CREATIVITY IN COMPENSATION SCHEMES: DO ENTREPRENEURS’ COMMON STRATEGIES RUN AFOUL OF WAGE & HOUR LAWS?

By: Zachary Fountas

The Hiring Problem

            A majority of small businesses fail within their first five years, and negative cash flows are common in the early stages of most startups. Preferred CFO notes a recent study by U.S. Bank which found that 82% of the time, the cause of small business failures is poor cash flow management. For the determined entrepreneur, the solution to this problem seems simple: recruit talented individuals to join the team and the business will start turning profits. The only issue: how do cash strapped businesses recruit top tier talent during the initial stages?

Stock Options and Their Legality

The entrepreneurial spirit and startup culture has developed creative compensation schemes to deal with limited cash flow. To combat the lack of funds, many startups choose alternative payment structures or employment arrangements such as offering stock options, contracting workers as independent contractors, or hiring trainee interns. There is no question that stock options can entice talented recruits to provide their services for below market value, especially if they believe in the company. Yet, startup culture has become comfortable pushing this scheme further, frequently offering stock options as compensation in lieu of any salary at all. Is it legal to offer stock in lieu of cash? The answer is generally no, with limited exceptions.

The Fair Labor Standards Act of 1938, codified in 29 U.S.C. Chapter 8, first created the right to a minimum wage in the United States. In 2018, only five (5) states have either set no minimum wage or have set a minimum wage below the federal level, and many states have increased their wage and hour law protections to exceed those of federal law. Massachusetts maintains a minimum wage of $11.00/hr for all employees which is to be paid in cash or check. According to the allowable payment forms, providing equity – regardless of whether the value of that equity meets or exceeds minimum wage – is insufficient to comply with the law.

            Given that it is clear that employees must be paid minimum wage in cash or check, why might entrepreneurs offer equity stakes in lieu of cash payment? First, many entrepreneurs erroneously believe that offering an employee equity converts his or her position into that of a business owner exempt from minimum wage laws. Second, entrepreneurs often think that the individuals receiving stock consideration do not qualify as employees under applicable law.

            The requirements for whether an individual is a business owner and exempt from minimum wage under the Fair Labor Standards Act is that they must be employed in a bona fide executive capacity, be engaged in managing the business, and hold a 20-percent equity interest in the company. In addition, the Act limits the maximum number of individuals (5) a business could theoretically exempt. Meeting these requirements is quite challenging for startups. Cognizant of running afoul of minimum wage laws, and unwilling to grant one-fifth (1/5) of the company’s equity to one individual, startups turn to an emerging alternative employment scheme: the independent contractor.

The Independent Contractor: Uber as a Case Study

            Independent contractors by definition are not employees, and as a result, employers are not subject to abiding by the same wage & hour regulations that govern employees. Therefore, successfully categorizing workers as independent contractors instead of employees could be the difference between failure or success for a business suffering a liquidity crisis. Over the past few years, the ridesharing app Uber has led the charge with respect to classifying workers as independent contractors. In 2015, Uber claimed to have 850 employees and 163,000 drivers, all designated as independent contractors.

            The budding gig-economy, spurred by the financial crisis of 2008, established a veritable Wild West of alternative employment arrangements. Uber seized the opportunity to designate drivers as “independent contractors” and realized massive success. This success has thrust Uber into the national spotlight which has subjected it to examining eyes. Uber has an uphill battle in the years to come as it defends against lawsuits in multiple states over its designation of drivers as independent contractors. The results – whatever they are – will have a profound impact nationwide. In Massachusetts, however, even a successful Uber defense to its classification may be of little help to the startup entrepreneur looking to avoid minimum wage laws. 

Massachusetts has a stringent independent contractor test that requires the worker to be:

1.      free from control and direction in connection with the performance of their services;

2.      performing a service that is outside the usual course of business of the employer; and

3.      customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

Uber may ultimately triumph in its claim that Uber drivers are free from the company’s control because they choose when, where, and to some degree, how to perform their services. It may also be able to succeed in its claim that it is a technology company, not a transportation company, and therefore drivers are outside the usual course of Uber’s business. Finally, it may prevail it claiming that driving, much like taxi-driving, is an independently established trade. If so, Uber drivers will be deemed independent contractors. It is unclear whether Uber will ultimately succeed, but even if it does, can most startups in the state – lacking the deep pockets of Uber – similarly succeed? Likely not. With few options left and a need for talent, many startups resort to hiring interns. 

Startup Interns: Another Employment Classification

A longstanding view of the Department of Labor is that individuals providing services for a company, who are not independent contractors, are “employees” unless those individuals satisfy statutory exemption or exclusion requirements. The trainee, or intern, exemption has a six-part test that must be met:

1.      The training, even though it includes actual operation of the facilities of the employer, is similar to that which would be given in a vocational school;

2.      The training is for the benefit of the trainees or students;

3.      The trainees or students do not displace regular employees, but work under close supervision;

4.      The employer that provides the training receives no immediate advantage from the activities of the trainees or students and, on occasion, his operations may even be impeded;

5.     The trainees or students are not necessarily entitled to a job at the conclusion of the training period; and

6.      The employer and the trainees or students understand that the trainees or students are not entitled to wages for the time spent in training.

            Though the Federal standards for trainee exemptions are lenient enough to be met, entrepreneurs in Massachusetts must also comply with state law. The Massachusetts Department of Labor Standards (DLS) determines whether an individual is an intern/trainee by the same test set forth above. However, according to a DLS opinion letter, “the Massachusetts Minimum Wage Law does not apply to trainees enrolled in training programs at charitable, educational or religious institutions.” It is unlikely that most for-profit startups will meet this definition. This reality, in conjunction with the prior independent-contractor test, strongly suggests that intern/trainees should be viewed as employees and paid minimum wage, particularly in Massachusetts.

            As a result, entrepreneurs must consider their employment schemes in conjunction with their overall business goals. If a member of the startup is integral to its success, granting the requisite equity for a business owner exemption might be the preferred – legal – option moving forward. On the other hand, should a cash poor startup desire to hold onto equity, contracting with individuals who have an independent trade and designing projects outside of its normal course of business may be the only way to avoid classifying a worker as an employee.