The common denominator for all start-ups – whether your start-up has $50 or $500 million in its coffers – is its people. As they grow beyond founders, each start-up and emerging technology company will welcome new faces into the organization to deliver on its business plan. Whether they are new partners, employees, freelancers, consultants or otherwise – it is the human capital engine that often dictates the success or failure of an otherwise brilliant idea.
While welcoming like-minded, passionate people into one’s organization can be source of immense pride for founders, it also presents employment law challenges and pitfalls that often go overlooked, much to the detriment of the bottom-line. Our experience in this space informs the top five most overlooked (and potentially most damaging) employment law pitfalls your start-up should avoid:
1. Improperly Classifying Employees as Independent Contractors. One of the biggest mistakes that start-ups make is improperly classifying their workers. In an environment where companies are in a perpetual state of raising funds, there is often a natural cycle of adding workers in ones and twos and as the company’s coffers dictate. Because of this economic reality, many start-ups will engage what they will deem “consultants,” “contractors,” “freelancers,” or even “interns” in order to help execute their business plan. But this loose-goosy nomenclature can have serious consequences from an employment law perspective.
First, the determination of who is a “contractor” and who is an “employee” is dictated not by the two parties, but rather by federal and state wage-hour laws that employ multi-factor tests. The tests, while varied, ultimately look to the degree of control the company has over the worker, whether the worker provides similar services to other companies and hold themselves out to the public for such engagements, the permanence of the relationship, as well as other factors. Independent contractors are not subject to wage and hour laws (such as overtime and minimum wage requirements); nor are they subject to payroll tax.
Not surprisingly then, the consequences to a start-up for mischaracterizing an employee as an independent contractor can be significant, if not crippling. These include the payment of wages (minimum wages and overtime) that the employee would have otherwise been entitled to had they been classified correctly. Payroll tax liability can also be incurred as a result of the misclassification, which can also carry with it interest and penalties at best, and criminal penalties at worst.
One helpful way to ensure you are classifying your workers correctly is to create an accurate job description. Creating a good job description is valuable on multiple levels: it lays the foundation for what the job is and what the job is not; it can help the employer (and their counsel) “reality check” the position to properly classify the job, it can be used to differentiate and evaluate candidates on job-related reasons; and it can be used as a benchmark to evaluate a worker’s performance as appropriate.
2. Violating Wage Hour Laws by Paying Employees with Equity Rather Than Paying Minimum Wage and Overtime. After classifying a worker as an employee, many start-ups find that they do not have the cash flow to pay an employee a standard hourly wage or salary, and choose to offer equity, either in lieu of or in addition to an employee’s wages. This raises several concerns.
First, as a general matter, stock and options in a company do not properly count for purposes of minimum wage calculations. The Federal minimum wage is $7.25 per hour, and many states and cities have minimum wage laws that are significantly higher. By offering a sub-minimum wage rate that is supplemented by equity, start-ups are violating wage-hour laws. Wage and hour lawsuits – which are up 438% since the year 2000 – are among the most popular – and most expensive to litigate and defend. So, it is essential that workers are classified and paid properly.
Overtime, and the failure to pay overtime is another minefield for start-ups. Wage-hour laws distinguish between exempt employees (those who are ineligible for overtime by making at least $455/week (the “salary basis test”), and whose job duties fall into one of several exemptions, including executive, administrative, computer professionals (the analysis of which is anything but straightforward). Any employee who does not meet these criteria – which may include CEOs and founders – are eligible for and must be paid overtime for time worked.
State law differences further complicate matters. For example, overtime in Silicon Alley (for hours worked in excess of 40 for non-exempt employees) is calculated differently than overtime in Silicon Valley (which also requires the payment of daily overtime for hours worked in excess of 8 in one day) . While a common practice, keep in mind that providing equity does not alleviate an employer from the minimum wage laws, nor the obligation to pay overtime to non-exempt employees. Just as with misclassification of employees as independent contractors, the financial ramifications of misclassifying an employee as exempt when they are truly non-exempt can be staggering and can undermine, if not cripple an otherwise sound business plan.
3. Maintaining Invalid or Ineffective Restrictive Covenants. Many start-ups prudently strive to safeguard their company’s treasures, secrets and intellectual property. Vehicles commonly employed are confidentiality agreements, non-competes, non-solicitations and NDAs to effectuate this end (collectively “Restrictive Covenants”). A non-compete provides that an employee will not work for a competitor after her employment ends. A non-solicit agreement can be directed at either customers and/or employees, and prevents a former employee from seeking out the company’s customers to do business with a new employer or poaching current employees to be hired by the new employer. Confidentiality agreements and NDAs protect certain information that is not publicly known.
But after committing pen to paper, too few founders and start-ups ask the critical questions: “Are my Restrictive Covenants really doing what we want them to do?” “Are they fit for purpose?” “Are they truly reasonable, and will they be upheld?” Since Restrictive Covenants are generally not self-enforcing, start-ups should also candidly ask themselves: “Am I willing to commit the time, money and resources to enforce these provisions in court?”
It is also important to be mindful that every state treats these types of agreements differently, depending on factors such as length of time, geographic reach, scope, and whether the agreement can be “blue penciled,” or changed by the court for reasonableness. In fact, in California, non-compete agreements are invalid, and their mere inclusion in an agreement may subject an employer to tort liability. It is essential that your Restrictive Covenants are properly drafted with counsel, that they are tailored to the individual to whom they are proffered (one size probably does not fit all), and takes into account where the company may seek to enforce those agreements.
4. Failing to Establish Any Workplace Policies. When in Doubt, Start with Two. Most start-ups are not concerned with creating robust employment policies when they have less than 5 employees on the payroll. While it is understandable that creating a comprehensive handbook is not on the top of the list of priorities, and indeed may not be practical given small numbers and the nascent stage of your business, all start-ups, no matter what the size, should at least have two: a sexual harassment and equal employment opportunity policy.
Under federal law (and many state and city law counterparts), an employer can demonstrate that having both a sexual harassment policy with a complaint procedure (so employees can let the company know if harassment or discrimination is occurring in the workplace) is a defense to a sexual harassment or other discrimination claim. If an employee files suit for sexual harassment or other discriminatory conduct, but never complained to the employer first, the employer can use that as an affirmative defense to the claim. Many state and city anti-discrimination laws apply to employers with only a single employee, and having a policy is a tremendous benefit should litigation arise.
A sexual harassment policy is relatively simple to establish, and it may be posted conspicuously in an employment manual, on the company’s intranet site, or provided separately as part of new hire paperwork. It is also beneficial to have the employee sign an acknowledgement form stating that they have received and understand the company’s EEO policy and its complaint procedure. Maintaining such internal controls will also put the start-up in good stead with strategic partners and customers.
5. Mismanaging Employees Who Leave Your Start-Up. Start-ups are often focused on just that – starting up. Unfortunately, it is inevitable that some employment relationships just will not work out. When an employee leaves, either voluntarily or involuntarily, start-ups should be focused on protecting assets. If an employee is being let go, you may wish to consider a separation agreement, where an employee waives his or her right to bring a lawsuit in exchange for an amount of money or other consideration. When terminating an employee, the last thing most employers want to do is give them more, but entering into such an agreement could be significantly less expensive than a lawsuit – representing a good long-term investment.
Start-ups will also want to focus on protecting its physical and intellectual property when employees leave the business. If the employee has access to or managed your company’s social media accounts, then it will be important to ensure that all passwords are returned or changed. Many lawsuits have been filed recently asserting that company social media accounts (including LinkedIn and Twitter) belong to employees who write for them, and that the followers or connections belong to the employee – an area of law that is still developing.
Further, if an employee was given a phone, tablet, or laptop, it will be imperative to have those devices returned. If the company allows an employee to use his or her own phone (e.g. the employer has a “Bring Your Own Device” practice), make certain that work email gets wiped from his or her personal phone.
And remember all of those Restrictive Covenants you had the employee agree to? Be sure to remind them on their way out that their obligations thereunder continue post-employment. Send “reminder” letters as needed. In the event a former employee begins to engage in conduct that potentially violates their post-employment obligations, consider ratcheting up the correspondence, both with the employee, and potentially their new employer.
While it may defy common sense and a company’s best intentions, it is often best to plan for the end – at the beginning.