Q: What is the difference between an independent contractor and an employee and what kind of documents do I need for each?
A: In the early stages of a business, many founders prefer to engage independent contractors or consultants to perform services. It allows the company to avoid implementing costly payroll processes and employee benefits and the company saves significant dollars that would otherwise have to be paid on employee-related federal and state taxes. In fact, it’s such a big savings that the IRS decided several years ago to crack down on improper classification of employees by imposing hefty penalties on the companies.
So while you might find it much more economical to label workers as independent contractors, make sure the label is correct. Here making this determination, here are a few things to consider:
- Do you want the person to work full time for your company and no one else? If so, that generally ruins any chance of independent contractor status. An independent contractor usually has more than one client and while she might work full time for a specific project, that wouldn’t continue longer than project completion.
- Do you want to train the person and have ongoing oversight (this is another big indication of employee status.) Usually an independent contractor presents the company with a finished project and is not told how to create that finished project.
- Are you offering health insurance, paid time off and expense reimbursement? If so, this is another indication of employee status.
- Do you want the worker to have a company email address and company business cards? If so, these are additional factors that indicate employee status.
You can find additional helpful guidance on the IRS website.
Independent contractor: In general, you engage an independent contractor with a simple consulting agreement. If you anticipate a long-term relationship with multiple projects, you might engage them with a Master Service Agreement that describes each project in a separate exhibit. If you’re engaging them to develop technology, it is very important that the agreement state that they are creating the technology for you as “work product,” which means that you will own what you’re paying them to create. Equally important is that if they have their own background technology that goes into creating your technology, you should have a perpetual, royalty-free license to use that technology. Any independent contractor you engage should sign a comprehensive confidentiality agreement.
Employee: You generally engage employees on an “at will” basis, meaning that you have the complete freedom to terminate the employee and the employee has the right to resign, at any time for any reason. Alternatively, senior management might be engaged for a specified term -- generally these agreements are much more detailed, with carefully described termination provisions. For instance, a termination without "cause" might trigger severance as well as acceleration on outstanding equity that is subject to vesting.
Every one of your employees (and possibly your independent contractors) should sign a Proprietary Information and Invention Assignment Agreement, which binds the employee to keep all of your proprietary information confidential and states that anything the employee creates while working for your company, belongs to your company. You should consider restricting a terminated employee’s access to your existing employees or customers. You might even impose restrictions on post termination competition.
Related: The 7 Deadly Sins of Hiring
How do I hire anyone when I can’t even afford to pay myself?
Many workers in the technology industry are familiar with equity compensation. While it might be difficult to find people who are willing to work only for equity, you can generally use equity as a good offset for cash compensation.
Don’t give away your equity freely (it could be worth a lot one day). Equity compensation should generally vest over four years with a one-year cliff, meaning that a quarter of the grant vests on the 1st anniversary of the grant and the remaining vests over the following three years, either monthly or quarterly.
Here are some market standard guidelines to consider for grants to non-founder management (will differ depending on location and stage of company):
Advisory Board Member or Director: .25% - .5% (two to three year vesting)