If you’re a startup founder of a C corporation, odds are good that you’re considered an employee under federal and/or state law. If you’re an employee, then you’re subject to certain protections under minimum wage and hour laws. So your company should likely be paying you (and your co-founders) a minimum wage. And no, startup equity is not a substitute for minimum wages.
With that said, it may not surprise you to learn that not all startups pay their founders minimum wage in the early days. In fact, most don’t. While I’m usually sympathetic to their reasons, the fact is that failing to pay minimum wage can lead to significant downstream consequences under certain circumstances. These consequences can include things wage and hour claims by ousted co-founders, which, by the way, can be brought against not only the company but also the officers of the company personally. So if you’re a founder and an officer, you should appreciate the potential exposure you’re taking on here in addition to the risk to the company.
At the risk of stating the obvious, the best way to minimize risk for startups and their officers is to comply with wage and hour laws from the start, including paying founders a minimum wage. But with the knowledge that not all, and in fact probably most, startups won’t do this, I find it’s helpful to lay out the different options for documenting founder employment relationships. From there, it pays to work through your particular situation with your startup lawyer to determine how to balance the risk factors.
Related: 83(b) Election For Startup Founders
Option 1 (Safe)
This first option is for the risk averse startup. As you might expect, this option is the one least taken by startups prior to raising meaningful outside investment.
The startup founders should sign employment agreements (typically, an offer letter coupled with a proprietary information and invention assignment agreement or “PIIA”) that set forth a wage that complies with federal and state wage and hour laws. The startup should then pay the founders that wage in accordance with any timing requirements (e.g., Washington requires wages be paid no less than monthly).
Related: Employee Offer Letters
Doing these things will ensure that there are no unpaid wage claims from a founder who leaves or government regulatory action. The problem, of course, is that the startup is probably using money loaned or contributed by the founders themselves to pay…the founders themselves.
Option 2 (Risky)
The second option tracks the first option in that the founders sign employment agreements that set forth a wage that complies with federal and state wage and hour laws. The difference is that the startup doesn’t pay that wage, or at least not until the startup raises outside investment., at which point the company may or may not retroactively compensate the founder for those unpaid wages.
The additional risks with this option are failure to pay wages that are owed, though there could be some mitigation here if the startup is later able to compensate the founder retroactively. That’s not to say that this would cause the startup to be in full compliance, but at least in that scenario money eventually does go to the founder.
This option can also lead to issues under Section 409A of the tax code, a complex provision dealing with deferred compensation, which could—perversely—penalize the founder.
So, in short, this isn’t ideal, but it does present some opportunities to mitigate minimum wage violations.
Option 3 (Riskier)
The third option, which in my experience is the most common one taken by startups prior to raising outside capital, is riskier still than options one and two. In effect, option three is a bet that failing to pay founders minimum wage pre-funding won’t lead to any regulatory action, unpaid wage claims, or other undesirable consequences.
To spell things out, the founders would not sign an offer letter identifying any wages to be paid; instead, the founders would sign only a PIIA to ensure, among other things, the IP they create for the company is owned by the company. The founders would then not receive any wages until the time they raise money from outside investors. Then the founders would sign the offer letter and start receiving wages.
To reiterate, failing to pay minimum wage can have real and serious consequences under the right circumstances. The reason why most startups hazard these risks, presumably, is that they do not materialize frequently enough to make the risks intolerable. But that fact, even if true, does not make them any less real. Proceed with caution and get help from your startup lawyer.
Option 4 (Riskiest)
The fourth and final option comes with an asterisk. This is because it involves classifying (or, more realistically in most cases, misclassifying) founders as contractors, rather than employees. It is likely the riskiest option on this list or at least on par with option three.
With this option, founders would sign a consulting agreement, rather than employment agreements. As a contractor, so the theory goes, the founder isn’t subject to protection by wage and hour laws. The problem is that it’s ultimately up to state and federal regulators to decide who is an employee and who is a contractor, not the startup (or the founder, for that matter). And the reality is that regulators at the federal and state level are showing less tolerance for worker misclassification.
Misclassifying a founder as a contractor can lead to back pay, penalties, and other undesirable consequences. It could also lead regulators to examine more comprehensively how a startup has classified its other workers to assess whether misclassification has occurred elsewhere. This not something you want to have to deal with. For that reason, it’s generally not advisable to try to classify founders as contractors.
Takeaways
This is one of those areas where labor law isn’t really responsive to the realities of life as a startup founder. I don’t expect this to change anytime soon. In light of that, I encourage startups and their founders to think carefully about what their risks are in this space, how they can be mitigated, and what their risk tolerance is. Only once you’ve gone through that process—ideally, with the help of a lawyer—should you settle on the option for documenting the founder employment relationships.
