Key Leasing Considerations for Startups
In the early growth stages, new companies often look for short-term leases for relatively small suites to enable the company to expand or scale back on the space and rent obligations depending on the success of the business. When the time comes for a new company to branch out into its first office space, the need to finalize the lease quickly can become very pressing. However, the legal issues and financial risks associated with short-term leases for small suites are, for the most part, very similar to those associated with long-term leases for large spaces. Most landlords will present the same form of lease to a tenant for a two-year, 3,000 square foot lease as they present to a tenant for a five- or ten-year, 50,000 square foot lease. In an ideal setting, a company would be able to engage counsel to negotiate for customary tenant protections throughout the lease. However, when time and resources available to devote to lease negotiations are scarce, tenants must prioritize issues in order to get to lease signing within the company's time and cost budgets. Although circumstances vary from lease to lease, there are some key considerations that are likely to be present in any commercial office lease.
1. Commencement Date. In a typical small-space lease, the landlord will be obligated to construct certain improvements for the tenant. Even in a so-called "as is" deal, the landlord usually agrees to some amount of work to ready the space for the tenant's occupancy. Often the landlord's initial draft lease will define the Commencement Date with a specific calendar date. However, whenever the landlord has any obligations to prepare the space prior to the tenant's occupancy, the lease Commencement Date should be defined as the date the landlord delivers the space to the tenant with all of landlord's work substantially completed. This protects the tenant against an obligation to pay rent beginning on a date certain when the landlord may not have completed the required work by such date. In addition, when the move-in date is mission-critical, the tenant should negotiate for a completion deadline by which the landlord is obligated to complete the required work, with appropriate remedies in favor of the tenant should the landlord fail to meet the deadline.
2. Condition of Premises. Most leases require the tenant to accept the space "as is" and the landlord's initial draft lease will contain broad disclaimers and waivers about the condition of the space. In order to protect against some of the hidden costs that may arise in "as is" deals, the tenant should insist that, notwithstanding any "as is" and other disclaimers or waivers, the landlord will be responsible to deliver the space to tenant in structurally sound, first class condition, with all systems serving the premises in good working order and with the building and premises in compliance with all applicable laws, including, without limitation, the Americans With Disabilities Act and similar state and local laws related to protections for the disabled. If the tenant plans to do its own construction work in the premises, the tenant should obtain a fact-specific analysis of the physical condition of the space and potential costs related to compliance work from appropriate construction consultants and counsel.
3. Operating Expenses. Landlords and tenants can spend considerable time negotiating extensive provisions regarding tenants’ obligation to pay its share of operating expenses. It is not uncommon for a lease to contain lengthy definitions of what is included and excluded from “Operating Expenses.” In a small lease, landlords and tenants may not have the appetite for such extensive negotiations and lengthy provisions, however tenants should still insist on some minimal protections related to operating expenses, such as:
- in a full-service lease, provide for a full 12 months of base year protection before the tenant begins paying operating expense increases
- in a net lease, negotiate a set cap on first year’s operating expenses and a set cap on increases (e.g., subsequent years capped at 3% of the prior year’s expenses)
- limit tenant’s obligation to pay for capital costs to those required for compliance with new laws (as compared to capital costs required to come into compliance with laws existing prior to the tenant’s lease commencement), with any included costs to be amortized over the useful life of the capital item
- set caps on insurance deductibles, especially for earthquake coverage
- exclude increases in property tax attributable to sale of the building
- include a general exclusion for expenses not customarily treated as operating expenses for comparable buildings in the market
4. Renewal Rights. Because the company’s future space needs are often uncertain, flexibility regarding term and size of space is a key consideration for many startups. For very short-term leases followed by one or two short-term renewal options, it may make sense to set the renewal rent at a fixed number. In many cases, the parties prefer to determine the fair market rent for the space at the time of the renewal. If renewal term rent will be based on a future determination of fair market rent, the tenant should negotiate for a balanced approach to determining what constitutes “fair market rent,” and avoid agreeing that the renewal rent will not be lower than the rent during the last month of the initial term. Eliminate provisions that extinguish renewal rights in the event of an assignment, but provide that the original tenant will be released from liability for renewals exercised by third party assignees.
5. Expansion and Contraction Rights. To maximize flexibility, negotiate for the right to expand into adjacent space and/or reduce the size of the original space. For expansion rights, landlords will include broad language making the tenant’s rights subordinate to any other tenants who have or may have rights to the space. To make an expansion right more meaningful, tenants should insist that the landlord identify any superior rights specifically and expressly provide that any future rights will be subordinate to the tenant’s right. For contraction rights, address the responsibility for construction costs to separate the surrendered space from the portion of the space the tenant will retain. If the tenant is to bear any or all of the costs, negotiate for a cost cap so the company can budget accordingly.
6. Assignment and Subleasing. Many leases have several restrictions on the tenant’s ability to assign or sublease. In addition, many leases provide that corporate transactions such as mergers, corporate reorganizations and change of control of the company are deemed assignments of the lease and therefore subject to the same restrictions as assignments and subleases. The ability to assign or sublease is important for tenants who may find that they have too much or too little space and the ability to engage in various corporate transactions can be a crucial part of the company’s business plan. Tenants should negotiate for the right to assign or sublease without landlord consent to any entity controlled, controlling or under common control with the original tenant entity. In addition, tenants should negotiate for corporate transactions to be permitted without landlord’s consent so long as certain basic criteria protecting the landlord are met, such as reasonable net worth in the surviving entity and continued use of the space only for the use permitted by the terms of the lease.
The considerations above are some of the key considerations for a commercial office lease. Every lease transaction is unique and should be analyzed based on the specific circumstances the company faces.
For more information about commercial leasing, contact Amy Carbins at email@example.com.