By: Jack Thaler, J.D. Candidate, Boston College Law School Class of 2017
November 2016
Life is hard out there for a startup company. You have finally come up with a brilliant idea, you are excited to make it a reality, and you know it is going to be a massive success. There is only one problem. You have no money! A serious challenge facing most startups, or any new business for that matter. Lets’ face it, your service or product is new, no one knows anything about you or your brand, and you probably aren’t best friends with Mark Cuban and his Shark Tank friends who can get you started with a large investment. So, how do you run this new business? As any business owner would know, there is only so much that one person can do. Eventually, you will need help with a variety of tasks in order to grow the business. This can be a problem for an entrepreneur who is short on cash. Most business owners want and need help operating their business, but cannot or do not wish to spend their cash on hourly or salaried employees. There are three commonly used tactics that entrepreneurs will try to use in order to avoid having to treat those working for them as employees. Each of these tactics should be approached with caution.
1.) Independent Contractors
One question that we frequently get from clients is whether or not they can classify the individuals that they hire as independent contractors. The answer depends in large part on the state in which the client is operating. In Massachusetts, however, the answer to this question will likely be, no. In 2004, Massachusetts amended its laws to make it more difficult for an employer to grant a hired worker independent contractor status. As a result, Massachusetts’s test for determining employment status is stricter than the federal requirements. The amendments create a rebuttable presumption that any person who performs services for another will be considered an employee. In order for an employer to overcome the presumption, the employer must show that the hired worker meets a three-prong test:
1.) The individual must be free from control and direction in connection with the performance of the service, both under contract and in fact; and
2.) The service is performed outside the usual course of the business of the employer; and
3.) The hired individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service provided.
For most businesses, this is a difficult test to meet and most of the individuals hired must be treated as employees. For a new business owner, this means complying with costly minimum wage and hour requirements, obligations to withhold income and payroll taxes, purchasing unemployment insurance, and providing other employee benefits. Obviously, this is a difficult realization for most entrepreneurs. Nonetheless, it is important to understand that non-compliance can have some serious consequences, including heavy fines and possible jail-time. It is also very important to understand that simply calling the hired individual an independent contractor in the employment contract will not be enough to meet the first prong of the test. This may be the most common mistake made by business owners who believe that by simply calling an individual an independent contractor it makes them one. The first prong of Massachusetts’s test states that not only must the independent contractor status be spelled out in a contract, but the relationship between the hired worker and the employer must be one of an independent contractor in fact. Meaning, that the employer must have very little control over the means in which the contracted services are performed.
2.) Unpaid Internships
Another tactic frequently used by entrepreneurs is hiring unpaid interns. Unpaid internships are by no means a new method used by employers to take advantage of free labor. In fact, they are still frequently used here in Massachusetts. However, these kinds of internships are frequently illegal. In Massachusetts, the legislature created a much more restrictive set of guidelines for hiring unpaid interns. Under the Massachusetts minimum wage law, an unpaid internship is almost impossible to implement legally. The law specifically states that only legitimate training programs run by charitable, educational, or religious institutions can operate legally without running afoul of the state minimum wage requirements. This rule makes it impossible for profit driven companies to hire unpaid interns. Non-profit companies that still wish to hire unpaid interns should understand that they must still follow the six factors adopted by the Massachusetts Division of Occupational Safety.
3.) Exchanging Equity for Work
Lastly, new entrepreneurs are consistently tempted to trade equity in their company for another’s services. For a new company, with relatively no value to speak of, this may not seem like such a bad idea. I mean what is the big deal, right? You need help and it is not like you are actually giving up anything other than some possible future value. Wrong. There are several concerns with such a transaction.
First, depending on the work being performed by the hired individual and the amount of equity exchanged, it is possible that the exchange is actually a violation of federal and Massachusetts minimum wage laws. The Fair Labor Standards Act provides that no employee may be paid in equity in lieu of the required minimum wage, unless they meet the executive-business owners exception. This means that the employee being paid in equity must:
1.) Be employed in an executive capacity; and
2.) Own at least 20% interest in the company; and
3.) Be actively engaged in the management of the business.
Obviously, most business owners have no intention of giving up such a large interest in their company. Consequently, business owners engaging in this kind of transaction will often find themselves in violation of the minimum wage laws and open themselves up to liability.
Second, for entrepreneurs who do decide to trade 20% equity for simple services, it is highly unlikely that they intended to give up such a large stake in the company. Giving up equity in the company equates to giving up some control. Although 20% does not appear to be of any real consequence when the business has little value, if the business owner expects the business to be a success, exchanging 20% of the company could end up being millions of dollars in the future. Additionally, if the company seeks out a large capital investments in the future, that 20% can no longer be used as a bargaining chip for a much more valuable investment.
Understanding the implications of engaging in such a transaction is imperative to succeeding in growing a company without compromising its legal integrity or potential future value.