For those of you I haven’t met, I am a corporate partner at Gunderson Dettmer – a Silicon Valley based law firm that works exclusively for technology companies and VC’s. I make my living working for startup companies but I want to help you spend less money on lawyers.
I spend an awful lot of time (usually on short notice the night before an important deal is supposed to close) fixing preventable problems. An awful lot of these problems relate to hiring, compensating and incenting early employees. All of them cost money and time that I would rather see invested in building teams and product.
The sections below may help you avoid last minute fire drills, unnecessary accounting or legal fees, angry investors and perhaps an occasional lawsuit or regulatory audit. Hopefully by highlighting a few of the most common employment related problems I can help you avoid them.
Mistake #1 of 5: Not Understanding Obligations to Prior Employers
Anyone who has spent much time around technology companies knows that it’s a really small world and the best people tend to bubble up time and again.
Great entrepreneurs tend to be involved with several startups over the course of a career and also tend to attract top talent from prior endeavors each time they strike out on a newco.
This tends inevitably to create issues with former employers that can range from minor irritations to full blown litigation; especially when the ex-employee is perceived to be doing something competitive at their new gig.
The key to avoiding problems in this area is all about timing – look at the issues BEFORE you start coding! While California law is relatively favorable to employees when it comes to these matters, employers are not without protection; especially with respect to intellectual property.
If you’re dusting off that invention assignment agreement from your old company to read the fine print AFTER getting the “nastygram” from your prior employer it may be too late for a course correction.
Before you or anyone else starts working on your new company, you should be asking:
- Is he/she still working for someone else?
- Is there any relationship between the business and technology of that former employer and what you propose to do?
- Does that person have any non-solicit or non-compete obligations?
- Has there been an analysis of whether the work the person will be doing will entail them using proprietary information that belongs to a prior employer?
- If any of these questions raise red flags, get qualified advice on these issues and be prepared to alter your plans if necessary.
The key is to preserve your ability to make changes or adjustments before you start down a path. The cost of a mistake in this area can he huge as a material dispute over IP ownership can literally render a company unfinanceable.
Mistake #2 of 5: Failing to be Informed About Employee Rights with Respect to Wages
The same employee-favorable regime that can help entrepreneurs when they are leaving a job, can cut the other way when it comes to a startup founder’s new role as the employer.
Paying your people can be a big challenge in the pre-funding stage and there are not always easy answers.
At a minimum, entrepreneurs need to understand the rules and be educated about the risks they take so they can minimize their exposure.
The bottom line is California requires employees make at least minimum wage (and at least two times that amount for exempt employees for whom you don’t have to pay overtime). Wages must be paid in cash. More importantly, claims for unpaid wages cannot be released or waived. Once someone has worked without pay, they can bring a claim and the burden of proof is on the employer.
Not surprisingly, the states doesn’t typically have the resources to actively pursue violations, where the practical risk often lies is when a relationship goes south and that co-founder or early team member leaves under acrimonious conditions and decides it’s time to get paid for the time they worked without salary.
Alternatively, you might have a great team that makes it all the way to an exit intact only to find that a public company buyer with a dramatically different risk tolerance doesn’t want to assume material exposure for unpaid wage claims and these matters become a real deal issue.
While there may be periods of time where there simply isn’t cash to pay salaries, companies can manage their exposure and mitigate risks if they get good advice on the rules, including the tax issues, and make educated decisions about how to document and manage these issues.
Mistake #3 of 5: Employees Versus Independent Contractors
Founders also need to be aware of the distinctions between employees and independent contractors/consultants.
Often, early stage companies will seek to characterize an individual as a consultant to avoid wage issues. Unfortunately under the law it is not as simple as calling someone a consultant and giving them a consultant agreement.
If the characterization is challenged, the relevant test can be complicated and is highly fact-specific looking at questions like whether the individual works for multiple firms, sets his/her own schedule, is obligated to comply with company policies, has to personally provide services, offers his/her services to the general public, etc. In short, if the individual acts like an employee, they may well be an employee under the law. The risk, of course, is that in characterizing an individual as an independent contractor, the company does not issue a W-2 and does not take income tax withholding or pay the employer portion of taxes like social security and disability.
If the individual is found to have been an employee, the Company will be on the hook for the failure to withhold taxes and there can be late penalties and interest as well.
In addition, you can find yourself right back in the position of having an overhang of potential claims for unpaid wages, overtime and other benefits.
Again, this is an area where startups need to be thoughtful about how they manage and document the issues. VCs may or may not flag these issues as being problematic for an investment. However, always keep in mind that the risk of adverse public companies or late stage companies who may be potential buyers may take a sharply different view of what level of audit risk is acceptable. Thinking through these matters upfront with someone who has “seen the movie before” (whether they be a business advisor, other entrepreneur or an attorney) is essential.
Mistake #4 of 5: Failing to File Those 83(b) Elections
Without getting too deep into the weeds, an 83(b) election refers to a tax code section that allows the taxpayer to make an election on when to pay taxes in connection with the acquisition of certain kinds of stock.
Founders in a typical startup will acquire their stock subject to vesting – if they leave the company, the unvested portion of the stock can be repurchased by the Company at cost, or at the lesser of cost or the then current fair market value of the stock. That repurchase right is the key element for 83(b) purposes.
A founder who makes the 83(b) election is electing to measure the tax consequences of the purchase at the time of the purchase. Failing to make the election means that the tax consequences are measured at every vesting date during the entire vesting period.
Since the tax is on the spread between the fair market value of the stock and the price paid, so long as fair market value is paid at the outset, there should be no spread at the time of the election and no tax on that acquisition (there will of course be tax on the gain when the stock is eventually sold).
The big “gotcha” in failing to make the election is that the fair market value is reassessed at each vesting period and it can change dramatically during the typical 4 year vesting period.
When you imagine that a typical startup (where founders’ stock is purchased for fractions of a penny) can conceivably go through several rounds of financing and even an exit or IPO during the standard 4 year vesting period, the tax consequences of that ever increasing spread between fair market value and the original purchase price can get really ugly.
83(b) elections have the added issue that the election must be made within 30 days of acquiring the stock or it is missed. There are no second chances or ways around the deadline.
Mistake #5 of 5, ignoring Internal Revenue Code §409A, is covered in the final part of this series.
