Steer clear of the bear traps that could catch out start-ups

Laura Gorman provides a checklist of issues for start-up tenants to consider when finding the right space. Start-up companies and entrepreneurs form a significant part of the UK economy. The October 2018 Budget announced an extension until 2021 of the British Business Bank’s Start Up Loan programme to make it easier for this sector to harness funding. Research by Moore Stephens in the same month revealed a significant increase in the number of “millennial directors” of small- to medium-sized enterprises (SMEs) (directors born between 1981 and 1996 of companies with a turnover of less than £25m per year) in 2017/18, citing one reason as the increased availability of flexible workspace. While start-ups may begin at the kitchen table or in serviced offices, many soon outgrow them. Those that need bespoke facilities (eg laboratories, manufacturing lines or storage) must source these early on from a third-party landlord. Likewise businesses that need larger, exclusive occupation of office space. In some areas there will be plenty of choice of premises; in others competition can be fierce (for example, Bidwells reported that in 2017 the vacancy rate for wet lab space across the Cambridge/Oxford/London “Golden Triangle” was running at less than 5%). Landlords who know how to package their property in a way that appeals to start-up sensitivities will be ahead of the game. Conversely, entrepreneurs who are well informed about potential bear traps in a draft lease can strike a better tailored, more predictably priced deal. Lease length Start-ups, particularly in the scientific or IT field, often derive seed funding from annual grants. If the award is not renewed, they may need to scale-down operations quickly. So a fixed five- or 10-year lease leaves them potentially exposed. However, a contracted-out short fixed term means potentially distracting upheaval if they are forced to move out while business is thriving. Landlords can solve this dilemma by either offering a longer term with regular break rights (eg five years with a rolling break right on three months’ notice after 18 months) or a shorter term with an embedded right to renew on like terms. The former is more popular in the research and development market. Cost predictability, including repairs Coping on a tight budget makes it important for new businesses to plan for overheads. They will look for fixed rents without review, which plays well with a shorter lease term. Bearing in mind the heavy burden business rates can impose, the tenant may also want to fix its contribution to rates as part of an all-inclusive rent, leaving the landlord with the risk if rates rise. If they are taking part of a larger building, or one building on an estate, the tenant will prefer a fixed service charge contribution. The landlord could meet this by offering an all-inclusive rent, a fixed service charge or a capped service charge (which allows for increase within a maximum parameter). All options are potentially dangerous if the landlord has let the rest of the building/estate on a conventional service charge scheme, because they leave the landlord with the risk of a service charge deficit on the start-up’s unit, which it cannot wash down to other tenants. If your start-up company baulks at the cost of a full survey (and its lender is not insisting) you might remind them that the costs of unexpected repairs can soon derail their budget. Where they are taking a lease of whole, it is likely to make them liable for all repairs. It is short-sighted not to assess the state of the building at the outset so they know what costs might materialise. If there are areas of concern, the tenant may ask for clauses to soften the repair burden, such as an exclusion of fair wear and tear, tying the repair obligation to a schedule of condition or excluding that particular item from the tenant’s repair obligation altogether. The last of these is the most suited to a new build, where the well-informed tenant may want to exclude its repair liability (or obligation to contribute to the costs of repair) for damage arising from inherent defects in design or construction. Landlords may offer, instead, a collateral warranty allowing the tenant to sue the architect or building contractor for those defects. This is not an attractive option for a start-up as it involves delay, dispute and legal costs, without relief from the repair costs in the meanwhile. Fitting out – cost, delay and reinstatement Start-ups often take premises that will need to be adapted to suit their business. Technical and scientific companies may need to fit out a lab with specialist, expensive equipment with implications for the building’s common services or EPC (possibly enhanced air conditioning, meaning plant on the roof and in risers; biosecurity entry systems; adapted lighting; etc). It is tempting (but a bad idea) for tenants to rush into completing the lease without also agreeing up front the terms on which the landlord will permit these works to proceed. They may believe the goodwill generated during lease negotiation means the landlord will agree the licence for alterations quickly, post-completion, once the tenant finally produces fit-out plans and specification. This is a dangerous assumption. In a tenant-friendly market, it is the carrot of lease completion that encourages the landlord to agree fit-out works and issue the licence (often without charging extra). Once the tenant is in, and reliant on the alterations clause, they may have less room for manoeuvre on what to propose, cannot easily influence the speed of consent and will have to pay the landlord’s costs. Start-ups also need to think ahead about the cost of reinstatement. Landlords will wish to ensure that, at the end of the lease, the property is left in a state that will not put replacement tenants off (or the tenant pays compensation for dilapidations so that the landlord can fund the necessary refit). The landlord’s focus on this will be more pronounced if the start-up wants to do bespoke alterations (such as conversion to a lab). Connectivity Most businesses need good broadband and telephony. Tech companies all the more so. This means the tenant must check out whether the services to their target building are adequate, or can be improved by bringing in more kit or a new supplier. Where they are taking a lease of part of a building, this can be a lot more complex than they expect. There may be an exclusive service deal with the existing supplier or physical constraints on available space in risers, the roof or communal basement. Tying down an agreement with all the relevant parties to permit what the start-up wants can be a slow process and they will bear the legal costs. Nor can they relax if taking a lease of an entire building. While they will not have to negotiate with other tenants, they may find that a telecoms supplier needs permission (wayleaves) from others for cables to cross their land. So the tenant should always check the quality of mobile coverage in the area and whether telecoms suppliers already have services in the adjacent public road. Fortunately there are relatively cheap standard searches to do this. Speed of deal Understandably, once they have found the ideal property, start-ups often just want to get in and going. The best way to do this is for both parties to be utterly clear with the agents at the start of negotiations. Do not wait until the deal has gone to the lawyers to draw your red lines. Also remember that, if signing up for a building still under construction, there will be an agreement for lease as well as a lease and licence for alterations to negotiate, which will take longer and cost more. As ever, the way to stress-free, quicker and cheaper agreement of property deals for start-ups is “be prepared”. Priorities for start-ups Flexibility of commitment. Start-ups prefer shorter leases, or the right to break early without penalties. Certainty of aggregate cost. With tight cash flow, there must be no hidden surprises. Aggregate cost includes rent and rates but also less obvious costs such as service charge, contribution to common facilities and potential repair costs (based on what the tenant has to repair and what state the property is in). Freedom to adapt the premises physically. Space needs to be fit for proposed use, without delay or cost. Excellent connectivity. No business can survive for long without swift and reliable broadband and telephony, so premises where this is already established, or can be brought in easily, will be attractive. Speedy completion. Start-ups are often in a hurry to get in. Laura Gorman is an associate in the real estate team at Penningtons Manches