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What
Technology Companies Need to Know About Office Leases
By
Jay Hollander
Summary: In
the euphoria of starting or expanding a business, many
high-tech companies treat their office space leases as
necessary evils instead of what they really are: opportunities
for growth or traps for the unwary. High-tech growth companies
have unique needs when it comes to office space, including
those relating to their infrastructure and growth requirements.
This article explains what to look for -- and how to negotiate
-- a lease for high-tech office space.
Introduction
From California's Silicon Alley to New York's Silicon Alley
and from the technology corridors of Boston to Austin, every
dot-com and technology company resides as much in a physical
office as it does in cyberspace. While understandably preoccupied
with valuations, brand-name recognition and, sometimes, profitability,
it is surprising that many up-and-coming companies fail to
pay adequate attention to the distinctly old-economy business
of real estate, and specifically, to negotiating a reliable
lease for their office space.
In
the euphoria of starting a business, or expanding with
the aid of venture or public capital, many high-tech companies
treat their office space leases as necessary evils instead
of what they really are: opportunities for growth or traps
for the unwary. This is truer than ever in major business
centers of the country where office space is scarce and
expensive.High-tech growth companies have unique needs
when it comes to office space, owing to their infrastructure
requirements, their often-explosive rate of growth, and
their methods of capitalization and expansion, methods
often involving strategic partnership and acquisition.Whether
your company is a dot-com, an incubator, a software or
technology development company or a content company, there
are five major categories of issues in any office lease
that are vital for you to appreciate, evaluate and negotiate.
They are the issues relating to use; identity of the tenant;
transferability; addition or contraction of space; alterations
and utilities; and security.
Identity
of the Tenant
Let's
say you're a young company, "fastgrowth.com, Inc." You're
flush with seed capital and a killer business idea or product
but way short on track record or clients, much less earnings.
You approach a landlord with an offer to rent 10,000 feet
for 10 years, knowing in your heart that, if all goes well,
you'll need more space in closer to 10 months than 10 years.You
have a lot of things to consider. First, before you offer
to sign on the dotted line, who should the named tenant
be?Traditionally, tenants in established businesses sought
to create dummy corporations to hold a lease, to avoid
exposing their business assets to collection. That capability
doesn't exist in the dot-com world, where today's landlords
are at once eager to get in on the technology bandwagon
and leery of the risk that such new economy companies represent.Do
you have options? This largely depends on the quantifiable
amount of the risk and which side in the negotiation has
the leverage. In New York, one of the tightest commercial
office-space markets around today, landlords commonly get
high multiples for "per square foot" rental rates and a
few years of rent as security deposits from start-up and
Internet companies. They get this partially in recognition
of the risk, but also because landlords in that market
simply can. When enough economic security can be offered,
it's possible that a non-operating entity might be acceptable,
especially if the operating entity isn't close to profits
-- but it's not likely.
Transferability
So,
if fastgrowth.com, Inc., must be the named tenant, how
else can it limit its risk if it has to move early -- for
good reasons of expansion or bad reasons of illiquidity?One
way has to do with paying adequate attention to transferability
clauses in the lease, most commonly the sublease/assignment
clauses, the negotiated substitute space provisions and
the use clause.Assignment/sublease clauses govern when
and whether a tenant can transfer its lease, in whole or
in part to another tenant. The main difference between
a sublease and an assignment is in the scope of the transferred
lease interest. Simply, an assignment transfers a tenant's
entire interest in its lease to another party, while a
sublease transfers either something less than all the space
and/or something less than the entire remaining term.Problems
often arise here not only as a result of negotiations over
the unadulterated "right" to sublease or assign, but also
what constitutes such a transfer and what conditions will
be attached to it.Many traditional leases shun the right
to sublease entirely in favor of a more limited right to
assign in connection with a sale or transfer of a business,
for the same use as specified in the lease. This is especially
so in a tight real-estate market where landlords see sublease
rights as allowing their tenants to rent space for their
own benefit instead of the landlord, essentially making
them competitors.Similarly, many traditional leases define
subleases or assignments as occurring any time there is
a change in control or majority financial ownership of
a company. And when an assignment or sublease clause is
triggered, landlord-tilting transfer clauses often seek
to allow the landlord to share in any "profit," usually
defined as anything received by the tenant outside of the
actual rent, net of leasing expenses. Such clauses almost
always require the landlord's prior consent to any transfer
as well.These restrictive clauses are entirely insufficient
for a new-economy tenant. But, what can be done about it?First
and foremost, be careful to exclude capital investments
in the company from the definition of assignment/sublease,
even if majority control is transferred, at least so long
as the founders remain in the company. In such cases, no
consent should be required. Second, negotiate hard to limit
exposure in cases where consent is required by seeking
to force the landlord to recapture the space if a requested
transfer is rejected. Third, if the property is a large
property with turnover, or if the landlord is a large landlord
with other comparable properties, try to negotiate a clause
in which the landlord must offer you other space. Fourth,
and regardless of any other protections you get, the clause
must require the landlord to act "reasonably" with respect
to the requested transfer. Lastly, depending upon how restrictive
the "use" clause in the original lease is, some flexibility
in use of the space must be negotiated, so that similar
-- and not just identical -- uses would be allowed upon
a transfer.
Security
Deposit
Another
aspect of limiting risk concerns something as basic as
the security deposit, or the amount of cash or credit the
tenant puts up to give assurances to the landlord in the
event that the tenant defaults in its rent or obligations
during the lease term.Landlords, generally being as risk-averse
as lawyers, do not like to take chances on companies that
may not be there a year or two from now. In places like
New York, where space is incredibly currently tight, dot-com
companies have been required to put up as much as two years
of security to secure a lease.So does a company like fastgrowth.com,
Inc., have any choices, or is it purely a landlord's market?
The answer is yes to both.In a landlord's rental market,
it is difficult to negotiate the amount of security, although
it is possible. What is more possible is to negotiate a
letter of credit, a banking device used to assure a landlord
that a bank will assure the credit of a tenant up to the
agreed-upon security amount. In a dot-com company, of course,
this amount will need to be fully collateralized, but it's
better than the landlord holding it.If the company is not
a public company, landlords also tend to require personal
guaranties of the company's principals. Over and above
the security deposit, such guaranties obviously put the
company's owners at risk. As the theory goes, defaults
are less likely to occur in these circumstances and, if
they do, there is a ready alternative source of compensation
to the landlord if it does.While, in any given case, the
requirement of some guaranty may not be avoided, a frequently
acceptable method of dealing with it is to execute what's
known as a "good guy" guaranty where the principals only
personally guaranty the tenant's obligations for so long
as the tenant actually occupies the space. In this way,
if fastgrowth.com has to leave, at least its owners will
have some protection.
Alterations
and Utilities
Of
course, fastgrowth.com must still be able to work properly
in the space until it has to leave. Here is where the related
issues of alterations and utilities rise to the forefront.Most
commercial spaces are rented in either an "as-is" state,
in vanilla-box condition, or in contemplation of initial
alterations that will either be made by the landlord up
to a certain dollar cost, by the tenant at its expense,
or in some combination of the two.Most tenants think of
alterations in terms of dividing walls and carpeting, but
for technology companies the infrastructure is the key.
More important, this vital aspect of alterations is not
only criticalat the outset of a tenancy but also as the
tenancy progresses, given the swift pace of technological
and communications innovation.Is the building wired for
high-speed Internet access? What flexibility will the tenant
have in selecting among emerging technologies? Does the
building allow DSL or T-1 but refuse to allow satellite
or cable? Will tenants be stuck with the one solution among
many available ones that just happens to be one in which
the landlord negotiated a fee from the vendor for each
tenant signed up?The key here is due diligence in advance
of lease signing. Not only must care be taken to ensure
that the originally preferred method of communications
and other features will be accommodated, but a technology
tenant like fastgrowth.com, Inc., must be assured of landlord
flexibility throughout the lease, in terms of being able
to secure permission for any wiring or infrastructure work
that must be done, so long, of course, as it does not permanently
harm the building and the tenant agrees to be responsible
for any damage or consequences related to insurance premium.What
about the heating and ventilation infrastructure? For example,
many units come with older heating, ventilation and air
conditioning (HVAC) units which, while in working or serviceable
order, are inadequate for the heat thrown off by the amount
of equipment often present in technology spaces.Here, again,
proper planning and provision for the allocation of expense
for any needed adjustments is key.Just as important, in
an age of ubiquitous computers and other electronic equipment,
is knowing the power loads that the space will tolerate
and how the tenant will be charged for them. The answer
to this depends upon how the power is brought to the space
to begin with.In many buildings, there are three basic
choices -- and methods of payment -- for power, ranging
from least to potentially most expensive. The three choices
are direct connection with the utility company; submetering;
and electrical inclusion.The differences among them can
be simply summarized as follows. Direct connection, which
allows the tenant to set up its own service account with
the local utility, or utility of its choice where deregulation
increasingly allows, is cheapest.The middle ground is known
as sub-metering. Here, the landlord arranges power to be
brought into a main switch in the building, with a specified
negotiated level of that power allocated to a particular
space. Each month, the exact amount of consumption is measured
by a third-party metering company, and the tenant pays
its share, inclusive of a surcharge to the landlord.The
potentially most expensive method of receiving power is
when a negotiated amount per square foot is directly built
into the rent, month in and month out, so the tenant pays
the same regardless of its actual usage. More importantly,
this amount is negotiated and agreed before the lease is
signed so that the tenant may never know what its actual
bills might have been. Worse still, while there is no way
to reduce the amount paid, typical clauses almost always
allow for increase if the usage is "extraordinary."Here,
then fastgrowth.com, Inc., has very clear choices, with
the only obstacle being the capacity of the building and
the negotiating prowess of its broker and attorney.
In
the rush to sign up office space in which to create their
next innovation, high technology companies like fastgrowth.com,
Inc., would do well to pay attention to their bricks and
mortar, as well as their clicks and orders, to ensure that
they have a secure real-world base for their cyberworld
activities. To the extent that these considerations are
overlooked by start-up and fast-growing technology companies,
they may find that the cyberworld gives them few places
to hide from a real-world landlord. Copyright © Jay Hollander, 2007. All Rights Reserved.
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