When Aaron Felder applied for a job with Homejoy, the on-demand housekeeping service, in May 2014, he figured he'd undergo some training before getting turned loose on bathroom grout. The closest he'd come to professionally cleaning was sweeping popcorn at a movie theater. But when the 26-year-old Bay Area native showed up for his interview--after completing a lengthy online quiz--he was told there would be no training. Instead, he was subjected to a "cleaning evaluation," two and a half unpaid hours in a client's home demonstrating his familiarity with the various tasks involved­--that is to say, cleaning it. Felder failed on his first attempt, but did it again and passed. For the next 13 months, he spent 20 to 30 hours a week cleaning houses and apartments around San Francisco and another 10 or so commuting between assignments. It was his only regular work.

For Homejoy CEO Adora Cheung, workers like Felder represented a conundrum. When Cheung and her brother Aaron launched the service in July 2012, they were so leanly staffed, she took some of the bookings herself, and quickly discovered that cleaning a house isn't as simple as she had thought. But hiring only experienced cleaners for Homejoy would have made the service more expensive, discouraging people from trying it. Training people was the obvious solution. Or it would have been, except that the IRS considers teaching a worker to perform a job "in a particular method or manner" a key sign that the worker is an employee, not an independent contractor. For Homejoy, the ability to classify its workers as independent contractors--the kind whose income is reported to the government on federal 1099 forms, not W-2s--was crucial. Hiring them as employees would have added 20 to 30 percent to its costs in the form of Social Security and Medicare deductions, workers' compensation insurance, paid time off, and other expenses. So Homejoy developed its hairsplitting approach, a vetting meant to establish some quality-control guardrails without explicitly telling workers how to do their jobs.

That distinction was lost on the labor lawyers who filed four separate lawsuits on behalf of employees who claimed that they'd been illegally misclassified as freelancers. Although Homejoy had raised $40 million in venture capital, the "misclassification" lawsuits made it impossible for Cheung to secure additional funding needed to stay solvent, according to the tech news site Re/code. This past July, Homejoy shut down. (Cheung did not respond to numerous requests for an interview. Details in this story are from past interviews.)

"The idea of job security is made up, anyway. We're talking about it as though it's still a thing."Bastian Lehmann, Postmates founder

Homejoy was the first casualty of the new labor wars. It won't be the last. If your business isn't clear about who is an employee, the war may come to you. Over the past five years, a posse of startups armed with cheap manpower and sophisticated software has been remaking the on-demand services market with an approach as disruptive as it is legally tenuous. It includes Uber, the alternative taxi dispatcher whose $50 billion valuation makes it the world's most valuable startup; Lyft, its biggest rival; TaskRabbit, which farms out errands and odd jobs; and Instacart, a $2 billion grocery-delivery service. Each has its own model, but what unites them is reliance on 1099 labor, and the legal and regulatory baggage that goes with it.

The founders say all they're guilty of is injecting some badly needed dynamism into the economy and giving consumers and workers alike options they didn't have before. "Overall, it's a very positive thing, creating a lot more jobs and economic improvement than harm," says Kevin Gibbon, CEO of Shyp, a shipping service. Criticisms of the 1099 employment model, they say, are rooted in nostalgia for an age when blue-collar jobs came with lifelong union guarantees and fat pensions. "We know we can't turn back the clock on the new economy," says Oisin Hanrahan, CEO of Handy, a cleaning-and-handyman service similar to Homejoy. People who go into the work force expecting to find a 1950s-style General Motors will miss out on the more entrepreneurial opportunities that exist in the so-called gig economy, says Bastian Lehmann, founder of Postmates, a startup that delivers meals in 40 markets. "The idea of job security is made up, anyway, by big companies that want you not to think about your job," he says. "We're talking about it as though it's still a thing."

But while the golden era of labor is gone, the laws that birthed it are still very much a thing, and lately they've been chafing hard against the on-demand sector. Uber, Lyft and Instacart are among the companies hit with class-action lawsuits like the one that did in Homejoy.* Filed in California, Massachusetts, and elsewhere, they seek Social Security and Medicare contributions, gas and mileage reimbursements, and other damages. Because so many potential plaintiffs are involved--Uber has an estimated 200,000 drivers in the U.S.--the damages could be huge. The prospect of such a huge payday has understandably attracted attorneys who would be unmoved by less lucrative worker grievances. "Plaintiffs' counsel are the labor unions of the 21st century," grumbles one CEO whose company is a defendant. (Most of the CEOs facing lawsuits won't talk on the record.) But courts have been receptive to misclassification suits. In September, in the most worrisome setback yet for 1099-reliant sharing-economy companies, a federal judge granted class status to Uber drivers, vastly upping the stakes on its legal defense and the likelihood it will have to settle.

Meanwhile, politicians and regulators are entering the fray. In July, the Department of Labor issued guidelines to clarify the distinction between employee and freelancer for the purposes of the Fair Labor Standards Act--and the new interpretations are not favorable to the new-economy model. Against this backdrop, Homejoy's shutdown had the look of a first domino toppling, and since then, many 1099-based companies have preemptively restructured their work forces. The founders of Shyp, Sprig, Luxe, Munchery, and Kitchensurfing, which are transitioning their workers to W-2 employees, say they'll spend more on labor but hope to make at least some of it back through more efficient operations. But efficiencies tend to come gradually and are hardly assured. Higher labor costs, however, are swift and certain. Shortly after granting its employees W-2 status, Zirtual, a startup that provided virtual online assistants, ran out of money and folded.

In the quest to vanquish inefficiencies, the on-demand business model favors elegant solutions and sleek technology. America's labor laws are anything but elegant and sleek. They're messy, clunky, vague, and idiosyncratic, but if your company operates in the on-demand economy, you're going to have to reckon with them.

 

If it seems like the laws that define work arrangements are poorly suited to the digital era, that's because they were written during an earlier one. Relations between worker and employer are governed by a welter of state and federal laws and regulations drafted in the first half of the 20th century to prevent child labor and other abuses in factories and on farms. The Fair Labor Standards Act, passed in 1938 as part of the New Deal, ushered in such innovations as the 40-hour workweek, overtime pay, and the minimum wage. "We're trying to fit this new economy into that old rubric," says Joseph Seiner, who teaches labor law at the University of South Carolina School of Law.

As the manufacturing-and-farming economy has given way to an information-and-service economy, the number of Americans making their livings from what economists call contingent labor has soared. In 1989, temporary or project-based employment accounted for 17 percent of the work force, according to the Bureau of Labor Statistics. That proportion has more than doubled, to 36 percent. Some 3.2 million Americans work at least part time for an on-demand service; for about a fifth of them, it's the primary source of income. By 2020, the number of on-demand jobs is projected to reach 7.6 million, according to a study from Emergent Research and Intuit. In surveys, on-demand service workers cite flexible hours as the biggest draw and low pay as their top complaint. Yet much of the fastest job creation in the gig economy is coming at the highly skilled, highly paid end of the marketplace, where physicians, lawyers, programmers, and other professionals sell their services on new marketplaces like UpCounsel, Doctor on Demand, and Upwork. From 2011 to 2015, the number of Americans earning more than $100,000 per year in 1099 income jumped 45 percent, according to MBO Partners, which supplies back-office support to the self-employed.

"We're trying to fit this new economy into that old rubric."Joseph Seiner, University of South Carolina School of Law, on the issue of 1099 contract workers

But the legal tests used to differentiate employees from freelancers are the same, regardless of how much they earn. To determine whether a job's income should be reported on a 1099 or a W-2, the law requires you to consider a number of questions: Is the work skilled or unskilled? An individual who's truly in business for herself likely has some kind of valuable expertise or talent to sell. Is the work an integral part of your company's core product or service? If you own a restaurant, your cooks are probably employees, since you need them every day, but the graphic designer who created your menu probably isn't. The list goes on and on. Do workers choose their own hours or do you assign them? Is it an open-ended relationship or a one-off transaction? Do you supply the tools they use, or do they buy them? Does a manager oversee the work? If they're providing services to customers, are they free to set the fees they charge, or do you determine them? All individual authorities--the Labor Department, the IRS, the states--have their own particular mix of criteria, but each of them seeks to clarify two essential facts: whether the worker is under your control, and who has the most power in the relationship.

Until recently, you could sidestep tough questions by presenting your company as a platform or marketplace that simply connects customers with providers and lets them transact. "I almost think of us as a logistics company," Uber CEO Travis Kalanick told a Chinese newspaper in July. But that stance gets them only so far. Consumers don't pay for clever logistics--they pay for experience and consistency of service. The genius of a successful on-demand startup lies in how it replaces human supervision with software sticks and carrots. Instead of performance reviews, you install user-generated ratings. In place of schedules, you provide economic incentives for working during peak-demand periods in high-traffic areas. Some companies, like domestic-services provider Handy, reward contractors who take on more hours by lowering the company's cut of their income. Workers who are too picky about assignments can be deactivated from the platform.

The gamble in this business model is that a carefully calibrated set of incentives will lead to a great consumer experience without setting off legal tripwires. Uber got as popular as it did as fast as it did not just because it connected passengers and rides, but because those rides were in clean, late-model cars, with polite drivers who offered breath mints and bottled water. "These companies, they don't want to be Craigslist," says Shannon Liss-Riordan, a veteran labor lawyer spearheading a number of the biggest misclassification suits, including the Uber class action. "There's an inherent tension in what they're trying to do--sell to the public this great new branded, consistent, high-quality service, yet deny that they provide any training to the workers or are controlling or instructing them in any way."

Case in point: Glamsquad, a year-old startup that sends freelance hair and makeup artists to a client's location. Glamsquad CEO Alexandra Wilkis Wilson told Inc. that the company requires stylists to undergo 40 hours of training to make sure they're able to re-create the brand's signature looks, like "The Vamp" and "The Starlet." When asked how that rigorous training squares with IRS guidelines on worker classification, Wilson demurred. A spokeswoman later attempted to amend Wilson's characterization, saying the "intense process" she described to Inc. is more a matter of vetting and auditioning than training. So, it's much like Homejoy's "cleaning evaluation," only 20 times longer and done at what Wilson called a "training studio."

No wonder the lawyers are licking their chops. But if startups are gravitating to the legal gray zones, it's because economic forces are pulling them in that direction. "The problem is people really do have episodic work that's gig-based," says Sara Horowitz, executive director of the New York City-based Freelancers Union. "If we just say everybody's been misclassified, it's not going to solve the problem. I don't want to be fighting a rearguard action over a manufacturing era that's over."

A hope for resolution resides in a rewrite of existing law. One path forward would create a third classification of worker called a dependent contractor, an employee type that would receive some of the protections of a full-fledged employee, perhaps disability and unemployment insurance but not expense reimbursement or overtime. (Canada and Germany already have this classification.)

Politically, however, the creation of a middle category of worker would be a hard sell, with labor unions likely to oppose it, says Brishen Rogers, a professor of labor law at Temple University, out of fear that it might tempt many big employers to eliminate fuller-benefit jobs. "This is often discussed as a way of essentially leveling up, but I don't see any reason to think the net effect wouldn't be a leveling down," he says.

 

Just after 5 p.m. on a golden San Francisco evening, Dan Cline pilots his banged-up Subaru station wagon through after-work traffic making dinner deliveries for Munchery, one of half a dozen well-funded startups hoping to corner the market for on-demand meals. After a year on the job, the tall, soft-spoken 46-year-old knows the four square miles of his delivery zone intimately: where it's safe to double-park, which streets snarl with weekend tourists. Cline drives the evening shift five or six days a week. He's trying to build up a business teaching drums during the day, but it's hard to find clients. "I never thought I'd be a deliveryman, but here we are," he shrugs.

Cline represents the latest plot twist in the on-demand labor saga. Unlike most of the couriers he battles nightly for curb space, he's a bona fide employee. Two years ago, before 1099 lawsuits were making headlines, Munchery's CEO, Tri Tran, made a decision to formally hire his workers. Tran wanted to make sure couriers, who are his startup's only human point of contact with customers, would feel loyal toward the company, represent it well, and be available when needed. Tran wasn't looking to be a trendsetter, but he wasn't alone for long. Shyp announced in July that it would begin transitioning its work force from 1099 to W-2. Luxe, a valet-parking startup, Sprig, a healthy meals provider, and Kitchensurfing, a personal-chef service, followed suit within weeks. Meanwhile, Instacart moved its in-store shoppers to W-2s in June but said making deliveries will continue to be contract work.

"If we just say everybody's been misclassified, it's not going  to solve the problem."Sara Horowitz, Freelancers Union executive director

Each of these enterprises offers its own rationale for why spending more on labor will pay dividends. Shyp's Kevin Gibbon says the company's intricate hub-and-spoke collection model requires a high degree of choreography. When a freelancer turns down an unappealing assignment, as they're free to do, "it really messes with our efficiencies and the operational process," he says. Luxe CEO Curtis Lee says his company can get away with a hit to payroll because its capital costs are so low to begin with: The only equipment its valets require is a smartphone and a metal scooter like one a child might ride. He expects to save some money on recruiting through improved retention. Sprig's Gagan Biyani says he's running "an intensely mission-driven company" and needs his couriers to be all-in so they'll evangelize for the cause.

In idealistic Silicon Valley, avoiding lawsuits isn't the kind of motive entrepreneurs will readily cop to, although it's clearly a chief factor. But there's a little more to it than that. The legal tussle may well divide the on-demand economy into two camps: the fundamentally sound companies--the ones that can figure out how to compete on any sort of playing field, as long as it's level, because they're selling a real innovation--and the companies that exist only because the current haze of legal and regulatory uncertainty paired with free-flowing venture capital has permitted them to flourish.

Gibbon, for one, believes the crackdown on worker misclassification has the potential to wipe out an entire tier of unimaginative, unsustainable "Uber for x" businesses whose only real "innovation" is shortchanging workers. "Some of the disruptions happening in these industries are just a matter of reduced cost, and those companies are going to run into problems," he predicts. In fact, it's already started. Just ask Homejoy's Adora Cheung.

 

*Correction: The original version of this story erroneously included Taskrabbit in a list of companies facing lawsuits over misclassification of independent contractors. 

From the November 2015 issue of Inc. magazine