Today’s online edition of New York Magazine’s “Daily Intelligencer” includes a comprehensive article on how Silicon Valley start-up tech companies using “the 1099 model” may be exposed to employment, tax, and benefit law liabilities that could drive them out of business or cause them to change to a W-2 model. Kevin Roose’s fine article is entitled “Does Silicon Valley Have a Contract-Worker Problem?”

Roose predicts that venture capital funding sources that have invested in 1099-model start-ups may not have anticipated their potential exposure to the types of class action lawsuits where the contract workers allege that they are not really independent contractors but actually misclassified employees. The article examines companies that use the 1099 model – such as TaskRabbit (errand service), Homejoy (house cleaning), Uber (car service), BloomThat (flower delivery), Washio (laundry services), and Spoonrocket (meal delivery) – and concludes that “If their [freelance 1099ers] are classified as employees then that suddenly makes their business model untenable.”

Three things seem to have prompted the article. The first was Roose’s hiring of a house cleaner through a San Francisco start-up called Homejoy, which was offering home cleanings in the Bay Area for $19. As Roose noted, that was not $19 per hour or $19 per room, but $19 for his entire home. Striking up a conversation with the cleaner, he found out that the worker was homeless and, to Roose’s surprise, was not an employee of Homejoy but an independent contractor referred to Roose by Homejoy. The second event was Roose learning that a federal appellate court had just ruled that FedEx Ground had misclassified 2,300 drivers in California that it had treated as independent contractors. The third was Roose hearing that Uber had been sued in Massachusetts and California in a class action lawsuit alleging that they were being misclassified as independent contractors. Roose asks: “Could courts destroy the 1099 model?” The answer to that question is below, but first I address investments by private equity firms in companies that use a business model built around independent contractors.

Hidden Due Diligence Risks

In my blog post in January 2013 entitled “Hidden Due Diligence Risk in Mergers, Acquisitions and Investments: Independent Contractor Misclassification Oftentimes Overlooked by Private Equity Firms, Hedge Funds and Other Investors,” which was republished in the American Bar Association’s January 23, 2013 Business Law Today, I observed that many due diligence reviews in mergers, acquisitions, and investments have ignored the issue of independent contractor misclassification liability, noting:

“This is a difficult exposure to identify unless the legal team digs below the information typically provided by the seller or available in public records. In view of the crackdown by federal and state governments on the misclassification of employees as ICs, an increase in state misclassification legislation, and a steady stream of class action lawsuits claiming that certain workers have been disguised as ICs, due diligence efforts should not overlook this often hidden exposure.” The article discusses what private equity firms should examine during due diligence, how to determine exposure to independent contractor misclassification liability, and the use of post-closing due diligence to minimize or eliminate this type of legal exposure.

“Could Courts Destroy the 1099 Model?”

The answer to Roose’s question is, yes – but only if the tech companies that use that model do not take care to structure, document, and implement their independent contractor relationships in a manner consistent with federal and state independent contractor laws, provided the business model, once properly designed and implemented, is not built on directing and controlling the manner by which the 1099ers perform their work. Appellate courts such as the one that recently doused FedEx focused on the independent contractor agreement drafted by FedEx as well as FedEx Ground’s own policies to conclude that, although FedEx arguably lacks control over some parts of its drivers’ jobs, such lack of control over certain parts of the drivers’ roles is not sufficient to “counteract the extensive control it does exercise” including the right to control the appearance of its drivers, its vehicles, the times the drivers can work, aspects of how and when drivers must deliver packages, and the decorum by which the drivers must conduct themselves.

In my August 29, 2014 blog post on that case entitled “Earthquake in the Independent Contractor Misclassification Field,” I concluded that FedEx Ground lost before the court in California because of its reliance on an independent contractor agreement and its policies and procedures that were good, but by no means good enough.  Plainly, although FedEx is a savvy company, close scrutiny by a court found that the very documents FedEx created were sufficient in degree to lead the court to rule against FedEx. As I noted, “IC agreements and policies and procedures that are not drafted in a state-of-the-art manner, free from language that can be used against the company, can cause businesses that use ICs to face class action litigation or regulatory audits or enforcement proceedings they may be able to otherwise avoid.”

This is not to say that every 1099 business model can be sustained under close scrutiny by the courts simply because its independent contractor agreement reads like a dream. Even a well-drafted independent contractor agreement has no legal value if it does not accurately reflect the actual structure of the relationship and is not implemented in a state-of-the-art manner, and the courts have regularly stated that they are not bound by what is stated on paper if it is not what is put into practice.  Further, even when well structured, elegantly documented, and carefully implemented independent contractor relationships survive legal scrutiny under federal labor, tax, or benefit laws, they may not pass muster under what we have referred to as a crazy-quilt of state independent contractor laws.

What Can Investors and Tech Companies Do to Minimize IC Misclassification Liability?

Many new and existing companies have resorted to a process such as IC Diagnostics™ to enhance their level of independent contractor compliance and determine whether a group of workers not being treated as employees would pass the applicable tests for independent contractor status under governing state and federal law.  That process also offers a number of practical, alternative solutions to enhance compliance with those laws, including restructuring, reclassifying, and redistributing 1099ers, as more fully described in my White Paper on the subject.

All too often – and not surprisingly – many start-ups seek out infusions of capital before they have taken the time and energy to examine legal compliance issues that may be activated by operation of their new businesses. Other times new businesses (and for that matter, many established businesses, like FedEx Ground) simply fail to document and/or implement their 1099 models in a manner that minimizes independent contractor misclassification liability.  And, as noted in my due diligence post and article, private equity firms and investors do not conduct the level of due diligence they should. Roose’s article is a good reminder that not all start-ups (as well as existing businesses) are investment grade, but the overwhelming number can be if time and resources are invested in independent contractor compliance as well.

Written by Richard Reibstein.