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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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