You’ve outgrown your co-working space. Now what?
Wondering how to navigate a commercial lease? LUNA’s own Hana Lee breaks down 5 key commercial lease considerations for startups.
Your MVP is out, revenue is trickling in, your team is growing and you’re looking for an office space to call your own. Congratulations on making it this far in your growth journey!
Many startups express hesitation about committing to a commercial lease, and it’s daunting to find and negotiate a leasing arrangement on your own.
On the flip side, growing into your own space is an exciting step forward. Finding a permanent space for your company gives you a base to cultivate your company’s people, culture, and products. Occupying your own space sends a strong message to employees and investors alike – I’m here to stay!
If you’re a startup considering moving into a more permanent location, we’ve got 5 tips to help guide the conversations you’ll be having with real estate agents and prospective landlords. Let’s break them down:
1. How long is your lease?
Commercial leasing agents will often describe the duration of a lease using phrases like “5x2x2” or “5+2”. Don’t worry, they aren’t asking you to do arithmetic. Lease durations (also known as the Lease Term) are split into two categories – Initial Term, and Options to Renew (if any)
Typically, the formula is:
[Initial Term] * [Number of Options to Renew] * [Number of years per Option to Renew]
In the case of a 5x2x2 lease, you would be offered:
one Initial Term of 5 years; plus
2 Options to Renew of 2 years each.
In the case of a 5+2, it would be:
one Initial Term of 5 years; plus
1 Option to Renew of 2 years.
The Initial Term is the duration that you are 100% committing to staying when you first sign the lease. If the initial Lease Term is 5 years, you are contractually obliged to stay at the premises and pay rent for 5 years.
What is the Option to Renew?
An Option to Renew is a right to stay in the premises for an additional Lease Term, which may or may not be the same amount of time as the Initial Term. As a tenant, you will generally have the right to decide whether you’ll exercise an Option to Renew (although in some cases, you may need to satisfy some requirements as set out by the landlord in the Lease, for example balance sheets for the last financial year demonstrating good financial standing ).
When can you exercise an Option to Renew?
If you choose to exercise an Option to Renew, you will need to do so during the last year of the Initial Term, usually between 6 months and 3 months from the end date of the Initial Term. Landlords have an obligation to notify you of these key dates, but we recommend diarising important dates in advance, just in case.
Keep in mind that in some jurisdictions, there may be a statutory minimum Initial Term. In Victoria, for example, any lease where the Retail Leases Act 2003 (Vic) applies will have an implied minimum Initial Term of 5 years. This gives tenants the benefit of a secured lease, without the fear of being kicked out of your premises only a couple years in. If you want a shorter Initial Term, however, it is possible to get a waiver to shorten the implied minimum Initial Term.
(For more information about protections under the Retail Lease Act 2003 (Vic) see this factsheet by the Victorian Small Business Commissioner).
Also, it is standard for market rent reviews to be conducted upon the exercise of a further Option to Renew, so you will need to be prepared for increases in rent in line with market rates at the time of renewal.
☝🏻 Hot tip:: Negotiate your lease term. You may want to have a shorter Initial Term, and longer Options to Renew, to test out how the premises work for your business. Or you may want to negotiate 2-3 Options to Renew, to guarantee that you can stay in the premises for 10-15 years if all is going well. Either way, the lease term is a key negotiating point and should be discussed with your team and with the leasing agent, to make sure the terms align with your company’s long term strategic goals.
2. All things cash money
Rent is often the second biggest expense for a company, after wages. You want to be sure there is enough money in the bank to pay your rent every month. But that’s not all.
In addition to rent, tenants in commercial premises pay heaps of other things which we’ve so kindly laid out as categories & examples for you below:
Outgoings — Council rates, utility bills, body corporate fees
GST — Payable on top of rent and outgoings, and most other amounts payable under the lease
Essential safety measure fees — Fire alarm tests, sprinkler system maintenance
Bond — Usually 1-4 months rent + outgoings, held as a bank guarantee
Legal costs — Reimbursing legal costs incurred by the landlord when granting approvals for things like extra fit out, transferring leases or granting subleases
Repair and maintenance costs — Yearly AC maintenance and 5-yearly repainting of the premises are standard terms
Rental increases — Fixed yearly increases, CPI increases or market rent reviews
As you can tell, the financial commitment of a lease is much greater than the monthly rent amount. The bond payment at the start of the lease, for example, means you will need a sizable chunk of cash to park away for the entire Lease Term.
The list of additional and unforeseen costs can quickly add up. Forgetting to take GST into account means you may blow out your budget by 10%. Failing to take a market rent review into account might mean your financial forecasts for the year ahead are way off the mark. You get the point.
Disclosure Statements to the Rescue
Fortunately, most jurisdictions require landlords to provide you with a Disclosure Statement prior to entering into a lease. The Disclosure Statement will set out estimated, or actual, costs incurred for outgoings, maintenance, rental increases, and other need-to-know information about the premises.
You can also try to negotiate caps on amounts payable under the lease for things like the landlords’ legal costs or AC servicing costs. Raising these items as sticking points early in the negotiation can often lead to better outcomes in the final lease agreement.
☝🏻 Hot tip:: Ask for a Disclosure Statement before agreeing to anything, check the figures and make sure you build in a healthy margin for lease expenses in your financial forecasts. Where possible, negotiate caps or fixed prices for lease-associated expenses.
3. Director’s guarantees and indemnities
As a startup, a lease might be your first (or only) major contract where a director’s guarantee is required. A director’s guarantee has serious implications for you personally as a director, so it is important to read the proposed guarantee in detail before you sign a lease.
Lease guarantees are often non-negotiable and are usually a “guarantee and indemnity” rather than just a guarantee. They ensure that the Director is personally liable to repay any costs that the company incurs under the lease and fails to pay (regardless of if the Landlord suffers loss or not). The Director can also be pursued separately to the company to repay these costs, even if the landlord hasn’t demanded repayment from the company first (not ideal and definitely scary.)
This means the personal assets of a Director will be at-risk if the company tenant doesn’t meet their obligations under the lease. Plus, if there’s a change in directorship, the landlord will often be required to give consent to change the lease, to replace the outgoing director’s guarantee with the new one.
☝🏻 Hot tip:: Signing a director’s guarantee puts founder-directors personally in the line-of-fire if anything goes wrong with the lease. When in doubt, obtain personal legal advice to understand your obligations.
4. Read the fine print
When you are negotiating a commercial lease, you can expect to go through some or all of the following steps:
1. Inspecting premises;
2. Filling in application forms or expressions of interest for a specific premise;
3. Negotiating a Heads of Agreement or lease offer document outlining major terms of the lease;
4. Reviewing the prepared lease agreement and disclosure statement; and
5. Signing, fitting out, moving in and lease commencement.
While big ticket items like the Lease Term, rent amount and initial fit out are discussed during the third stage, there are many ‘fine print’ items that are included as standard clauses in the actual lease agreement, which is not presented to you until after an offer document is signed.
It’s ideal to anticipate these ‘fine print’ items and negotiate a better position for yourself in step 3, but many prospective tenants find that there’s no opportunity to do so. It’s also difficult to negotiate terms when you don’t know they exist!
Some common ‘fine print’ items you may see in the actual lease agreement are:
Requirements to show revenue on an ongoing basis, if you are located inside of a shopping centre;
Demolition and relocation clauses;
Requirements to repaint, refinish or maintain the premises (including landlord installations);
Lengthy (and costly) landlord approvals processes if you want any additions such as external signage;
No guarantee of allocated parking spaces, even though the premises has a car park;
Restrictions on use of common areas outside of specified hours;
Additional costs payable for using the premises outside of business hours; and
Restrictions on use of the premises.
Lengthy and crazy, but true.
Capping lease-related costs is a big sticking point. As we said in tip #3, we recommend that you obtain a copy of the disclosure statement as soon as possible instead of waiting until the lease documents are prepared, so that you have an early idea of the total costs payable.
☝🏻 Hot tip:: Familiarise yourself with the ‘fine print’ items as early as possible in the lease negotiations.
5. Negotiate incentives
Even though it might feel like you are on the back foot of negotiations as a prospective tenant, keep in mind that securing a good tenant is a huge win for commercial landlords. Easy going, well-paying and long-staying tenants is a key source of consistent revenue for commercial landlords.
Don’t be afraid to negotiate ‘deal sweeteners’ when looking around for prospective office spaces. Asking for 1-3 months free rent at the start of a lease is a common ‘ask’ and can help you get settled into a new location while you make the place work for you.
For example, say you are a small batch micro winery, and you’ve found the perfect location in a warehouse in Abbotsford. The only problem is the premises are currently set up as a beauty salon.
Landlord contributions to fit out is another common negotiating perk (fit out is real estate speak for ‘what’s inside of the premises’). If the premises had to be completely renovated on the inside to fit your purposes, you can ask the landlord to contribute to the cost of making the premises work for you. One thing to note, however, is landlord contributions to fit out may include a clawback clause if you terminate the lease earlier than the agreed Initial Term.
Leases also include a ‘make good’ clause which means you need to put the premises back to the way it was when you first entered the lease. If you drastically fit out the premises, you may find that you are caught out at the end of the lease with a huge bill for renovating the premises back into a beauty salon. But don’t worry – you can also negotiate the extent to which you need to ‘make good’ the premises when you leave.
Try to be creative in your negotiations with a commercial landlord. Some of them will be receptive to providing things that may be of huge benefit to you, but little cost to them. Ultimately, you are guaranteeing rental income for the landlord for the entire Lease Term, and there’s no harm asking for some perks in exchange for your long-term commitment.
☝🏻 Hot tip:: Be creative and negotiate incentives.
Entering into a commercial lease (like many other decisions that you make as a startup) can be daunting – but it doesn’t have to be.
If you’ve got questions on preparing, negotiating or reviewing a commercial leasing arrangement, get in touch.
By Hana Lee
