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APRIL 24, 2000

Selling Their Souls to Be in Silicon Alley

It's not easy -- or cheap -- for cyberspace entrepreneurs to find office space in the Big Apple's trendiest areas


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When PredictIt! CEO Andrew Merkatz sought space in Silicon Alley -- Manhattan's high-tech nucleus -- last August, he struck out. Landlords doubted that his Internet company, which sells ordinary people's predictions of sports results and stock performance, would survive to the end of a multiyear lease.

Eventually, Merkatz persuaded Philip Katz, owner of MacArthur Holdings, to lease him about 5,000 square feet in midtown for six years. "Sure, I was reluctant at first," Katz says. "The company had no track record, and its financials pretty much consisted only of the venture capital that had been invested and monthly expenses."

What won him over? Merkatz paid $40,000 to finish the space, an expense landlords usually assume, on top of a hefty security deposit. If the company goes belly up, Katz has a finished space he can rent for even more. And Merkatz? He's out $40,000, unless he can negotiate payment from the next tenant.

EPICENTER OF HIP. Rough deal? Merkatz doesn't think so. "We've grown from 3 to 38 employees over the past nine months," he says. "I don't know what we would have done if we hadn't found our space when we did." He pays slightly less than $30 per square foot per year -- about $150,000. Raw commercial space in Manhattan now averages $40 a square foot -- $50 in midtown. So Merkatz got a bargain -- maybe.

Merkatz' deal shows the predicament New York City dot-coms are in. High-tech startups are flooding into Manhattan to be in the epicenter of media, design, and hipness. According to a PricewaterhouseCoopers and New York New Media Assn. study, over 1,700 Net companies opened shop in the city last year -- three times as many as in 1997.

But few Web entrepreneurs have the revenues -- let alone profits -- to afford the city's most desirable business district. Desperate to be where the action is, dot-coms are making extraordinary financial concessions and paying astronomical rents, burning through precious venture capital or cash raised in the public markets to pay for it.

SECURITY SACRIFICE. That's a questionable business practice in the best of times. But the recent stock market volatility makes it even more risky. If the Internet bubble bursts, killing such companies' ability to raise money, the dot-coms' real estate deals could have dire consequences for the companies -- and even some entrepreneurs personally.

A look at the conditions Manhattan landlords exact to accept such financially shaky tenants shows why. Normal commercial tenants -- those with revenues and profits -- pay a security deposit worth two or three months' rent on a 5-to-10-year lease. "Dot-com automatically means one year's rent for security, sometimes two," says Andrew Rasiej, a former real estate broker, now the chief executive of Digital Club Network, a Net company that streams live music performances over the Web. That means that if a company goes under or just wants out of a lease, it will likely sacrifice several hundred thousand dollars in deposit money.

Then there are the improvements -- essentially free capital improvements for landlords -- that have become big chips in dot-com lease negotiations. The more a company will invest, the better its chances of winning a space. And dot-coms' sophisticated technical needs make their offices expensive to set up -- even if the entrepreneurs don't buy Philippe Starck chairs.

PERSONAL LIABILITY. "To take a raw space in New York -- given the nature of the market -- means you're looking at a $1 million-to-$2 million soup-to-nuts move-in fee for 20,000 square feet," says Adeo Ressi, executive vice-president for corporate strategy at Web developer Xceed, which recently acquired his Web-design company, MethodFive. Before the acquisition, Ressi was looking for new space for MethodFive. "We were considering doing another round of financing, 25% of which would have gone to renting and developing a new space," he says.

Ominously, some landlords even require -- and get -- personal letters of credit from entrepreneurs to secure space -- making them personally liable for the huge rents if their companies can't pay. "Internet companies don't have the background or the financials that are traditionally required by landlords," says Peter DeCheser of Massey Knackal Realty Services. "The balance sheets of Net companies in their embryonic state really frighten them. They're concerned that some of these companies won't be around in a year, so they try to get as many kinds of credit guarantees as they can."

Surprisingly, venture capitalists don't see their protégés' Manhattan rents as excessive. "We're not telling our companies to look elsewhere," says Stuart Ellman, general partner for RRE Ventures, a New York-based venture-capital firm with stakes in 11 Silicon Alley startups. "I don't mind paying an extra $50,000 to $100,000 in rent if I can attract the right people, and right now, the best talent wants to be in the city."

BOROUGH PUSH. New York City, meanwhile, sees opportunity in the dot-coms' pain -- to spread the high-tech wealth to less prestigious parts of the city. "Space is at a premium in Manhattan, so we're trying to drive the success of Silicon Alley to other boroughs," says Michael Carey, president of the Economic Development Corp., a division of the Mayor's office.

Carey has identified 200,000 square feet of what he calls "smart space" in northern Manhattan and the other boroughs. The city is offering significant incentives to companies that relocate to those areas, Carey says. These incentives include low-cost energy rates, commercial rent tax waivers for landlords, and tax credits for every employee the company must relocate. Companies that take the city up on its offer can also expect to find rents between $10 and $18 per square foot and Internet-ready spaces. So far, the program, dubbed Digital NYC Wired to the World, has attracted PSINet and teen-girl clothier Delia's Online to Long Island City, Vast Video to Astoria, and Urban Box Office to 125th Street in Harlem.

The market volatility has given some CEOs pause about signing such onerous deals for new digs. But they don't necessarily see themselves as potential victims. Digital Club Network's Rasiej, whose company plans to expand to 70 employees from 20 over the next three months, has put his search on hold. He looked at 35 to 40 spaces over six weeks to no avail. "I think a lot of space will open up soon, because we're going to see a fair share of dot-coms go out of business or merge with other companies," he says, from his current office in Union Square, a trendy downtown neighborhood that's saturated with Net firms. "This way, maybe we can even get space that's already built out, so all we have to do is change the sign on the door."

Will it take another tech-stock meltdown for entrepreneurs to stop taking huge risks for the sake of trendy addresses? Some say they're coming to the realization that their success hinges more on how well and fast they build a business than where they do it. "Our companies are being smart about where they look," says Dan Schultz, managing partner for venture firm Draper Fisher Jurvetson Gotham. "They know there's good office space in places other than Silicon Alley." Besides, he adds, "the Alley is really only a state of mind" -- and one that can surely be attained two or three subway stops away for a fraction of the cost.

By Stefani Eads in New York


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