3 Common HR “Gotchas” That Could Get You During Due Diligence

With startup founders squarely focused on product development, market fit, and scaling strategies, the significance of solid HR practices can easily be overlooked. What many founders fail to realize, however, is that neglecting HR compliance can lead to significant red flags during due diligence with VCs and other prospective investors.

Investors scrutinize a startup’s operations from every angle, and a lack of proper HR practices can be a deal-breaker. In this article, I’ll share three of the most common HR pitfalls startups encounter and offer concrete action steps to avoid them. By proactively addressing these issues, you can safeguard your startup’s future and present a more compelling case to potential investors during due diligence.

1. Employee vs. Contractor Classification

Improper classification of employees vs. independent contractors (ICs) can be a significant issue during due diligence, as it reflects on your startup’s attention to detail, legal compliance, and risk management capabilities. In fact, misclassification of employees vs. contractors is one of the most common HR gotchas we’ve seen startups face during a due diligence process. Investors need assurance that your startup has correctly classified its workforce and is in full compliance with applicable labor and tax laws.

Misclassification of employees vs. contractors is one of the most common HR gotchas we’ve seen startups face during a due diligence process.

The IRS and state labor departments use various factors to determine correct classification, including:

• Behavioral Control: Does the company control what, how, and when work is performed?
• Financial Control: Are the business aspects of the worker’s job controlled by the payer? (e.g., method of payment, reimbursement of expenses)
• Type of Relationship: Are written contracts or employee-type benefits in place? Is the work performed a key aspect of the business?

Any inconsistencies, errors, or potential liabilities related to worker classifications can raise concerns about your startup’s financial health, operational efficiency, and legal exposure, potentially jeopardizing funding opportunities or affecting the terms of the investment deal.

Six Action Steps:

1. Conduct a Worker Classification Audit: Review the roles and responsibilities of all workers, including job descriptions, work schedules, and contractual agreements. Assess whether the nature of the relationship and the working conditions align more closely with an employee or an independent contractor.
2. Consult Legal and HR Experts: Engage with legal counsel and HR professionals who specialize in employment law and workforce management. They can provide guidance on classification criteria, review your current practices, and help you make informed decisions that comply with federal and state regulations.
3. Implement Written Agreements: Create written agreements that clearly define the terms of engagement for both employees and independent contractors. Include details such as scope of work, payment terms, duration of the engagement, and termination clauses. A well-drafted agreement can help establish the nature of the relationship and protect your startup from potential misclassification claims.
4. Monitor and Review Classifications: Regularly review and update your classification decisions to reflect changes in job roles, business needs, and legal requirements. Monitor the working relationships and conditions of your workers to ensure ongoing compliance with classification criteria and make adjustments as necessary.
5. Seek Feedback from Workers: Engage with your workers and seek feedback on their roles, responsibilities, and working conditions. Understanding their perspectives can help you identify potential misclassification issues and make necessary adjustments to improve compliance and foster positive working relationships.
6. Address Classification Issues Promptly: If you identify misclassification issues, address them promptly and take corrective action to ensure compliance with classification criteria and legal requirements. This may involve reclassifying workers, adjusting compensation and benefits, or renegotiating contractual agreements to align with the correct classification.

2. State Registrations

Another common HR gotcha that can haunt startups during investor due diligence is missing or incomplete state registrations. State registrations are the process of registering your business with state labor and employment agencies when you hire employees in a particular state. These registrations are mandatory and serve as a way for states to monitor and enforce various employment laws and regulations. Requirements can vary significantly between states, covering areas such as unemployment insurance, workers’ compensation, state income tax withholding, and disability insurance.

Employee state registrations may seem like a bureaucratic hassle, but they’re a critical component of HR compliance that can’t be ignored. Ensuring proper registration protects your employees and your business from financial and legal risks, and also strengthens your startup’s credibility and appeal to prospective investors.

Employee state registrations may seem like a bureaucratic hassle, but they’re a critical component of HR compliance that can’t be ignored.

Six Action Steps:

1. Determine State Registration Requirements: Research the specific state registration requirements for employers in each state where you have hired employees.
2. Register with State Labor and Employment Agencies: Complete the required registration forms and applications with the appropriate state labor and employment agencies in each state where you have hired employees.
3. Comply with State Reporting Requirements: Ensure compliance with state reporting requirements by filing necessary tax returns, wage reports, and other employment-related documents with the appropriate state agencies. Familiarize yourself with the filing deadlines and submission methods for each state to avoid late penalties and potential compliance issues.
4. Maintain Accurate Employment Records: Keep accurate and up-to-date records of all employee information, including hiring dates, wages, hours worked, tax withholding allowances, and benefit elections. Maintain separate records for each state where you have registered to facilitate compliance with state-specific reporting and record-keeping requirements.
5. Monitor State Registration Status: Regularly monitor the status of your state registrations to ensure ongoing compliance with registration requirements and to identify any potential issues or discrepancies that may require attention. Renew or update your registrations as necessary to reflect changes in your business operations, workforce, or legal obligations.
6. Seek Legal, HR, and Tax Guidance: Consult with legal counsel, HR, and tax professionals who specialize in state employment laws and tax regulations to ensure that your startup’s registrations are accurate, complete, and compliant with applicable state requirements. They can provide guidance on compliance issues, help you navigate the registration process, and assist with ongoing compliance monitoring and reporting.

3. Payroll Taxes

Mistakes in either of the two areas listed above (Worker Classifications and State Registrations) inevitably lead to issues with Payroll Taxes, the biggest HR “gotcha” area of all. Failure to accurately file and pay federal and state payroll taxes can snowball into an extremely expensive mistake. It can leave your startup on the hook for millions of dollars in back taxes and fines and easily tank a promising VC deal.

Failure to accurately file and pay federal and state payroll taxes can snowball into an extremely expensive mistake.

Proactively addressing payroll tax compliance issues and maintaining a strong track record of accurate and timely tax payments demonstrates your startup’s commitment to ethical business practices, financial transparency, and responsible governance.

Eight Action Steps:

1. Classify Workers Correctly: Ensure proper classification of employees vs. independent contractors to determine the correct payroll taxes to withhold and remit. Misclassification can lead to underpayment or overpayment of payroll taxes and potential legal consequences.
   (Refer to the action steps in the first section of this article.)
2. Complete State Registration Requirements: Register your business with state labor and employment agencies when you hire employees in a given state.
   (Refer to the action steps in the second section of this article.)
3. Understand Payroll Tax Obligations: Educate yourself on the various payroll taxes that apply to your startup, including federal income tax withholding, Social Security and Medicare taxes (FICA), federal unemployment tax (FUTA), and any applicable state and local payroll taxes. Talk to a startup tax professional to understand the tax rates, wage bases, and filing deadlines for each type of payroll tax to avoid miscalculations and penalties.
4. Withhold Payroll Taxes from Employee Wages: Withhold the correct amount of federal, state, and local income taxes, as well as Social Security and Medicare taxes, from employee wages based on the information provided on Form W-4 (for federal taxes) and state withholding forms (if applicable).
5. Pay Employer Share of Payroll Taxes: Pay the employer’s share of Social Security and Medicare taxes (FICA), federal unemployment tax (FUTA), and any applicable state and local payroll taxes based on employee wages and applicable tax rates. Ensure timely payment of these taxes to avoid penalties and interest charges.
6. File Payroll Tax Returns and Reports: File required payroll tax returns and reports with the IRS, state tax agencies, and any applicable local tax authorities on a regular basis. This may include Form 941 (Employer’s Quarterly Federal Tax Return), Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return), and state and local payroll tax returns and reports.
7. Make Timely Tax Payments: Make timely tax payments to the IRS, state tax agencies, and local tax authorities by the due dates specified for each type of payroll tax. Use the Electronic Federal Tax Payment System (EFTPS) for federal tax payments and follow the payment methods and deadlines set by state and local tax authorities for state and local tax payments.
8. Reconcile Payroll Tax Payments and Filings: Reconcile payroll tax payments and filings regularly to ensure accuracy and compliance. Compare the amounts reported on payroll tax returns with the amounts paid and withheld from employee wages to identify and correct any discrepancies or errors promptly.

Investors are increasingly focused on the compliance and governance practices of startups, as these factors directly impact the long-term viability and profitability of the business. By prioritizing HR compliance and addressing potential pitfalls proactively, you can build a solid foundation for sustainable growth and demonstrate your commitment to operating a responsible, scalable, and investor-friendly business.