By UpCounsel Attorney Josh Garber
Hiring new members of the team is a daunting task for any employer but especially startup founders. Employment law can be a confusing and time-consuming minefield, and the consequences of making a mistake can range from costly to financially devastating.
While most startup founders would love to make sure every member of their team is well paid, has great benefits, gets the time off they need and more, companies are faced with investor interest, and runways and resulting budgets that can prevent them from achieving these goals.
The first year of operation can often make or break a startup. Below is a list of the top employment law issues startups face in the first year and what to consider when faced with these matters.
1.) Employee Classification
It’s crucial for employers to classify their workers correctly to avoid lawsuits and substantial government penalties.
It’s crucial for startups to classify their workers correctly to avoid costly litigation and substantial government penalties.
Employee v. Independent Contractor
This very headline is enough to give some companies chills. Whether workers are correctly classified as employees or independent contractors is a hotly-contested issue, currently playing itself out in state and federal courts throughout the country.
Financially, it boils down to this: hiring a contractor is much cheaper – by about 40 percent – than hiring an employee. When hiring an employee, employers must pay federal and state taxes, unemployment insurance, health insurance, among other costs – all of which they can avoid by hiring a contractor.
The test to determine whether a worker is an employee or contractor boils down to one central issue: control – does the employer control where, when and how the work is performed? If so, the worker is very likely an employee. But the test is much more complicated, and startup founders ideally would hire employment counsel before classifying workers because the penalties for misclassifying employees as contractors can be huge.
In California, state penalties alone range from $5,000 to $25,000 per violation, and on top of that, the IRS imposes a penalty of 1.5 to three percent of the employee’s wage. This is in addition to any lost wages and overtime the employer may owe.
Exempt v. Non-Exempt
A common misconception, particularly among early-stage companies, is that salaried employees are not entitled to overtime pay. In fact, whether or not employees are salaried has little to do with whether they can collect overtime.
And a company’s failure to pay overtime and give appropriate breaks to nonexempt employees can be incredibly costly, resulting in back pay, waiting penalties and fines.
The test to determine whether a worker is an employee or contractor boils down to one central issue: control.
To determine whether an employee is exempt from overtime pay, an employer must determine if the employee qualifies for an exemption, the most common of which are administrative, executive and professional.
Under each of these exemptions, employees must have the authority or power to make independent choices – free from immediate direction or supervision – in matters of significance to the company.
In other words, employees’ titles don’t affect whether they are exempt. Only their actual job responsibilities matter.
Keep in mind that there is usually an income requirement for employees classified as exempt. In California, for example, in addition to meeting all of the aforementioned criteria, an employee must be paid at least two times the minimum wage ($41,600 annually) to qualify for an exemption.
2.) Equity Incentive Plans
A major way startups attract top talent is through offering equity in the company. Doing so, however, is no easy task.
From the start, companies should develop an equity incentive plan, including how much equity to divide among employees, the number of shares granted and vesting schedules. Depending on the employee’s background and value, equity offerings can vary drastically.
In determining what equity to offer employees, startups must consider their investors. While a company may sometimes be able to offset lower salaries with a greater number of shares, it needs to be sure that it’s not giving away so much equity that it can’t attract top talent in the future, dilutes the investment of angels and other investors, or that the contract is worded in a way that can cause disputes over vesting schedule and payouts later on.
A common misconception, particularly among early-stage companies, is that salaried employees are not entitled to overtime pay.
Because of the risks and benefits associated with offering equity to employees, it’s important for startups to seek out legal advice in setting out their equity plans.
3.) Paid Time Off Policies
Startups are faced with stiff competition and pressure to provide the best benefits – with their peers offering employees paid gym memberships, free beer, shuttles to work and catered lunches.
Before startups to decide to provide these perks, they must first decide how much sick and vacation time they will allow employees to take each year.
Under a traditional paid time off (PTO) system, an employee accrues a certain number of paid days off per year, and the employee can use those days off for sick leave, vacation pay or other approved reasons. When an employee leaves the company, the employer must pay the employee out for any days they have accrued and haven’t used. This can be a huge cost for employers.
This is partially why “unlimited” time off has become a trend among startups. Under an unlimited vacation policies, employees who leave the company do not create the financial burden of an unexpected accrued leave pay out.
Practically speaking, unlimited time off policies have largely benefited employers, and employees generally take less days off.
A traditional PTO policy can result in huge, unexpected costs when an employee leaves your company.
4.) Creation of Employee Handbooks
At what point is your company ready for a comprehensive employee handbook?
Employee handbooks serve many purposes – they promote a company’s culture, articulate the company’s discretionary employment policies and help prevent future employment-related litigation.
While there are many benefits to having an employee handbook, early-stage companies often aren’t ready and don’t have the resources to cementing their employment policies.
For instance, when a company only has a handful of employees, it may not make sense to spend a great deal of time legally outlining a paid parental leave or remote working policies.
But as they build out their teams, startups should prioritize creating an employee handbook to ensure they’re in compliance with the law, including disability leave, parental leave and sexual harassment laws. This is particularly important for early-stage startups, which don’t have dedicated HR teams.
For key hires like C-level executives, and key departures, such as co-founders, startups should hire outside counsel.
5.) Employment Contracts
Startups should determine whether to hire an attorney to draft an initial set of employment documents (such as offer letters, separation agreements and stock option grants) or to download these documents off the internet or take them from other companies and avoid a lawyer altogether.
After receiving a draft of employment contracts, cash-strapped startups often customize the documents themselves for future hires and firings. Others use an attorney each time documents are signed.
For key hires, such as C-level executives, and key departures, such as co-founders, startups should hire outside counsel.
It’s worth keeping in mind that even the smallest phrasing change in employment contracts can have significant ramifications, so hiring an attorney to draft and review these documents is the ideal route once revenue starts coming in.
These are just a few of the many employment law issues faced by startups in their first year. It’s wise for startups to hire trusted legal counsel with experience in employment law to advise them as they scale in order to avoid major costs and penalties.