Rolling the Dice

SoMa landlords trade space for stock options in hopes of cashing in on the next Netscape

The hottest commodity in San Francisco's frenzied South of Market office market can be crystallized in two words: stock options. 

Staking their wealth on the success of their tenants, some property owners in the former industrial area south of the Financial District are rolling the dice with high-growth, space-starved Internet startups. A growing number are taking stock options, or warrants, in lieu of rent or security deposits. 

Crazy? Perhaps, said brokers and landlords around Multimedia Gulch and other booming SoMa neighborhoods. 

"You could exercise warrants at a price that's worth less than the paper it's printed on," warned Douglas Rosenberg, one of the area's biggest owners/developers. 

But that hasn't deterred Rosenberg and others from considering warrants as a component of deals with the predominantly "pre-profit" companies scouring the area for space. In fact, most would be more than happy to do so. 

"We'd certainly entertain it," Rosenberg said. 

Few options transactions have been completed. There's resistance on both sides: Promising companies and their venture capital backers are hesitant to hand over potential riches to their landlords. Building owners have their own financial backers to satisfy, who may not be comfortable placing large bets on the Internet bubble. 

But the fact that it's being actively discussed illustrates the new dynamic reshaping the relationship between landlords and tenants in an area that's become one of the country's hottest real estate markets and ground zero for the torrid Internet industry. 

Fueled by venture capital money and market hype, Internet and other high-tech startups can require huge chunks of top-quality space within months of founding. 

Witness Looksmart Ltd., an Internet directory that is close to signing a 135,000-square-foot lease just nine months after settling into a 3,700-square-foot, nondescript basement space several blocks away. 

Worth the risk? 

But that poses a quandary for landlords. These companies are hungry for space and have plenty of venture capitalists' cash -- now. But are they reasonable bets over a landlord's usual time frame of five to 10 years? In the mile-a-minute Internet industry, how can you tell which companies will sizzle, and which will fizzle, in the long term? 

"There's a much bigger debate about whether the Internet is a fool's game or a new Industrial Revolution," commented Steve Anderson, a broker with CAC Group in San Francisco. "Only time will tell." 

In this brave new world of leasing, landlords must scrutinize tenants as never before, looking for creative ways to both safeguard their investments and potentially strike it rich. 

"Landlords are having to be much more involved in the process," said Jay Cahan, CEO of SoMa boutique brokerage HCM Commercial Properties Inc. "It's a little more in-depth than just (having tenants) hand over last year's tax return." 

It means poring over business plans, checking into the background of management and evaluating a company's investors. Landlords also want to know a firm's "burn rate" -- how fast it's going through cash -- and finding out about its ability to raise more money. 

Even then, determining an Internet start-up's creditworthiness can be akin to soothsaying. 

"It's like reading fortunes," said Jay Edwards, director of leasing for the China Basin Landing office complex near the San Francisco Giants' new downtown ballpark. 

"It definitely takes some readjusting in how we typically qualify tenants," noted Jonathan Parker, whose San Rafael-based real estate company Monahan Parker Inc. just inked a 10-year deal with startup E-greetings Network for a 56,000-square-foot building on New Montgomery Street. 

Protecting landlords' interests 

Warrants aren't the only way building owners are protecting themselves. 

The No. 1 weapon is letters of credit. The financial instruments, typically guaranteed by a bank, pay a property owner a specified amount in the event a tenant becomes insolvent. Some prefer them to cash security deposits, which can be frozen in bankruptcy proceedings. 

LCs can get quite expensive. E-greetings, for example, has an LC in the $2 million range, sources said. 

"Security being provided is as varied as tenants -- anything from a simple one-month security deposit to a year's prepaid rent to letters of credit to combinations of the two," said CAC's Anderson. 

Rosenberg, who is doing the Looksmart deal and recently signed a major lease with another hot Internet firm,USWeb/CKS, ticked off a list of "claw backs" -- provisions set up to get back at faulty tenants. 

These include irrevocable LCs consisting of six to 12 months rent, earnings provisions demonstrating an ability to create positive cash flow, and net-worth covenants in which a firm is forced to increase its deposit or LC should its value fall below a certain level. At the same time, if earnings exceed certain thresholds, the LC can be lowered. In many deals the value of the LC "burns down" over time. 

Then there are the more qualitative assurances, such as the track record of a firm and how many rounds of VC funding it has had. 

"We like to see a little bit of gray hair," said Rosenberg. 

Despite all these checks, picking the right tenants is causing Rosenberg to grow some gray hair of his own. 

"You hope and pray you're making the right call," he acknowledged, a stunning admission from the jaunty developer who has forked over more than $120 million snapping up properties in the last two years. 

Tough on tenants 

But local brokers said it can be tough for tenants. 

Many are paying for tenant improvements themselves or offering a year's rent up front, said Michael Pitre, a broker with tenant-rep brokerage Julien J. Studley. 

In some cases, owners who don't want to put any money into their properties don't have to. Web design company Frog Design, for example, took a 12,000-square-foot former warehouse at 420 Bryant St. and offered to pay for all the improvements in exchange for a discounted rent, a local broker said. 

Generally, for deals over 15,000 square feet, tenants can't lease space without letters of credit, can't sign for less than three years, and rarely can build in an option for space to expand, said Cushman & Wakefield's Chris Roeder. 

Creative accounting 

Warrant swapping, while new here, made multimillionaires of some Silicon Valley developers in the 1970s and 1980s who bet that a small stake in upcoming computer hardware and software firms could one day be worth millions. 

Only this time, it's the Internet. The pace of change is faster, the companies' prospects are more difficult to grasp, and the likelihood that they will end up here today, gone tomorrow is even greater. 

That's not stopping landlords from plunging into the Internet boom. Consider GreatCoffee.com. 

Tony Russo, co-founder of the dot-com retailer of gourmet coffee, smelled the reality of San Francisco's torrid office market -- with overall downtown vacancies running around 5 percent -- after deciding he could no longer run his Net startup from a cramped flat in Cow Hollow. 

"We found out pretty quickly it's much easier to find 5,000 square feet for three years than it is for 1,600 square feet with an option to expand," said the Stanford Business School grad, who at 34 is brewing his third startup. "You have to be creative or know somebody," he griped. 

His solution: trade ownership in his fledgling firm for a break on his three-year, 1,600-square-foot lease with Flynn Land Co. at 600 Townsend St. 

It's a two-pronged gamble. Taking warrants saves earnings-poor companies like GreatCoffee valuable cash for more pressing needs such as hiring new employees. For landlords, the fixed-price stake might one day result in a mother lode of dough if the company hits it big. 

"If they make it, we get a lot more money than we would have otherwise," said building owner Greg Flynn, who knows Russo from his own days at Stanford. "If they don't, we lose out." 

It's a gamble most property owners can't resist. But despite the many safeguards being employed, some are wondering if it all makes sense. 

"I didn't get into a lengthy discussion of their business plan," admitted Parker, the developer who inked the 10-year deal with E-greetings in a lightning-quick three days. "I'm not an expert in Internet greeting cards." While he looked at the 5-year-old company's history, its investors, and the number of rounds of funding, he has his lingering doubts. 

Said Parker: "Ten years from now, we might all look back and say, `What were we thinking?' ".