Policies to fix startup office space, attract companies to cities
Tech Tuesday: Incubators are only scratching the surface — political leaders need to understand the dynamics of securing office space for a high-growth company and how to fix it.
Lawmakers have a tall order in trying to move the needle on the 90 percent fail-rate for startups. The main issues plaguing startups — failed product market fit and the lack of experience — are largely out of their control.
However, one of the most pronounced issues lawmakers can help with is operating costs — office space is bloating lean startup budgets.
For the last several years, policymakers around the U.S. have invested in public incubators and accelerators as a means of helping early-stage companies with financing, mentorship and, of course, office space. These investments are important for filling gaps in the market, but there is little evidence these investments have paid off.
In addition, incubators and accelerators are limited to earliest-stage startups. When a company grows to double-digit employees, a new set of challenges arise that public officials need to think critically about.
This week’s Tech Tuesday post is focused on how policymakers can help growing companies with higher chances of success through addressing the challenges in the commercial real estate market by:
- Incentivizing flexible lease terms
- Backloading leases
- Creating smarter tax incentives
Commercial real estate costs reaching all-time highs
Commercial rent is nearing all-time highs, particularly in startup-heavy cities such as New York and San Francisco. In 2015, real estate services firm CBRE reported a seven-year high in office investment and rental rates.
“Gross asking rental rates for office space continued their steady rise in Q4 2014, averaging $28.30 per sq. ft. at year-end. Following 15 consecutive quarters of rising rents, the U.S. average ended 2014 only 2.4 percent below its 2008 prior peak” wrote CBRE.
This trend continued through the end of 2015 according to real estate firm Jones Lang LaSalle (JLL) with demand outpacing supply.
“[central business districts] remain the premier location for many tenants” reported JLL, pointing to the growth in urban downtowns.
While this impacts all businesses, it disproportionately hurts high-growth startups in two ways. First, it adds to the overhead of a company and takes valuable dollars away from recruitment, equipment, and sales — which are directly feeding a company’s growth.
Second, high-growth startups have more dynamic space needs. With an established company, their employee base will remain fairly constant year over year, making their office space needs equally predictable. In contrast, high-growth companies are planning to grow 2–3 times over the course of a single year.
For example, take a 25-person startup. Marketwatch estimated the average cost of office rent per employee in NYC at an astronomical $14,800. That is roughly $370,000 for a year for 25 employees.
However, that startup is looking to grow to 75 employees by year-end and 150 by the end of year two. Since commercial leases are multi-year and moving is an expensive endeavor, that startup needs to look for a space big enough for the 150-person company. That would be a commitment of nearly $4.5 million in rent for just 25 employees according to Marketwatch.
Even in the least-expensive city on the list, Atlanta, that startup would need to invest $600,000 upfront versus a measly $100,000 for a similar-sized company without aggressive growth goals.
To make matters worse, the average commercial lease is longer than three years. With high-growth companies focusing on month-over-month growth, planning three years out isn’t just difficult, it’s nearly impossible.
CB insights reported that the second highest reason for startup failure was “running out of cash.” This leads to another issue with high office rent: Startups need to be in major cities where rent is the highest. When Smartasset looked at the top cities with low costs for startups, none were major US cities. However, their competition and talent are in urban cores. Young professionals moving into cities has pulled large corporate entities back into the cities as well.
In order to disrupt or compete with an existing industry, high-growth companies need to attract top talent and clients, so moving away from city centers can be even more detrimental than the real estate costs, further stacking the odds against them.
Sorry WeWork, startups need their own office
Despite the marketing by private players such as WeWork, coworking spaces are not the answer.
The venture-backed unicorn has been capitalizing on this pain in recent years, ballooning to a $10 billion valuation. WeWork offers prime space in urban downtowns for up to 100 employees at an organization. However WeWork themselves are dealing with high real estate costs and their business model is essentially charging a markup on office space to entrepreneurs in exchange for handling the long-term lease startups can’t commit to.
The perception of startups today is that entrepreneurs and teams can work from anywhere. While this can work as a small team, it creates more challenges as a company scales.
Take a B2B Software-as-a-service (Saas) company for example. Early on in a SaaS company’s life, they can sell a new solution to the “innovative” buyers in the market, but as they progress the hardest chasm to cross is to the “pragmatic buyer.”
How is this related to office space?
Well, try establishing legitimacy with a pragmatic buyer — someone who is looking to purchase the safest and most reliable option — during a sales meeting at a coworking space.
This applies to hiring as well. A startup’s talent team is trying to attract the best employees by selling the company’s brand and culture. Bringing an interviewee into a WeWork is really selling WeWork’s brand, not the company’s.
The same logic applies to employee morale, marketing events, investor meetings, and public relations in general. Eventually, to beat established companies, a startup needs to be a little bit like an established company.
Policy solutions
Here are a few ways lawmakers can look to rectify the market inefficiency and promote growing startups:
Incentivizing flexible lease terms
The most glaring challenge for startups is that most commercial leases are upwards of 3-to-5 year commitments at best. Because of the natural growth needs of startups explained above, subleases have become the best bet for smart operations teams because building owners would rather sit on a vacant space than rent out to short-term tenant.
Providing financial incentives to sign shorter term leases could help limit the commitment startups need to make and compensate building owners for the opportunity cost of bringing on startups. Startups would then have the opportunity to rent from the building owners directly, secure tenant improvement dollars, and would not need to navigate limited sublease markets.
Backloading leases
Lawmakers offer flat grants as the model policy for startups, but that is an inefficient use of funds. For startups, the issue is paying for large space before they need it without breaking the bank. A better solution would be to backload leases with the rest subsidized by public funds. In this instance, startups would pay for the space they use while building owners get a full tenant’s worth of rent.
For example, a company may pay 25 percent of the total lease in year one, 50 percent in year two, and pay the full lease by year four with some sort of opt out clause if they fail early. The government would then subsidize 75 percent in year one, 50 percent in year two, and have it off the books by year four. This would also allow the government subsidizing these leases to stretch out their funds over a couple of years instead of paying up front — ultimately leading to more money to go around each fiscal year.
Creating smarter tax incentives
Stop limited tax incentives to development zones for startups. One favorite of policymakers is to create an “innovation zone” in an area of the city they want to develop. This makes perfect sense from a city planning perspective, but tends to be a mismatch for what startups need.
Take the District of Columbia’s first tech corridor launched in 2014 under former Mayor Vincent Gray. In theory, it was a great idea — provide a grant to early-stage startups so they can move into their first office along Georgia Avenue where the city could use more commercial offices. There were a few existing successful tech companies with offices near there in LivingSocial and Blackboard.
The problem? There was very little commercial office space available in the corridor and it wasn’t close enough to the business district. Plus, an even smaller number of building owners along the corridor wanted to rent to startups without the operating income to maintain the lease long term. The spaces that were available needed significant upgrades, which strapped startups could not afford through a limited grant of just $25,000 to $200,000.
Again, startups need to establish credibility and legitimacy as they scale. Incentivizing them to move away from established companies has the opposite effect.
Implementing these solutions could help startups commit to larger office spaces earlier without straining their budgets. It’s better for startups, better for building owners, and, ultimately, better for cities as a whole.
FiscalNote office operations guru Karen Hodson contributed to this post.
