The office real estate market is exceptionally hot right now for the “creative/open” office space desired by internet and other high-tech companies. Demand in the West L.A. and Santa Monica area far exceeds supply, and this demand is spilling over into secondary areas such as Culver City and the South Bay, and even into the Miracle Mile and Hollywood. The market is going to remain exceedingly tight for a while because very little inventory is coming on line in the near future, and much of that new inventory is already pre-leased during the construction phase. The result is that as a tenant looking for such office space, you will have to move quickly to find and lock up the space. You also do not have the luxury of long, detailed lease negotiations, but you will have quickly address your most important issues to finalize a lease. This article will help focus your attention on the special risks and issues that are raised in the negotiations by an internet company for office space.

Tip 1: Be flexible in negotiating security deposits, letters of credit and guarantees. The most critical issue which needs to be addressed is the creditworthiness of your company. Landlords traditionally have evaluated a tenant’s net worth in underwriting a lease, but with so many new start-up companies, the old rules no longer apply. Companies with little operating history, and no tangible net worth, are demanding, and leasing prime office space. You may have to share detailed information about your business with the landlord to educate the landlord, some of which may be sensitive, and you should consider entering into a confidentiality agreement with your landlord before sharing that information.

Landlords are relying on significant security deposits, letters of credit and guarantees to provide lease security. As a general guideline, landlords will want coverage for all of their out-of-pocket expenses, i.e. tenant improvement allowances and brokerage commissions in exchange for entering into a lease, and, for companies which are true start-ups, will require a large security deposit, usually 4-6 months’ base rent, in addition to the traditional first and last months’ rent. In all circumstances, whether the security is in the form of a deposit, a letter of credit or a guarantee, the amount of the security should properly burn-off over the term of the lease, even after there has been a lease default so long as the default is properly cured. The use of a letter of credit can be advantageous for a tenant: depending upon the tenant’s relationship with its bank, a tenant may be able to negotiate a less than 100% coverage requirement with the bank, making this alternative cost effective.

Tip 2: Explore alternatives to provide adequate lease security. There are other alternatives to make a deal acceptable to a landlord which should be explored during the course of the negotiations. For example, some landlords will require that tenants directly pay for all or a portion of their tenant improvements. A new development is that some landlords are requiring that at least part of the tenant improvement allowance be treated as a separate loan obligation, which can be evidenced by a note, in addition to the standard requirements for security deposits and letters of credit. This gives landlords comfort that in the event of a default they have some certainty as to the amount of damages that they will be able to collect by suing on a separate note in addition to pursuing traditional lease remedies. However, as this is a new development, it is still an open question if these separate obligations will stand, or, if there is a default, if the landlord will have to treat the loan as part of the lease obligation, subject to all of the various state law protections for tenants under landlord/tenant law. From a drafting perspective, tenants must be careful that if the landlord receives money from other sources for the tenant improvements which are the subject of the loan, such as from insurance proceeds, this should offset the tenant’s loan obligation.

Whenever you pay for a portion of your tenant improvements, always insist on a subordination, non-disturbance and attornment agreement (“SNDA”). As a general matter of law, a tenant’s lease will always be subject to the interest of the landlord’s current lender. This means that if the landlord ever defaults on its loan, and the lender forecloses on its building security, the lender will not be obligated to accept the building subject to your lease rights, and could begin eviction proceedings. Under an SNDA, if there ever is a foreclosure, the lender will be obligated to recognize the rights of the tenant, and the tenant will be obligated to recognize the rights of the lender as the new landlord. While we always recommend that the tenant obtain an SNDA, it is especially critical when the tenant stands to lose a substantial financial investment it has made in its space.

Consider the use of warrants and stock options as “sweeteners” for the landlord. There has been a lot of attention given to the fact that in the Bay Area, where the office space market is even tighter than the local market, landlords are now routinely requiring warrants and options from tenants as part of the “bidding process” for office space, and there is concern that local landlords will follow this practice. A tenant considering this option to make a lease deal or to avoid a large security requirement must be cautioned: no amount of warrants and options will make a marginal tenant look like a good candidate in the eyes of a landlord, and in order to satisfy a landlord who is unsure about a start-up company, a tenant may have to give up a much larger equity share in its company that is desirable from a business perspective. Our advice is confirmed by the experiences of many of the commercial real estate brokers in the area who are familiar with the business concerns of internet companies, including Hunt C. Barnett, a leading real estate broker and senior managing director with Insignia/ESG, who routinely points out to his clients that landlords will request warrants and options in addition to, and in not in lieu of, the types of full security coverage described in this article, so that the granting of warrants and options will not make a deal more cost effective for a tenant. A better use of warrants and options is to use them as consideration for special benefits, such as additional free rent, an increased tenant improvement allowance, or access to special services, as some local landlords have already started to do.

Accept delays in certain tenant concessions. Some landlords will delay granting tenant concessions, such as free rent, until later in the lease term to make sure that the tenant will remain in the space long enough for the landlord to recover the cost of the concession. By delaying the costs of these tenant concessions, landlords are more likely to be flexible with respect to other security requirements.

Tip 3: Negotiate rights to expand your space. With the market being as tight as it is, it may be very difficult to obtain any expansion rights. At this time tenants are entering into leases which contain the concept of “must-take” space, i.e. space which a landlord reserves for a tenant that must be taken down by a date certain, usually within 6 months to 2 years of the commencement of the lease. Given the fluid economic condition of many tenants, landlords may require that they approve the financial condition of the tenant prior to the tenant actually taking down the additional space. In such a case, a tenant should negotiate a fall back position regarding extra security or additional letters of credit or other guarantees to make sure that the tenant can still take down its space, notwithstanding any change in its financial condition.

Tenants must carefully review any expansion rights that are offered by landlords. Landlords will try to limit tenants’ rights to expand into designated space by reserving the right to negotiate with an existing tenant in the designated space, even when the existing tenant does not have an extension option. The reason for this is that it is much cheaper for a landlord to negotiate with an existing tenant already located in its space, than to have to build out that space to meet a new tenant’s requirements. Therefore, even though a tenant may expect, for example, that its neighbor’s space will be available when the neighbor’s lease expires, this in fact may not be the case. Landlords may also try to impose additional restrictions on the location and size of the available expansion space, and also on the timing of the exercise of those rights.

Be careful if you plan to lease extra space now and try to sublet it until you are ready to use it. Landlord’s routinely put “recapture” provisions in their leases, allowing them to take back any space that is the subject of a proposed assignment or subletting, on the grounds that it is the landlord, and not the tenant, that is in the leasing business. This puts the landlord in direct conflict with a tenant which is trying to “space bank” its square footage to accommodate future growth. Strategies that a tenant can take include limiting the time period when the landlord can exercise its right (say after the third year of the lease) to allow tenant enough time to move into all of the space or placing a threshold on the space that the landlord can recapture (say any space involving more than 50% of the tenant’s space) when it is likely that the tenant is looking for an exit strategy instead of trying to reserve space for itself..

Tip 4: Make sure your rights to assign your lease conform with your business plans. Landlords’ routinely allow tenants to freely assign their leases to affiliates, but often reserve the right to approve any reorganizations or sales of, or other changes in the control of, their tenants. Tenants should try to have these consent requirements deleted to prevent landlords from delaying, or conditioning, any sale of the company, any major capital investment or even any initial public offering, especially where these are planned in the near future for a start-up company. All extension rights, expansion rights, termination rights, signage rights, rights to satellite dishes and other special rights should be available to all successor tenants by reorganization, sale or merger.

Be careful if you plan to let other start-ups “incubate” in your space. One unique aspect of internet companies is that these companies often fund, develop and oversee other start-up companies, which do not necessarily fit the strict definition of affiliated or related companies under their leases, in order to explore and develop new business ideas. Ownership and management control of the tenant may not be substantially identical with the ownership and management of these other start-ups and therefore may not be automatically permitted under the lease.

Tip 5: Negotiate an exit strategy. In the event your company will need to expand, or is bought out and will need to move, it may be wise to negotiate a termination right. Landlords will usually require a significant notice period, for example, 4-6 months’ notice, as well as a significant payment, usually equal to the value of the unamortized tenant improvement allowance and brokers commissions, as well as certain compensation for “down time,” such as 2-6 months’ of base rent, in exchange for the right to terminate the lease early. A termination right can be a very expensive option, but it provides a tenant with certainty in the event it must move, and it avoids drawn out negotiations with the landlord regarding any early termination.

Tip 6: Have a clear understanding of what your “use” will constitute. Often tenants and landlords have completely different understanding of what comprises a “general office use.” Phone banks, special call centers, service centers, recording studios, screening rooms and other types of intensive computer use may not be what a landlord had in mind for your space. Landlords have legitimate concerns regarding the intensity of various uses, the appropriateness of such uses for a particular building, and the potential for wear and tear on a building and its equipment systems. Given the high-tech nature of internet companies, and their common desire to operate on a 24-hour a day, seven-day a week basis, some landlords are now imposing occupancy and/or density restrictions.

Tip 7: Evaluate your utility requirements. Internet company tenants have a reputation for long hours of operation, and tenants are rightly concerned about charges for excess electricity use and after-hours HVAC. Most landlords now provide an allowance for electrical usage, usually based on a rate of certain kilowatt hours per each normal business hour, calculated on an annual basis. This means that you will not be charged for all electricity usage starting at 6:01 P.M. each day, but your landlord will reserve the right under your lease to install a separate meter, and charge for excess electricity usage. As a practical matter, landlords have not often actually required separate meters, except in the case of special purpose areas, such as special computer centers or 24-hour communication centers. When the landlord does charge for excess usage, the cost should be landlord’s actual cost, without profit or overhead.

The cost of after-hours HVAC usage should also be addressed in the lease, and should be based on landlord’s actual cost, without profit or overhead. Given the intensity of a tenant’s use of its premises, the tenant may evaluate the desirability of installing separate HVAC units for its space. This may be costly, especially if “base building “work needs to be done to the landlord’s building to accommodate the units.

Tip 8: Evaluate your requirements for satellite dish/ antennae facilities and access to riser space. The ability to locate a satellite dish or other antennae facilities on the roof or elsewhere on the landlord’s building is a valuable right and many landlords are now requiring a special license fee for this right. Most importantly, landlords will require that they be completely released from any liability related to the use of those facilities, except for actual damages that they may directly cause, and will, in all instances, not be responsible for lost business profits. A tenant will have to look to its own insurance for this protection. In addition, a tenant may have special cabling needs for video conferencing, etc., and the tenant should make sure that the building has the capacity to accommodate this cabling. Given the extensive cabling requirements of some tenants, landlords now carefully review the installation and labeling of all cabling, and often require that it be removed at the end of the lease. The most important issue to address in connection with these facilities is security concerns. Tenants should insist that landlords spell out their procedures for accessing the facilities and any special emergency procedures.

Hopefully this article will help you in reviewing lease proposals and focusing on the issues which are of the most importance to you.

Lee Silver and Sylvia D. Lautsch are with Ervin, Cohen & Jessup LLP.