Misclassifying Workers Can Cost You, Big Time

When are freelancers really your employees?

By Ilan Mochari

Ron Bourquin isn't the first executive to find out that the contractors he'd hired were actually his employees -- at least in the eyes of the law. But three years ago, after Bourquin's company inadvertently failed to pay payroll taxes for "between 6 and 10" of its workers, he learned the hard way.

Like many high-tech companies, Cardima Inc. -- a $3.5-million maker of heart catheters based in Fremont, Calif. -- relied on freelance consultants for highly specialized tasks. The problem was that some of the company's independent contractors logged 40 hours a week, worked exclusively for Cardima, and were paid by the hour. To the state of California, those conditions meant that they were Cardima employees. Bourquin, Cardima's chief financial officer, says that the company was required to pay the state a lofty sum, somewhere "under $25,000," in a settlement.

This type of misclassification error is common, according to employment-law experts. "Often small businesses believe that simply putting a label on a worker will solve the problem," says Jeffrey Pasek, chairman of the Labor and Employment Law Department of Cozen and O'Connor, a law firm based in Philadelphia. "They think that if they say someone is a contractor and the worker agrees, then it must be so."

Once Cardima realized it had violated the law, it enlisted a consulting firm to develop a questionnaire for prescreening potential workers. Questions included the following: "Can the worker document that he is in business as an independent contractor?" and "Can the worker prove that he has other clients and pays for all work-related expenses himself?"

Grilling prospective freelancers and keeping records of those results are just two measures that all businesses that use independent contractors should take. Noreen McDermott, a lawyer at the Palo Alto, Calif., branch of law firm Baker & McKenzie, suggests that companies hire only contractors who have incorporated. "That affords you the protection of being able to say that the contractor is an employee of his own corporation," she says. Another key factor to consider, McDermott adds, is the way in which the worker is compensated. A true contractor is paid not by the hour but by the project, with specific goals, fees, and completion dates set out in a contract.

Cardima now retains part-time help through a temp agency. Yet using a temp agency doesn't automatically exempt a business from paying payroll taxes and providing benefits. Pasek recommends getting indemnity agreements from all temp firms. But McDermott warns that even having indemnity agreements won't protect companies that are proved to be skirting employee-related costs.

Both agree, though, that state and national authorities are auditing employee misclassification like never before. And as with any government audit, you are guilty whether you meant to break the law or not.

Independent Testing

If you want to comply with state and federal regulations on classifying workers, talk to an HR expert. Rules vary from state to state.

Still, there are some basic guidelines suggested by the following experts: Andrew Schultz, president of Pro Unlimited Inc., the $110-million workforce-management consultancy in Boca Raton, Fla., that solved Cardima's ailments; Noreen McDermott, a lawyer with the firm of Baker & McKenzie, in Chicago; and Jeffrey Pasek, a partner at the law firm of Cozen and O'Connor.

  • Pay independent contractors by the project, not by the hour. Separate contractors from the mainstream workforce. Almost anything -- a contractor's presence on your softball team or at company meetings -- can be used to prove that the contractor is an employee.
  • Bar contractors from company resources. Truly independent contractors pay their own expenses, use their own equipment, and work on their own premises.
  • Screen all incoming workers. Use a lawyer-approved written test, asking questions about the contractors' independence.
  • Reassess the classifications of your workforce every six months. Regulations can change, as can your relationship with a worker. --I.M.

Hot Tips

If a big, newly public competitor of yours is getting good press, don't be alarmed about some new threat. First, do a little background check before you buy an analyst's hype about a competitor. Analysts at investment banks often take a shine to companies that they've taken public. That's the finding of a new study by Cornell University's Johnson Graduate School of Management. The authors -- associate professor Roni Michaely and Ph.D. candidate Kent Womack -- tracked more than 200 "analysts' recommendations of companies that completed IPOs in 1990-1991." According to their research, companies plugged by an analyst whose firm did not underwrite the initial public offering performed 50% better than businesses recommended by an analyst at the bank that orchestrated the offering. --Mike Hofman

Like most business owners who resell equipment, Kevin Dowd knows what it's like to be short on cash. Dowd is president of Atlantic Computing Technology Corp., a $6-million, 15-employee network-security company in East Hartford, Conn. To resell hardware, he first has to buy the equipment himself, then wait 30 days for the customer to pay him. Under those conditions, some owners would keep cash in the business by not paying themselves. Dowd preserves cash by paying himself but refusing to cash the check until he knows the business can cover it. That way, the payroll bookkeeping remains clean, and the cash supply doesn't run out. --I.M.

Consultants with Commitment

Ever feel like your consultants are concentrating more on boosting their careers than on helping your company? "Consultants are motivated by many different things, the least of which is doing great work for clients," says Paul Sanabria, cofounder of BDirect Capital Inc., an Internet start-up.

After Sanabria started his Boston-based company, in March 1999, he outsourced his technology development to a consulting firm. "We held a 'beauty contest' and invited the best players in," Sanabria says. He hired the start-up NerveWire, a Newton, Mass., company that offered something that the other firms didn't -- an investment in BDirect.

NerveWire works on a contractual basis and uses the investment strategy as an additional incentive for its own employees, all of whom have shares in the company's NerveWire Ventures fund. Malcolm Frank, president and CEO of NerveWire, professes that that model is actually preferable to a straight service-for-equity one because it offers the client more protection. "If they don't like the work we're doing on the consulting side, they can throw us out, though we've still made the investment," Frank says. So far, NerveWire has invested in 3 of its 20 clients and is planning more of those investments in the future.

Frank has even designated a separate team to perform due diligence on its clients. "The ultimate gravy was NerveWire Ventures' participation in our initial round," Sanabria says. "When an organization is willing to put money in another organization, that says two things. One: we believe in your idea. Two: we're going to make sure that if you're successful, we're successful. If you fail, we fail. There's no better alignment of incentives."

But does that really improve service from the consultants? Yes, says Carmen Pons, a program manager at NerveWire and a veteran of Andersen Consulting. "It makes a difference to know that the time and effort you're investing are going to mean something," Pons says. That translates into more loyal consultants who are actually putting in late nights for the client, instead of just racking up billable hours. --Anne Marie Borrego

He's His Own Distributor

Bill Dunman, who founded Hank's Beverage Co. in 1995 with four partners, says his sweet, frosty brew goes down easy in the company's hometown of Philadelphia, the birthplace of commercial root beer. What can be sticky is finding someone to bring the soda to people beyond those city limits.

When Hank's was launched, a number of distributors called to ask if they could carry the root beer. But in the past 5 to 10 years, those distributors consolidated. Now the few remaining ones carry so many brands that they are loath to add new ones. "There are literally hundreds of new beverage products that the average consumer will never see," Dunman says.

To extend his market reach, Dunman changed his distribution strategy. Instead of wrangling with stubborn distributors, he goes right to the stores that sell his soda. He asks retail outlets to help him find space on trucks that are already delivering other products to their stores. One Philadelphia-area grocer -- Genuardi's Family Markets, a 34-store chain -- referred him to a snack distributor that was willing to carry cases of Hank's. "Many of the smaller beverage companies are looking for alternate routes to market," says John Sicher, editor and publisher of Beverage Digest, a newsletter based in Bedford Hills, N.Y. "Sometimes that can be successful. The question is, Can someone who doesn't primarily do beverages get adequate shelf space?"

So far, so good. The snack trucks now deliver 500 cases of Hank's a month to Genuardi's stores. --Jill Hecht Maxwell

The Quotable Entrepreneur

"Entrepreneurship is like camping. You're complaining the whole time, but when you look back at it, you think, 'That was pretty neat.' " --Jim Steiner, founder and president of Quality Imaging Products, a Lake Forest, Calif., remanufacturer of printer cartridges

My Biggest Mistake

Mary Engelbreit
Designer and founder of Mary Engelbreit Studios, a $100-million provider of greeting cards and gifts

Early on, we were prompted by a number of requests to produce tabletop products like dishes and gravy boats in addition to our greeting cards and picture frames. We negotiated a deal to have that stuff produced for us, but it wasn't a very high-quality program, and the whole thing sort of petered out.

In 1995 a huge, very prestigious tableware company approached us. I was absolutely thrilled. We held creative meetings with its people, and they were excited about any ideas we offered. We signed a contract and drew a bunch of designs. It looked like the license from heaven.

Then the bomb dropped. They called while I was out of town on vacation to tell us that the company was going bankrupt. My partner had to call me with the bad news. Never in our wildest dreams did we imagine it could happen. It was like hearing Tiffany's was going bankrupt. I was so disappointed because we were really counting on that licensing agreement to be our introduction to the home-furnishings world -- to get our foot in the door.

What annoyed me the most was that while we were creating the artwork, the manufacturer's people knew all along that it was headed for bankruptcy. Maybe they were in denial.

We learned we shouldn't have put so much trust in the manufacturer's reputation. We hadn't done our homework in terms of financials.

The experience changed the way we handle licensing agreements. We now check companies out backward and forward. We research their distribution: what they sell and where they sell it. And we ask up front if there are any problems we should know about. Since then we've negotiated deals with huge companies, but we never assume, no matter how big the name is, that it will be a guaranteed success. We're more realistic.

The good news is, we are now able to use the artwork. This fall we're producing dishes with Enesco. The experience made us more careful, and now we have signed the best licensing agreements since we've been in business. --Written with Jill Hecht Maxwell

Riders on a Trend

One way to add some sizzle to your products is to tie them to a trend -- even when it's based on a product that's not your own.

The trend: The iMac
The product: The i-Collection
The spin: Milano Series International Products Ltd. founder Bruce Parisi has been selling his Officio Collection desk accessories in an assortment of colors since 1997, but it took the Dallas-based Container Store to hitch the transparent letter trays and tape dispensers to the rising star of Apple's iMac. "We try to give our products some identity," says Jill Nance, a buyer at the Container Store, which rebranded the products as the i-Collection. "When we saw the line of pastel products, we knew that naming it the i-Collection would give it that identity." The $160-million retail company started featuring the products in its catalogs alongside matching iMacs late last summer.

The trend: Beanie Babies
The product: Personalized Beanbag Animal Organizer
The spin: Lillian Vernon Corp. knew that Ty's Beanie Babies were hot. David Hochberg, vice-president of public affairs for the catalog company, says it wanted to get in on the trend but didn't want to compete against the legions of stores that were already selling the stuffed sensations. "We didn't want to sell the hottest or latest thing, but we wanted to sell an accessory to the hottest and latest thing," Hochberg says. The product, a modified over-the-door shoe organizer designed for holding Beanie Babies, has made it onto the company's best-seller list; approximately 275,000 units have been sold since the product was introduced, in July 1997.

The trend: PokÉmon
The product: PokÉmon Card Protectors
The spin: After Clipp Designs Inc.'s $2-million-plus success with its tag protectors for Beanie Babies, the Chicago-based company searched for the next big trend to accessorize. Judy Tompkins, cofounder of Clipp Designs, saw a new opportunity in providing protectors for PokÉmon trading cards. She found the manufacturers of the protective sleeves commonly used for baseball cards and resold them as PokÉmon card protectors. But Tompkins acknowledges that there is a negative aspect of piggybacking on a trend: when the fad fades, so does demand for the piggybacked items.

She had come up with the PokÉmon trading-card sleeves after the Beanie Babies market died down and she was forced to downsize her operation. And now, with PokÉmon on its way out, Tompkins hopes that adults will keep buying Beanie Babies as collector's items and continue to drive demand for her other products. --A.M.B.

Ed Lilly: In a Former Life


Present life: CEO and president of Serta Inc., the $760-million-plus maker of mattresses based in Itasca, Ill.

Former life: A buyer for a department store in Philadelphia called Strawbridge & Clothier, part of a family-owned chain. In 1970, when he was 26, Lilly began as an assistant buyer in the toy department; he left the chain eight years later. "If, as a buyer, you wanted to put a new vendor on the floor, you couldn't just do it," Lilly says. "You had to do your homework about how the product would affect everything large and small -- distribution costs, floor space, sales, profits. That meant creating a program and having a clear rationale that could sell management on why the vendor would improve the total store picture."

Lessons learned: When trying to change the status quo, master the minor details and use hard facts to build consensus. "Today we do about $200 million in national accounts," Lilly says. "When I got to Serta, it was only about $8 million. One reason was that our pricing was too high, because of our raw-materials costs and labor rates. Things had to change, but in dealing with 27 manufacturing plants we felt there'd be initial resistance. So we commissioned a group to do a time-motion study. The study gave objective numbers of what our labor costs should have been. It became easier to persuade the managers that we needed to get better."

Lilly encouraged each plant to follow its own plan for optimizing production. "The Serta plants were independent from each other, and each was different," he says. "Their cost structures varied depending on unionization and what they made. Plus historically, they were fairly autonomous anyway. They might have resisted another centralized plan from the corporate office." --I.M.

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