“Let’s Just Call Them Independent Contractors”

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.

A “Winter of Investment Discontent”

By: Entrepreneurship & Innovation Clinic Student

November 2016

A cold air mass has been moving slowly across the United States, from the Silicon Valley all the way to Boston, Massachusetts. As it passes from state to state, the skies darken, a strong northwest wind picks up speed, and temperatures quickly drop, indicating an impending polar destruction. In its wake are thousands of little crops, barely matured from their seed stage, dead and covered in frost. Only the most cold-tolerant, the mostly matured plants, survive. Farmers who once had high aspirations for budding, plentiful crops that would feed their families for years to come, are left in despair with little direction for what to do next. This cold air mass is called “winter” and it is predicted to cause a national freeze that will last the next twelve to eighteen months.

“Winter,” more commonly known as the dreaded “down round” in the investment finance world, has left its killer frost on even the most innovative startup companies. A “down round” is a “financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing.” Private startup companies (companies that have yet to go public on the market—most early-staged startup companies—also called “venture-backed companies”) in particular dread “down rounds” for several reasons:

(i)                 A round at $0.10 per share lower than a prior round carries much more baggage than a $0.10 up round carries goodwill;

(ii)               “Down rounds” are detrimental to employee morale because in order to continue to attract investment to retain capital and talent, evidence of rapid growth in a company is often required—a “down round” is evidence of the opposite;

(iii)             Following a “down round,” investors who hold preferred stock with anti-dilution protection (protection from dilution when shares of stock are sold at a price per share less than the price per share paid by prior investors) will sometimes look to renegotiate the price of the prior round to more closely reflect the valuation of the company, which has a negative impact on, and actually magnifies, the dilution to common stockholders from the financing, resulting in a smaller percentage of ownership for the common stockholders; and

(iv)             Investors in a startup company that has experienced a serious “down round” are often forced to “write down” the value of their other existing holdings in their financial statements, which can have a negative effect on the fund’s ability to continue fundraising for the startup company.

Ultimately, the goal of most startup companies is to go public in order to expand the growth of the company in their specific market; this goal cannot be attained if the company stops receiving, or receives significant less financing from venture capitalists. A “down round” makes going public incredibly difficult; the ability of a startup company to continue producing returns after a “down round” is significantly hindered.

In the second quarter of 2016, the market saw a spike in “down rounds” from the previous quarters. According to a report issued by Cooley LLP, seventeen percent of the financing rounds in that quarter were “down rounds.” This is compared to the mere three percent experienced in the second quarter of 2015. Of the 154 deals that Cooley analyzed from the second quarter, twenty-one percent were “down rounds,” which is triple the number when compared to previous quarters. Other law firms experienced similar trends in the second quarter, with most reporting that the number of “down rounds” from the first quarter of 2016 to the second, increased by at least four percent. Moreover, firms have reported that invested capital in the second quarter decreased by an overall fifty-seven percent from the prior quarter, indicating a major cooling in the venture capital market. Industries that experienced the worst “frost bite” included life sciences and software startup companies—companies that had experienced a boom in the market in previous years.

This harrowing trend in the venture capital market suggests that entrepreneurs are no longer commanding significant valuations like they had in prior quarters, and investors who backed these private startup companies are reevaluating their market expectations. Market analyzers have concluded a few reasons for the rise in the dreaded “down round.” One reason is that in previous quarters, investors were valuing startup companies at such high levels, that the companies could not match valuation upon their next round of financing. Over-valuation is a significant problem for many startup companies who must prove their worth to investors in order to continue receiving funding. Companies that fail to meet valuation are not as lucrative to investors, and as discussed above, can cause serious headache to the venture capitalists. Market analyzers have also pointed to the demise of the “unicorns” as a potential reason for the rise in “down rounds.” Unicorns are private companies with valuations of $1 billion or more. In the past, venture capitalists threw massive dollars at these companies, but as of late, the valuation of the unicorns has fallen significantly.

Venture capitalists are now predicting that “‘the true day of reckoning lies ahead’ for overvalued startup companies and ‘will hit home in the next several quarters’.” To be exact, this “winter of investment discontent” is predicted to last twelve to eighteen months, and to impact seed-staged startup companies the most. Whereas seed-staged startups are experiencing a freeze in investment, middle-staged “mature” startup companies are experiencing a steady stream of cash flow. In part, this is because these mature companies have already proven their worth, and are a safer bet for investors to receive anticipated returns.

Recommendations

So what can seed-staged startup companies do to receive venture capitalist funding? During an interview with Cooley LLP, Felicis Ventures’ founder and managing director Aydin Senkut, indicated that “the best way to counter [down rounds] is for companies to be a lot more hawkish on cash management.”   Felicis Ventures recommends to all of their companies not to set maturity dates below nine to twelve months, and to take sixth months as the absolute minimum time to be able to manage a funding round. Other investors, such as Seattle angel investor Jon Staenberg, recommend that seed-staged startups figure out ways to avoid raising money to get profitability. If companies don’t need venture financing, then they can avoid the dreaded “down round” that other startup companies have experienced. Investors also recommend that founders look at the industries that haven’t been as effected by the market freeze—namely, the food technology industry—and try to fit their products in that “hot” market.

Whereas larger startup markets, including the United States and China, have experienced, and are predicted to continue experiencing a “winter” of investment for months to come, other markets such as India have continued to flourish. “India is one of the highest growth businesses we have anywhere in the world. It has strong double-digit growth,” reported John Flannery of GE Healthcare. Because of India’s strong business growth, major investors in the United States are looking to India for future, more reliable investment options. Investors find Indian business’ focus on cost, quality and outcomes particularly attractive. In the past few years, investment in India has spiked, and analysts predict Indian markets to continue to grow despite other markets experiencing “global economic uncertainty.” So perhaps American seed-staged startup companies should pack their bags and take a twelve to eighteen-month vacation to warmer weather. I hear India is pretty nice this time of year.