Avoiding the Snowball Effect

How to Prevent the Collapse of the On-Demand Economy

Last month, federal judges cleared the way for employment lawsuits against Uber and Lyft to go to trial. Additionally, since March, a slew of labor lawsuits have been filed in state and federal courts against Homejoy, Caviar, Postmates, and Instacart. This new crop of suits comes behind the major class-action labor lawsuit filed against Handy in October. And the lawsuits aren't just limited to new startups. In November, Google was also sued for worker misclassification.

You know that old cartoon trope where a character, usually the villain, trips and falls off the side of a mountain while in hot pursuit of someone else. As the pursuer careens down a snow-covered slope, he turns into snowball, which quickly grows and sweeps up whatever is in its path. Eventually, the giant snowball crashes, leaving the dastardly villain slumped and disoriented with little birdies circling his cartoon head. That’s what I picture when I think of the way some tech companies are dealing with labor law.

All of these cases are focused on determining if tech companies misclassified employees as independent contractors.

According to the IRS, the rule for deciding if a worker is an independent contractor or employee, “… the payer has the right to control or direct only the result of the work and not what will be done and how it will be done”. In addition to the IRS’s definition, standards of worker classification vary by state. Coincidentally, many of the states with the most startup activity also have more employee-friendly labor protection policies. Ultimately, nearly all state-based standards center on the degree of control an employer exercises over a worker.

Generally, independent contractors are not entitled to minimum wage, overtime, workmen’s compensation, or medical and family leave. Because they are also not required to pay payroll or social security taxes for contractors, companies that hire independent contractors can save anywhere from 20 to 40% in labor costs. In return for limited access to benefits and reduced labor protections, these independent contractors supposedly enjoy greater flexibility and control over their work. However, some workers allege that the way many tech companies use independent contractors amounts to exploitation.

Startups in the “on-demand economy” economy rely heavily on independently contracted labor to reduce costs while meeting consumer demand.  Should the workers suing startups prove successful, the resulting penalties could threaten the foundation of the on-demand economy.

Getting Caught Up in the Snowball effect

Though a bit dramatic (and perhaps revealing of my intense love of cartoon classics), the snowball metaphor is not so much of a stretch. Non-compliant companies (particularly those with a little bit of press attention, some investment, or a nice valuation) may find themselves snatched up in careening snowball of regulatory crackdowns, driving lawsuits, fuelling further sanction. Given the rise of interagency cooperation, it is entirely possible for an unemployment benefits application or misfiled 1099 to turn into a state tax investigation, which evolves into a federal investigation, the findings of either of which trigger a lawsuit, perhaps even a class action.

Federal and state governments across the country are engaged in a bipartisan effort to crack down on employee misclassification. Potentially, investigations can arise from tax authorities, federal and state labor agencies, unemployment and workmen’s compensation bureaus, and specialized task forces, or some combination thereof. Given the sheer amount of regulatory agencies and actors interested in misclassification, for companies engaging workers in multiple states, that aforementioned snowball can quickly turn into an avalanche.

Why? Simply put, worker misclassification costs governments a ton of money and it is on the rise.

An estimated 3.4 million employees are misclassified, costing the US $49 billion in unpaid and underpaid taxes. And that’s just on the federal level. State coffers also get shorted by misclassification. In California, for example, the government collected nearly $180 million in back taxes and fines just from companies audited over a three year period. In this post-recession climate, that amounts to a hard source of revenue to pass up.

Finally, violators make easy targets. After all, why raise taxes or slash budgets when you can just force startups to follow the law. Where those startups also challenge entrenched interests or pose other regulatory problems, such a crackdown starts to look like a win-win.

Costs of the Avalanche

Where the cascade really picks up speed is in the area of cost. The price paid by companies found to be in violation of the law could put them out of business. For example, according to Fast Company, should plaintiffs prevail, Handy could be forced to pay nearly $600 million. That’s a hefty price for a company that’s only raised $60 million since 2012.

And it doesn't stop with litigation. Companies found to engage in wilful misclassification could also be on the hook for back taxes, unpaid workmen’s compensation, and Affordable Care Act fines. In addition to those federal penalties, violators will have to pay state fines. In California, such fines could include repayment of back payroll taxes subject to interest and a 10% penalty; $5,000 to $25,000 in fines for each violation, and criminal charges.

Then, there are the long-term costs of non-compliance. Lawsuits can deter investment and postpone IPO’s. Keeping in mind Bill Gurley’s SXSW prediction of dead unicorns, it is entirely possible that the impact of lawsuits and fines could have a more pronounced effect on investment and valuations than in years past. On a broader level, widespread non-compliance with labor law and ensuing regulatory crackdowns could endanger existing state incentives designed to attract startups. After all, it makes relatively little sense to invest in startup growth if a state can’t collect taxes or increase stable employment.

Finding A Way Forward

Regardless of the regulatory hurdles that need to be overcome, the on-demand economy has a lot to offer. Companies that provide higher levels of convenience, service, and value are good for consumers. Having a higher degree of control and more flexibility tends to make workers happier. Expanded markets have the potential to benefit society on a larger scale. Many insist that given these benefits, the new model is here to stay.

So, how do startups in the on-demand space avoid the avalanche? Some companies may be tempted to play it safe and wait on the outcomes of the pending labor cases. But that’s a dangerous bet, since it doesn’t prevent plaintiffs from filing new cases, potentially in any state where a company has workers. As I've written before, even when resolved at an early stage, lawsuits are expensive.

Employers can’t simply contract their way out of misclassification either. No matter what kind of documents a worker signs or files, their employment status will be determined by conduct or actions affecting the nature of their employment.

Real change is needed, and tech companies could start by:

Utilizing Staffing Agencies — A short-term solution, applied while companies determine their long-term strategy, would be to shunt the bulk of responsibility for human resources off to another party, like a staffing agency. For this period, the staffing firm would be responsible for determining the employee’s tax status , managing benefits, and offering tools and training. Many tech companies already rely on these firms to staff short-term projects or more quickly fill skills gaps. Startup companies could hire through them for independent service delivery contractors the same way that they often do for developers and designers.

Unfortunately, using staffing firms has downsides which make them less ideal for the longer term. Staffing firms are designed to plug short-term holes in an organization, not replace an entire component of a company’s labor force. They are expensive, charging much more than it would cost to hire an independent contractor directly. And they don't necessarily absorb all of a company’s risk. In states with more stringent independent contractor laws, like California, companies who hire through staffing firms that misclassify workers could still face liability.

Self-regulating and Internally Restructuring — A more proactive and sustainable solution would be for companies to self-regulate, through collective examination of industry practices and internal restructuring of their business models. In the current litigious climate, self-regulation offers a way for the industry to get ahead of the rising tide of lawsuits and avoid the ire of zealous regulators. Often in the case of labor relations, regulators tend to be more forgiving of those industries and actors that make a good faith effort to abide by the law. Furthermore, in the current climate of unexpected budgetary surpluses, state regulators, less desperate for revenue, might be more willing to work with industry.

Some startups, like Managed by Q, have chosen to employ breakaway business models at the outset, classifying workers tasked with service delivery as full time employees. Others, like TaskRabbit, have revised their models, deciding to pay their contract workers a minimum wage. Of course, these individual solutions may not be appropriate for all companies. Though laudable, they aren't necessarily scalable and have not yet shown long-term success in the marketplace. Companies would be wise to develop tailored solutions which account for their individual need. Such solutions, when deployed under the umbrella of an industry wide push towards compliance, have a greater potential for greater impact and longer term success.

Advocating for changes in the law — While pursuing self-regulation, tech companies should join other stakeholders in pushing for changes to the law which take into account the changing nature of the economy. Some scholars have advocated for the creation of a third category of worker, which falls in between independent contractors or employees. These workers, known as dependent contractors, who take on project-work but have less control over their assignments or terms of employment, could be entitled to some benefits and training, without incurring the same costs as full employees.

Ultimately, ongoing battles concerning labor misclassification of workers in tech reflect broader global shift towards contingent employment across sectors. I've wrestled with this issue as both an academic researcher and an international labor lawyer. Globally, in industries from media to financial services to higher education; contingent employment is on the rise.

Tech companies have a critical role to play in the evolution of work on a national and global scale. They must decide what kind of labor economy they want to create.

To that end, entrepreneurs should ask themselves a few pointed questions:

Do they want a labor market in which a large percentage of entry level employees receive luxurious perks and high salaries while hands-on service providers, often the faces of a company, live in poverty?

Should they, the very drivers of innovation, perpetuate age old models of exploitation?

Will they wait for regulators to decide their business models for them?

I believe that many startups can still avoid the avalanche. But, to do so they need to get ahead of the snowball coming their way. Only then is mutually beneficial, positive, and productive change possible.