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Security Deposit

What Landlords Require and Why

Landlords typically require security deposits and sometimes require guarantees. Landlords require them because they want to cover the risk of a tenant defaulting and the related cost of downtime and re-leasing space. The amount of the required security deposit and the extent of guarantees will vary depending on:

1. the landlord's perception and understanding of a tenant's credit;
2. the amount of up-front dollars the landlord has to invest to get a tenant; and
3. market conditions.
Tenant Credit. There are no generally accepted standards that landlords use to evaluate tenants' credit. However, most tend to focus on the total net worth of a company. This is obviously an issue for start-up firms that do not have established credit and not much of a balance sheet. Throughout this section, we offer ideas on ways to ease the burden of security deposits, however, they are typically a difficult negotiating point.

Amount of the Security Deposit. The amount of the security deposit is typically based on the landlord's up-front costs. These include: (1) cash/work offered by the landlord; (2) free rent; and (3) brokerage commissions.

An example of how the amount of the security deposit might be calculated as follows:
Total Square Feet 7,000
Initial base rent $40 per square foot
Term 5 years
Free rent 2 months, $46,667
Cash/work $10 per square foot $70,000
Estimated brokerage commission $53,200
Total $169,867

From the above example, a conservative landlord would look to obtain at least $169,867 in security deposit. Premiums or discounts from this dollar amount may be obtained by the landlord for a variety of reasons. Some of these reasons could include: (1) the landlord has a good or bad opinion of a tenant's credit or current or future financial standing; (2) competing offers for space are allowing the landlord to demand better economic terms; (3) as with all other economic terms, the landlord wants a particular tenant because of the tenant's reputation or stature in an industry that it believes may help the reputation of the building; and (4) the landlord may generally decrease economic terms for space that has been vacant for a long period of time (unusual in the current market.)

Market Conditions. As with any other economic lease variable, the required security deposit will be impacted by market conditions. However, the deposit is intended to cover a landlord's worst case position. Particularly in tight markets, landlords have greater negotiating leverage and can increase their security deposit cushion in case of tenant defaults. In down markets, landlords may be forced into deals where they spend more than they receive in a security deposit.

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Structure Of The Security Deposit

Security deposits are most commonly structured in two ways: (1) cash deposit; or (2) letter of credit.

Cash Deposit. This is payable upon signing of the lease and is deposited into an account controlled by the landlord. Depending on the negotiations, tenants may be able to obtain a "burndown". This means that after certain periods of time or attainment of certain milestones, portions of the security deposit may be refunded to a tenant. For example, a recent client obtained a burndown of 15% of the security deposit after three years and another 15% after four years. Of course, the tenant would not qualify for the burndowns if it defaulted during the period leading up to that date. An example of a milestone is achieving a certain net worth. The latter is more difficult to structure but we have achieved it with major New York landlords. However, it does require more negotiation than an agreement to reduce the deposit after passage of certain time periods.

A letter of credit ("LOC"). The LOC acts as a substitute for cash from the landlord's perspective, but can be more cash-efficient from the tenants' perspective. If a tenant has an existing banking relationship that affords them extension of credit, the LOC can free up cash for other uses. However, many start-up firms may be required to deposit the full amount of the LOC with their bank thereby negating the cash flow advantage. Commercial banks tend to charge around 1% of the total amount per year as a fee. If the LOC is renewed year after year it is known as evergreen. As noted above, a burndown may also be possible on the LOC amount. A word of caution - landlords almost always want the LOC based on their forms. Request a copy of the landlord's form before starting with your bank's form.

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If guarantees were not difficult to collect on, landlords would probably use them more often. Accordingly, if a landlord is concerned about credit, it is more likely to just increase the amount of the security deposit than require a guarantee. However, the tighter the market, guarantees can be a turning point to closing a deal. One guarantee method is called a "good guy" guarantee. Typically a principal of the company is required to sign personally and the personal guarantee remains in place until the company vacates the space. The advantage to the landlord through this method is that it has a lever to force the vacancy of the space. If a tenant defaults, the landlord wants to re-let as soon as possible. Accordingly, the defaulted tenant is expected to act like a "good guy" and pack up and leave.

Among start-ups, another type of guarantee that is becoming more common is for a corporate investor or fund to guarantee the lease. From this structure, the landlord expects that the financial strength of the investor or fund will outlast what may be the temporal nature of the start-up.

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