Properly Classify Founders and Early Hires as Employees

Big surprise: Yes, we’re still dealing with employee misclassification in startup land. Sometimes, employee misclassification is a risk assessment founders make and a balanced risk they take until they can afford to pay everyone properly through payroll. Other times, it’s a complete unknown when it comes to issue-spotting.

Startup founders love the 1099 answer for founders and early hires: no payroll tax, no benefits, easy to unwind. The problem is that most founders and their early developers/engineers fail worker classification tests almost by design.

1. Almost every legal test in the US — federal, state, or IRS — and a fair number of tests that apply abroad ask who controls how, when, and where the work happens. A co-founder CTO reporting to a President/CEO, or an engineer developing IP the company monetizes and working set hours scheduled by the CTO, is more likely classified properly as an employee, not an independent contractor.

2. Outside of control, it also matters whether the person is economically dependent on one company, or genuinely running their own business with multiple clients. In the case of most PaaS and SaaS startups, for the full-time, exclusive co-founders and the early hires (usually developers/engineers), the work provided is in fact the core business. They are making what the company is selling. If the company sells software and the "contractor" is the one writing that software, then their work isn't peripheral, which weighs heavily against contractor status.

3. Simply labeling someone an independent contractor doesn't save the day — calling someone a consultant or having them invoice through an LLC doesn't change how courts and agencies look at the actual working relationship. Individuals cannot waive their right to wage and hour protections in California.

4. Finally, fully remote hires residing and working entirely from home in California can trigger California's test even if the company has no California office at all.

Bottom line: Almost none of the classic "everyone's a consultant" early-stage arrangements survive real scrutiny, which is exactly why misclassification shows up as a red flag in financing and acquisition due diligence down the line.

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Transcript:

Lindsey Mignano:

Hi everyone, I'm Lindsey Mignano. So thankful to be here with Nichola here from our firm. We are talking about something that happens quite often, especially in the Bay Area in California, believe it or not, which is employee misclassification. We have a lot of earlier stage startup founders who are confused as to whether they themselves or maybe some of their early hires, their engineers or their developers are independent contractors of their company or are employees.

One of the conversations we have most often is advising them that they are not independent contractors of their company, but rather part-time or full-time employees.

Because Nichola has been at our firm for a while now and has had many of these same conversations herself with our early-stage startup founders, I'm gonna turn it over to her so she can talk a little bit more about this topic.

Nichola Xani:

Yeah, absolutely. So one of the main questions I get is why are startup founders and early hires, such as engineers and developers, not properly classified as independent contractors here in the US? And it's a great question and it comes up constantly at the seed stage because founders often want the 1099 answer, so no payroll tax, no benefits, easy to unwind.

But most founders and early engineers fail the classification tests almost by design for a few overlapping reasons. So I'll jump into those reasons.

First is control, and control is the central problem. So every test, federal, state, or IRS, asks who controls how, when, and where the work gets done? An early engineer who's told what to build works out of the company, Slack and GitHub, follows a strict schedule and answers to a founder or CTO, looks like a controlled employee and not an independent business.

So true contractor status requires the worker to control their own methods and their own schedule. Another overlapping reason is economic dependence. So courts and agencies ask whether the person is in business for themselves. So that could mean juggling multiple clients, marketing their services, bearing the risk of profit or loss, or whether they're economically dependent on one company for their livelihood. So an engineer working full-time exclusively for one startup with no other clients fails that test almost automatically.

Another point to look out for is integration into the core business. And if the company's product is software, which, as most of our clients here at MLG, the contractor is the person writing that software, and their work isn't peripheral. So it's the business itself. And several tests, including the federal economic reality test, weigh heavily against contractor status when the work is integral to, rather than separable from, the hiring company's core operations.

And then I would say lastly, what I want to touch on is labeling does not control the outcome. So calling someone a consultant in an agreement or having them invoiced through an LLC doesn't change the legal analysis, unfortunately. And agencies and courts look at the actual working relationship rather than the paperwork. So net effect for founders at the earliest stage when know cash is tight and everyone is a consultant on paper, almost none of the classic engineer or co-founder arrangements actually survive a real classification analysis, which is exactly why this shows up as a due diligence flag in financing and acquisitions later on.

Lindsey:
Absolutely. And we have a lot of clients who maybe not even are in California, but their employees or their co-founders are in California. They work completely from home in California. Does California law apply in that case? I mean, that is a question that always quite comes up, especially when none of these companies, being so early stage, none of them have a headquarters.

Nichola:

So California is one of the states that heavily relies on what's known as the ABC test. And it's a very detailed test. You have to check the yes box to each one of those answers in order to classify as a consultant. And, you know, if you're if you have an employee a consultant or an employee working from home, you need to look to the state where that employee resides rather than the state where the company is incorporated.

Granting Equity to Advisors & Early Hires: Differences between Restricted Stock, ISOs, NSOs

Many founders using online incorporation services adopt a stock plan at formation, often reserving 10–15% of the company's shares for future grants, and those shares may sit unused until the company has raised some financing and is ready to start issuing equity in earnest. (Founders: We generally prefer a 10% Option Pool at incorporation, rather than something larger like 15%.)

Two questions come up constantly once grants begin: (1) whether to give someone restricted stock vs. options, and the steps required to do so; (2) whether to issue ISOs vs. NSOs from an Option Plan.

1. On why most companies get a 409A valuation before issuing options:

Most founders know that they have to get a 409A valuation first before issuing options from a Stock Plan, whereas sometimes founders exercise their best educated judgment, in good faith, to estimate FMV when issuing shares outside of a Stock Plan. For option grants, companies generally want a defensible fair-market-value determination, and an independent 409A valuation is the standard way to obtain safe-harbor protection before granting options. Granting options below FMV can trigger adverse Section 409A tax consequences for the holder, including a 20% additional federal tax. In practice, startups can usually obtain a 409A for a few thousand dollars online, with more complex or CPA-backed, defensible valuations running several thousand dollars more, and the valuation should typically be refreshed at least annually or after a material financing event.

2. On the differences between ISOs v. NSOs:

The eligibility rule is straightforward — ISOs can only be granted to employees, while NSOs can be granted to employees, contractors, advisors, and directors. The tax distinction is where things get interesting — NSOs generally create ordinary income on the spread when exercised, while ISOs generally do not create regular federal income tax on exercise, although the spread may be subject to AMT. If ISO shares are held at least two years from grant and one year from exercise, a qualifying disposition generally allows the gain to receive long-term capital gains treatment. That's why ISOs are often the default for employee grants, while NSOs are used for contractors, advisors, and any portion of an employee grant that exceeds the $100K ISO limit.

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Transcript:

Lindsey S. Mignano:

I've got Nichola again here with me today. We're talking about something important and comes comes up often in our practice area, which is the creation of stock plans and the issuance of stock plan equity to early stage hires. For the most part, what we are seeing due to the prevalence of online incorporations is that most startup founders will already have a stock plan.

Usually 10 to 15% of their authorized shares set up at incorporation by their online incorporation service. So that's anywhere from like a 1 to 1.5 million stock plan. They often don't use it right away. they might grant some restricted common stock subject to a 4:1 or two-year vesting schedule from outside of the plan before they start using the plan. And they start to use the plan usually right about when they can maybe afford having regular 409A valuations, usually after some.

maybe seed financing, depending on how big the seed financing is. it is something that comes up often in our practice where they might ask us, like what's the difference between granting restricted common stock versus an option from an plan? And then if I'm granting options from inside the plan, you know.

What kind of options should I be granting? what's the difference between ISOs versus NSOs in terms of who we grant them to and why? And why do I have to get a 409A valuation in order to grant these options? Very common questions. And we have Nichola here today who's gonna help tackle them.

Nichola Xani:

This is one of the most common questions that founders ask, and I think it's worth being precise about both halves of the question. So to tackle the first, the ISO versus NSO, who can receive them? So ISOs or incentive stock options can only be granted to employees, not contractors, not employee directors, not advisors. On the other hand, NSOs or non-qualified, non-statutory stock options can be granted to anyone. So employees, contractors,

Advisors, board members, whoever you want. And the second part is the tax treatment when those options get exercised. And this is a big one. So with NSOs, the spread between the exercise price and the fair market value at exercise is taxed as ordinary income at the time of exercise, subject to withholding. And then the company gets a corresponding tax deduction.

With ISOs, there's no regular income tax at exercise at all. The spread is only a potential AMT or alternative minimum tax preference item.

If the holder meets the holding period requirements, so that's two years from grant, one year from exercise before selling, then the entire grant on sale is taxed at long-term capital gains rather than ordinary income. And the company gets no tax deduction if the ISO holding periods are met. So in practice, ISOs are generally better for employees from a tax perspective, assuming they hold long enough don't get hit hard by AMT.

Which is why they're the default for employee grants at most startups. NSOs are what you're kind of stuck with for contractors and advisors, and are also used for the portion of an employee's options that exceed the $100,000 ISO cap. And then to address the second half of the question: why the 409A valuation has to come first, Section 409A of the Internal Revenue Code governs deferred compensation.

And stock options are treated as a form of deferred compensation unless they're exempted, which requires the exercise price to be set at or above the fair market value of the common stock on the grant date. So if a company grants an option with a strike price below the fair market value, even unintentionally, as can happen from time to time.

the options become subject to 409A's penalty regime. So the immediate income tax is on vesting, not on exercise. And there's an additional 20% federal penalty tax plus interest, which falls on the option holder, not on the company. And a qualified independent 409A valuation is what gives the company a rebuttable presumption of reasonableness under the IRS Safe Harbor. So without that, the burden falls on the company to

prove after the fact that its strike price was fair market value, which is a much harder and riskier position if the IRS or an acquirer's diligence team ever challenges it. So that's why a 409A valuation needs to be refreshed regularly, default rules every 12 months or sooner if a material event like a priced financing round, since a new preferred round resets what fair market value of the common stock actually is.

So the two questions actually do connect to directly. whether you're granting ISOs or NSOs, you need a defensible strike price to avoid any 409A penalties. And getting that valuation is what lets the board set that price with confidence instead of guessing.

Lindsey S. Mignano:

And there's tons of 409A providers out there. A lot of you might use online incorporation services with online cap table management software. You might be able to get a $3,000-ish dollar 409A valuation there. Alternatively, some of you may choose a CPA firm instead. maybe you want a defensible 409A valuation. In other words, you want a CPA who will stand up.

And defend it in case it was ever challenged. Those are slightly pricier. We've heard of anything from six to ten thousand , depending on how much traction you've been doing in business and you know what the scope of the defense obligation would be. but there are tons of providers out there. There's no excuse not to get one anymore. you have been fairly warned.