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Jonathan Barr, Jimmy Fokas and Maria Luevano Author Article for Corporate Governance Advisor

Entrepreneurs with sound business ideas commonly make decisions that hinder early growth and capitalization. During the “Romance Phase,” the idea for a new product or service is fully developed, the initial team of talent is identified, and initial funding is acquired. Love is in the air. This is the time when several poor decisions are made that reduce the flexibility needed to support future growth and capitalization.

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To solidify the early team of talent and the initial funding source, entrepreneurs want to memorialize their plans for the company or a new officer before the sometimes expensive and more complex step of drafting formal stock option, equity grant and employment agreements. That sounds like a great idea, but a verbal promise, a written memorandum of understanding or an offer letter can easily create a contractual entitlement to specific compensation, promised equity, a certain position or continued employment for an extended period of time. The current talent may be great for this phase, but startups will need flexibility to hire the talent needed for the next phase. The initial funding source may ask for equity, but the equity promised to the initial funder may make the business less marketable to future investors. Informal promises by founders tend to address only what the company will give, not what the company will need. Additionally, promises of equity to co-founders, funders or subsequent service providers that are vague in terms of amount, form and timing can create liability for the company.

Entrepreneurs often know skilled executives willing to work for deferred compensation or equity, which seems helpful when a startup is waiting for funding or is low on cash. Taking advantage of these willing contacts seems like a prudent idea, but a person who is not a clear owner of a business but provides services to the business must be paid in accordance with federal and state law no matter how small the company. Future promises of pay or equity do not satisfy state or federal wage laws. Consequently, small portions of equity handed out to obtain services when cash is low cannot be used as an alternative to minimum wage/salary requirements.

And no, the government and courts do not care that the person agreed in writing to deferred compensation or equity. There is no lawful option for an employee to agree to waive or delay their rights under state and federal wage laws even for a future equity grant. So even if individuals will happily work for free in exchange for future equity or cash when the company grows and secures additional funding, it is not an option for persons who are not the owners of the business.

Using independent contractors instead of employees is a common plan by entrepreneurs to stay nimble and avoid complications. The days of simply avoiding employment problems by retaining independent contractors are over. It is much harder than most people think to classify a worker as an independent contractor. State and federal laws are continuing to narrow who can legitimately work as an independent contractor. Consequently, this is a very limited strategy to avoid federal and state wage laws. The willing agreement of a worker to be an independent contractor provides no protection for the company if the government or court subsequently determines they were misclassified.

Some entrepreneurs hire unpaid interns, which allows the startup to train and vet future new hires without having to pay when funding is tight. Although college students need internships to add to their resume, using unpaid college interns to help with low cash flow is not an easy solution. Unpaid interns must meet very specific requirements to be exempt from state and federal wage laws. The federal government looks at multiple factors, including to what extent the internship will provide training that would be similar to that which would be given in an educational environment, including hands-on training provided by the college or university, and to what extent the internship will be tied to the intern’s formal education program by integrated coursework or the receipt of academic credit. The ability to hire unpaid interns is more limited than most people believe.

If during the Romance Phase equity was diluted and employees were promised continued employment, needed flexibility for growth is lost. A venture capital or private equity firm will look for compliance with wage and hour laws during due diligence. An investment in solid legal documents and guidance to establish a compensation program that is compliant with the law while meeting the company’s current and future needs will provide the flexibility and stability needed for growth and attracting capital.

Common Bad Decisions Startups Make During the Romance Phase

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