Employees vs. Contractors ─ A Due Diligence Challenge

It seems as though the employee vs. contractor issue is popping up all over the news. Virtual assistant startup company Zirtual just fired over 400 employees by email because the company couldn’t sustain its payroll once it converted contractors to employees. The Wall Street Journal has also highlighted the many startups that are now grappling with some version of this issue.

The employee vs. contractor question needs to be considered during due diligence, especially as the issue becomes more common.

You may wonder, why does this matter? And if it’s so difficult to convert contractors to employees why are companies doing it?

“1099 Employees”

Many companies today have what we call “1099 employees,” which of course is an oxymoron. You can have 1099 independent contractors, or you can have employees. Unfortunately, some businesses have been treating contractors as if they were employees, primarily to save on costs like healthcare and benefits, which employers are required to provide for employees. It sounds like a good plan, especially for small startup companies with low margins, but you run into legal trouble when your “contractors” actually work as full or part-time employees.

If the company is employing “1099 employees” (contractors who should really be employees), and you are forced to convert them, the costs can be significant. The founder of Zirtual, Maren Kate Donovan, said in a LinkedIn post, “Simple math is add 20-30% on to whatever you pay an IC [independent contractor] to know what it will cost to have them as an employee.”

In addition, a business that is using contractors as if they were employees is exposed to myriad legal issues. Homejoy Inc., a startup cleaning company, was unable to raise more venture capital due to four lawsuits. The business was forced to close.

Take a Closer Look at Workers

A simple way to start your workforce due diligence is to find out how many contractors vs. employees work at the company. A lot of contractors at the seller’s company should raise a yellow flag. It doesn’t guarantee that something is amiss, but you should investigate further.

That’s not to say you have to walk away from a company that uses contractors, or even one that is using contractors as employees. It’s simply an area that needs to be explored. If contractors used by the company should really be re-classified as employees, what would it take to convert them? Does this change the deal for you?

One option is to convert all contractors to employees before the acquisition closes. If the problem is serious enough, you may even decide to walk away from the deal. Whatever you choose, return to your objective acquisition criteria before making your decisions.

People usually think about financial due diligence, but in light of recent news I encourage you to take a second look at the seller’s workforce. You don’t want to discover post-acquisition that all your contractors need to be reclassified as employees. Find out BEFORE you close the deal.

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