The Industry Secret Killing Your Startup in San Francisco
What if I told you as a Founder you’re unknowingly hurting not only your chances of success but your fellow entrepreneurs’ chances of success as well?
What if I told you that as an investor you’ve been turning a blind eye to your portfolio companies’ self-sabotage?
Office space.
Aside from hiring immensely talented engineers the second largest budget item that can do the most damage to a company’s bottom line is an office lease obligation.
But that’s not a secret — or is there more to it?
The market
Normally real estate wouldn’t be such an issue but in San Francisco, our very own “49 square miles surrounded by reality”, office rates have now surpassed the peak of the dot com prices.
Why?
Because out of the 23 billion dollars invested in startups last year alone $11 billion dollars of investment capital went into San Francisco based startups.
And landlords are cashing in.
We know tech has taken over San Francisco’s commercial real estate inventory but it’s the lease terms at which they’ve taken over that has lasting damage to our community.
Here are a few of the terms Founders are signing up for:
- $100 per sq.ft. rents
- 5+ year lease term commitments
- 6 months — 12 months of security deposit
- Personally guaranteeing a lease
- Equity investment options given to landlords
Sound familiar?
You’re probably saying I get it, it’s a tough market but I don’t control the market.
Actually — you do.
“Market rate” is defined by actual lease deals executed between a landlord and their tenant.
But how do you find out about what types of deals are “market”?
The truth about brokers
A Founders job is to grow an idea and build a team (hopefully out of a flexible non-committal type space) — not to know the ins and outs of commercial office leasing.
Cue the expert.
As a Partner at 357 Investments my clients know me as a Connector or Space Consultant but in the world of real estate transactions I’m recognized as a Tenant Representative.
I don’t resonate with the word broker but after having tried the route of shifting the commercial real estate game through the startup world I realized a broker is what I would need to become to help with the evolution of workspace.
Although they often all look the same — in actuality there are two different types of commercial real estate brokers.
Listing brokers
Client = Building Owner/Landlord
A listing broker is hired by property owners to market available spaces and work with the best interest of the building owner/landlord in mind to ensure future listing opportunities.
Any broker that has had their name on a property flyer that is not a sublease from a tenant falls into this category.
Tenant Representatives
Client = Tenant/Company
A tenant representative has no listing agreements with any landlords. These brokers are hired by companies to protect the tenant’s best interest with market knowledge and lease negotiation experience.
The Secret
Less than 10% of the brokers in San Francisco are exclusively representing companies.
Here’s the dirty secret of the industry: when you hire a commercial real estate broker, more often than not, that person has a built-in conflict of interest to work against you.
This would be like hiring a lawyer who also happens to act as your opposing council.
What this means in practical terms is that your lease deal points (rate, term, security deposit etc.) will favor your landlord, not you. Which can result in your company becoming just another “genius” startup that tanks.
Not a recipe for success, right?
But wait — there’s more. Not only are you or your portfolio companies being represented by an expert that wants to get the best deal for their clients, i.e. the landlords, but the same broker will be paid for “representing” your company since they opened the door to show you the office space.
Let’s put that into real life context.
- Joe sees a sign that says “creative space available” on a building.
- Joe calls the listing agent’s number on the sign.
- Joe tours the space.
- Joe signs a lease for 20,000 sq.ft. for 5 years.
- Joe just gave the listing broker an additional $200,000 to his original fee for a lease deal that favors the landlord.
Procuring brokers also known as Tenant brokers are paid $1.50-$2.00 per sq.ft. multiplied by the years of lease term the tenant signs up for.
$2 x 20,000 sq.ft. x 5 year term = $200,000 commission
Now Joe didn’t write a $200,000 check to the listing broker, but the owner did. Unlike residential brokers who get paid a percentage of the purchase price, commercial brokers get paid a flat fee.
This means that there is no direct correlation between asking rate and compensation to a listing broker — hence you and your portfolio companies are creating your own “fair market” with the deals you sign up for.
Adding Value
Now you’re probably wondering well if I didn’t actually utilize a broker in the transaction that “represents me” then I can apply the $200,000 in commission to my lease deal right?
No.
Per Joe’s story above he didn’t utilize a real Tenant broker and the Landlord’s broker instead just took both his original listing fee plus the procuring brokers fee and charged it to the Landlord.
So what can you do to ensure a good deal?
Unfortunately there isn’t a public metric system or “Yelp for Brokers” created yet that provides tenants with a ranking system that speaks to the quality of deals done by each individual broker. Until then you can do the following:
Vet your broker
Ask the right questions before working with a commercial real estate broker.
Do you have any listings?
Vet this instantly to ensure you have someone working on behalf of your team and not pushing listings on you because they can double end a deal.
In your search will you include off market spaces as well?
Good Tenant brokers have a pulse on the market and know when teams are moving out, moving in, subleasing etc. before the space makes it to Craigslist, CoStar, 42floors, Loopnet etc. You could easily do your own search on any of those sites yourself. Adding value to the search process has more to do with leveraging market knowledge of who signed what/where/when and accessing spaces not yet marketed.
Do you or your associates at your Tenant brokerage firm have the same space requirements?
Even if they are exclusively a Tenant brokerage firm, if they have the same requirements for multiple clients (ie. 20,000 sq.ft. of tech creative office space in SOMA) then you’ll end up in a bidding war created by your own broker leveraging his/her own clients against one another for a space. Read your exclusive agreements carefully. Transparency should be a factor in your decision-making process.
What is an example of a great deal you’ve done for your client?
A great Tenant broker should be able to tell you about not only their impressive deals they’ve done in a tough market for their tenants but also about how they have leveraged their own commission to get their client into the space that will be beneficial to the company’s success. For clients of 10,000+ sq.ft. I’ve often put a portion of my commission I’m paid by the landlord back into the deal for my client in free rent, a lower asking rate, a lower security deposit etc.
Speak Broker
As a commercial real estate broker with a background in startups who also happens to be an investor, I can say from experience that when my own skin is in the game I take a 2nd and 3rd review of a legally binding agreement that I know can make or break my investment — an office lease is one of those agreements.
If for whatever reason you decide not to utilize someone else’s fluency in market knowledge or leverage a large sum of money paid to a real estate licensee to your advantage and instead negotiate your own office then at the very least learn how to speak the language.
Why this matters
When bad office leases in San Francisco happen at higher than actual market pricing — there are currently at least three listings at $100+ per square foot per year in SOMA — they not only hurt the company that signed on the dotted line but also set off a chain reaction for owners to expect the same deal be done in their building.
A poorly researched real estate decision not only could prevent a company from living to see year two, but also raises the barrier to entry in San Francisco, prices out other startups/other potential future investments, and hurts our community as a whole.
As entrepreneurs, we all know failure comes with the territory. But if you’re going to fail, don’t let it be because of four walls.
