Courtesy of our colleagues Merrili Escue and Nancy Kawano.

Most startup businesses are faced with the challenge of making the most efficient use of every dollar of their financing.  As a result, creative cost-cutting measures are essential to increase available working capital. 

For the unwary employer, however, cutting the wrong corners can be financially disastrous and may crush the life out of a new venture with enormous penalties, possible double damages, expensive litigation and potential individual liability for officers and directors.  Two of these mistakes are thinking wages to employees can be deferred (or equity provided instead of wages) until the company has more cash, and  failing to understand who qualifies as an employee vs. an independent contractor and who is entitled to receive overtime pay. 

Below is the first of a two-part overview to help identify and avoid the most costly employment mistakes companies can make.  Part two will follow in DLA Piper’s next Emerging Growth and Venture Capital newsletter, which you can sign-up for here.

Deferring payment of wages until the company has more cash

The first employees of a company are typically the founders and/or individuals with a significant personal interest in the company.  To conserve capital, these individuals are often willing to forego cash compensation for their services, typically for equity or an understanding that they will be paid at some later, undetermined date.  Unfortunately, such arrangements violate the wage and hour laws in every state.  In addition, such violations can trigger investigations by government enforcement agencies, including the tax authorities.  Any agreement to waive these legal requirements, and avoid or delay payment of wages that are due to an employee, is invalid and unenforceable. 

A company may believe it may never face negative consequences for deferring payment of wages.  But it is essential to keep in mind that employees may not remain with the company forever.  It is when such employees leave, or, worse, when management or new investors ask them to leave, that the prior deferred-wages arrangement becomes an issue.  Such employees may then claim they have been vastly underpaid or were not paid at all, and may sue, seeking reimbursement for unpaid wages and overtime, penalties, interest and possibly attorneys’ fees.  Some claims may expand into class actions.  The prospect of this enormous financial liability can delay refinancing efforts or a potential sale.  Needless to say, the impact can be devastating. 

As a general rule, any individual who is permitted to work for a company is an “employee” and must be paid cash compensation, on regularly established paydays.  Further, each employee must be paid the applicable minimum wage for every hour worked, and overtime premiums, if applicable.

Avoiding legal liability for this problem is very simple:

  • know and understand the applicable wage and hour requirements, including those for minimum wage and overtime pay;
  • establish proper employee pay procedures; and
  • establish regular paydays.

Companies may always use equity awards or bonuses to enhance the total compensation package for an employee, but must always pay each employee at least the minimum wage per hour worked (or the equivalent in salary) and overtime where appropriate. 

Failure to properly classify employees/contractors

A.   Most employees are entitled to overtime even if they are paid a salary

Many startups pay all of their employees a fixed salary to simplify their payroll and because the company believes that if employees receive a salary they are not required to track the employee’s work hours or pay extra for working overtime.

Unfortunately, this belief is false. Payment by salary is only one part of a two-part test for exemption from the overtime requirement.  The second, and most critical, part of the test requires an analysis of the nature of the employee’s position and duties.  Furthermore, the exemptions from overtime are very limited.  Any company in which all or most employees are classified as exempt from overtime will be suspect.

What happens if an employee is misclassified?

  • The employee may bring a claim for unpaid overtime, going back up to four years.
  • A whole host of derivative claims is also likely, such as claims alleging failure to keep accurate time records, and, in states like California, claims alleging failure to provide meal and rest breaks, with corresponding penalties.
  • Even with very few employees, a company can be subject to class action litigation, and penalties can multiply exponentially because they are assessed per employee and per pay period.

A conservative estimate of the potential penalties for a single employee, in a California misclassification case for example, is between $33,000 – $41,000 per year, not including the unpaid overtime or attorneys’ fees (which often exceed the amount of the actual unpaid wages or penalties).  Thus, the potential exposure for even a small company can quickly reach several hundred thousand dollars, potentially robbing a startup of its operating capital.

To avoid this problem, companies must not assume an employee is exempt from overtime merely because the employee is paid by salary.  Rather, companies should classify employees only after proper analysis and application of the appropriate two-part test for exempt status.  Class action litigation is currently on every plaintiff’s attorney’s radar, so it is advisable to act conservatively.

B.  Most individuals providing services to a company are employees, not independent contractors

In another misplaced effort to cut costs and avoid having to establish payroll and other infrastructure, companies sometimes classify persons who provide services – including its executive officers – as independent contractors, when they are truly employees.  The company pays the contractor a fee that may not comply with the minimum wage and overtime requirements for employees and does not withhold or pay any employment taxes.

When the relationship ends, however, a dissatisfied service provider may claim to have been an employee who was not properly paid.  If that is proven to be true, there will be liability for unpaid wages, including overtime, and the resulting derivative violations and penalties mentioned above, as well as liability for failure to properly withhold and pay employment taxes.

The determination of independent contractor status is based on the application of multiple factors, not merely the preference of the company and the individual.  While the legal tests to determine independent contractor status vary by government enforcement agency, and require a complex analysis, if the work an individual is doing is integral to a company’s business, and there is ongoing work, rather than a discrete project, the individual is most likely an employee.

Both the federal Department of Labor and the state agencies responsible for enforcing the labor laws are making the prosecution for misclassification of independent contractors a top priority.  To avoid this problem, a company should act conservatively when determining independent contractor status.  If the person truly is an independent contractor, a written agreement documenting the relationship is essential.

Avoiding exposure                                      

The failure to properly classify individuals as employees or to properly pay employees in a timely manner, in accordance with legal requirements, can create significant financial exposure to a company.  However, these risks can be avoided or corrected with proper guidance and creative problem solving advice from counsel familiar with employment laws, who understand the unique problems and needs associated with startup companies.

Please note that this post is intended to provide a high-level overview and does not purport to comprehensively address all employment issues that emerging companies may face.