It’s not uncommon to arrive at an impasse when negotiating the security deposit for a commercial office lease, since it can often be the final business point to negotiate during the proposal process following the landlord’s review of the tenant’s financials. So what do you do when the landlord proposes a security deposit that’s substantially higher than your expectations or capabilities?
It’s first important to understand how the landlord arrives at their determination. To say building owners are somewhat risk adverse is like saying fish prefer to swim in water. Different factors motivate different ownerships, but generally they’re looking for a security instrument that will cover at least a portion of the following in the event of a default:
• Transaction expenses such as brokerage commissions and legal expenses
• Tenant Improvement Allowance / Construction & design costs
• Vacancy loss (as landlord relets premises)
How big that portion is will depend on the tenant’s credit: several factors include the length of the tenant’s operating history, existing debt obligations, burn rate (if investor-backed), profitability and current cash position.
Here are a few solutions you can propose to overcome a deadlock when there’s disagreement in the security deposit:
• Burn Down: Propose a structure whereby the cash security deposit burns down over time, either in the form of a rental credit or a return of the cash. Example: the security deposit amount burns down by one month for every year the tenant makes timely rental payments.
• Irrevocable Letter of Credit (LOC): In lieu of a cash security deposit, a landlord may agree to the tenant securing the lease with an LOC. The main advantage to this is that the cash stays on your balance sheet and is thus deployable for salaries and operating expenses. In the event of a default, the landlord may draw upon the LOC at which point it becomes a liability; however, until then it’s simply an off balance sheet disclosure.
• Cash Security Deposit / Pre-paid rent: This is a hybrid of the Burn Down. Example: give the landlord a one month cash security deposit and prepay 6 months’ rent in advance.
• Good Guy Clause (GGC): This is a great solution for start-ups with limited cash and a short operating history, and landlords who are worried about a costly eviction process if the tenant defaults. Basically, an individual signs a personal guarantee with the landlord that’s terminated as long as the tenant agrees to vacate the premises and leave it in good condition if they can no longer afford to pay rent. Read more about the GGC here.
Even with the above solutions, a landlord and tenant are still too far apart on terms. Revisit the path your landlord took in determining the dollar amount, and consider ways to reduce their economic exposure. Perhaps you could take the premises “as is” and defer tenant improvements until later, or your broker could agree to defer their commission until a later date (personally, I do this for startups often).
Finally, you may simply need to consider a different property with a different ownership structure that is less risk-adverse, or perhaps a co-working space until your company matures (read “Co-working: the good, the bad and the kombucha keg”).
In closing, it’s important to agree to the security deposit early on in the process so you do not waste time if you ultimately arrive at an impasse.