Many emerging companies begin their corporate life without a firm grasp on critical issues related to wage and hour laws. With limited financial and human capital at the outset, emerging companies have a tendency to take a reactive approach to HR, often with devastating near term effects. With its initial core group of employees, an emerging company may try to keep the purse strings tight and seek an alternative to regular wages. As it expands, an emerging company might bring on new personnel as independent contractors, or in a joint employment arrangement in lieu of a direct hire model. Armed with a heightened understanding of the legal landscape, and with adequate preparation, emerging companies can maintain compliance with wage and hour laws and regulations and avoid the expensive hazards associated with transgressions in this complex and ever-evolving area of employment law.
The First Employees
In an emerging company’s infancy, its first employees are often the founders and/or others who have invested their capital, intellectual property, or unique talents in the enterprise. In these early stages of development, oftentimes the primary objective is to keep the cash-poor company’s newly minted coffers as full as possible by compensating employees and other service providers with equity in lieu of wages, or by deferring wage payments to a later date. These practices, while frugal, are problematic for a few reasons.
The first obstacle to this form of frugality is the federal Fair Labor Standards Act (“FLSA”) and its state law equivalents, which require employers to regularly pay all non-exempt employees at least the minimum wage and an overtime premium. The FLSA applies to employees who work for businesses with annual sales of $500,000 or more (“enterprise coverage”), or who are engaged in interstate commerce (“individual coverage”). While a fledgling startup may not meet the enterprise coverage sales threshold in its first year or two, individual coverage is much broader. Under the United States Department of Labor’s rubric, virtually any contact by an employee with another state will trigger coverage. This includes, but is by no means limited to, manufacturing goods to be sent out of state, regularly making telephone calls to people in other states, and traveling out of state on business. In short, the FLSA covers virtually all workers, and those few that are not covered will likely be protected by state law.
Thus, in addition to coverage under federal law, most states have wage and hour laws that apply even more broadly. For example, some state and local laws require employers to pay a higher minimum wage than the $7.25 called for by the FLSA. Several of these cities and states are popular sites for startups, including California ($11.00 per hour), Massachusetts ($11.00 per hour) and New York City ($11.00 per hour up to $13.00 per hour depending on the number of employees). Where the FLSA and state or local laws differ, the more employee-generous rule must be applied.
Coverage under the FLSA and state wage laws cannot be privately waived, even pursuant to a written agreement signed by the worker. This is not to suggest that every early employee should be considered an hourly wage earner, as there are special exemptions for various positions discussed in greater detail below which may apply to one or more employees. Suffice it to say, however, that in the early days of an emerging business, it is critical to appropriately define the terms of the relationships between the company and workers, and to ensure they are paid in accordance with all laws on the federal, state and local levels.
Irrespective of the rules, it is common for many startups, typically comprised of a group of likeminded and forward thinking individuals, to believe they will never face negative consequences for promising equity grants in lieu of wages or deferring payment of wages—that everyone is part of the team and looking out for the company’s best interests. This optimism, while laudable, is at times misplaced for the simple reason that employees, including founders and early believers, may not remain with the company long enough to reap the rewards of equity participation. It is when these individuals leave, or, worse, when management or new investors force them out, that grants of equity in lieu of wages or a deferred-wages arrangement go from thrifty ideas to costly headaches. These departing employees may claim they have been underpaid or were not paid at all, and may sue, seeking not only reimbursement for unpaid wages and overtime, penalties, interest and possibly attorneys’ fees. Some claims may expand into class actions as the company grows but, even before then, the company can be subjected to audits from the federal and/or state Departments of Labor. These audits, once started, usually expand to and consider all workers and not just the one who raised the issue. The prospect of this enormous financial liability can delay capital raising initiatives, refinancing efforts, or a potential sale. Avoiding the pennywise, pound foolish practice of seeking alternatives to wage payments will avert these often costly headaches.
Independent Contractor or Employee
For a variety of reasons, including avoidance of payroll taxes and the myth that independent contractor classification provides more flexibility in the relationship, such as the right to terminate the relationship at will, some emerging companies classify initial service providers working full or part-time for the company as “consultants” or “independent advisors,” many times with the promise of a salaried position once the company is more suitably funded. Some of these independent contractors are issued options in lieu of cash compensation. In the event the independent contractor label is misapplied, this may, in addition to raising the specter of civil liability for FLSA and other wage/hour law violations, result in misdemeanor criminal liability for willful failure to pay wages. Viewed through the lens of a federal and state administrative agency enforcement, the practice of mislabeling employees as independent contractors as a cost-saving measure is fraught with risk. When a service provider is misclassified as an independent contractor, a number of consequences can arise: i.e., the employer is not withholding regular taxes or FICA; the employer is not remitting payroll taxes; and, depending on the number of other workers classified as employees who may be enjoying some benefits, the employer is not properly offering those benefits to the misclassified contractor. Unsurprisingly, the IRS and state Departments of Labor are aware of this practice and routinely audit companies suspected of misclassifying employees as independent contractors, often resulting in significant penalties and fines.
In short, prior to designating a service provider as an independent contractor or consultant, a little consideration, analysis, and documentation can go a long way.
The Obama-era Department of Labor (DOL) issued guidance on misclassification that took an expansive view of these relationships, strongly favoring an employment relationship in order to maximize the protective reach of wage and hour laws, unemployment compensation, and workers compensation. The Trump DOL rescinded this guidance in favor of a more traditional approach that examines the economic realities of the relationship between the provider and the employer. Under this approach, courts typically consider some combination of the following factors:
the extent to which the work is an integral part of the business;
Typically, if the work being performed is “integral” to the employer’s business, an independent contractor designation is inappropriate, especially where other company employees perform the same or a similar job. The work can still be integral if it is performed remotely.
the individual’s opportunity for profit or loss and investment in the business depending on his or her managerial skill;
If a worker’s managerial skills affect his or her opportunities for personal profit or loss, this factor will support an independent contractor relationship. This factor addresses a worker’s ability to impact his or her own bottom line, not the employer’s.
the extent of the relative investments of the employer and worker;
If a worker’s investment in a given project, including the assumption of risk, is comparable to the employer’s investment, this factor will support an independent contracting relationship.
the degree of skill and independent initiative required to perform the work;
If a worker’s duties require special skills, business judgment, and initiative, this factor will support an independent contracting relationship. The focus is on business skills, independent judgment and initiative. Technical skills are not determinative of an independent contractor relationship.
the permanence or duration of the working relationship;
Independent contractors will tend to be those workers who provide services for the duration of a given project, not for a period of time. A common mistake is to view a part-time or seasonal worker as an independent contractor simply because the position is temporary.
the degree of control exercised by the “employer” over the manner in which the work is to be performed.
Control should not play an outsized role in the determination. The question is not whether the putative employer is looking over the worker’s shoulder but whether the method or means of performing the services is determined by the worker or the company. To be an independent contractor, the worker must actually control meaningful aspects of his or her performance akin to conducting one’s own business.
It is important to note that no single factor in the economic realities test is determinative; rather, the factors are considered as a whole. It is perhaps equally important to note that the label assigned to the relationship, whether by the employer, the worker, or by an agreement of the parties, is not controlling and usually given little or no weight. The question is whether the alleged independent contractor is in business for him or herself, or instead is economically dependent on the employer.
Some states, including California, Massachusetts and Connecticut, use a slightly different approach referred to as the “ABC” test. Under this test, an independent contractor designation will only pass muster upon a showing by the company that:
(A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
(B) the worker performs work that is outside the usual course of the hiring entity’s business and/or place of business; and
(C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
Each of these factors must be met to rebut the presumption that a worker is an employee. This is less flexible than the economic realities test, and the costs associated with defending a misclassification claim under this rubric can be significant. A recent decision in California highlights the challenges companies face in misclassification cases. In Dynamex Operations W., Inc. v. Super. Ct. of Los Angeles, 4 Cal. 5th 903, 232 Cal. Rptr. 3d 1, 416 P.3d 1 (2018), two delivery drivers asserted that they were misclassified as independent contractors and therefore entitled to seek relief for alleged violations of California’s wage and hour laws. To determine whether the two drivers could bring a class action claim against Dynamex, the California Supreme Court adopted the ABC test, establishing a standard that assumes all workers are employees and not independent contractors, unless the hiring entity can establish every component of the ABC test. The presumption of employment may be rebutted but generally reflects hostility to independent contracting in a state that is well known for attracting emerging businesses.
This is not to suggest that an independent contracting arrangement is impossible, or even inadvisable. It is only to say that the relationship should be thoroughly vetted, understood, and documented before it is implemented. Independent contracting is not just an easy work-around for wage and hour obligations.
Freelance Isn’t Free
Some venues have recently broadened the protections for workers against potential misclassifications. For example, under New York City’s “Freelance Isn’t Free” Act, a “freelance worker,” defined broadly as any person, whether or not incorporated or using a trade name, who is retained as an independent contractor to provide services in exchange for fees exceeding $800, either by virtue of a single contract or multiple agreements which have been entered into during any 120-day period, must be provided a written contract that includes, among other things, a specific description of the work to be performed, the value of the services, the rate and method of compensation, and the date payment is due. The Act provides for penalties where full and timely payment pursuant to the contract is not made. If the contract does not provide for a specific payment date, the due date shall be deemed to be 30 days after the work is completed. Hiring parties cannot require freelancers to accept less than the agreed-upon payment as a condition of compensation. In addition, companies are prohibited from retaliating against a freelancer for asserting rights protected under the Act. The Act includes penalty provisions for violations, including a $250 fine for failing to provide a written contract, double the amount due for failing to make full and timely payment, statutory damages, civil penalties of up to $25,000, and attorneys’ fees.
As part of its classification decisions, emerging companies doing business in New York City should ensure that all new agreements with independent contractors comply with the Act’s requirements.
Another common wage related issue for emerging businesses concerns the use of salaries in lieu of hourly wages and, more broadly, the widely held misperception that compensating employees on a salaried basis automatically entitles the company to classify those employees as “exempt” from minimum wage and overtime laws. Indeed, some emerging businesses attempt to simplify their payrolls, and endeavor to circumvent the hassle of compliance with wage and hour laws by paying all employees a fixed salary for all hours worked on the assumption that overtime pay is not required. Through such classification as well, these companies believe that if employees receive a salary, especially if it’s a relatively high salary, they are not required to track the employee’s work hours. Unfortunately, under both federal and state law, simply paying an employee a salary does not of itself alleviate the need to track and pay for all hours worked, and to pay overtime. Instead, payment by salary is only one part of a two-part test for exemption from wage and hour laws. The second, and arguably more critical, component of the test requires an analysis of the employee’s position and duties.
There are seven FLSA wage and hour exemptions commonly applicable to emerging companies: business owners, executive, administrative, professional, computer, outside sales, and highly compensated employees can all be considered exempt if they satisfy the following tests. While the FLSA exemptions have been widely adopted, and adapted, by the states, some states do not recognize every exemption. For example, California does not recognize the highly compensated employee exemption, so emerging businesses cannot rely on that exemption under California’s wage and hour laws. Also note that the minimum salaries discussed below are drawn from the FLSA; state and local laws may provide for greater minimum salaries.
An employee who owns a bona-fide 20-percent equity interest in the company and is actively engaged in its management will be exempt from the FLSA’s wage and hour requirements.
The business owner exemption is frequently claimed, and sometimes later disclaimed, by early-stage employees. It is sadly common for founding members of emerging companies to accept an equity grant, and the business owner exemption, only to claim a misclassification when an aspect of his or her relationship with the other founders sours. To avoid misclassification hazards, and to claim this exemption, it is critical to ensure that the employee’s equity interest is both appropriately memorialized and valued, and made in good faith. A hollow, verbal 20-percent equity grant issued to avoid cutting a paycheck will not pass scrutiny.
Minimum Salary: $455/week
The employee’s primary duty must be managing the business, or managing a customarily recognized department;
The employee must regularly direct the work of two or more full time employees (or the equivalent of two full time employees);
The employee must have the authority to hire or fire other employees, or the employee’s suggestions and recommendations as to the hiring, firing, advancement, promotion or any other change of status of other employees must be given particular weight.
Minimum Salary: $455/week
The employee’s primary duty has to be office or non-manual work directly related to the management or business operation of the employer or its customers and the employee must exercise discretion and independent judgment with respect to matters of significance.
Minimum Salary: $455/week
The employee’s primary duty has to be the performance of work that is predominantly intellectual in character in a field of science or learning, with knowledge gained through a prolonged course of specialized intellectual instruction. The employee must also consistently use discretion and judgment.
There is also a creative professional exemption wherein the employee’s primary duty must consist of work requiring invention, imagination, originality or talent in a recognized field of artistic or creative endeavor.
Minimum Salary: $100,000 per year
The employee’s primary duty includes performing office or non-manual work;
The employee customarily and regularly performs at least one of the duties of an exempt executive, administrative or professional employee
Minimum Salary/Fee: $455/week or hourly rate of at least $27.63
The employee must be a computer systems analyst, computer programmer, software engineer, or similarly skilled;
Primary duties are highly technical and include, among other things: determining a computer system’s hardware or functional specifications, designing or testing computer systems/programs based on user or system design specifications and the machine’s operating systems.
It is important to note that a company’s help desk personnel do not qualify for this exemption.
Minimum Salary: None.
Primary duty must be making sales or obtaining orders or contracts for services, or for the use of facilities for which consideration will be paid;
Employee must be customarily and regularly engaged away from the employer’s place of business.
A thorough and honest audit of the workforce of an emerging company to determine whether to classify employees as exempt or non-exempt can make a random, or targeted, audit by the federal or state DOL, or a wage claim from a former employee, much less burdensome on a new company.
Note that the salary thresholds for the executive, administrative, professional, and computer exemptions are, in 2018, an almost astoundingly low annual sum of $23,660. The FLSA minimum salary threshold has not been adjusted in over a decade. An attempt by the Obama-era DOLto more than double the salary threshold was blocked in 2017. At least one court has questioned the legality of a salary threshold in the first place. U.S. Secretary of Labor R. Alexander Acosta has suggested the salary threshold should be adjusted up to “around $33,000” per year. It is anticipated that the US DOL will begin the rulemaking process in 2019 with an eye toward implementing changes by 2020. In addition to this likely change, as discussed above, some state and local laws currently require higher minimum salaries for exempt employees. These state and local salary thresholds and exemption requirements must be reviewed in connection with any classification decision.
Before an emerging company makes the decision to classify an employee as exempt, it should undertake a careful analysis of an employee’s duties and ensure the employee’s salary meets the necessary weekly minimums, or other compensation requirements, for an exemption to apply. While this may seem like a daunting, or even onerous task, appropriate classification from the outset can avoid costly disputes and financial liabilities.
Joint Employment Considerations
Another consideration for emerging companies concerns the joint employment arrangements that occur when an employer uses a staffing agency, either for administrative convenience, or based on the presumption that its liability is totally passed on to the agency for any compliance issues. There are two types of joint employment relationships: horizontal, where an employee has employment relationships with two or more employers and the employers are sufficiently associated such that they jointly employ the employee; and vertical where an employee has a relationship with one employer (staffing agency, subcontractor, etc.) and the “economic realities” show that the employee is really economically dependent on, and employed by, another entity; typically a contracting employer. Below we focus on vertical joint employment due to its greater relevance to emerging businesses.
The analysis for vertical joint employment focuses on the relationship between the employee and the potential joint employer. Where an emerging business uses a staffing agency or subcontractor, the focus will be on the worker’s relationship with the emerging business.
Although they bear the same label, the economic realities test for vertical joint employment is different from the economic realities test for independent contracting. For vertical joint employment, courts will generally look at some combination of the following factors:
Whether the potential joint employer directs, controls, or supervises the work performed.
Whether the potential joint employer has the power to hire or fire, modify employment conditions, or determine rates of pay.
Whether, depending on the industry at issue, the employee’s position is permanent, full-time, or long term.
If the employee’s work for the potential joint employer is repetitive, rote, unskilled, and/or requires little or no training, this is indicative of economic dependence between employee and potential joint employer.
Whether the employee’s work is integral to the potential joint employer’s business;
Whether the work is performed on the potential joint employer’s premises;
Whether the potential joint employer performs administrative functions for the employee (payroll, workers comp, etc.)
No single factor is determinative and courts tend to apply the factors flexibly. It behooves an emerging company to carefully consider the realities of its relationships with staffing agencies and subcontractors to avoid unintended, and unwelcome, employment relationships. In general, while companies can pass the responsibility for tax and other withholding to the staffing agency, which is the technical “employer,” nevertheless a joint employment relationship can still lead to liability for an emerging company for wage and hour law violations as well as violations of other state and federal laws governing the employment relationship, including leave and discrimination laws.
Another classification consideration often faced by emerging businesses is the internship relationship. Many emerging companies are tempted to bring on young, energetic talent at a low wage rate or avoid paying wages altogether in favor of an educational experience. However, the federal and state Departments of Labor have turned a keen eye to these relationships. Emerging companies can look to interns as useful members of the workforce, but they should not do so without offering an appreciable benefit in exchange for the interns’ work.
Interns that qualify as employees are entitled to the protections afforded by federal and state employment laws, including minimum wage and overtime pay requirements. The analysis turns on whether the intern or the employer is the primary beneficiary of the relationship. To make this determination, courts will look at what the intern receives in exchange for the work he or she is performing. If the intern is highly compensated, it is unlikely that any further inquiry will be necessary. Ultimately, a court will look at the economic realities of the relationship and consider the following factors:
Extent to which intern/employer understand there is no expectation of compensation.
Extent to which internship provides training similar to what would be given in educational environment.
Extent to which internship is tied to intern’s formal education program by integrated coursework or receipt of academic credit.
Extent to which internship accommodates intern’s academic commitments by corresponding to the academic calendar.
Extent to which internship’s duration is limited to period in which it provides beneficial learning.
Extent to which intern’s work compliments, rather than displaces, the work of paid employees while providing significant educational benefits to intern.
Extent to which intern and employer understand that the internship is conducted without entitlement to a paid job at the conclusion of the internship.
As with the other economic realities explored above, these factors are non-exhaustive and should be balanced as a whole; no one factor is more or less important than others. The caution here for for-profit emerging companies is to ensure that interns who are brought into the fold are offered an appreciable benefit in exchange for their hard work.
A major consequence of misclassification, whether by non-payment wages to an altruistic early employee, by nonpayment of overtime to a worker misclassified as exempt, or by failing to pay all wages earned by someone misclassified as an independent contractor, is the variety of damages available pursuant to state and federal laws. Indeed, federal, state and local laws carry significant penalties for failing to pay the wages required by law, including civil fines, penalties, double and triple damage awards, attorneys’ fees, as well as the potential for criminal penalties. Emerging companies need to also keep in mind that liability is not restricted to the entity, but rather, in most cases, may be borne by the individual decision-makers as well.
Arbitration agreements are a common tool used by many companies in an effort to minimize the costs of employee wage claims, but they carry pros and cons. Arbitrations tend to be private proceedings, avoiding the inherently public nature of state and federal court, allowing an emerging company to avoid unwelcome publicity related to an employee’s grievance. Arbitration with a single employee is in most cases less costly than a jury trial. Additionally, arbitrator’s awards tend to be smaller than awards from state and federal juries. Arbitrators can be more professionally inclined, eschewing the emotion and bias that can accompany a jury’s award. With the United States Supreme Court’s recent decision in Epic Sys. Corp. v. Lewis, 138 S. Ct. 1612, 200 L. Ed. 2d 889 (2018), holding that employers can enforce arbitration agreements with class action waivers, emerging companies can view arbitration as an employer and single-employee transaction as opposed to a collective action with a massive award on the line. The comparatively lower cost, efficiency, and enhanced likelihood of a reasonable award should factor into an emerging company’s consideration of arbitration agreements.
A significant drawback to arbitration concerns appellate review. Although employers are loath to lose an arbitration, if the facts aren’t favorable, or if the arbitrator simply rules against the employer, arbitrator’s awards can only be vacated under very narrow circumstances. In fact, under the Federal Arbitration Act, even an arbitrator’s mistake of law is not grounds to vacate an award.
In addition to appellate concerns, although arbitration costs remain comparably lower than litigation costs, they have grown more unwieldy in recent years as arbitrators have taken on more complex disputes and permitted more aspects of traditional litigation to seep into arbitration proceedings. Employers also frequently face the expense of compelling employee arbitration disputes, a proceeding that has to occur in a court before arbitration commences. Coupled with the fact that employers typically bear the burden of paying for the arbitration, cost should not be an afterthought.
If an emerging company does opt for arbitration, it should exercise great care in crafting the arbitration agreement, giving due consideration to every detail, including the time to claim arbitration, choice of arbitrator, and the rules to govern the arbitration.
Other Wage and Hour Considerations During the Employment Relationship
In addition to determining the appropriate classification for its workers, an emerging company has other wage and hour considerations once the employment relationship has been established, including paid sick leave, rest breaks, and travel time.
Paid Sick Leave
A number of jurisdictions, including eleven states, New York City, and the District of Columbia require employers who meet certain criteria to provide employees with paid sick leave, even where the entity has a modest number of employees. Each paid sick leave law has its own unique characteristics, but there are a number of common denominators. Covered employers are typically defined by the number of people they employ. An emerging company should review state and local laws to determine what paid sick leave requirements, if any, it must follow.
Because it carries serious implications in a locality that attracts emerging businesses, we will use New York City’s paid sick leave law for illustration purposes. New York City’s law requires employers with five or more employees who are employed for more than 80 hours per calendar year in the geographical confines of New York City to provide all its employees with paid sick time. This determination can be made using a joint employer analysis, discussed above, and does not depend at all on where the employee maintains his or her residence; if a business is found to employ five people for 80 hours per year in New York City, up to 40 hours of paid sick leave per year, accrued at a rate of one hour for every thirty hours worked, must be provided. Notably, this applies to employers who are themselves located outside of New York City; the focus is on where those five employees perform their work.
For any paid sick leave law, if an emerging business offers its employees paid sick leave that is more generous than the state or municipal law requires, provided the paid leave is accrued at a rate equal to or faster than the law requires, they will likely be in compliance with the law. For example, if an employer permits its employees to accrue up to 80 hours of paid sick leave at a rate of one hour for every 20 hours worked, the employer will be in compliance with the New York City sick leave law’s accrual requirements.
Beyond sick leave accrual, emerging companies need to be mindful of state and local law, as well as their own internal policies, concerning the accrual and payout of accrued paid leave. For example, in California, any accrued leave time is considered wages that must be paid out upon termination of the employment relationship and this cannot be waived. Other jurisdictions carry accrued time payout requirements as well; an emerging company should ascertain what state and local laws require, and be sure to track accrued employee time to remain in compliance.
Most employers provide their employees with meal and rest breaks throughout the work day and a number of states require employers to provide such breaks. The question of whether those breaks are compensable depends on the break. Regulations promulgated by the US DOL provide that while breaks are not mandated, where breaks are given, those of 20 minutes or less in length are compensable because they are deemed to primarily benefit the employer. Here again, state and local laws must also be reviewed to ensure compliance.
A final, but by no means the final, consideration for emerging companies is whether employee travel time is compensable when non-exempt employees travel for work. The general rule is that travel away from home is worktime when it cuts across a regular workday, and travel outside of a regular workday as a passenger on a train or airplane is not worktime. FLSA compensable worktime does not include employee commuting time, and the use of a company vehicle does not transform non-compensable travel into compensable time. An emerging business with employee travel considerations should also consult state and local laws concerning compensable travel time.
Obviously, a myriad of pitfalls face emerging companies in the area of wage and hour law that are too often overlooked or not given serious consideration due to the distraction and complications of corporate law applicable to starting a venture in the first place. However, taking a proactive rather than reactive approach to employment law obligations can save emerging businesses from immeasurable financial hardships and headaches. Devoting the time to consider, strategize, and appropriately implement employment relationships will ensure that an emerging company can focus on its own growth and success, rather than the worries of attracting the scrutiny of the Department of Labor and the courts when the “honeymoon” period between a new company and a worker turns sour.
This article is part of a series called, “Legal Issues for High-Growth Technology Companies.”