Start-ups are always confronted with how much space to lease and for how long, and whether a landlord is going to approve their credit (and discover the start-up has no real credit, given the burn rate). Coupled with this is the inherent desire to limit exposure to real estate—meaning the cost to build out space, the longer term required for a direct lease, and the risk that you have taken down too much space or taken down too little space, or have picked the wrong location. While incubators may be good for some companies, it offers little in the way of privacy and there is an inherent cost in the stock warrants that the incubator may require.
The alternative is the “sublease.” A sublease is a lease, and the company, as a “subtenant”, has the same obligations that a tenant has under a lease. The only difference is that the subtenant’s landlord (usually referred to as a “sublandlord”) is itself a tenant under a “master lease”—or a direct lease with the owner of the building—and you, the subtenant, generally have to assume all the obligations of your sublandlord under the master lease. At first blush, that makes it seem even more burdensome—not only do you, the subtenant, have obligation to your landlord under the terms of your sublease, but because your landlord is also a tenant under a lease, you have to assume the obligations of your landlord, as the tenant under the master lease. In actuality, these obligations are simply the normal obligations you would have to assume under any lease. And the benefit to you, the start-up, is that you are leasing space that is already built out, and in most cases you get to use the furniture and kitchen that is already there, and you get to use the fiber and voice and data infrastructure that is already there. All at a large savings to you. Why? Because in most cases you are subleasing excess space from another company—a company that may be further along in its life cycle than your start-up, and that has excess space, and is willing to sublease the space for a cost that is less than the market rent that you would pay if you enter into a direct lease with a landlord. And since your landlord has already sunk the money into its furniture and equipment, it is only trying to recapture a fraction of that cost from you, the subtenant.
In addition, while credit is always important, your landlord, the subtenant, is usually going to scrutinize your credit to a lesser extent than a direct landlord. Why? Because it is incentivized to cover its obligation under a larger lease—under which it is already responsible and is willing to take a bit more risk than a landlord in the business of renting space. Finally, sublease terms come in a variety of flavors—there is much more flexibility in a sublease than the standard 3 or 5 year term that a landlord is willing to offer. The reason is simply that tenants decide to sublease for a variety of reasons at different stages in their lease and therefore the available periods of occupancy are much greater in the sublease market than in the direct lease market.
Yes, there are issues to consider in a sublease—the biggest risk is that you, the start-up subtenant are at the mercy of your landlord’s performance under the master lease. In other words, if you only sublease a portion of your sublandlord’ s premises, and your sublandlord, as the tenant under the master lease, defaults under that master lease—your sublease is at risk and can be terminated. While there are some legal strategies that can be adopted that minimize this risk, those are not common place. Therefore, taking over an entire lease—as a subtenant—is sometimes preferable, unless you can get comfortable with the creditworthiness of your sublandlord.
Getting direct contact with the master landlord—the owner of the building, can also be difficult, because the owner of the building—the master landlord—is not in contract with you, the subtenant. His contract is with your landlord, as the tenant. Again, there are legal strategies that can be put in place and those are generally much more effective and common place.
Lastly, remember that in the large majority of cases, a sublease requires the consent of the “master landlord”— so your landlord, who is a tenant under a master lease, is obligated by the terms of the master lease to get the master landlord’s consent, and that consent is an important pre-condition to the effectiveness of the sublease. In most cases, the lease governing your landlord’s occupancy of the premises will provide that the master landlord will not unreasonably withhold consent to a sublease.
The bottom line is that a sublease is common for startups, and the legal strategies that can be put in place can minimize many risks that are inherent in the sublease structure. A sublease is a worthwhile alternative to a direct lease and does reduce a company’s exposure to real estate. Subleasing can present the right opportunity for your company, and real estate brokers get a commission just like in a lease, and there is usually a letter of intent that sets out the general terms of the sublease, just as in a lease. We recommend that you have a lawyer review the master lease before you enter into the sublease, and have a lawyer draw up the sublease document. Attorneys in the Firm’s real estate group are expert in these types of transactions.
This article originally appeared in Inside Counsel Magazine