5 Lease Tips for Startups

Generally when thinking of a lease arrangement between a landlord and tenant we have in mind a long term relationship. We think in terms of years. The parties enter negotiations optimistically with the hope that the tenant’s business will be a success. While startups have that same optimism, the future may often be undefined and less certain. Their time horizon is often not thought of in years but rather in months or weeks. (When is the next influx of funding coming in? When will the next round of lab results be completed?) The nature of the startup is such that the companies should carefully consider certain issues when leasing space.  Startups need to think ahead, while at the negotiating stage, and try to anticipate as best as they can how their business may change (for better or worse) in the future.

1. Evaluate your Space Needs. While there is inherent optimism at the creation of a new business that it will grow and thrive, startups should be sure not to commit to more space than they need.  Instead, try to negotiate expansion rights in the lease either in relation to particular space or a right of first opportunity to lease new space in the building as it becomes available. On the flip side, startups need to anticipate that the business may not grow as hoped or, perhaps, the business model evolves in such a way that the space initially required is no longer necessary.  Explore the possibility of a contraction right in the lease giving the tenant an opportunity, at a certain point in the lease term, to surrender a portion of the space to the landlord. Be wary of a lease provision that considers tenant in default if the space is abandoned. If the company fails fast there may be a window of time where there are no business operations going on and the company will need time to unload the lease via an assignment or sublease.  As long as the company continues paying rent and maintaining the space as required under the lease, it should not be at risk of a lease default solely because business operations cease.

2. Know The Lease Costs. Oftentimes cash is tight in a startup.  It is important to assess all of the company’s expected operating costs.  Be aware of all the costs in the lease beyond the fixed monthly rent amount.  Typically, landlords will transfer the operating expenses of and real estate taxes allocated to the building to their tenants on a proportional basis.  Find out in advance of signing a lease what these figures have been historically and explore negotiating a percentage cap on how the company’s particular portion of those expenses can increase year-to-year so future expenses can be better anticipated.

3. Explore Space Alternatives. Consider subleasing space initially instead of a direct lease with a landlord.  A sublease situation will allow a shorter term, at a cheaper rent, leaving more flexibility for changing needs down the road.  Also look into incubator spaces.  Incubator spaces are built out by landlords with startups and early stage companies particularly in mind.  They provide a more affordable option as there are common shared spaces (such as conference rooms, kitchens, laboratories services, etc) so less exclusively leased space is required.  Incubator spaces can have the additional upside of collective enthusiasm amongst a group of tenants starting new ventures.

4. Termination Rights.  While disfavored by landlords, it is worth at least having a discussion during negotiation about termination rights.  If a straight out right to terminate is not acceptable (as it likely would not be), explore the possibility of a clause that permits a termination option if revenue benchmarks are not met or if expected funding does not come in.  This may be palatable to a landlord as the lack of revenue and funding would not bode well for the ability of the tenant to make future rent payments over the long term.  Another compromise to allow tenant an out would be the upfront negotiation of a  formula for calculating an early termination fee should tenant wish to end the term in advance of its stated termination date.

5. Assignment/Sublease Rights.  Key provisions in the lease allowing tenant flexibility are the assignment and sublease provision.  A startup company must focus on these provisions as they can provide critical lease exit strategies. Perhaps tenant’s business has become successful and another company presents a lucrative buyout deal or perhaps the opposite scenario comes to pass and tenant’s business is not doing well and tenant wants to close down.   Either of these scenarios may necessitate the transfer of tenant’s lease.   A good way to think about transfer as an exit strategy, while at the negotiating table, is to put yourself in the mind of the prospective acquirer of the tenant’s business and/or lease.   The first thing a prospective acquirer of the lease will look at is how the transfer can be accomplished and at what cost.  The customary way is by assignment, or if the entire company is purchased, by merger or acquisition of the capital stock of the tenant.  With this in mind, a tenant obviously wants to negotiate a liberal transfer provision.  Absolute prohibition against assignments, subletting or changes in control of the tenant entity are unacceptable from a tenant’s perspective.  At a minimum, tenant should require landlord not to unreasonably withhold consent to transfers of the lease and should expressly negotiate certain permitted transfers that will not require consent such as 1) transfers to affiliates; 2) mergers, consolidations or sales of stock; or 3) sale of all or substantially all of tenant’s assets.  As a compromise position, assignment can be conditioned on certain criteria of the proposed assignee, such as creditworthiness.  Be wary of a transfer provision that requires tenant to notify landlord in advance of a permitted transfer as the acquisition deal may require confidentiality until the sale is consummated.   Tenants should also be wary of transfer provisions that are seemingly favorable but have unacceptable results such as a recapture right by landlord if a transfer is requested (assuming the lease is an asset tenant wished to maintain) or the inability of a transferee to exercise certain rights such as extension options.