Why your startup is probably breaking the law – and whether you should care [updated]

SEE UPDATE#1 BELOW

Most startups are in “bootstrapping” mode, which often includes compensating founders and early employees only with equity. In the early-stage community, we view that kind of frugality commendable, and respect founders who go all-in with equity. The problem is, labor laws require a company to pay its employees at least minimum wage (in Illinois, $8.25 per hour), to pay them regularly (in Illinois, at least every two weeks) and to pay time and a half for all hours worked over 40 in a workweek. Most state laws are similar, and the U.S. Department of Labor also enforces federal labor laws and regulations. In all likelihood, if you are a startup, you are violating these laws – even with regard to yourself.

A few common misconceptions are running loose, purporting to explain why a company is not obligated to pay employees. Let’s run those down.  

We are founders. We don’t have to pay ourselves anything.

Wrong. Although you are the founder, you are a company employee just like everyone else, so the company’s legal obligations to you are no different.

We are paying ourselves; we’re just deferring payment until the company has the cash to pay. 

While salary deferral may seem like an attractive way to conserve cash, under Illinois law, you have to pay every employee, at least semi-monthly, all wages earned during the pay period. You can set up some sort of deferral or bonus program to conserve cash – provided you pay minimum wage at the required interval.

I am an executive employee, so I am “exempt” under the Fair Labor Standards Act and similar state labor laws.

Nice research, grasshopper! Yes, workers in certain job categories, including executive, administrative, and professional roles, may indeed be considered “exempt” from wage and hour provisions. However, exempt status is also subject to a salary test. Under that test, employees must be paid, on a salary basis, not less than $455 per week. So if you are paying your executive and administrative employees a salary of $455 a week, or paying them the minimum hourly wage, you’re in good shape. Otherwise, not so much.

UPDATE #1 5-27-14: Someone was kind enough to point out that Fact Sheet #17B issued by the U.S. Department of Labor, entitled “Exemption for Executive Employees Under the Fair Labor Standards Act (FLSA)” states a “special rule for business owners”:

an employee who owns at least a bona fide 20-percent equity interest in the enterprise in which employed, regardless of the type of business organization (e.g., corporation, partnership, or other), and who is actively engaged in its management, is considered a bona fide exempt executive.

This is good news as far as the federal rules, and one generally would expect state rules to be indentical. However Illinois, for example, expressly adopted the version of the regulations prior to this, intentionally excluding the 20 percent rule. So it’s likely that this rule does not apply in Illinois, although absent some abusive conduct by the startup, though one might reasonably discount the enforcement risk. 

Thanks to Aaron Gelb and Joseph K. Mulherin from Vedder for explaining the Illinois twist.

We use independent contractors, not employees, so these laws don’t apply anyway.

If your service providers are indeed independent contractors, then this is correct. The Fair Labor Standards Act and similar laws apply only to employees. The problem is that most of your workers probably cannot be properly classified as independent contractors. It makes no difference whether the service provider agrees in a contract or swears on a stack of bibles that he or she is an independent contractor. That status is determined based on a wide variety of factors – 20 in the IRS’s test – each driving at the issue of how “independent” that person truly is. In Illinois, you can expect your service providers to be considered employees unless they work independently, perform services different from the business of your company or perform them outside of your company’s place of business, and they are engaged in an independently established trade, occupation, profession, or business.

Be advised: the misclassification of independent contractors is seeing increasing governmental scrutiny and enforcement. This is probably the area in which you have the greatest exposure as a startup, warns my friend and colleague Aaron Gelb, an employment law shareholder at Vedder Price P.C. in Chicago.  Misclassification, Aaron explains, can lead to a variety of legal claims down the road, including discrimination, wage/hour, workers’ compensation, unemployment, and employee benefits.

So what is the upshot? Well, it might make sense to have some kind of narrow startup company or sweat-equity exemption to the wage and hour laws. We could all lobby for that. Until that happens, this is one of those areas of the law in which trouble is unlikely to find you unless someone helps it to find you. You are probably not going to report your own company if you are a director or executive officer of that company with legal responsibilities. But an unhappy former employee, with an axe to grind or something to gain, might.

My general view is that companies should just pay at least the minimum wage; the financial hit, even with payroll taxes included, is not that big for a startup with a small handful of employees. If you don’t want to or you are so strapped that you simply can’t, so be it, but understand the risks that you are taking. At a minimum, however, you should endeavor to pay the appropriate wages to those employees who do not have an actual ownership stake in the company; in other words, those people less likely to be loyal to you and more likely to sue if they are let go.

If you want to discuss what would be involved in assessing your exposures, we are here.


Categorised as: Employment Law, Legal Issues