Consultants

One of the most common legal missteps among emerging companies involves the classification of the people doing the work. In the earliest days of a startup, founders often bring on talented individuals as “consultants” or “independent contractors,” compensating them primarily or exclusively with equity. This arrangement feels natural when cash is scarce and everyone is pitching in to build something from the ground up. But what begins as a practical solution can quickly become a significant legal liability if the company does not revisit these classifications as it matures and secures funding.

This article provides a high-level overview of the risks associated with worker misclassification, the key legal frameworks that govern these determinations, and the steps founders should take to clean up classification issues before they become costly problems.

The Common Pattern: Early “Consultants” Who Are Really Employees

It is extremely common for pre-revenue startups to engage early team members as independent contractors or consultants. The logic is straightforward: The company cannot yet afford salaries, payroll taxes, or benefits, so it issues equity in exchange for labor. On paper, the individual signs a consulting agreement, invoices the company (or doesn’t), and is treated as a 1099 worker for tax purposes.

The problem is that many of these individuals are, as a matter of law, employees regardless of what the agreement says. Classification is not a matter of mutual agreement between the parties. It is determined by the nature of the working relationship under applicable federal and state law. If the engagement looks and feels like employment, then government agencies and courts are likely to treat it as such.

When these individuals are never reclassified, the company accumulates exposure over time. That exposure includes unpaid wages, overtime, employment taxes, penalties, and potential liability under both federal and state law. These issues often surface at the worst possible moment: during due diligence for a funding round, an acquisition, or in response to a complaint filed by a disgruntled former worker.

Why Reclassification Should Be a Priority After Funding

Securing any meaningful financing event should serve as a trigger for the company to revisit every worker classification. There are several reasons for this.

First, the original justification for the consulting arrangement, namely the inability to pay cash compensation, has likely changed. Once the company has capital, it has the resources to bring workers onto payroll and provide the protections required by law. Continuing to classify a worker as an independent contractor when the company now has the means to pay wages and withhold taxes weakens any argument that the arrangement was legitimate.

Second, investors and their counsel will scrutinize the company’s employment practices during due diligence. Misclassification issues are a well-known red flag. Unresolved classification problems can delay or even derail a financing, reduce the company’s valuation, or result in specific indemnification obligations imposed on the founders.

Third, as the company grows, the risks multiply. More workers mean more potential claimants. Longer periods of misclassification mean larger back-pay and tax liabilities. And the shift from a small, informal team to a structured organization makes it increasingly difficult to argue that any given worker was genuinely operating as an independent business.

The bottom line is that reclassification is not merely a housekeeping exercise. It is a critical step in putting the company on sound legal footing for its next phase of growth.

Federal Law: The Key Frameworks

At the federal level, worker classification is governed by several overlapping tests, depending on the statute at issue.

The Fair Labor Standards Act

‍The FLSA uses an “economic reality” test to determine whether a worker is an employee or an independent contractor. The inquiry focuses on whether the worker is economically dependent on the company or is in business for themselves. Factors include the degree of control the company exercises over the work, the worker’s opportunity for profit or loss, the worker’s investment in equipment or materials, the permanence of the relationship, the degree of skill required, and the extent to which the work is an integral part of the company’s business. The Department of Labor has historically taken a broad view of employment under this test, and the consequences of misclassification include liability for unpaid minimum wages and overtime, liquidated damages, and attorneys’ fees.

The Internal Revenue Code

‍The IRS applies a common-law test that examines the degree of control and independence in the relationship. The IRS groups relevant factors into three categories: behavioral control (whether the company directs how the work is done), financial control (whether the company controls the business aspects of the worker’s role, such as how the worker is paid and whether expenses are reimbursed), and the type of relationship (including written contracts, benefits, and the permanence of the engagement). Misclassification under the tax code can result in liability for unpaid employment taxes, penalties, and interest. In some cases, officers of the company may face personal liability under the trust fund recovery penalty.

Exempt vs. Non-Exempt Classification

‍Once a worker is properly classified as an employee, the company must also determine whether the employee is exempt or non-exempt under the FLSA. Exempt employees are not entitled to overtime pay, but they must meet specific salary and duties tests. The most commonly applicable exemptions for startups are the executive, administrative, professional, and computer employee exemptions. Each requires that the employee be paid on a salary basis at or above a specified threshold and that the employee’s primary duties satisfy specific criteria. Founders should not assume that simply paying a salary or giving someone a managerial title is sufficient. The analysis turns on the actual duties performed, not the job title.

State Law: Where the Rules Get Stricter

Many states impose classification standards that are more restrictive than federal law, and compliance with federal standards alone does not guarantee compliance at the state level.

California’s ABC Test

‍California applies a particularly stringent standard under its ABC test, codified by Assembly Bill 5. Under this test, a worker is presumed to be an employee unless the hiring entity demonstrates that the worker (A) is free from the company’s control and direction in performing the work, (B) performs work that is outside the usual course of the company’s business, and (C) is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. Prong B is often the most difficult to satisfy for startups, because early workers are typically performing tasks that are central to the company’s core business. California law also provides for significant penalties for misclassification, including penalties under the Private Attorneys General Act, which allows employees to bring representative actions on behalf of the state.

Other Notable State Frameworks

‍Several other states have adopted or are moving toward ABC-style tests, including Massachusetts, New Jersey, and Illinois. New York applies a similar multi-factor test and has aggressive enforcement mechanisms. States vary considerably in their approaches, and companies with remote workers in multiple states must ensure compliance in each jurisdiction where a worker is located, not merely where the company is headquartered. Founders should be particularly attentive to any state in which the company has workers, as the applicable test is generally determined by the worker’s location.

Cleaning Up Past Misclassification

For companies that have already been operating with misclassified workers, there are several steps to consider when undertaking a remediation effort.

The first step is to conduct an honest internal audit. Identify every individual who has been engaged as a contractor or consultant and evaluate each engagement under the applicable federal and state tests. Determine which individuals are likely misclassified and assess the duration and scope of the exposure.

The second step is to consult with experienced employment counsel. Remediation strategies vary depending on the jurisdiction, the number of affected workers, the duration of misclassification, and the company’s financial position. In some cases, the IRS Voluntary Classification Settlement Program may be available, which allows companies to prospectively reclassify workers with limited look-back liability in exchange for a modest payment. Similar programs or settlement frameworks may exist at the state level.

The third step is to transition misclassified workers to employee status going forward. This includes placing them on payroll, withholding applicable taxes, providing required benefits, and ensuring compliance with wage and hour laws, including proper exempt or non-exempt classification.

The fourth step is to address the equity arrangements already in place. Early equity grants made to individuals who should have been classified as employees may have been structured as contractor grants, which have different tax treatment than employee equity awards. Companies should work with both employment counsel and tax advisors to evaluate whether corrective filings or revised equity documentation are necessary, particularly with respect to Section 409A of the Internal Revenue Code, which governs deferred compensation and imposes significant penalties for noncompliance.

Finally, companies should implement classification policies and procedures that will prevent these issues from recurring as the company continues to hire. A brief intake process for every new engagement, whether employee or contractor, can go a long way toward ensuring that the correct classification is applied from the outset.

For private companies backed by venture capital investors, acquisition is frequently the most likely path to liquidity. Founders are often laser-focused on product development, market expansion, and fundraising, without devoting the same early-stage discipline to ensuring the company is well-positioned for a future exit via a merger or acquisition.

M&A preparedness is not a late-stage exercise, but an operational strategy to position your company as an attractive, high-value target to potential acquirors.

Corporate Governance

Some of the most common obstacles to efficient M&A processes stem from issues related to corporate governance. Complex capitalization tables, unclear chain of equity ownership, and unresolved governance issues can create transaction delay and, depending on the structure of the transaction, loss of leverage.

Companies should consider focusing on three key areas of corporate governance to be prepared for future M&A processes: capitalization table discipline, stockholder rights, and board and stockholder alignment.

Capitalization Table Discipline

Maintain clear documentation of all equity issuances with proper board and stockholder approvals; confirm board minutes are complete, approved by the board, and signed; verify that 83(b) elections have been timely filed with respect to restricted stock grants to founders and early employees; and ensure 409A valuations are updated following major events that may impact valuation (such as a financing) and, absent such events, at least annually.

Stockholder Rights

Ensure all stockholders have signed the relevant stockholder agreements and that the company’s management team understands the protective provisions embedded within such agreements; similarly, ensure that the company’s management team is familiar with relevant provisions of any investor side-letters (think drag-along mechanics, rights of first refusal, and co-sale rights).

Board and Stockholder Alignment

Understand what approvals are required to approve a sale or merger of the company and whether any investor has blocking rights.

Contracting Discipline

Material contracts, such as key vendor and customer agreements, collaboration agreements, and licensing arrangements, are some of the first diligence requests in an M&A process. These contracts often contain assignment or change-of-control provisions that can require third-party consent, accelerate payment obligations, or trigger termination rights or other contractual rights that could significantly impact the trajectory of a deal. Accordingly, it is important for companies to maintain clear records of all material contracts, ensuring that all contracts are fully executed and include all attachments, exhibits, amendments, and restatements. Companies should track whether any material contracts have upcoming renewals or expiration dates. Additionally, tracking key provisions in such material contracts that may be triggered by an M&A (such as third-party consent requirements) will help streamline the M&A diligence and consent process.

Intellectual property is another value-driver for life sciences companies and technology companies, making it vital for companies to have documentation that clearly delineates intellectual property ownership. Companies should verify that all employees and contractors have signed Proprietary Information and Inventions Assignment Agreements (PIIAAs), review consulting agreements to confirm that intellectual property created by consultants/contractors has been validly assigned to the company, and obtain confirmatory assignments from founders and early contributors, if needed, and at the appropriate time. For companies with affiliated entities, confirm that the company’s core intellectual property assets sit within the target entity and not within any affiliated entities.

Being proactive can save time and expense during the M&A diligence process.

Regulatory Compliance

Depending on industry and geography, regulatory risk can become a gating diligence issue. Companies should identify areas of risk and preemptively resolve any outstanding compliance risks (e.g., data integrity, marketing, industry-specific licensing, etc.). In particular, life sciences companies should consider pursuing regulatory planning with the assistance of healthcare and/or FDA counsel (as needed) to ensure, among other things, that regulatory filings, communications, and approvals are complete and accessible.

Deal Team Preparation

Once the company has decided to start a sale process, identify at the outset who will be part of the core deal team, which will typically consist of a select number of employees and outside advisors. Members of executive management and other key internal personnel with specialized knowledge about the company’s corporate governance, labor and employment practices, employee benefits structure, assets (IP, real estate, etc.), litigation exposure, and regulatory compliance are typically included within the core deal team. Further, at the appropriate time, companies should engage outside advisors, such as outside legal counsel, financial/tax advisors, and investment bankers, all of whom can help quarterback the transaction and efficiently drive the deal process.

After the deal team is in place, consider implementing deal confidentiality procedures to maintain the integrity of the sale process:

• assign code names to the project and company participants;
• limit working group size and access; and
• consider antitrust issues and the use of “clean team” agreements and data rooms.

Data Room Readiness

Prepared companies treat diligence readiness as an ongoing process and not an exercise triggered by a letter of intent or term sheet. First, select a virtual data room that provides strong security and activity tracking. Second, build the company’s data room with organizational discipline, using logical folder structures (corporate, IP, finance, regulatory, benefits, etc.) and uploading documents in a searchable, digital format with consistent document naming conventions. Lastly, in connection with building the data room, flag with the guidance of deal counsel any confidentiality concerns and access restrictions that need to be put in place. For example, are there any documents that need to be redacted or anonymized? Does the transaction present antitrust sensitivity requiring documents to be shared through a “clean room”?

In all, a well-maintained and categorically organized data room significantly accelerates a sale process and signals sophistication to potential acquirors.

The most successful exits rarely begin when a banker is engaged. Ideally, they begin years earlier with strategic and operational foresight. Companies that understand the value of M&A preparedness can preserve negotiation leverage and act more decisively when M&A opportunities arise. After all, engineering an exit is more than closing a deal — it is positioning the company so that the right deal finds you.

Many private companies are having to grapple with the realities of lower valuations. When a new Section 409A valuation values the company’s common stock at a lower price than any past Section 409A valuations relied on to grant prior stock options, the company may want to consider repricing the stock options held by its service providers. Where an existing stock option has an exercise price higher than the company’s current valuation, the result is an “underwater option.”

While repricing can restore some of the incentive and retention value of employee equity, it raises a host of valuation, perception, legal, tax, and accounting considerations that a company must manage.

Is a repricing necessary?

If the decreased valuation is a temporary situation that is expected to shift and change in a short period of time, or the long-term value is expected to be significantly greater than the current price, a repricing may not be necessary. This is particularly true if the value that is added to the option as a result of the repricing is not significant from a long-term perspective (i.e., the adjustment in price is relatively small). For example, if an employee held 1,000 company stock options that were currently priced at $2 per share, but that could be repriced to $1 per share, it may feel like making this change would be a significant repricing. However, if, a few years later, the company were to have a liquidity event where the shares were sold at $100 a share, this repricing only added an additional $1,000 to the total sale amount of $99,000, which is an increase of only 1 percent. Contrast that to a situation where the shares are ultimately sold at $3 a share. Repricing the options to $1 a share would still only add $1,000 to the total sale amount, but that would effectively double the holder’s total sale proceeds from $1,000 to $2,000.

While companies may not be able to predict the ultimate sale price, it is useful for a company to look at what a healthy potential exit will look like and how significant this repricing would be in that context, to ensure there is material value being added as a result of the repricing.

Negative Aspects of a Repricing

At first blush, most people would expect employees would be happy to have their options repriced as it gives them additional potential equity value; however, repricing options can introduce worry about the long-term value and prospects of the equity and, as a result, impact employee morale. Repricing can, and often does, have a positive impact on employees, but employees may also interpret it to mean the equity they hold is decreasing in value and that they are less likely to get the hoped-for. This can be particularly true where there are multiple repricings over a period. Repricing can also impact employees’ trust in management, especially if the message coming from management is about how well the company has been doing during that same period. If the future value of the shares is perceived to be weak, it creates jitters among the service providers and can negatively impact retention and hiring. The impact is exacerbated if the company is in an industry where most companies are doing well, as opposed to general market downturns impacting all similar companies. Finally, a company repricing can be a signal to investors that the company does not perceive as much long-term value in the shares and can actually lead to low-ball investment proposals, creating a self-fulfilling prophecy. Companies need to carefully weigh both the long-term and short-term impact of a repricing and its perceptions by service providers and investors.

Repricing Terms & Participation

If the company has decided that a repricing is necessary to properly incentivize its employees, the next consideration is what terms the company should offer in connection with the repricing. While a private company may be tempted to use the repricing as a chance to add vesting or other terms favorable for the company, anything other than a simple repricing (e.g., changing only the price) adds considerable cost and complexity for the repricing and could trigger the tender offer rules as discussed in more detail below.

Generally, only current service providers can participate in a repricing. This is because the repricing is effectively treated as a cancellation of the prior grant and a grant of a new award at the new price. All new awards need to be granted pursuant to a valid securities law exemption; thus, the repricing is generally limited to service providers that satisfy compliance under Rule 701 (discussed more below). If a significant number of former service providers are impacted by underwater stock options, the company should consult with counsel to determine the best path forward.

Tax Considerations

Any time a company wants to do a repricing, it needs to consider Section 409A compliance and Incentive Stock Option (“ISO”) tax issues.

Section 409A Tax Compliance

Section 409A governs deferred compensation, including stock options, and imposes severe tax penalties on options granted with an exercise price below fair market value. Section 409A penalties include an immediate income inclusion plus a 20% extra tax for the option holder. Any option repricing must therefore be done in compliance with Section 409A. In practice, this means the new exercise price cannot be less than the then-current fair market value of the underlying stock as of the repricing date. To ensure this, companies generally obtain an updated Section 409A valuation before repricing options. The board will use this valuation to set the repriced exercise price at or above fair market value, preserving the options’ exemption from 409A. Furthermore, a single repricing is usually not a risk under Section 409A, but successive repricings may be. While market volatility may tempt companies to repeatedly adjust option prices, serial repricings can be seen as the company not having a fixed price for options (e.g., the repeated repricings are seen as chasing a price to the bottom), which could be a Section 409A violation. Each modification should be carefully considered and tied to a material change in value (not minor fluctuations), and any subsequent repricings should be analyzed for their impact under Section 409A.

ISOs

Repricing an ISO is deemed a grant of a new ISO. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more non-qualified stock options (“NSOs”) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (specifically, the prong requiring the ISO be held for two years from date of grant) will restart from the repricing date. Whether these changes are sufficiently material to require the consent of the option holder or a company tender offer should be analyzed by the company in consultation with its counsel under the terms of the plan (such as plan limitations on ISO grants and changes to existing grants) and applicable securities law.

Securities Law Considerations

A repricing raises securities law issues under Rule 701 and could trigger tender offer issues.

Rule 701

Rule 701 of the Securities Act of 1933 is the primary federal exemption that allows private companies to offer stock options and other equity compensation to employees without registering shares with the Securities and Exchange Commission. Repriced options count toward Rule 701 limits and disclosure thresholds. Importantly, as noted above, a repriced stock option is generally treated as issuance of a new security which must qualify for an exemption at the time of repricing. Therefore, the company must ensure that the repriced options, taken together with other equity compensation issued in the same 12-month period, do not exceed Rule 701’s size limits (the greater of $1 million, 15% of assets, or 15% of outstanding securities). Moreover, if the value of the repriced options, taken together with other equity compensation issued in the same 12-month period at the time of repricing, exceeds $10 million, the company must provide the required disclosures under Rule 701 (financial statements, risk factors) to all participants. Companies should keep in mind that, because Rule 701, by its terms, covers offers to current employees, directors, consultants, and advisors, it is generally not available as an exemption for repricing options to former service providers.

Tender Offer

An issuer tender offer under Rule 13e-4 and Regulation 14E of the Securities Exchange Act of 1934 (the “Exchange Act”) encompasses an offer by the company to security holders to exchange securities, which offer is open for a limited time and involves decisions by the holders. Importantly, a “simple” unilateral repricing that changes only the exercise price to the new Section 409A valuation while leaving the other terms the same is generally not thought to rise to the level of a tender offer. However, an option repricing where the option holder’s consent or action is needed may require compliance with tender offer rules, which are triggered because the option holder is making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company then must observe a host of requirements under the Exchange Act. Also note, if the option is an ISO, keeping an exchange offer open more than 30 days might affect ISO status, so companies with ISOs will sometimes limit the offer window to 29 days to be safe.

Corporate Governance Considerations

A repricing will also raise a number of corporate governance issues, including approval requirements and fiduciary duties.

Board Approval

In almost all cases, repricing will require approval by the company’s board of directors (or a committee with delegated authority). The board should formally approve the repricing terms (who is eligible, new exercise price, timing, etc.) via a resolution. This is both a governance requirement and a key part of the board fulfilling its fiduciary duty (documenting that it considered the repricing and found it in the company’s interest to retain talent). The board should also be mindful of any conflicts of interest that may arise, particularly if grants to the directors are implicated.

Stockholder Approval

For private companies, stockholder approval of a repricing is typically not required unless the company is contractually obligated pursuant to agreements with investors. It is crucial to review the stock option plan documents, the company’s charter or organizational documents, and any investor agreements (such as an Investor Rights Agreement) before proceeding. Credit agreements or other contracts might also restrict modifications of equity incentives.

Fiduciary Duties and Legal Risk

A company’s decision to reprice options should also be evaluated through the lens of fiduciary duties and fairness to all stockholders. While repricing is aimed at benefiting employees (and, by extension, the company, through improved retention), it does effectively transfer potential economic value from existing stockholders to the option holders. Directors must justify the repricing as a reasonable, informed, and fair decision. To withstand scrutiny, the company’s board should document the business purpose, such as, for instance, maintaining team morale and productivity during a downturn. Additionally, to the extent any holders benefiting from repriced stock options are directors, officers, or controlling stockholders of the company, the company should be mindful of the safe harbor requirements under Section 144 of the Delaware General Corporation Law and obtain the appropriate approvals.