When venture capital and real estate mix, something has gone terribly askew. I am not talking about innovative companies like Zillow or Realtor.com but rather old fashion real estate ownership. One of the least understood liabilities for entrepreneurs is their long term lease. Some firms go as far as to sink significant sums into buildouts or outright RE ownership.
The problem is that no matter how you cut it, RE is an unproductive asset to a technology firm but a necessary evil. Every dollar sunk into RE is a dollar that can’t be spent on sales & marketing or R&D. Furthermore, it creates a senior lien to all equity. This gives your landlord control when liquidity gets tight.
Entrepreneurs make a variety of common errors when it comes to real estate:
1) Failure to Understand the Liability Impact: when an entrepreneur is signing a lease, he/she often focuses on the monthly lease rate. While trying to limit the term, he/she is focused on near-term survival often and the lease rate is enemy number one. So, you often see firms locking in 7 or 10 year leases to get the lower rate. For a 20,000 sq ft space, at $18/ft for 10 years, the company has just signed up for a $3.6m liability. If the company is going to be around for years to come, why is this an issue?
— a) if you sell the company, you are stuck with it and it comes out of the purchase price
— b) if you run into trouble, the landlord is often the largest debtor and will drive the restructuring process.
If you see that you are going to be running into a potential liquidity squeeze (and you trust your investors), make certain that they put a secured, convertible note in place (subordinated usually to bank debt). This puts them ahead of the landlord and gives you leverage to negotiate hard with him/her. The alternative is bankruptcy and the secured note would take the company, leaving the landlord with nothing. Unsecured, the landlord is pari passu and will play hardball.
2) Overestimating Future Space Needs: entrepreneurs are optimists. They tie their RE estimates to their sales estimates. Since they will be doing $15m in year two and $30m in year three, they will need space for 100 people within 36 months. Guess what? Sales don’t ramp as expected ever nor does the headcount. You end up with reams of unused space that you are paying for and frantically have to sublet. As you grow, pack ’em tight and limit stand alone offices. The best insurance is to have a right of first refusal on adjacent space in year 3 or 5.
3) Building the Taj Mahal: pride goeth before a fall. Entrepreneurs sometimes feel that they need to have impressive digs to be taken seriously by perspective customers and partners. I have never seen a company get business because they had impressive office space versus their thriftier counter-part. It is usually because the CEO wants to feel more established and successful. You can always get affordable space if you hunt around. And, be modest in how you build it out.
4) Failure to Use a Good Tenant Rep: I don’t know why all firms don’t use tenant reps since the service is free (the landlord pays out of his side). Also, entrepreneurs pick firms that don’t work either with smaller firms often or don’t deal in the office space types appropriate for an early stage company. Ask your VC or other entrepreneurs who they have had success using.
5) Locking in Rates at the Peak: companies often find themselves expanding and feeling "immortal" during market highs. This is also when lease rates are at their highest. We are seeing a little of this return in the current market. When rates have risen and capacity is tight, be careful about locking in long-term leases and large space commitments. If you have to unload it later, you will get killed on the sublet as rates will drop back down.
6) Insufficient TI: make certain your deal has a strong tenant improvement component ($30+/ft). This helps with limiting your upfront buildout cost, but is also essential should you need to sublet as new tenants will demand it. If you don’t have enough, they will make you pay for it out of your own pocket.
Other random advice…make certain you have a buyout clause in your lease (usually around the 5 year mark). Negotiate down the letter of credit. While it is not cash out today, it will impact how low the bank will let you draw your capital to. Negotiate hard on the # of months for the line or the deposit. And, in general, be Spartan.
I view RE as a necessary evil in the start-up world. I don’t trust landlords further than I can throw them. They need predictability and consistency in their model because of the debt they assume to build/buy buildings. They have little appreciation for the volatility of the technology world and no appreciation for equity. When you get into trouble, very quickly, you can find yourself dealing with an unbending adversary. You need to protect yourself by being conservative in your space assumptions, Spartan in your aspirations and rational in your lease structuring. Religiously try to keep RE costs and total liabilities as low as possible.
This is a great post on a commonly overlooked area.
When I was in Silicon Valley at a funded startup, more than 75% of our space went UNUSED for 13 months. Even after 18 months, we still used less than 60%. It was an insane waste of valuable cash. Moves are inconvenient and expensive, but wasting money in advance is just crazy.
And I would absolutely second your point about retaining a good tenant rep — it is critical to making a good decision & getting a decent deal.
I am agree with this blog. I am in real estate profession and found this posting very good.
Vikram Arora
http://www.primeyards.com
Real Estate in India
As a real estate guy, the best advice I can give is to negotiate short leases if you are a startup. If your needs change, you can get out. You will pay more for the luxury, but lets face it, startups are just not attractive as tenants. All a real estate guy wants is to be paid market rents on time without interruption for decades at a time. We’re just not in the business of fighting with bankrupt businesses over liabilities when we can just turn around and lease the same space to an accountant that will be there for 20 years. We don’t want the hassle of dealing with failing businesses. All it does is cost us money. Money for lawyers. Money for leasing agents, money for the new tenant’s TI. Money in lost rent.
I think a lot of entreprenuers think landlords will like the fact that their comany is growing and will need more space. We don’t care. We only have a certain amount of space and we want to lease it all NOW. It’s not that we have little apprecaition for technology volatility, its that we have no tolerance for it because we gain no benefit from it. Everything that makes a company a good VC investment makes it a crappy tenant.
Think about it. You have 5000 square feet to rent. Do you rent it to TechnoBubble Inc who just got $5M in series A or Jones Accoutning, who wants a 5 year lease with two 5 year options?
Another thing – the real estate market will dictate the terms of the lease when it comes to things like TI. Tight market and you won’t get squat. Bad market and you’ll get free rent and lots of TI. Use a tenant rep who knows the market. They’re not hard to find.
Bottom line – don’t be an idiot. In most markets you can generally move a small company without too much pain. Understand where you are in the tenant pecking order (at the bottom) and negotiate a lease that makes sense for both you and the landlord. Don’t try to game the system, or you could end up in a really bad situation.
Thanks for posting this. Very helpful in reminding startups to focus on the value they can add.
great post! i submit the following:
1) Start early. Real estate leases can take sixty days to document, architectural documentation and permitting can take thirty days, construction itself can last 120 days. For a sublease, many tenants forget once the sublease ink is dry, the landlord can take up to 45 days to officially approve the sublease. By ramping up the learning curve earlier, tenants can be more opportunistic with market alternatives. (We recommend commencing the process 12-18 months ahead of a lease expiration).
2) Focus on total costs. Too many tenants focus only on a base rent number. This strategy only serves to play to a landlord’s strengths. A particular building’s $40 rent number will differ from another building’s, based on what is included or excluded, i.e., cleaning, water charges, security guard, overtime air conditioning, etc.
3) Create a space program. Every landlord’s definition of space varies, so why eyeball it? With a space program based on actual needs, a tenant creates a template of usable square footage required that can be overlaid onto any floor plan. The space plan will quickly identify space inefficiencies in comparable properties.
4) For construction projects, hire a project manager. A PM will act as tenant watchdog and manage to a defined budget and equally important, a finite schedule. A good PM will save much more money than the PM fee.
5) Explore municipal incentives. Many govermental grants associated with job creation exist which can help offset lease costs. We see many companies neglect these benefits.
Like visiting the IRS or the oral surgeon, leasing office space can be a painful process. Additionally, most tenants only lease space once every 5-10 years. By starting early and planning appropriately, tenants can insure a more satisfying outcome.