First Time Founders Series: No. 4 - Employees and Contractors

This fourth installment of our 2020 First Time Founder Series is all about onboarding your team.

You’ve formed your company, maybe you are talking to investors or have already secured funding, and now you are ready to expand your team and accelerate growth. These are exciting times. But missteps with your team, especially your employees, can result in some significant legal liability. Let’s cover some basics so you can have thoughtful and informed discussions with your advisors.

Employees or independent contractors.
Employees are covered by federal and state employment laws. You are required to pay them wages on a regular schedule, withhold employment taxes from those wages, and provide certain benefits. Few startups handle payroll and benefits themselves. Many companies (and other startups) offer these services. Shop around and find the best fit for your needs. Ask other founders who they use.

There are no payroll and benefit requirements for independent contractors. You can pay them on any agreed frequency, and you do not have to withhold taxes on those payments. No benefits required.

Employees receive a Form W-2 at the end of the year. Independent contractors receive a Form 1099.
Who can be an independent contractor? There are various tests for confirming independent contractor status, and well-educated folks disagree on the application of these tests (see “The elephant in the room” below). Here is a very brief list of some key questions: (1) are the worker’s services tangential to your core business, (2) does this worker control when and how they do their work, (3) are they doing similar work for other companies, and (4) is this an experienced and independent worker?

If you answered “yes” to these questions, an independent contractor relationship may be fine after a quick check with your lawyer. Examples here could be a bookkeeper (assuming you are not disrupting the bookkeeper industry) or a website designer (assuming you are not in the business of website design). If you answered “no” and still want an independent contractor relationship, you need a longer conversation with your lawyer. An example here could be a UX designer.

Hiring someone as an independent contractor when they should be an employee is called employee misclassification, and it is illegal. You risk significant penalties and other consequences. Employee misclassification has always been an issue for startups. Sometimes misclassification is out of ignorance, and other times, a startup intentionally takes on the legal risk. An experienced advisor can help you understand the risks and, more importantly, help you discover your own risk tolerance. Take the time to get informed and make the best choice for you and your startup.

Now the paperwork.
All employees and independent contractors should sign written agreements before they start. Employees typically sign short offer letters that outline their compensation, who they report to, paid time off (PTO) policies, and other benefits. More critically, you need all your employees to sign an employee confidentiality and inventions assignment agreement. This agreement is much longer than the offer letter and covers critical terms: (1) it prohibits your employee from disclosing your startup’s confidential information and (2) it reaffirms that everything your employee creates on company time and using company resources belongs to the company, not the employee. These agreements have become fairly standard over the years, but there are deviations from place to place. In some tech hubs, non-competition provisions are common, and in others they are not (or they are illegal). 

Your independent contractors will sign a contractor agreement. This agreement typically covers their specific work and compensation in an attached statement of work (SOW). The body of the agreement is reserved for confidentiality and invention assignment provisions, similar to your employee agreement. You may also want more involved work acceptance provisions depending on the deliverables. There are often different forms for technical and non-technical contractors. There are also very short forms for your wonderful advisory team (who should still be subject to confidentiality obligations). .

As you grow, you should start to think about employment policies and procedures. When you first start out, it is perfectly fine to lean on your payroll provider for any mandatory policies in your area. 

Cash compensation.
You’re a startup, so you can pay entirely in stock options, right? Wrong. Wage and hour laws trump any agreement you made with your employee, even if your employee is ready and willing to work for free. Employees must receive cash compensation. Contractors can work for equity alone. And you, as the founder, may qualify for a business owner exception that allows you to be an employee but not take a salary (this is expert stuff that depends on where you live, talk to your lawyer).

Startups routinely trip over two wage-and-hour issues:

  1. Exempt versus non-exempt. Non-exempt employees are paid less and entitled to overtime. Exempt employees are paid more and not entitled to overtime. Each state has slightly different requirements for exempt workers, including minimum salaries that are much higher than minimum wage. Be wary of those minimums, especially for your sales team. You may assume your star salesperson is exempt because she will make a small fortune in commissions, but her base salary makes her a non-exempt employee entitled to overtime. 
  2. Computer professional exemptions. Some states have separate requirements for computer professionals. Your programmers in Colorado must be paid at least $27.63 per hour (or over $57,000 per year) and meet certain duties requirements to qualify as exempt employees. In California, the requirement is $46.55 per hour (or over $96,000 per year) with slightly different duties requirements. These minimums may seem low for experienced programmers but consider a recent code school graduate on a trial period with your startup. If you’re paying less than these minimums, they are a non-exempt employee entitled to overtime.

A good payroll provider and lawyer can help you track the requirements and spot the issues here.

Equity compensation.
Most startups issue stock options to their workers. Like your founder stock, stock options are subject to securities laws. Telling your workers that you will give them options is only the first step. Stock options are typically issued under a formal plan. Your board of directors approves both the plan and then each stock option. In some states, you may also have filing requirements for securities law compliance.

More specifics on stock options is beyond the scope of this series. As always, talk to your advisors. There is a wealth of knowledge out there. Get informed about Section 409A and setting the option exercise price, about vesting schedules and acceleration terms, and about how much equity you should offer.

The elephant in the room.
We cannot discuss this topic without mentioning Uber, Lyft, and California Assembly Bill 5 (AB 5). Most gig economy workers are hired as independent contractors. Employee advocates have been arguing for years that these gig workers are misclassified; they should be employees and get employee benefits. Uber, Lyft, and many others disagreed. California sided with the employee advocates and passed AB 5. It went into effect in January 2020. Uber, Lyft, and others did not reclassify their workers. California sued. There was a standoff in August that may be repeated. Reasonable people disagree on how this will end.

So why do you care?
Thanks to the AB 5 lawsuit, there is a lot more focus on employee misclassification these days, not just in California but across the country, including here in Colorado. That means more risk for your startup if you get it wrong. Don’t be shy about seeking expert advice here. 

Always those formalities.
The next installment of this First Time Founders Series will discuss why keeping your corporate house in order and minding the formalities is more than a “nice to have.” These preparations can set you up for a successful exit, whether that exit is an acquisition, IPO, or passing the business on to the next generation.

Originally posted on the Galvanize blog.


Moye White