6 legal mistakes startups need to avoid when hiring employees

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

legal issues

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.

2. Mischaracterizing employees as independent contractors. Startups often confuse employees and independent contractors, sometimes intentionally. The benefit of such mischaracterization is that independent contractors (synonymous with consultants or advisers) are not subject to wage and hour laws, meaning they don't need to be paid minimum wage and are not subject to payroll taxes. Some startups use the "try before you buy" strategy of hiring a so-called contractor for a three-month term before deciding whether to "convert" him or her into an employee. However, neither the companies nor the contractors themselves are free to decide what type of relationship they are creating. Federal and state laws dictate what constitutes an employee versus an independent contractor. California, for example, has a multi-factor test to distinguish independent contractors from employees, including whether the worker provides his or her own supplies and instruments, whether the worker renders services on the company's premises, the type of services being rendered, the permanence of the working relationship and whether the parties believe they were entering into an employer-employee relationship. Note that whether the parties sign an "employment" or "consulting" agreement is therefore not a dispositive factor.

Mischaracterizing an employee as an independent contractor will generally result in a violation of wage and hour laws. Consequences to the company include payment of the wages to which the employee would otherwise have been entitled and payroll taxes with interest and penalties. Criminal penalties could also apply. Startups should work closely with counsel to ensure that workers they hire as independent contractors can in fact be classified as such.

3. Using bad agreements. Whether from sloppiness, haste or scant resources, startups often fail to use proper forms of employee agreements. At a minimum, every startup employee should sign an offer letter or employment agreement and some form of confidential information and inventions agreements. Not using proper agreements leads to all sorts of uncertainties. Can such an employee be terminated by the company without notice? Is the employee entitled to severance upon termination? Does it matter if the termination is for cause, and what does "cause" mean? Is such an employee required to keep company information confidential? Does such employee's work product belong to the company?

A proper offer letter will set forth the employee's title, compensation (cash and options) and any benefits. It will also indicate whether the employment relationship is "at will" and can be terminated at any time by either party. The offer letter will help avoid misunderstandings and disputes when the employment relationship terminates. For executive-level employees, an employment agreement may be in order. In addition to the items covered by an offer letter, it will also generally cover special benefits (e.g., bonus incentives) and circumstances under which the employee may be entitled to cash severance and/or acceleration of vesting of stock or options.

Every employee should also sign the company's standard form of confidential information and inventions agreements. At a minimum, such an agreement subjects the employee to a duty of confidentiality with respect to the company's information. It also establishes that inventions made by the company in the course of the employee's work for the company belong to the company. These protections are particularly important to technology companies.

4. Using unenforceable noncompetition provisions. Employee confidential information and inventions agreements generally also contain some form of noncompetition and nonsolicitation provisions. A noncompetition provision prohibits employees from working for competitors of the company, and a nonsolicitation provision prohibits employees from hiring away other employees or contractors. The enforceability and permitted duration and scope of these provisions vary from state to state. For example, in California, "noncompetes" are generally enforceable during the term of employment but not following termination. (There is an exception to this rule, where the employee enters into a noncompetition agreement in connection with his or her sale of a business, but even then the post-employment noncompetition agreement must be reasonable in duration and scope.) California also limits nonsolicitation provisions: Although a former employee can agree not to target his or her former colleagues, that former employee can still hire such persons that come to him or her on their own initiative or in response to a general solicitation (e.g., a job listing). Again, startups should work closely with their legal advisers to ensure that the agreements they use are specifically tailored to the jurisdictions where they have employees.

5. Conflict with former employers. New employees may bring with them materials that belong to former employers or other parties, such as computer code or confidential customer lists. A new employer's use of such materials may subject it to costly litigation. Startup companies should prohibit their employees from bringing materials owned by others or subject to confidentiality on the company's premises or otherwise using such materials in rendering services to the company. Such prohibitions are included in a properly worded confidential information and inventions agreement.

6. Not offering the right amount or form of equity compensation. Stock and stock options are widely used to align employees with the company's long-term business goals. But these forms of equity compensation are also expensive and tricky to administer correctly. Stock cannot be given away, or sold for less than fair market value, without triggering tax consequences to the recipient of the stock. Stock options must be granted pursuant to a carefully constructed plan that follows applicable state and federal tax, securities, labor and other laws. Employee options must have exercise prices set at a fair market value that is determined in compliance with the increasingly complicated rules under Internal Revenue Code Section 409A. Securing third-party valuations and administering an option program with proper board and stockholder approvals is expensive and time-consuming. Unfortunately, even the best-run startups often discover they have expensive issues to fix with respect to their equity compensation programs when they are in a due-diligence process relating to a venture capital financing, acquisition or initial public offering. The most practical advice in this area is to postpone such programs until you can afford to administer them correctly.

Of course, the above is by necessity only a partial list of potential pitfalls relating to employees and employment law. There are many other issues to consider, including background checks, proper employee manuals, how to address harassment or discrimination issues, and handling reviews, discipline, terminations and layoffs. And California is not the only state that is differentiated by its employment law. But the theme is the same. Young startups need to be in front of these issues so that they don't undermine what is otherwise a sound business plan.

Peter N. Townshend is a partner with the Emerging Companies practice of the law firm of Perkins Coie LLP. George Colindres is counsel with that practice. Lauren T. Howard is an associate with the firm's Labor & Employment practice.

Copyright © 2011 IDG Communications, Inc.

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