‘Gulch’ Awash With Internet Start-Ups

Several years ago, South of Market was still a roughhewn neighborhood where rents were cheap and junkies and transients common on the streets.

That was before this area south of downtown emerged as the Multimedia Gulch, before Internet firms began snatching up airy warehouses, before the vacancy rate dipped below 1%.

The gulch now has the tightest rental market in San Francisco, a fact that weighed heavily on Deborah Newton as she looked to move her software start-up to a larger office.

As vice president of operations, Newton expected to pay the going rate of $40 to $50 a square foot and to fork over as much as a year’s rent as a security deposit. But she never guessed that her new landlord would want one more thing: a cut of the start-up’s stock.

“While we were looking at a site, our broker warned us that the landlord will want stock warrants,” Newton said. “Our VP of finance had heart failure over it. He said, ‘We’re absolutely not giving up warrants.’ ”

In recent months, a growing number of start-ups in San Francisco and the Silicon Valley have been faced with the same choice: Give up shares in the company or look for space elsewhere.

For firms in San Francisco, the choice is a Catch-22. Internet-related companies need four times as much space as is available in the city, according to the CAC Group, a San Francisco-based real estate firm. Looking elsewhere often means crossing to the East Bay for lower rents--but also moving away from funding sources and a talent pool that usually prefers San Francisco.

Demanding stocks is not yet standard practice in the Multimedia Gulch. Large Internet companies such as eBay and Organic Inc.--firms that have proved their staying power or have impressive financial backing--have negotiated leases without giving up equity. But if demand continues to soar, real estate agents predict that even these larger companies won’t be spared.

Landlords say that taking stocks is a way of offsetting the risk of renting to newer start-ups.

“They’re relatively unproven companies,” said Dave Murphy, the director of real estate at the San Francisco-based Flynn Land Co. “Taking warrants is a way for landlords to justify the risk we’re taking by renting them space.”

Warrants turn into actual stocks after a company goes public.

Tenants, however, say there is little risk for landlords when they can demand a year’s rent as security deposit and can take advantage of the tight market.

But owners of many start-ups can’t afford to debate issues of fairness, said John Dillon, president and chief executive of the Web site www.sales force.com. Passing up space means a delay in production, which he said can be suicide in a sector where having a product out first often separates the winners from the losers.

“It’s critical to establish your brand first,” said Dillon, who gave stocks to his landlord. “If you’re spending your time haggling over a real estate deal, forget it. I couldn’t afford not to give warrants.”

Newton and her colleagues at Just In Time Solutions eventually reached the same conclusion. The start-up found space in a neighborhood next to the Multimedia Gulch and gave the landlord a 1% share.

In this landscape, tenants must convince landlords that shares in their companies are valuable, said Ralph Marx, co-founder of Acteva Inc., an online event-planning Web firm.

“We made a full-on VC pitch to our landlord,” said Marx, referring to the process of getting funding from a venture capitalist. “We brought out the whole team, brought in an investor, dragged out the power-point presentation. It was interesting, because landlords were asking some of the same questions that the investors do.”

Marx said it was a different story in 1997 when the start-up first moved to South of Market, a neighborhood of industrial warehouses and lofts.

“Three years ago, I would have been completely flabbergasted at the concept of doing a VC pitch to a landlord,” Marx said. “We’ve adjusted to it. But yes, it does feel unfair. Why should a landlord get the same stock warrants as someone who works for years to actually help build the company?”

In the mid-1990s, when the Multimedia Gulch was emerging, some cash-strapped start-ups began bartering stock options for lower rent or reduced security deposits, said Simon Poulton, who works for Whitney Cressman Ltd., a commercial real estate firm.

“You had people with dreams, but they didn’t have the world’s greatest cash resources, like they do today,” Poulton said. “They would persuade a landlord to take a risk by giving him stock options.”

Since then, the scarcity of space has created less fraternal tenant-landlord relationships.

The growing acceptance of the trend simply highlights the business environment in San Francisco’s new economy, said Joe Perez, co-founder and chief executive of i2e2.com. The gaming Web firm enticed its landlord by offering stock options before being asked.

“Everything you do here seems to require options and warrants,” Perez said. “Pretty soon you’re going to go to the dentist and they’ll start asking for warrants.”