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Negotiating Leases for Start-Ups

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As part of our Emerging and High Growth Companies 101 series we talk about securing commercial leases.

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Negotiating Leases for Start-Ups

  1. 1. Osler Hoskin & Harcourt LLP What You Need to Know Negotiating Leases for Start-Ups October 12th 2017 Paul Morassutti - Osler, Hoskin & Harcourt LLP Matthew Ritchie - Osler, Hoskin & Harcourt LLP
  2. 2. Why is your lease important? • Governs the use of the space in which you run your business, in which your employees work, where your customers or investors come to visit • Like a marriage contract, but with someone you just met and that you have to live with for 5 or 10 years, who has more money and power than you, and does not want to treat you fairly (or with much respect) 2
  3. 3. DOCUMENTS The Deal Terms – Letter of Intent versus Offer to Lease • First step is to settle the deal terms before negotiating the Lease • In Canada, convention is to use a binding offer to lease • Contains the pertinent business terms that will be reflected in the Lease • Once signed there is a binding deal • Offers may have conditions in each party’s favour(e.g. board / senior management approval of the terms, satisfaction with the cost of any tenant’s work that needs to be completed, satisfaction with the Tenant’s covenant) 3
  4. 4. DOCUMENTS • In the US, convention is to use non-binding letter of intent • Tends to be shorter, but landlord can keep marketing the space and can accept a better deal if it comes along • No deal until the Lease is signed, so risk is that the landlord accepts a better deal. 4
  5. 5. DOCUMENTS The Lease • Long, very landlord-friendly, and not very user-friendly • Landlord will provide the tenant with its form of lease, amended to reflect the terms of the offer or LOI, and the parties will negotiate and then sign this form • Once a binding offer is signed, tenant’s leverage (such as it was) significantly decreases • From the tenant’s perspective, it is therefore important to negotiate not only the deal terms but also the most important lease terms at the offer stage • Focus on items that can cost tenant money or interfere with operation of tenant’s business 5
  6. 6. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 1. Financial Covenants • Tenants will need to satisfy the landlord that their financial covenant is satisfactory, which may be difficult for a start-up • A deposit of 2 months’ rent (first and last) is very common • Many start-ups also need to provide a higher security deposit and sometimes a guarantor or indemnifier • Letter of credit or pre-paid rent can also be used 6
  7. 7. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 2. Inducements • Tenant Improvement Allowances, Rent-Free Periods or other credits are all inducements • These are all payments made by Landlords to induce tenants into agreeing to lease space BUT the cost of the inducement, plus interest at above-market rates (currently 8 – 10%), is factored into the rent so the tenant is ultimately paying the cost of the inducement with interest • As tenant is paying for these “inducements”, they should not be forfeited unless the Lease is terminated (ex. not by a transfer or a default that is cured within the applicable notice period) 7
  8. 8. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 2. Inducements (continued) • Tenant must also satisfy certain conditions before payment of the inducement, such as: ◦ Lease is signed and rent payments have commenced ◦ Tenant is occupying substantially all of the premises ◦ No liens have been registered against title to the Building as a result of tenant’s work and the lien period under the applicable construction lien statute has expired ◦ Tenant provides a statutory declaration of an officer stating that all contractors have been paid, together with receipts for costs incurred (if allowance is to compensate Tenant for improvements to the Premises) ◦ Tenant has fully completed the tenant’s work, landlord has approved tenant’s leasehold improvements and same have been carried out in accordance with plans approved by the Landlord 8
  9. 9. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 3. Operating Costs • Landlord will flow all costs of operating the building to the tenants, usually in their proportionate share of the building. • Issues arise when landlords attempt to include costs that are not direct costs of operating the building into Operating Costs. • Usually the biggest ticket issue with Operating Costs relates to the treatment of capital expenses. • There is a list of standard exclusions that a tenant can insert in leases to reflect the guiding principles described 9
  10. 10. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 3. Operating Costs (continued) • For example, if a landlord replaces the roof and it costs $1 Million, how are these costs included in a lease? • The cost of such a capital expense should be amortized over its expected lifespan (in accordance with accounting rules), so the “first year” portion of a capital expense is included in the current year and interest on the unamortized portion, plus interest, of such capital expenses should be included in Operating Costs in future years • Amortizing capital expenses prevents a tenant from being tagged with an enormous expense for capital improvements in the last year of a Lease 10
  11. 11. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 4. Management / Administrative Fees • Landlords will charge a fee to compensate them for handling the day-to- day operation of the Building • Market standard management fee was traditionally 15% of all Operating Costs, excluding realty taxes. • The market standard has been shifting towards 3% – 5% of the revenue “receivable” from the Building (i.e. all rent paid by the tenants, all operating cost charges, etc.) • Some Landlords have a management fee on all Operating Costs (including Realty Taxes) plus an administrative fee on all revenues of the building / development (i.e. a double fee). • Landlord should never have the right to add or amend management or administrative fees during the term. 11
  12. 12. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 5. Repair / Restoration of Premises at End of Term • Leases typically provide the Landlord with the ability to instruct the tenant which leasehold improvements and fixtures to remove or provide that the tenant must restore the premises to base building standard. • Tenants should always retain the ability to remove their trade fixtures and personal property and should try to eliminate end-of- term removal obligations or at least restrict them to non-standard leasehold improvements. • Tenant’s maintenance and restoration obligation should always be subject to reasonable wear and tear. 12
  13. 13. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 6. Relocation / Termination Rights of Landlord • Leases often contain rights that would permit a landlord to relocate a tenant’s space to a different space in the same building • Provides landlord with the ability to accommodate a prospective tenant that needs “your” space • Relocation will disrupt your business, will cost you money and you may get a different layout or external view • Best to delete it, but if you must include it, then insist that the relocated premises should be substantially similar to your existing premises and the landlord should be responsible for providing comparable leasehold improvements in the relocated premises. All direct costs of such a relocation should be to the landlord. • Landlord forms often include a right of the landlord to terminate the lease if it wishes to redevelop a building. This is a right that should be excluded but if it is included, tenants should at least be given a long notice period sufficient to find alternate premises, such as 12-18 months, plus be reimbursed for any of tenant’s unamortized leasehold improvements. 13
  14. 14. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 7. Transfers • Typically drafted to be very landlord friendly. There are several terms that tenants should negotiate: a. Permitted transfers to affiliates and subsidiaries; b. Permitted changes of control – can provide Landlord comfort by stating that tenant will have equal greater Net Asset Value after change of control. Landlords may not agree to this. Emerging companies are often purchased within five years so this is especially material for you; c. Landlord to not unreasonably withhold consent; and d. Landlord should not have any termination rights upon request for consent (a to d should all be described in the Offer to Lease) 14
  15. 15. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 7. Transfers (continued) Tenants should ensure there are no rights in leases that are personal to the Tenant entering into the lease that would cease to exist upon a transfer taking place, such as the right to a tenant improvement allowance, free rent period or right to extend the term of the lease 15
  16. 16. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 8. Insurance • Leases will include a list of insurance requirements of tenants and tenants will be required to pay for the premiums of the landlord’s insurance policies as an Operating Cost. • Tenants should always consult with an insurance advisor to ensure satisfactory insurance can be obtained. • All insurance policies should contain mutual waivers of subrogation so that the insurance company that pays a claim cannot then sue the party that caused the damage of injury. The intention is to have most risks insured by either the Landlord’s insurance or the tenant’s insurance, and with no right of the insurer to come after the Landlord or tenant for reimbursement. This is only fair seeing as the tenant pays for its own insurance, and also pays the premiums of the landlord’s insurance as an Operating Cost • The parties should also indemnify each other for all costs associated with risks for which they are required to be insured. 16
  17. 17. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 9. Events of Default • Tenants should always be given written notice of default plus a reasonable time to cure it • For monetary defaults, a short cure period is standard (e.g. 5 days). • For non-monetary defaults, the cure period should be longer (e.g. 20 days) but provide that the cure period can be extended if such a breach cannot reasonably be cured within such time frame, provided that the tenant is diligently pursuing curing the default and it is eventually cured. • Landlord’s remedies include terminating and suing for the present value of rent for the balance of the Term; distraining against inventory/personal property; suing on the covenant; suing every month 17
  18. 18. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 10. Term and Extensions • Consider the appropriate length of term for your business. Are you entering into a five year lease for space that will only be suitable for the next year? Do you want the right to extend beyond 5 years? • The typical commercial lease term is five years but a shorter or longer term can be negotiated. • Tenants often negotiate the right to extend the term for at least one five year period. 18
  19. 19. TOP 10 LEASE ISSUES FOR EMERGING COMPANIES 10. Term and Extensions (continued) • The extension right should only be conditional on there not currently being a default beyond any applicable notice or cure periods, and not conditional on there not having been a transfer or no default having occurred in the past • The extension should be on the same terms as the lease, except for the base rent, which should either be specified in the lease or should be the market rent, and to be determined by arbitration if the parties cannot agree on the rent. This prevents the Landlord from arguing that they could not come to an agreement on rent so the clause is not enforceable and you cannot extend the term. 19
  20. 20. QUESTIONS? 20
  21. 21. The future of commercial insurance
  22. 22. Main types of insurance 1. General Liability 2. Professional Liability 3. Cybersecurity 4. Management Liability 5. Auto 6. Crime Nothing in this document should be taken as insurance advice or recommendations. This is purely an informational document. Please visit Zensurance.com to get learn more, buy a policy and reach the state of Zen!
  23. 23. General Liability Main Coverages Example claims What to watch out for • Product Liability • Premises and contents • Libel/slander • Non-owned auto • Employer’s Liability (“Workers Comp” for tech) • The hardware device you manufacture catches fire and burns down a house • You accidentally infringe on someone’s copyright • An employee drives to a nearby deli in her own car to buy lunch for the team and gets into an accident • Get flood and sewer- backup – it is worth the extra premium • Property – know how much you are covered for fixed property vs. electronics • Sub-limits. Although you may have a ”$2M limit”, individual items may be sub-limited
  24. 24. Professional Liability / Errors & Omissions (E&O) Main Coverages Example claims What to watch out for • Professional Liability • Third party cyber security (if you are getting a tech policy) • Your accounting software inaccurately calculates a tax liability, and your customer is fined by the CRA • You fail to meet a contractual deadline resulting in a financial loss to your client • Hackers leverage a weakness in your software to hack your customer’s systems • If you are a software company, make sure you get a Tech E&O policy with Privacy/Data coverage • Often customers ask for big limits, but you can negotiate down • Sub-limits. Although you may have a ”$2M limit”, individual items may be sub-limited
  25. 25. Cybersecurity Main Coverages Example claims What to watch out for • First Party (your own costs) • Customer notification • PR support • Business interruption • Fines/penalties • Extortion/ransom • Fraudulent instruction • Third Party (others’ costs) • Your servers are brought down • Customer data is leaked to the public • Your data is held for ransom • An employee accidentally emails out sensitive customer information • Do you have both First and Third party coverage? • The specific coverages included in your policy – this varies a lot • The allowable trigger events • What is required in order for your claim to be honored • Sub-limits. Although you may have a ”$2M limit”, individual items may be sub- limited
  26. 26. Management Liability Main Coverages Example claims What to watch out for • Directors & Officers • Employment Practices (EPL) • Fiduciary Liability • Unfair termination or harassment of an employee • Misuse of investor funds • Bad investment or business decisions resulting in bankruptcy or big financial losses • Seed investors feeling unfairly treated upon Series A funding • Are both D&O and Employment practices included? EPL is very important • Definition of insured • Bankruptcy exclusion – make sure it is not included • Are you covered for employees based outside of Canada? • Sub-limits. Although you may have a ”$2M limit”, individual items may be sub- limited
  27. 27. Auto Main Coverages Example claims What to watch out for • Collision: accident with another vehicle • Comprehensive: colliding with a fixed object • Loss of Use • Rental Vehicle coverage • Your vehicle is vandalized • You hit a deer while driving north of the city • You get into an accident while driving for business purposes • You rent a vehicle for business use and get into an accident • If you have 5 or more vehicles, you may qualify for a “Fleet” discount • Getting a telematics device could help reduce the premium • Don’t confuse this with Non Owned Auto
  28. 28. Crime Main Coverages Example claims What to watch out for • First party (theft of your own property) • Third party (theft of someone else’s property) • An employee skims 1 cent off of every transaction your platform processes • An employee steals all the monitors in the office • Is electronic crime included? • Does the coverage extend to contractors? • Often customers have a requirement for crime by default, but you generally only need it of you deal with physical cash or valuables
  29. 29. Zensurance

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