Legal Briefs

Swap Rent for Dot-Com Stock? Ask Tough Questions Before Proceeding

With the explosion of dot-com and high-tech companies, some property owners are experiencing a new phenomenon: tenants offering stock options or warrants in lieu of other forms of payment for lease transactions.

This trend raises legal and business issues to consider before any such leases are signed. Commercial real estate professionals must take steps to ensure that they and their lenders have financial security in lease transactions with promising, but unproven, companies.

How It Works
Initial public offerings that make dot-com shareholders millionaires overnight are well known. Now these companies are tapping other industries’ desires to share in their windfall by trading stock or warrants for goods and services.

Start-up companies may grow rapidly, but they often lack the capital and financial track records to lease the space they need without tying up too many resources in real estate requirements such as rent, security deposits, and letters of credit.

Some start-ups are allowing landlords to purchase stock or exercise stock options in the tenant company at an agreed-upon — and presumably favorable — price, enabling the landlord to share in the tenant’s IPO profits or venture capital funding. In exchange, the landlord may eliminate a security deposit, lower the lease rate below market averages, or provide a free lease period that otherwise would not be given under current market conditions.

Property owners should not sign a lease with such terms until both parties have agreed to the shareholders’ agreement or other documents establishing the landlords’ rights in the tenant company.

While there’s profit potential, there’s also potential that the deal won’t cover tenant improvement costs. How do property owners know if their tenants are the next Microsoft? Though they can’t be sure, they thoroughly should analyze the transaction from business and legal perspectives.

Issues to Consider
Taking warrants or stock options instead of rent or other security for leases is complex, and the due diligence necessary to understand what is being offered is time-consuming. Savvy landlords should underwrite the prospective tenant as if the landlord were a prospective lender or venture capital source. This will mean working with lawyers, accountants, and other professionals.

Landlords should determine whether a tenant’s business plan makes sense; how and when funding is achieved; what factors adversely could affect the company’s business plan or funding; and how the company has addressed those factors. Also, if the company relies on key employees, what assurances are there that they won’t leave? Landlords should be satisfied with the answers to these questions before agreeing to trade rent for stock.

Next, a thorough legal review of the company’s proposed corporate documentation should be undertaken. Issues such as shareholder rights and the length of time the landlord or its principals will be required to hold the stock before selling must be negotiated fully to achieve the benefits the landlord thinks it is getting.

For example, can the landlord’s share in the company be reduced without consent to get additional equity funding for the company? Dilution of the landlord’s share may be acceptable in certain instances. The landlord must understand its rights in the company and when those rights can change.

Landlords not willing or able to put the time and effort into arranging a more complex transaction may be better off with the simpler and more secure cash and letters of credit. However, with care and planning, accepting warrants or stock options as part of a lease transaction can be a win-win situation for those willing to try something new.

Carol C. Honigberg, JD

Carol C. Honigberg, JD, is a partner in the real estate group at Reed, Smith, Hazel, & Thomas LLP in Falls Church, Va. Contact her at (703) 641-4220 or chonigberg@rssm.com. The discussion of legal issues in this column is for informational purposes only. Results may vary depending on state laws and individual circumstances.

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