The Smarter Startup

Surviving Due Diligence, Part 2: Employee vs. Contractor


Misclassification of employees and independent contractors is one of the most common pitfalls startups face during a due diligence process.

Welcome to the second post of Burkland’s Surviving Due Diligence blog series. These posts focus on areas that can delay or derail investment rounds, exits, and other important transactions and sometimes embarrass founders right when they’re most hoping to display their business prowess. In our first post, we discussed Sales Tax as one such issue often belatedly dealt with by startups, frequently with expensive consequences (see also Dave Coultas’ great State-by-State Sales Tax Checklist).

In this post, we’re going to delve into another landmine out there for unsuspecting startup founders — Employee vs. Contractor classifications.

Some background: As CFOs to hundreds of venture-backed startups, we’ve seen countless extraordinarily gifted and visionary founding teams being great at whatever their company does – they’re brilliant engineers, consumer marketers, developers, product managers and more – but they’re often pretty inexperienced when it comes to running a company. Usually, this is either because they aren’t aware of the finance and administrative requirements involved, or because they’ve de-prioritized them in favor of product development and market traction. Most startup founders eventually encounter difficult questions from investors, vendors, partners, and regulators about the more mundane administrative, financial, and regulatory aspects of running the business. At that point, a mad scramble often ensues – chaos that at best distracts the team from strategy execution, and at worst, causes unnecessary fines, interest, and penalties. Sounds dramatic? It can be.

Along with Sales Tax, misclassification of employees and independent contractors (ICs) is one of the most common issues faced by startups going through a due diligence process.

Along with Sales Tax, misclassification of employees and independent contractors (ICs) is one of the most common issues faced by startups going through a due diligence process. It’s easy to see why – technology has enabled large swaths of the startup economy to work remotely, and the COVID-19 pandemic further scattered most startup teams all over the place. At the same time, the gig economy has put legions of freelancers and independent contractors just an email away from working with virtually anyone, anywhere, simultaneously widening the talent pool and dramatically slashing the costs. Let’s be honest – which startup founder hasn’t been tempted to bring an awesome developer aboard as a 1099 independent contractor instead of hiring them as a W-2 employee just to save money?

However, this is a tricky path to navigate. Correlated with the rise in remote work, most states, notably California and New York, have significantly tightened the regulations around who exactly qualifies as an “employee” under the law and are thus subject to state and federal payroll taxes. Both states have published guidelines and checklists to help companies determine how their workers should be classified.

If someone is only working for you and you are their primary/sole income source, they’re probably an employee regardless of how you or anyone else classifies them, and misclassification is extremely expensive to remedy if you’re audited.

A quick three-step test can help founders determine whether their ICs should actually be considered employees. Generally, all IC’s are free from:

  1. Supervision
  2. Direction
  3. Control in duty performance

If someone is only working for you and you are their primary/sole income source, they’re probably an employee regardless of how you or anyone else classifies them…

A true IC is told what the company needs done and is left alone to do it. They negotiate their own fees, and offer their services to the general public. They typically own their own computers and equipment and are free from employee-esque things like vacation policies and performance reviews. Their work is often bounded by a finite statement of work and/or contract date instead of being open-ended. In fact, keeping someone as a 1099 forever can be considered tantamount to employment.

Importantly, an employer-employee relationship may exist regardless of how the company and IC define it. This is true even if the IC has signed a statement agreeing to be treated as a contractor, and the IC billing you through a separate company is NOT a safe harbor if you are the IC’s only “client” and they’re tightly controlled by a company employee. It should also go without saying that any IC with managerial or leadership responsibilities is not a bona-fide “contractor.”

Why is this important? Simple – compliance. If a state Department of Labor decides to audit your payroll and determines your IC’s should have been classified as employees, the company will be on the hook for penalties and interest on the payroll, workers compensation and disability taxes it should have paid on their wages. Like with sales tax, most states have voluntary disclosure programs that will waive some or all of the penalties for companies that come forward on their own, but remedying worker misclassification is a very expensive and time-consuming lesson nonetheless.

Any misclassifications can – and do – become a major issue, potentially delaying or torpedoing a financing round.

In our experience as fractional CFOs for venture-backed startups, we’ve observed that state payroll audits are not typically when the problem comes to light. Instead, it’s when VC firms perform investment diligence. With higher state scrutiny on this issue, institutional investors are increasingly including classifications in their due diligence lists, and often require a company to show compliance with relevant state regulations. Any misclassifications can – and do – become a major issue, potentially delaying or torpedoing a financing round.

Founders should work with their CFO to periodically review the status of their ICs to determine whether any should be converted to full or part-time W2 status. They should also develop basic policies for determining whether a new hire can be legitimately considered an independent contractor. Get these classifications right early on, well before you enter a diligence discussion with an investor or acquirer – you’ll save no small amount of time, money, and anxiety, and avoid one of the most common startup due diligence landmines.