THE PITFALLS OF PROPERTY LEASES
Every entrepreneur who starts a business is focused (or should be focused) on the usual things—product, production and labor costs, and marketing, among many others.
Those are all perfectly valid concerns. But one other issue tends to fly under the radar of many entrepreneurs’ attention: property leases.
At first glance, that may seem like a relatively minor concern. After all, property is nothing more than a place to conduct business. If you have a place that suits your purposes, what else is there to worry about?
A lot.
This goes back to an issue I raised in the prior chapter. When planning for the future, it’s natural for entrepreneurs to map out plans they fully expect to run like clockwork—a complete and unqualified success. Most likely, no entrepreneur in the history of business has ever started something without utter confidence that the venture would move forward and flourish.
But it’s equally valuable to draw up a plan B of sorts—one that turns out significantly less successful. Again, that’s something you should feel free to keep to yourself, though it’s essential to anticipate what things will be like if, by chance, your business struggles or, even worse, fails to survive.
That’s where property leases can come into play, and not necessarily in a good way. If your business does struggle or go under completely, and you decide to give up (in my view, something that many businesses do way too early, but we’ll get to that later), what happens to the property you were leasing for the business?
If you haven’t been proactive, you keep on paying. That’s what can happen.
Think about that for a moment. You may be paying a relatively small amount to lease property—say $5,000 a month—on a five-year lease. If things go bad and you’re forced to close, everything comes to a sudden halt—except for your lease payments. If you’ve been in business for two years and shut down, that’s $5,000 a month for the next three years—$180,000—that you may have to keep paying, even though your business is long gone, all because the landlord hasn’t found a replacement tenant.
What many entrepreneurs fail to realize is that leases can be comparable to taking out a bank loan. Regardless of what happens, you owe that money, and the bank—or in this case, the landlord—is going to make certain you pay it.
If you try to refuse to pay what you owe, watch out. Like any lender, your landlord can bring a suit against you and garnish any assets you have. They have every right to collect what’s owed them, like anyone who loans you money. Signing a lease is exactly like signing a promissory note. When you put your name on the lease, you’re guaranteeing that you’ll pay what’s owed on that lease.
It goes without saying that this situation can cripple you financially for years to come. For instance, if you shut down your business at an outside location and try to keep it going in your home or garage, you’re still burdened by a lease payment for space you no longer use. Thinking about giving up on the old business and starting something completely new? Again, you’re going to have to do it with a financial burden hanging over your head—often a very significant one.
LISTEN!
Fortunately, the situation doesn’t have to turn out that way, but you need to know a few strategies before you sign on the dotted line. First, try negotiating a clause that allows you to cancel your lease if revenue projections haven’t reached a certain goal by the six-month or one-year anniversary of the lease.
Another choice is a buyout clause. This gives you the option of paying to terminate your lease if your business isn’t generating sufficient revenue to afford the expense. The downside is that a buyout clause can be expensive, maybe as much as fifty cents on the dollar of the amount owed for the remainder of the lease. This can depend on prevailing market conditions and how confident the landlord is about finding a new lessee to take your place.
As another form of protection, pay attention to the length of the lease. First, if you’re just starting out with a relatively new business, a long lease can be a bad idea—the longer the lease, the longer your liability if your business doesn’t succeed. The general rule of thumb in terms of shielding your liability is the shorter, the better.
Of course, a landlord may not be particularly enthusiastic about a short lease. He or she wants as much security as possible, so any tenant is locked in for the longest time possible.
This can be addressed by a lease with term options. For instance, you agree to an initial two-year lease with more options to renew when that time period ends—for example, options of two or three additional years. While that gives both you and your landlord additional flexibility, understand that the landlord will likely insist that any additional options will mean an increase in the rent you pay every month.
If you’re looking at term options, negotiate them in your favor. For example, make it clear in your lease agreement that you’re the one who has the right to exercise the additional term options, meaning that your landlord has to agree, as long as you stick to the requirements outlined in the lease terms.
Another strategy is making certain you have the option of finding someone else to sublease the property if you can’t make a go of it. In this situation, somebody else effectively takes over your lease, freeing you from further financial responsibility. To avoid problems, ensure your lease says your landlord can’t unreasonably refuse to consent to a new tenant who’s financially qualified.
Of course, this is all part of doing your due diligence before signing a lease. Get a sense of the rent on comparable properties, to make sure your financial commitment is in line. Understand all the costs tacked on to the lease payment itself. Review any stated increases in lease payments, as well as your obligation for utilities and other expenses.
Lastly, it’s never a bad idea to work with an experienced real estate attorney to address these and other issues. That can make your lease a valuable component of your business rather than a needless liability.
TILMAN’S TARGETS
• Make certain you understand how to get out of a lease early, including buyout provisions, subleasing, and other options.
• In general, look for a short-term lease—ideally, with renewal options that you can choose to exercise.
• Know all costs associated with a lease.
• Work with an attorney experienced in commercial real estate to help negotiate the best possible lease package.