As you may already know, I spend a good deal of my time representing startups, particularly tech startups in their search for office space in New York City and beyond. I've represented companies like Facebook, eBay, and adap.tv among others.
The recurring question I am asked by these companies when we search for space is, "how do I sign a long term lease when I could have double the employees in a year?" This is an interesting question, and depending on the tenant, there are many ways to answer it. The best answer is not always (as my clients often think) to find the shortest term space possible. There are several issues with short term space:
1) Many landlords will not sign short term deals, so you are limited in the number of buildings you can look at.
2) To find a short term deal you may have to take a sublet from an existing tenant. Sublets bring additional risk exposure and provide more limited rights within your lease.
3) In a down market (like we're in now), short term deals leave you vulnerable to where the market may be when your lease term is up.
4) A short term deal generally results in a space that is not customized to your liking. Whether you are doing the work yourself, or getting work done by the landlord, it's challenging to amortize a full build-out over a short term lease.
5) Signing a short term deal means incurring moving costs multiple times in a short time period. Moving costs can be substantial. Think about, IT and phone wiring, phone systems, packing, movers, furniture cost and assembly/disassembly, letterhead, employee downtime, etc., etc.
Despite the downsides to a short term deal, there are several benefits:
1) You can meet your short term needs without limiting your long term growth plans.
2) Short term sublets are generally much cheaper than direct leases. In fact, the shorter the sublet the cheaper it is.
3) In an up market, you may see a weaker market when your lease is up.
It is important to weigh these pros and cons, but also to think about other ways to accommodate growth. Here are some common tactics:
1) Right to Terminate: Negotiate a long term deal with a landlord, with the right to terminate after x years with y months notice. A provision like this will let you get out of your lease early to accommodate your growth, but allows you to lock in a favorable lease rate for a long term and have the peace of mind that you won't have to move to soon. However, there is a cost to a termination provision. The landlord will often insist on a penalty at the time of termination. This penalty commonly includes the costs of unamortized landlord's work, unamortized brokerage commissions, and perhaps up to a few months of rent.
2) Right of First Offer (ROFR): Negotiated term that gives you the first right (but not obligation) to lease any space that becomes available in the building when it is available. Generally "small tenants" do not get this right unless they are relatively large given the size of the building. However, variations of this right are more common. Perhaps the landlord will give you the right to any space that becomes available on your floor, or is contiguous to your space. Or perhaps, you can have the right of "second offer" because another tenant already has the right of first offer.
3) Right of First Refusal (ROFR): Similar to the Right of First Offer, the tenant has the right to space that becomes available. In this case, the landlord can negotiate a deal with another tenant. Before signing that deal, the landlord is obligated to offer the same deal to the existing tenant with the ROFR. ROFR is very uncommon as it puts a very tough restriction on landlords that a landlord will be reluctant to incur. It also makes it difficult for the landlord to negotiate with other future tenants in good faith, as those tenants may not be willing to negotiate a deal if there is a chance they will lose it to the tenant with the ROFR.
4) A Put Option: If you know that a particular space in a building will be available during the term of your lease, you could negotiate a put on that space that will obligate you to take it (at a pre-negotiated price or Fair Market Value) when the space becomes available, but you will be guaranteed to have that expansion space, and you will be able to plan for it. Again, this is uncommon, as it is restricting and somewhat risky for the tenant.
5) Early Termination with Expansion: A variation of the right to terminate on a specific date, is the right to terminate with expansion in a given building or with a given landlord. A tenant that is growing quickly but is not large enough to negotiate a Right of First Offer may choose a right to terminate early if they expand with a specific office building, or within the portfolio of buildings owned by a landlord. In this case, there will likely be little or no penalty assuming that the tenant moves into a space that is x percent larger or x percent more in rent than the space they are already in. This is a win/win for the landlord and tenant, as the tenant gets out of their obligation for their existing space, and the landlord leases a larger piece of space. As noted below, from a practical standpoint, a landlord may be willing to accommodate this request without a specific provision in the lease, but the provision never hurts.
6) Renewal Option: Similar to a Right to Terminate, a Renewal Option (or multiple renewal options), allows you to accommodate growth without committing long term. A renewal option can be negotiated with a set rental rate for a set term at the time that it is exercised. More commonly, renewal options are at "Fair Market Value" (FMV) or a percentage of "Fair Market Value" (often 95%). I put Fair Market Value in quotes, because at the time of renewal, determining FMV is often tricky, and landlords and tenants rarely agree on what FMV should be. Often the determination of FMV is disputed, and the decision is left to an arbitrator which is paid for by the tenant and the landlord.
7) Choose Your Landlord Wisely: A smart broker and a smart tenant will lease space with a landlord with a good reputation, and with good business sense. If you lease space in a building with a reputable landlord with a lot of space in their building or in their portfolio, the landlord will do everything in his/her power to accommodate your growth. Tenants that pay their rent on time and are growing quickly are incredibly valuable to landlords. If they're smart, they will do what they need to do to not lose you.
8) Choose your Building Wisely: If you expect that you will need a very large piece of space in a building in the next few years, it may be wise to lease now in a building that a large tenant is expected to vacate in the near future. For instance, Facebook recently leased 40,000 sf in 335 Madison Avenue (Bank of America Plaza). Bank of America leases about 200,000 sf in the building, and their lease is set to expire at the end of 2013. It is expected that B of A will be vacating their space at the end of their lease. This could be a great opportunity for Facebook to become an anchor tenant without having to make a fourth office move in New York City.
9) Take a Calculated Risk: As you may have figured out, many of these options presume that the tenant has significant leverage over the landlord. If you are a large tenant in this market, you often do. However, small tenants often do not. Despite the fact that we are in a down market, small space is still in short supply, and small creative spaces preferred by start-ups (wood or concrete floors, exposed ceilings and duct work, high ceilings, etc.) is even harder to come by. With that in mind, small tenants do not have a lot of leverage. This doesn't mean that you should definitely not make a long term deal. If you believe the market will be stronger at the time you may want to vacate your space, you can sign a long term deal, and hope to at lease break-even when you sublease. Of course, if you need to sublease your space due to growth, this will be what we call a "champagne and caviar" problem. If you don't need to, you will be happy that you're locked into a long term deal with a favorable lease rate.
I hope this lends some clarity into the process of planning for a quickly growing company. Of course, there many other elements to consider, and nuances to each of these scenarios, but these are the major points to keep in mind.