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6 legal mistakes startups need to avoid when hiring employees

An otherwise sound business plan shouldn't get sabotaged by any of these missteps

By Peter N. Townshend, George Colindres and Lauren T. Howard
August 25, 2011 10:44 AM ET

Computerworld - Startup companies, even those founded by seasoned entrepreneurs, are prone to making the same legal mistakes when hiring and compensating employees. These employment law missteps can subject young companies to potentially crippling consequences. Following are the six most common legal mistakes made by startups with respect to their employees. By avoiding them, entrepreneurs can ensure that they will succeed or fail on their merits and not because they stepped on an employment-law land mine.

1. Violating wage and hour laws. Under federal law, most types of employees must be paid a minimum wage of $7.25 per hour. Some states and local governments have even higher minimum wage requirements -- for example, California's minimum wage is $8 per hour, and the city of San Francisco's is $9.92. Startups tempted to lower their burn rate by paying employees with stock or stock options alone should be aware that most such arrangements violate minimum-wage requirements. First and most importantly, stock and options don't count for purposes of minimum-wage calculations. Second, when wages are paid in part with stock, startups should be mindful to appropriately value the shares (more on this later when we discuss options) and remember that payroll taxes are still due (in cash) on such "sweat equity."

A related problem is the failure to pay overtime. Federal and state laws separate employees into "exempt" and "nonexempt" categories. Exempt employees are generally salaried employees (as opposed to hourly employees) who are paid at least $23,600 per year ($33,280 per year in California) and perform exempt job duties, such as executive, professional or administrative duties. All other employees are nonexempt, and they are entitled to 1.5 times their regular rate of pay for time worked in excess of (a) 40 hours in a week and (b) in California, eight hours in a day. Startups often fail to keep track of employee hours and to pay overtime. Some also purposefully mischaracterize nonexempt employees as exempt in an effort to avoid paying overtime.

Another common mistake is to attempt to defer compensation. Wages, once earned, must be paid on a normal payroll system and cannot be deferred, even if the employee agrees to the deferral. For example, if an employment agreement says that an executive's salary is $200,000 per year but that $50,000 will be paid on normal payroll and $150,000 deferred until the company's next financing, that executive can at any time file a claim for the "deferred" compensation (plus interest and penalties).

The consequence of violating wage and hour laws can be severe. If caught, the company will at the very least be required to pay unpaid wages and payroll taxes with interest and penalties. In certain cases, the company and its executive officers can also face criminal penalties, including fines and imprisonment. The discovery of such violations during the due-diligence process also has the potential to derail a financing or an acquisition. These are relatively easy problems to avoid (albeit with cash!) so every startup should be aware of the laws and work closely with legal counsel or human resources professionals to establish a proper timekeeping procedure and ensure that all employees have been correctly characterized and are being paid in the appropriate manner.

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