The True Cost of Misclassification: Contractors vs. Employees for Startups
I spent the early part of my career watching founders make the same critical mistake over and over: misclassifying their workers. Much like deciding whether to get married or just live together, the choice between hiring contractors or employees carries significant legal and financial implications that many startups overlook until it's too late. We often look at these relationships as simple decisions based on immediate cost savings, but there's so much more at stake.
Let me share a cautionary tale: Homejoy, a home cleaning startup that raised over $40 million, ultimately shuttered in 2015 largely due to misclassification lawsuits.[1] Their model relied on classifying cleaners as independent contractors rather than employees, a decision that initially allowed them to scale quickly without the overhead of employment taxes, benefits, and other employee-related expenses. When the inevitable legal challenges came, the company couldn't recover. Contrast this with Managed by Q, a similar service that explicitly hired cleaners as employees from day one. While it required more initial capital, the company avoided costly litigation and eventually sold to WeWork for $220 million in 2019.[2]
A Tale of Two Startups: Homejoy vs. Managed by Q
The difference between success and failure often comes down to properly structuring your workforce from the beginning. So what exactly differentiates a contractor from an employee, and why should startup founders care?
First, control. When you hire an employee, you can dictate when they work, how they work, and what tools they use. With a contractor, you can only control the result of the work, not how it gets done. If you're micromanaging your "contractors," congratulations – in the eyes of the law, you might have employees, not contractors.
Second, financial control. Contractors typically have their own equipment, set their own rates, and incur their own expenses. They should have multiple clients and the opportunity for profit or loss. If your contractor works exclusively for you on your schedule using your equipment, you're venturing into employment territory.
Third, relationship type. Contractors perform temporary or project-based work, while employees typically handle core business functions indefinitely. If your "contractor" has been developing your main product for the past two years, they're probably not a contractor.
The consequences of getting this wrong can be detrimental for startups. Beyond the Homejoy example, misclassification can lead to back taxes, penalties, and interest that can easily reach six or seven figures. In California, penalties can include $5,000-$25,000 per violation under Labor Code 226.8.[3] Not to mention the IRS penalties, which include 100% of both the employer and employee portions of FICA taxes, plus additional penalties.
The Real Cost of Misclassification
And unlike marriage where you can often avoid legal entanglements by simply not getting hitched, there's no "just living together" option when it comes to workers. Either they're properly classified as contractors or they're employees – there's no middle ground.
Here's where I see founders make the worst mistakes:
1. Hiring "contractors" but treating them like employees by setting their hours, micromanaging their work, and requiring them to attend company meetings
2. Keeping contractors on for extended periods (years) doing the same work employees do
3. Having contractors work exclusively for their company
4. Not having proper independent contractor agreements in place
Each of these mistakes can cause deals to fall apart when investors discover massive misclassification liabilities lurking beneath otherwise promising companies.
Of course, there are legitimate reasons to use contractors. Early-stage startups often need specialized expertise for short-term projects – design work, legal services, or specific development sprints – before they can justify full-time roles. This approach makes sense when the work is genuinely project-based, outside your core business functions, and when the contractors maintain independence in how they perform their services.
The key takeaway: hire contractors for projects, hire employees for positions. And when in doubt, consult with an attorney before making these decisions – it's far cheaper than fighting the IRS, state tax authorities, or class-action lawsuits down the road.
Contractor vs. Employee: Know the Difference
An ounce of prevention here is worth a ton of cure. Getting this right from the beginning isn't just about legal compliance – it's about building a sustainable foundation for your company that won't collapse when you're finally gaining traction.
Please note, while I've tried to cover the high points, employment law varies significantly by state and is constantly evolving. California's ABC test under AB5 is much stricter than federal standards, and other states have their own variations.