Legal Landmines: How to Steer Clear of Employment Law Pitfalls in Your Early-Stage Startup
This short article provides some key points for startups to consider in dealing with employment law compliance.
For startups trying to get a product or service off the ground and to customers, founders often tend to focus on building (as they should) and not necessarily on complying with legal minutiae in the area of employment law. However employment law issues are as important as, say, protecting a startup’s intellectual property, engaging in investor financing, or ensuring securities law compliance.
Start with Financial Planning
Solid financial planning is crucial for early-stage startups, as it sets the foundation for long-term growth. This includes budgeting, cash flow management, and forecasting to cover operational costs, legal compliance, and growth opportunities. According to a CB Insights study, 29% of startups fail due to running out of cash1. Ensuring legal compliance in areas such as employee classification and payroll taxes is integral to effective financial planning.
Work with a Financial Advisor
Engaging a financial advisor with startup experience can help prevent common financial pitfalls and ensure compliance with employment laws. Financial advisors offer valuable insights on budgeting, tax planning, and investment strategies tailored to a startup's unique needs. Forbes highlights that the cost of fixing financial mistakes, such as tax penalties or fines for non-compliance, can far exceed the cost of working with a financial advisor from the outset2.
Consider Funding Options
Early-stage startups have several funding options, each with its financial implications. Bootstrapping, angel investors, and venture capitalists offer varying degrees of control, ownership, and growth opportunities. Startups must weigh the pros and cons of each funding option and align them with their growth strategy and legal compliance requirements.
Manage Payroll Taxes
Understanding and complying with payroll taxes is essential for early-stage startups, as non-compliance can result in severe financial consequences. For example, the IRS imposes penalties ranging from 2% to 25% for late or unpaid payroll taxes4. Startups must ensure they accurately classify workers as employees or independent contractors, withhold the appropriate taxes, and submit timely payments to avoid penalties and maintain a strong financial position.
Provide Competitive and Compliant Employee Benefits
Attracting and retaining top talent requires competitive employee benefits. However, startups must also comply with legal requirements related to benefits administration. For example, the Affordable Care Act mandates that businesses with 50 or more full-time employees offer health insurance coverage5. Failure to comply can result in financial penalties, which can harm a startup's financial health. By offering a comprehensive benefits package that adheres to legal guidelines, startups create a positive work environment and foster long-term growth.
We asked John P.J. Mattiace from Mattiace Tetro LLC, an employment attorney who has dealt with startup clients at all stages of their lifecycle, to provide some key points for startups to consider in dealing with employment law compliance. We believe that this article will help early stage startups prevent themselves from dealing with costly issues later which could hamper growth and even make it less likely to be a target for investment or a later merger or acquisition.
What are some of the most common employment law issues faced by startups, and how can they avoid them?
Those are our TOP-3 common employment law mistakes that almost every early-stage startup founder makes.
1. Misclassification of employees
One of the most significant legal pitfalls for early-stage startups is misclassifying employees as independent contractors. While this is often done to retain flexibility and reduce costs, it can result in severe legal and financial consequences.
For example, misclassifying workers can lead to hefty fines and penalties. In some cases, companies may be required to pay back wages, including overtime pay, to misclassified employees. This can quickly add up to a significant financial burden, especially for small startups.
To avoid these issues, startups must ensure that they classify their workers correctly according to the jurisdiction they operate within. This is not always straightforward, as different regions and countries have varying legal definitions of independent contractors versus employees. It's essential to review the legal standards for classification and consult with an employment law expert if needed.
Another critical step in avoiding misclassification is to review and update agreements, policies, and employment documents to ensure they support the worker's correct classification. For example, the terms and conditions of a contract should clearly state whether the worker is an employee or an independent contractor. Additionally, startups should ensure they have appropriate procedures and practices in place to maintain accurate records and manage their workforce correctly.
Moreover, the classification of workers as independent contractors or employees can also have significant tax implications. If a worker is misclassified as an independent contractor when they should be classified as an employee, the company could be liable for back taxes and penalties for failing to withhold the appropriate payroll taxes.
2. Failure to pay overtime
Startups will often fail to properly keep track of employee work hours and pay overtime correctly. This is sometimes because it is difficult to do, or they just don’t have the resources to devote to ensuring accuracy. Although this might be understandable as startup teams focus on building and saving money, it is still unlawful and can result in wage and hour lawsuits that are almost always costly and time consuming. Along with misclassification, this type of liability is also a major headwind to being a target for investment and acquisition. To avoid this, startups should make sure that they have folks devoted to maintaining accurate records, and ensure their employees are properly classified as exempt (or non-exempt) from overtime under state and federal wage and hour laws. For instance, the federal wage law - the Fair Labor Standards Act - provides that employees who are non-exempt must be paid overtime at a rate of one and a half times their regular rate of pay for any hours they work over 40 in a workweek.
3. Unlawful discrimination and retaliation
Discrimination is also an important employment law issue that startups must avoid. It can take many forms, including race, gender, age, and disability discrimination. In addition, state and local laws may protect a plethora of additional categories, all known as “protected classes” of workers. It is unlawful to discriminate on the basis of any worker’s membership in a protected class. Moreover, if an employee complains of some unlawful treatment, it is also unlawful to take negative actions against them. To avoid an issue in these areas, startups should create a workplace culture that values diversity and inclusion, but also ensure that it carries out workplace policies and discipline on a consistent basis to avoid discrimination, and also to make sure not to take adverse actions against workers who complain of potentially unlawful conduct. It is also a legal requirement to provide anti-discrimination and anti-retaliation training to employees as well.
How can startups ensure compliance with labor laws and avoid costly lawsuits?
Startups first and foremost need experienced employment counsel so that they can stay up to date with changes in the law, something that is a challenge as laws in this area are updated frequently. Counsel will be able to also ensure the startup receives detailed guidance on how to comply with classification, wage and hour, and discrimination laws. An experienced human resources person can also help ensure laws and regulations are complied with.
Startups should also make sure they maintain accurate records, and enter into contracts and implement policies that are clear and consistent. They must also be easy to understand, and not have ambiguous, unnecessary, or contradictory language. This applies in particular to contracts with independent contractors, and documents sent to employees like offer letters and employee handbooks.
The cost of failing to comply with these laws can be steep so it is important to take compliance with these laws seriously. It is hard to put an exact number or range on the cost because each company’s situation and potential exposure to claims is different, but there are some categories of damages startups will generally be responsible for. For instance, in a discrimination or retaliation claim, a claimant would be entitled to backpay (which is any pay the employee lost because of the company’s treatment), frontpay (any future loss in pay the employee lost because of the company’s treatment), punitive damages (for which there is no set amount and depends on the court’s judgment based on the egregiousness of the company’s conduct), and attorneys fees and costs incurred by the employee. For a failure to pay overtime claim (which is usually included in a misclassification claim), a claimant would be entitled to the amount of the unpaid overtime, liquidated damages (which, again, varies based on the applicable law but under federal law is an amount equal to the unpaid overtime), and an employee’s attorneys fees and costs. Some states, like New York and New Jersey, have laws that call for employees to be entitled to triple the amount of unpaid wages owed. Misclassification claims will call for the same amounts as failure to pay overtime claims, but will add also unpaid benefits, withholding taxes and penalties, and additional liquidated damages that, again, vary based on the state you are operating in.
Navigating employment laws and regulations can be challenging for startups. By understanding common employment law issues and implementing best practices to ensure compliance, startups can avoid costly lawsuits and build a strong foundation for their business. With proper financial planning, expert guidance, and attention to legal details, early-stage startups can mitigate potential legal landmines and set themselves up for success.
- CB Insights. (2019). The Top 20 Reasons Startups Fail. Retrieved from https://www.cbinsights.com/research/startup-failure-reasons-top/
- U.S. Small Business Administration. (n.d.). Choose your business funding. Retrieved from https://www.sba.gov/business-guide/plan-your-business/choose-your-business-funding
- Internal Revenue Service. (2021). Topic No. 752 Failure to Deposit Penalties. Retrieved from https://www.irs.gov/taxtopics/tc752
- U.S. Department of Health & Human Services. (n.d.). Affordable Care Act (ACA). Retrieved from https://www.hhs.gov/healthcare/about-the-aca/index.html