 million in taxes. Even if Lin returns to the Knicks, the poison pill contract has become a legitimate way for lower-income teams to compete for talent -- and force their wealthier rivals to reconsider the amount they spend on players.

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Historically, the richest teams in sports have also been the most successful. In basketball, one player is often the difference between a championship and a failed season; outsized salaries reflect the value of one star player in a roster of five. Teams sometimes useĀ  "toxic offer sheets"-- deals chock full of lucrative signing bonuses -- to lure away players from cash-strapped, rival teams. The less affluent team can't match the signing bonus, and has no choice but to let the player go.

The "poison pill" contracts-- used this year for the first time in the NBA --- are like toxic offer sheets, inverted. They offer modest (by NBA standards) salaries for the first two years of a three-year contract -- as stipulated by the NBA. But the salary jumps dramatically in the third year, to deter the player's original team from resigning him.

The inflated, third-year salary is key to the "poison pill" because NBA teams have a cap on how much they can spend on their teams' annual salaries. (For the 2012-2013 season, the league salary cap is $70 million.) For every dollar a team spends above that salary cap, it must pay a one-dollar "luxury tax," a number that will rise in the future.

Less affluent teams like the Rockets can use a poison pill contract to compete with the Knicks, which is already spending close to the salary cap on existing players.

Teams can only offer poison pill contracts to a small group of younger players -- roughly five percent of the league. They must be restricted free agents -- players who can receive offers from other teams, but must automatically re-sign with their original team if that team decides to match an outside offer. Of these restricted free agents, only those who are either second-round draft picks or undrafted free agents with under three years of experience can receive a poison pill deal. That talent pool is small, but significant, producing perennial All-Stars like Manu Ginobili, Marc Gasol and Gilbert Arenas.

When faced with a competing poison pill offer, the original team has two bad options. If it matches the offer, the team is stuck with the player for the duration of the deal, since no other team will want to pay the huge third-year salary, says Rahat Huq, who blogs about the Rockets at Red94.net. Because these contracts are guaranteed, a team must pay out the player's entire salary, even if he gets injured or bombs.

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The other option is to not match the offer, which for the Knicks would mean losing millions of dollars in Jeremy Lin-fueled ticket and memorabilia sales.

In theory, poison pill contracts should force basketball's richest teams to reconsider the annual fortune they spend on players— or risk watching their talent, and a chance at a title, slip through their fingertips. But industry insiders doubt that the new contracts will change the profligate spending of affluent teams.

Noah Croom, an NBA agent and former Assistant General Manager for the Vancouver (now Memphis) Grizzlies, points to teams like the Knicks, Chicago Bulls, and Los Angeles Lakers, which don't usually develop talent internally, and instead rely on huge salaries to acquire proven stars through free agency deals and trades. Because each player has such a huge impact on a team's success, teams will keep paying top dollar for talent even if they risk losing those players when their contracts expire.

Instead, says Croom and others, expect poison pill contracts to become a standard weapon for NBA managers -- assuming the newly signed players deliver a return on the team's investment. "I can also see a situation where teams make aggressive predatory plays [for players] in the beginning of the collective bargaining agreement, and if a number end up being mistakes, the GMs might have a case of buyer's remorse," says Tom Penn, an ESPN analyst and former Vice President of Basketball Operations for the Portland Trailblazers.

If the rumors are true, the Houston Rockets -- not the Knicks -- will benefit from Lin's star power, thanks to the poison pill contract that lured him to Texas. From there, it's up to Lin to prove he's a $25 million man.

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