How a bad lease can bankrupt your small business!

A friend of mine was recently hired as the CFO for a struggling young technology business.  After about a week on the job he called me for some advice.  He knew I had a lot of experience in commercial real estate..20 years to be exact...and he feared he had a big problem with the company's office space lease.

I picked up a copy of the lease, and by page two, I knew this was no small problem.  This start-up company had unwittingly made about every mistake a small business can make when leasing space for a new business...and now, it could bankrupt them.

It all started when the business founders were happily funded by a venture capital company.  They needed space in a hurry, and one of the founders knew of a great building close to his home. They called the broker on the "for lease" sign (who always exclusively represents the owner) and began negotiations on the space.  It was a tight market, they needed space in a hurry, they were really smart computer programmers, they negotiated a lower base rent, then signed the lease. 

When the first rent bill came in, they were stunned. 

You see, there was a little clause about operating expenses in the lease that they did not fully understand.  This was a 20,000 square foot building, they leased the entire first floor and were occupying 50%..or so they thought.. but the first floor, where they were leasing the space also contained the elevator lobby, the front entrance, a two-story atrium with a glass roof that leaked energy like a bucket with a hole in it and a huge kitchen..big enough to cater a wedding.  Actually, when they started placing the furniture, they really only had about 7,000 square feet of usable space, and 3,000 square feet of "other" space.  Not only did they have to pay the base rent of $40 a square foot on the usable space, they had to pay $40 a square foot on the lobby, kitchen, and atrium space.  In addition, they were paying 50% of all the operating expenses of the entire building...another $14 a foot on ALL 10,000 square feet, which by the way was exceptionally high, but since they did not have the right to audit the charges, they had no option except to pay them. 

To make matters worse, since the top half of the building was vacant, the owner's lease called for them to pay 100% of the utility and HVAC (heating, ventilating and air conditioning) bills, because clearly, they were the only one using it!  When I sat down and did the math with them, they found out that on a usable square foot basis, they were paying almost $72 a foot all in. Ouch! And to add insult to injury... they had signed a 10 year lease with annual rent escalations of 3%.

About two years into the lease, business was not doing a well as planned, they actually downsized and could fit into 3,000 square feet.  They could sublease their space, but the market had dropped to around $32 a foot and....they were paying about $75 by now.  If they subleased the space, they would have to pay brokerage commissions, and construct demising walls and entrances to separate their business from the sub tenant's.  Actually, they would lose money subleasing the space.

We tried everything to help them.  But the lease was so one sided, they had no option.  We spoke to the Landlord, but his position was that he had nothing to lose by doing nothing.  He had personal guarantees from the business owners, so even if the company went out of business, he was going after them personally for his money.  When the venture capitalists learned of this situation, they pulled their funding, and unfortunately, the company declared bankruptcy.

While this is an extreme example of how a bad lease can kill a small business, many small business owners fall victim to unfavorable lease terms every day.  In fact, small business owners are more likely to have bad leases than big companies.

Big companies have in-house real estate departments and experienced legal representation, plus the best brokerage representation in the business.  Commercial brokers get paid a percent of the space leased, times the rent paid, times the term of the lease.  They get paid a lot of money for a large company lease.  Small commercial leases, with short lease terms pay very little, so it is frequently difficult for small business owners to get the most qualified commercial brokers to represent them.

After 20 years in the business, I decided that small business owners needed a resource that would help them understand the complex nature of commercial real estate lease clauses. www.mysquarefeet.com is the website I started where small business owners can go to get basic information (for free) on leasing commercial real estate, such as: calculating the amount of space needed, measuring space, hidden expenses, working with brokers and selecting a team to help.

I am also starting this blog, so small business owners can post their commercial real estate stories.. good and bad.. and hopefully help other entrepreneurs avoid problems. 

Give me your feedback, ask your questions, and submit your stories.

Comments

[MySquareFeet]

MySquareFeet responds: Good idea, we will try to provide definitions for technical terms in the future. We cover many of these definitions in our "Leasing Guide" on our site at www.mysquarefeet.com.

[katty]

If you are going to write about leasing info you should include the technical terms so that lay people will better understand their contracts. ie: talk about ratios,rates, commom space( this is not unusable space, this is space shared by everyone) etc.Good luck, nice idea.