Leasing "Bootcamp" for Startups

You've finally made the decision to leave coffee shops behind and rent office space. You begin searching online, maybe even find a few places you like. You contact the listing broker and make an appointment to tour the space. It's perfect for your business. The broker tells you the market is hot and you need to move fast (FYI, they always say that!). By the time you get home you find an email from the broker sitting in your inbox with a overwhelming 30 page lease attached. The broker says "don't worry it's a "standard" lease and fair to both parties, besides the only important part is the term and rent." While this is your first foray into commercial real estate, you wonder why then do we need the other 29 pages? The answer is because commercial leases are binding legal documents that outline your responsibilities and protect your rights, and, most importantly, they can have a substantial impact your business going forward.

Whether you're “office sharing” or entering into a more traditional leasing arrangement, there are five things to focus on:

1. Letter of intent ("LOI"). This document is exchanged up front, and lays out the general terms to be incorporated into the lease. Many brokers will insist on skipping this step and go right to the lease, but if the landlord hasn't agreed on the basic business terms you're wasting time and money presenting him a formal lease. The LOI makes sure everyone is on the same page before drafting the lease, thus saving you unnecessary legal fees. The broker will usually prepare the LOI, but before you sign it make sure it says that it is a non‐binding expression of interest, and not a binding contract. Bottom line, make sure what is in there is what you want from a business perspective (i.e., rent, build‐out, security deposit, type of use, access, kitchen, pets, bicycles, ect.).
2. Insurance and Indemnity. Allocation of the risk is an important concept in leases that determines which party bears the responsibility to respond to risk when something occurs in the leased space or building. Your ability as a small business to respond to the risk is satisfied by obtaining insurance coverage. Work with an insurance agent to review the insurance requirements in the lease, and, unless you have a prior relationship with the agent, make sure to obtain several quotes as prices many vary significantly. Included in leases are long provisions where the tenant indemnifies the landlord if certain events occur (i.e., tenant assumes the risk whether or not caused by tenant). As your company grows, indemnity provisions can be negotiated—but for a startup “it is what it is”—so insurance is critical.
3. Assignment and Subletting. Your name is going on the lease, so you are ultimately responsible. If plan on sharing the space with others, make certain to discuss this in advance with the landlord, as many leases will contain a default provision if you try to assign or sublet the space without the landlord's permission. For businesses that expect to grow through new or additional rounds of financing, this provision is particularly important because these could trigger a "change in control" of the ownership of your company which could lead to a default under the lease. Make sure to discuss this possibility as well.
4. Personal Guaranties. Startup tenants may have a difficult time negotiating a lease that doesn't include a personal guarantee; however, you may be able to negotiate to limit the scope or impact of such guarantee. There are several ways to accomplish this (see Negotiating Personal Guarantees in Commercial Leases), so it is important to discuss these options with your attorney.
5. Tenant Improvements. It is extremely important to understand how the space will be built out, including electrical, HVAC and data/voice. While some tenants may want to control of this process, in the long run it's better to have the landlord perform the work (at landlord’s cost). You have your own business to run, so let the landlord deal with construction delays and legal compliance issues. This after all is their expertise, not yours. 

Rent in commercial leases usually has three components and you should get familiar with these as they go directly to the bottom line:

• Base Rent. This is the base amount you are paying for occupying the space.
• Additional Rent. The amount that is based on your percentage share of expenses incurred by landlord in owning and managing the building. These expenses can vary based upon what services are included as landlord's operating expenses, so it is important to review this list. 
• Tenant Expenses. The lease may require tenant to pay service providers directly for certain services instead of reimbursing landlord as part of additional rent. For example, this can be janitorial services within the leased space, separately metered electrical, and taxes on your personal property. 

Negotiating commercial leases involves a wide array of terms and options. If you need assistance in negotiating your commercial lease, please contact the attorneys at Morsel Law.

Legal Pitfalls in Negotiating Your Commercial Lease

Signing a lease is an important decision for any business, whether you're expanding your operations or a newly formed startup moving into its first space.  Retaining an attorney to review your lease is important because entering into a lease for your business is a significant investment, even if your business does not require a huge space.  For example, a 10-year lease at $7,500 per month means a $900,000 investment across the life of the lease.  With such a substantial sum of money on the line, investing in legal advice to ensure you have an agreement that protects the interests of your business makes considerable sense.  

Lawyers experienced in lease negotiations understand how duties, costs and risks of ownership should be shared between a landlord and a tenant.  A good lawyer with experience in leasing will be on the lookout for several legal landmines that can result in significant financial burden for a small business owner.  Small costs can add up quickly for a small business owner and understanding the language of your lease with the help of a lawyer can prevent getting buried by unexpected costs in the long-term.

The location.  Everyone at one time or another has heard the saying that the three most importance factors in real estate are "location, location and location."  Although many tenants understand this concept, they fail to address the conditions that make the location so desirable in their lease.  For retail tenants, visibility and access can be of critical importance, yet tenants fail to address this issue in their lease.  Sometimes, to their dismay, they are left with few options when trees or signage obscure visibility, a fast-food restaurant is built on an out-parcel immediately in front of their storefront, or the curb cuts in the parking lot are changed that results in impeded access to their store. Perhaps the store was initially in an attractive location in the mall, but visibility has been diminished due to the landlord's installation of a fountain or redevelopment of the mall directs foot traffic away from the store.  For an office tenant, perhaps the key points are the amenities and condition of the property.  Office tenants can negotiate to include a provision in the lease that requires landlords to maintain the property in a certain condition and provide services that are consistent with the level of service that made the location desirable to the tenant.  Tenants are sometimes surprised to find that in many leases the landlord has reserved the right to relocate the tenant to a different space in the building or shopping center.  Although it is preferable to delete this provision, this is not always possible; however, a tenant can often address the provision in other ways.  Perhaps the tenant will have a termination right if it is dissatisfied with the relocated space, or the number of relocations can be limited, or the area of the relocation can be limited (e.g., the lease could provide that the relocated space must be on one of the top five floors of the building).

Understanding the Rent Obligation.  Many clients focus solely on the base rent rate and fail to understand the many other components that can affect the total rent obligation.  For example, the manner and method by which a landlord measures the space will affect the amount of rent you pay. Rent is typically calculated on the basis of rentable square feet in the leased space; however, there is a significant difference between rentable square feet and usable square feet, particularly in office buildings where the common areas on multi-tenant floors are allocated and included in the calculation of rentable square footage.  Some landlords are more aggressive in the manner in which they calculate rentable square footage, which ultimately results in higher rent.  In addition, unless you have a true "gross lease," base rent is but one component of the total rent expense.  Typically, the tenant is also responsible for its pro rata share of operating expenses, which can include a share of the real estate taxes, common area maintenance expenses and insurance expenses.  Tenants can end up paying for costs that aren’t core to the operating of the office building or shopping center or that extend beyond the life of their lease if they don’t read the language carefully.  These additional pass-through charges can be substantial and can represent a significant rent expense. Some leases allow a landlord to put a new roof on the building and charge the entire cost of the roof under operating expenses in a single year, even though a roof is considered a structural element which can have a lifespan of 20 to 25 years.  Replacement of a roof is usually considered a landlord’s expense, but at the very least, operating expenses associated with capital expenditures should be spread out over a number of years, with charges stopping at the expiration of the lease.  When comparing locations, a prospective tenant needs to consider these expenses and the manner in which the prospective landlord calculates them.  Also, don't forget to consider the meaning of any "free rent" periods.  Many tenants have been surprised to find that the landlord's offer of "free rent" did not extend to operating expenses.

Repair and Maintenance Obligations.  Who is responsible for what repairs?  Leases differ widely on this issue.  In a "triple net" lease, the entire obligations for repair and maintenance are shifted to the tenant.  In an office lease, most repairs are performed by the landlord, although the landlord typically charges the tenant for alterations or improvements such as new carpet or repairs that are due to an act of the tenant.  Many tenants are surprised by the repair provisions of their leases, and first become aware of them when a major repair is required.  In a retail lease it is not uncommon for the tenant to be responsible for the maintenance, repair and, if necessary, the replacement of the HVAC unit serving its space, which can be quite a shock and expense for an unsuspecting tenant.  Although it may not be possible to shift these obligations to the landlord, a prospective tenant should have the premises and its mechanical systems inspected prior to entering into the lease so it is better informed as to the likely costs it can expect to incur for maintenance and repair.  The tenant must also remember that shifting the responsibility for maintenance and repair to the landlord may not absolve the tenant from financial responsibility if the costs for such maintenance and repair are included in operating expenses that are charged back to the tenant as additional rent.  For example, a landlord may be responsible for the maintenance and repair of the roof and the parking lot, but if such costs are passed on to the tenants, then the tenants are really bearing the financial burden.  Accordingly, in order to have a complete understanding of the maintenance and repair obligations, and the financial burdens they entail, the maintenance and repair sections of the lease must be carefully reviewed in conjunction with the lease provisions dealing with operating charges.

Understanding the Assignment and Subletting Provisions.  Most leases provide that the tenant may not assign or sublet without the landlord's consent and that the landlord may withhold its consent for any reason or no reason. In addition, many leases provide that an assignment includes by definition a change of control in the equity or management of the tenant.  These provisions can have a major impact on a tenant's ability to engage in corporate transactions or exit a location for an alternative site.  Many tenants are surprised that landlords, and particularly retail landlords, are often resistant to a request that their consent to assignment or subletting not be unreasonably withheld.  The landlord will often take the position that it should be the sole judge as to the suitability of a proposed subtenant or assignee.  However, when pushed, most landlords will at a minimum set forth the requirements and parameters which will be used to judge the suitability of a proposed subtenant or assignee.  These parameters may include, for example, suitable financial statements, reputation and experience.  For the retail lease it is also important to remember that the permitted use provisions can have a direct impact on the ability to assign lease or sublet the premises.  For example, if the lease allows the premises to be used solely for a retail sales, then any assignment or subletting would have to be for the same use.  Most tenants would prefer the flexibility of being able to assign or sublet for a use that is different from their own; however, most landlords would prefer to limit this flexibility.

Improvement Allowances.  Leases can get even more complicated with construction obligations, therefore, it’s important to negotiate which party is responsible for what part of the construction process.  Included in this negotiation is the amount the landlord is willing to give in allowances. Since construction projects can take years, and recessions and budget cuts can occur between a project’s start and end date, tenants should be aware of what they’re responsible for and what they’re owed in the event that things go differently than expected.  For example, the landlord is responsible to pay a tenant improvement allowance after the tenant had finished the tenant’s work; however, between the signing of the lease and completion of the tenant’s work, the landlord suffered financial problems.  The lender foreclosed on the property and, since there wasn't any assurance to provide financial support for the landlord's promise to pay the allowance, the tenant found itself in the unhappy predicament of not having its allowance easily forthcoming and having to work through issues with the foreclosing lender, at substantial unbudgeted expense.  

The common pitfalls listed above are only a few of the problems that can be encountered in a typical commercial lease.  Leases are negotiated documents that represent the written culmination of a negotiated transaction and although there are obvious similarities between many lease transactions, each transaction is unique and accordingly each lease is different.  There is no "standard form" lease that is appropriate for all situations.  Having a lawyer who is familiar with the leasing process, lease documents and their hidden traps is the best way of ensuring that your transaction will go as smoothly as possible and that the lease accurately represents your understanding and expectations, and protects your interests.  If you have questions about your lease please contact us Morsel Law

Negotiating Personal Guarantees in Commercial Leases

Since the economic collapse a few years ago, there have been many significant changes in the business landscape.  As tenant defaults have increased, landlords are frequently requiring personal guarantees of commercial leases.  However, personal guarantees can be negotiated to provide terms reasonably acceptable to both landlords and tenants.

Generally, the individual who signs a commercial lease on behalf of a tenant does so in their capacity as an officer of that company.  If the tenant goes out of business and the lease was not personally guaranteed, the landlord's only recourse is to file a claim against the failed company.  The officer who signed the lease has no legal obligation for the debt.  Landlords may perform financial due diligence on the tenant's officers and require the individual entering into the guarantee has the financial ability to fulfill the tenant's obligations under the lease in the event tenant defaults.  Landlord's can also require annual updates to the officer's financials and, if the officer's financial health has declined, require tenant to replace the guarantor with another individual acceptable to landlord. 

Unless you are a major corporation with extremely strong financials, a tenant may have a difficult time negotiating a lease that doesn't include a personal guarantee; however, a tenant may be able to negotiate to limit the scope or impact of such guarantee.  One potential option would be to include an expiration date of the guarantee in the event tenant meet certain milestones.  The milestones can include things like establishing a history of timely rental payments and tenant's financial stability, which over a period of time may give the landlord the confidence to release the guarantor from its guarantee.  For example, on a seven-year lease term, the personal guarantee would only be in effect during the first three years if the tenant meets the milestones set forth in the guarantee.

Another possible limitation that could be included in the personal guarantee is what's commonly referred to as the "good guy" guarantee.  This type of guarantee protects landlords against tenants who vacate the premises early with no prior notice.  The landlord agrees not to enforce the obligations of the tenant against the individual guarantor, even though the tenant has vacated the premises prior to the end of the term of the lease, but only if the tenant (a) provides the landlord with advance notice of its intent to vacate, (b) leaves the premises in good condition and (c) is current on rent up to the date of departure.   

Another way to limit the guarantee is to cap the amount guaranteed by listing a fixed dollar amount. Alternatively, the cap could be set based upon a fixed number of months of rent.  For example, in the event the tenant breaches under the lease and we assume the landlord should be able to find a replacement tenant in no more that five months, the guarantee could set a liability cap of five months of rent.  Also, the tenant can request that the guarantee be waived upon transfer of ownership.  So in the event the ownership of tenant is transferred to a new owner, the guarantee terminates.

Negotiating a commercial lease involves a wide array of terms and options.  If you need assistance in negotiating your commercial lease, please contact the attorneys at Morsel Law at www.morsellaw.com.