Written April 19, 2019
When bootstrapping, it is common for founders to not pay themselves any cash compensation. This approach is sometimes also applied to other service providers, who receive just stock option compensation. Despite the prevalence of this practice, certain rules must be followed or the company will be setting itself up for liability. And investors avoid liability.
Liability issues most often arise with the severance of minority co-founders or independent contractors.
A minority co-founder, who has not been paid any cash compensation is not working out and is let go. If this co-founder feels aggrieved, she might sue the company, and the other founders personally, for failing to pay the minimum wage. The minority co-founder may face an uphill battle to prove her claim, but this situation would be a thorn in the side of any startup, with the potential to grow into a costly lawsuit. You can avoid this entire scenario by simply paying the individual at least the minimum wage in cash.
You classify a service provider as an independent contractor, and you do not pay them cash. Instead, you pay them in equity subject to a vesting schedule. The person works for a while, but their work is unsatisfactory so you terminate them. Their equity is unvested, and so it all reverts to the company. This person may not only sue you for failure to compensate them, but they might also assert that they own the IP they created while working for you because you didn’t pay them anything for it. It is obviously in a startup’s best interest to steer clear of these issues. So, it is important you handle paying people correctly. (A payroll service like Gusto is affordable and automates all the documentation required.)
What are the Laws?
For founders acting as corporate officers, it is generally difficult to escape “employee” status and the minimum wage and overtime requirements. Under the federal income tax law, an officer of a corporation is defined as a “statutory employee” which leads to a similar classification under the wage and hour laws. Admittedly, the federal Fair Labor Standards Act has an exception to the minimum wage for 20% or greater equity owners, but many states, including California, Washington, New York, and Maryland do NOT have similar provisions. Because the state minimum wage levels are higher than the federal standard, these are the applicable rules to startups with workers in those states.
The risk with not paying your employee co-founders (and if they are an officer of the company, then they are likely an employee) at least the minimum wage is that they might sue you personally if things don’t work out. This is one reason investors usually want to know if a company has severance plans in place before they invest. Failure to pay severance when a company runs out of cash is another potential source of troubles for directors and officers of the company.
Here are the Startup Rules
If you are the majority founder, you are probably not going to sue the company. So, you can probably not pay yourself in the early days. But this situation will change as your company grows, particularly when you begin to solicit investment funding. Investors are going to want to have the assurance that there is zero potential for outstanding wage claims.
For minority co-founders, pay them at least the minimum wage to avoid the risk of a lawsuit. While it is true that independent contractors are exempt from minimum wage laws, if the co-founder is an officer of the company, contractor status may be unattainable. Worker classification is a highly fact-specific inquiry and largely depends on how much control the company has over the individual.
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