Employee or Contractor? Why Most Startups Get It Wrong

You're building fast. You need help. You bring someone on as a contractor because it's faster, cheaper, and there's less paperwork.

Six months later, that person is working full-time hours, using your tools, attending your standups, and doing work that's core to your product. In the eyes of California law, they're an employee. And the fact that you called them a contractor doesn't change that.

Misclassification is one of the most common and most expensive legal mistakes startups make. Here's how to avoid it.

Why classification matters more than you think

The consequences of getting this wrong aren't theoretical. Misclassification can result in:

• Back taxes, penalties, and interest owed to state and federal agencies
• Liability for unpaid overtime, benefits, and worker protections
• Lawsuits from the misclassified workers themselves
• Audits from the IRS, Department of Labor, or state agencies
• Complications during due diligence that delay or derail a fundraise or acquisition

That last point is the one that catches most founders off guard. When an investor's lawyer starts poking around your hiring practices, a misclassified workforce is a red flag that can slow your deal to a crawl.

The tests courts actually use

There's no single federal test for classification. Courts and agencies look at a combination of factors, and different jurisdictions apply different standards. But the common threads come down to three areas:

Behavioral control. Does your company control how the work is done? Do you set the schedule? Provide training? The more control you exercise, the more it looks like employment.

Financial control. Does your company provide the tools and equipment? Can the worker realize a profit or loss from the engagement? Do they serve other clients? If the answer is "you provide everything and they work only for you," that's an employee.

Relationship type. Is there a written contract? Are you providing benefits? Is the relationship ongoing or project-based? Is the work a key part of your regular business?

California's ABC Test: the strictest in the country

If you have anyone working in California, you need to know about the ABC Test under AB5. To classify someone as a contractor, all three prongs must be met:

A. The worker is free from the control and direction of the hiring entity.

B. The worker performs work outside the usual course of the hiring entity's business.

C. The worker is customarily engaged in an independently established trade, occupation, or business.

Prong B is the one that catches most startups. If someone is doing work that's core to your business, like a software engineer at a software company, they almost certainly fail Prong B. Full stop.

What about foreign contractors?

Foreign contractors present different considerations. US employment laws may not directly apply, but you should still:

• Have a proper consulting agreement with IP assignment provisions
• Understand local labor laws in the contractor's country
• Consider using an Employer of Record (EOR) if the engagement looks more like employment
• Ensure proper tax documentation (W-8BEN forms)

Just because someone is overseas doesn't mean you're off the hook. Local laws in their jurisdiction may be even more protective than US law.

The practical playbook

Here's what we tell every founder who asks:

1. Default to employee status for anyone doing work that's integral to your business. If you're not sure, err on the side of employment.
2. Reserve contractor status for truly independent professionals with their own businesses, serving multiple clients, in non-core functions. Think: a freelance graphic designer who works with ten companies, uses their own tools, and sets their own schedule.
3. Get a proper consulting agreement in place. It should reflect the true nature of the relationship and include IP assignment provisions.
4. Talk to your lawyer before the engagement starts. Not after the audit letter arrives. Not when the investor's lawyer asks about it during diligence. Before.
5. Comply with all requirements as if service providers are employees: minimum wage, overtime, withholding, benefits. If there's any ambiguity, treat them as employees.

The bottom line

Misclassification feels like a shortcut. It's not. It's a deferred cost that grows every month you ignore it.

The fix is straightforward: when in doubt, treat people as employees. Get your agreements in place early. And if you're not sure where the line is, ask before you cross it.

At Fellow, we help founders set up compliant hiring structures from day one, so classification never becomes the problem that slows down your next raise or your next hire.