You have your great idea, business plan and some seed capital from friends and family; now you are ready to build out your team. At this critical stage, often over-looked are the various rules governing the employment relationship, especially around compensation. This oversight then comes back to haunt you when potential investors are kicking the proverbial tires during your first major capital raise and they want your company to make representations and warranties regarding the company’s compliance with various compensation and employment laws.
There are two common mistakes made by start-ups. Avoiding these can spare you from unnecessary headaches and save money:
1. Don't misclassify employees as independent contractors.
One of the most common practices of small companies is to engage a host of "freelancers", sometimes referred to using the misnomer 1099 employees because, oftentimes, the company cannot afford to have dedicated full time staff. However, just because you call someone a "freelancer" (and they agree to be so called) does not mean they are not considered employees in the eyes of the law.
Employers are required to withhold income, Social Security and Medicare taxes from employee compensation, pay unemployment taxes on wages paid to employees and provide state workers' compensation coverage. Employers are not required to for properly classified independent contractors. If you misclassify an employee as an independent contractor, and fail to make these required withholdings and tax payments, your company could be subject to penalties, interest and back taxes.
The Internal Revenue Service and most state agencies use a 20 factor test to determine whether a person is properly classified as an independent contractor. The factors focus on primarily on behavioral control, i.e, the "when, where and how" in providing the services. The IRS and state agencies view the classification narrowly, and the general assumption is that the individuals are employees.
Unless you are engaging someone to perform a discrete one-time project or provide a service unrelated to your business (think of the contractor painting your new office space), it is usually a better practice to assume that the individual should be classified as an employee.
2. Don't fail to pay certain employees overtime pay.
Another common mistake made by young companies is to pay their employees on a salary rather than hourly basis, and assume that because they are paid a salary employees are not entitled to overtime pay.
Under both federal and generally all states' laws, employees are entitled to be paid time and a half for all hours worked over 40 in each work week, unless they are properly classified as executive, administrative or professional employees. Whether the employees fit into one of these categories and therefore not entitled to overtime pay depends largely on the nature of their primary duties. Generally, only employees with authority to make independent decisions over matters of significance are properly classified as exempt from overtime. You should carefully consider whether an exemption is available for a particular employee. Failure to do so can be costly: federal laws and many state laws will award punitive damages and attorney’s fees, in addition to the unpaid overtime, on wage claims brought by employees.
I know you have many things to focus on in your venture but, as the saying goes, an ounce of prevention is better than a pound of cure. It’s better to get it right in the beginning than pay the consequences down the road.
--Jessica Catlow is an employment attorney at Mintz Levin. She represents both companies and executives regarding executive compensation issues in the context of mergers and acquisitions, venture capital investments, and private equity financing.