Your business has several forms of leverage available to it, allowing it to create more value. One of the most important is the ability to hire people.

Contractors vs. employees

There is a distinction in US employment laws between employees and people who work on behalf of a firm but are not employed by it. This includes freelancers, consultants, and contractors; for the sake of not repeating ourself, we’ll call them contractors below.

Employees have their activities at work substantially controlled by the firm. Contractors are operating their own businesses and happen to have the firm as a client of their business; their relationship with the firm is more similar to that of a vendor with their client than an employee with their boss.

Many smaller businesses, including internet businesses, would prefer to be able to employ people as contractors, because there is less paperwork required than for employees, the direct cost is lower, and it is fractionally easier to get into and out of relationships with contractors. The laws of the United States and individual states have some protections built for employees that do not apply to contractors.

Determining if someone is an employee or a contractor

The IRS lists three tests to determine worker status, each of which has several prongs:

• The relationship test
  
• The behavioral control test
  
• The financial control test
  

Unfortunately for entrepreneurs, these tests don’t have so-called “safe harbors”—there is no simple way to say, with certainty, that someone classified as a contractor will certainly be held to be a contractor. The tests are a balancing act—the examining official will weigh the different factors against each other to come to a determination. If it is important for you that someone be classified as a contractor, you should know your position on each issue, and you should try to have it be overwhelmingly clear (and documented) that the tests consistently point to a contractor relationship.

This is a complicated area of law. You should discuss it with your attorney prior to hiring anyone.

How do I employ someone?

Assuming you’ve made the decision to hire someone as a full employee, you’ll want to consider having an employee offer letter and an employee handbook. Your employment contract will generally be short and standardized across all employees at your company. Your employee handbook will be somewhat longer and outline a variety of policies your company has instituted that you expect employees to be familiar with.

Both your employment offer letter and your employee handbook will be written by lawyers and likely not that customized to the specifics of your company at first. These are risk-mitigation devices for the business; the chief purpose is making it clear that every employee has been given adequate notice of a variety of things that, in your jurisdiction, you need to provide explicit notice for. This is highly dependent on your particular jurisdiction, which is one reason you’ll always want to talk to a lawyer prior to hiring someone for the first time.

Intellectual property assignments

Companies produce “intellectual property” (IP)—copyrights, patents, and inventions—as a matter of course. IP can be as simple as “words on your website” or as complicated as a fully functional software application or business process.

It is critically important that technology companies, particularly product companies, own all IP produced for it by employees and contractors. If it does not, an employee or contractor could later claim that you are infringing on their IP by continuing to operate your business, and force you to either shut down, excise their IP (at great cost), or pay them an exorbitant amount of money to go away.

This is not a speculative threat for internet companies. IP is likely central to the entire operations of the company. Many internet companies have trajectories where certain events, like receiving investment or closing an acquisition, are gated on intensive due diligence investigations regarding proper IP ownership. The combination of these factors make anyone with unassigned IP in a company into a headache if they're willing to cooperate or a very expensive problem if they’re not. Note that, as a company progresses, it will tend to part ways with an employee or partner in less-than-ideal circumstances at least once; you do not want to have IP issues be a stick available to whack you with should that happen.

There is a relatively simple method for insulating your company from IP issues: work with counsel to obtain signed IP assignments from everyone who works for your company, without fail. This includes all founders of the company, all employees, and anyone who works for the company in any capacity, including independent contractors and entities performing work for hire for you. It does not matter if someone is only a customer service contractor or a freelance web designer brought in for a day.

It is also easier to ask everyone to sign an IP assignment agreement than to track who should have signed an agreement, particularly as that changes—the tech industry is rife with CTOs who were hired as summer interns four years ago and haven’t signed a new contract since that day.

Your lawyers can draft an IP assignment for you, which you’ll either include in your standard employment agreement and contractor MSA or which you’ll ask to be signed separately but at the same time. Your agreement will likely default to the company owning everything an employee even thinks of during their term of employment with you. Employees might push back on this, and their reasoning may or may not be sound; if necessary, your lawyer can debate it with them. Generally, you should stick with the form you’ve been provided except in extreme circumstances.

Most law firms that do substantial amounts of business with internet companies will have a template IP assignment ready to go for a nominal fee. They’re often fairly long, as this is a very high-salience issue for internet companies, and these agreements do get tested in a variety of high-stress scenarios with huge amounts of money on the line.

If your company eventually gets a movie made about it, having an IP assignment ready from day one will prevent one subplot of that movie being having to pay a ridiculous amount of money to someone who never really worked for you.

Many internet entrepreneurs are surprised how insistent investors and lawyers are about this topic. For technology companies, IP is the business. Moreover, IP ownership issues are usually much easier to address on the front end (when the IP may not be worth as much) than the back end (where the IP may have proven integral to the company’s success), so paying attention on the front end is key to ensuring you’re free from issues down the line.

Equity for employees

We’ll eventually write more about this topic. In the meanwhile, know this above all else: Most sophisticated founders avoid giving equity (or rights to acquire equity, like stock options) outright to either founders or employees. Instead, they insist on “vesting,” where the right to equity or options is earned over a period of time. The standard in Silicon Valley is “four-year vesting with a one-year cliff”; the individual has no rights to equity or option exercises during the first year, has rights to 25% of the award instantly on the date of their first anniversary, and receives rights to the remainder evenly over the next 36 months.

Vesting is critically important. Founding teams break up—frequently. Employees quit or get fired—frequently. You may not want a material portion of your company to be owned by someone who worked for you for six weeks…five years ago. It might complicate discussions about receiving investment or selling the business, and it may not align incentives with the sustained effort over time that builds meaningful companies.

Payroll

Your company will be required to calculate and withhold an anticipated amount of taxes from any employees of the company. (In the United States, employers withhold an anticipated amount of taxes, but employees file a tax return once a year to actually calculate how much is “really” owed—they then settle up directly with the government for the difference.)

Many US employers “run payroll” every other week, traditionally on Friday. Some pay twice a month, on the 15th and last day of the month. It is less common to run it monthly (which may or may not be allowed in your jurisdiction); some employers run it weekly, which is more expensive and more work but which results in employees getting paid more often, which they enjoy.

At smaller scales, some founders attempt to calculate payroll for the founding team and first few employees by themselves. Virtually all startups with more than a handful of employees will choose to use a payroll service to manage the calculation of payroll, deduction of withholding taxes, submissions of quarterly withholding tax returns, and other assorted operational tasks.

Your payroll process does not typically include contractors, who are responsible for their own tax payments and who are paid periodically after they invoice you (under the terms of your contract) rather than on a very predictable schedule like most employees are.

Your business will, once a year, issue an “informational return” to every employee or contractor of your business. In the United States, most employees will receive a W-2, and contractors will receive a 1099-MISC. These will generally be filed by your accountant or payroll service on your behalf. When you hire someone, you will ask them to fill out a W-9 form to receive their social security number or other individual identification number, which will be required for running payroll for them. If you hire someone who is not a US citizen or permanent resident and who does not actually perform work in the United States, you may not be required to pay employment taxes on them, but you should collect their information on a W-8BEN to document this choice. For specifics, please ask your accountant—international taxation is very fact specific and can get tricky, particularly once bilateral tax treaties come into play.