Employees & Consultants
The people you hire to work at your startup will either be employees or independent contractors (commonly referred to as consultants by startups).
When startups hire employees, they typically have the employees sign offer letters. When startups hire consultants, they usually enter into consulting agreements (or independent contractor agreements) with the consultants.
For both employees and consultants, startups should also enter into agreements to make sure (1) the worker is bound to confidentiality and (2) the company owns the IP the worker creates. These agreements are typically called Confidential Information and Invention Assignment Agreements (CIIA Agreements) or Proprietary Information and Invention Assignment Agreements (PIIA Agreements).
At the federal level, the U.S. Department of Labor (DOL) and IRS have separate criteria for determining whether someone is an employee or consultant.
Under the DOL guidelines, whether someone is an employee or consultant depends on how economically dependent that person is on your startup:
If the worker is economically dependent on the employer, then the worker is an employee. If the worker is in business for him or herself (i.e., economically independent from the employer), then the worker is an independent contractor.
See Wage and Hour Division, U.S. Department of Labor, Administrator's Interpretation No. 2015-1, http://www.dol.gov/whd/workers/Misclassification/AI-2015_1.pdf.
The IRS looks at the degree of control and independence:
Facts that provide evidence of the degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
See Internal Revenue Service, Independent Contractor (Self-Employed) or Employee?, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee.
Various states also have their own criteria as well. You should check the state where your startup is located, as well as any states where you hire people, to see what their criteria are.
Note that in most cases, the classification does not depend on the term or documents used by the startup. A government agency may classify someone as an employee even if you refer to them as a consultant and have them enter into a consulting agreement. The penalties for misclassification can be serious.
Federal law typically requires that employees be paid at least the federal minimum wage, and some states (including California) and municipalities have implemented their own higher minimum wage standards. The minimum wage is a cash standard, so companies can’t use stock or options to satisfy this requirement. This means that startups cannot legally pay employees in equity compensation alone, even though many startups still do this.
Federal law has an exception for employees that own 20% or more of a business, which can apply to many founders if certain conditions are met. However, not all states with minimum wage laws have a corresponding exception. For example, California's minimum wage laws do not have such an exception. This means that California's minimum wage applies to founders in California, even when the federal minimum wage does not.
Some people may have entered into contracts that restrict their ability to work as employees or consultants. For example, a person who is a full-time employee at one company may be contractually prohibited from working for another company at the same time.
Advisors are a type of a consultant. Startups typically enter into an advisor agreement with them, which roughly covers the same topics as a consulting agreement and CIIA agreement would.
Paid interns are a type of employee. To hire a paid intern, a startup should use an offer letter and CIIA agreement, just as they would with any other employee.
It is almost always impractical for startups to legally have unpaid interns. Under the Fair Labor Standards Act, as interpreted by courts, unpaid interns are only permitted when the employer "derives no immediate advantage from the activities of the intern... and on occasion its operations may actually be impeded" (in addition to other requirements).1