Catch 22: Founders Must Pay Themselves Before Their Company Earns Revenue

It’s a common scenario for start-up founders: a few friends join together to build a company, each working long hours without pay in exchange for a promise - or at least a hope - that the company will be successful and they will be paid back tenfold for their initial time and sacrifice. However, even though this is common practice, it may violate California law and has the potential to be very costly for the company and the directors personally if things turn sour.

Minimum Wage Requirements and a Minor Exception

All employees in California must be paid at least minimum wage, at the rate set either by the state or the city where the employee is working. While there are various factors for classifying a worker as an independent contractor versus an employee, generally someone who is working full-time or more for a company on a long-term basis is considered an employee, and so the minimum wage requirement applies to many founders.In addition to the minimum wage requirement, which can be paid on an hourly basis or salary, employees may also be entitled to be paid overtime and receive meal and rest breaks. These additional requirements depend on if the employee is classified as “exempt” (no overtime or breaks required) or “non-exempt” (overtime and breaks required). Employees are considered “non-exempt” unless they meet certain requirements to be considered “exempt” (this blog post describes the most common exceptions to wage and hour requirements)¹ and are paid a salary that is at least equal to double the minimum wage for full-time employment. For California employers with 25 employees or less, this is currently $41,600 per year, and for California employers with over 25 employees, the minimum salary amount for exempt employees is $43,680. Therefore, unless founders meet the criteria for an “exempt” employee, additional penalties can be imposed for not paying them for overtime or meal or rest breaks.One additional exception to the non-exempt classification is that employees who own at least 20% of the company and are involved in management of the company may be classified as exempt employees. However, whether a founder is classified as a non-exempt or exempt employee, she or he must still be paid at least minimum wage or a salary equal to the applicable state or city requirements, so this exception does not release companies from paying founders that fall under this exception.

Where Things Can Go Wrong

While anyone who is starting a company likely knows about minimum wage, it is important to understand that this is an absolute requirement for any company that has employees. It is not a defense to these requirements that the company doesn’t have money to pay its employees. Further, any agreement to contract around minimum wage requirements is unenforceable, so a founders agreement or other contract waiving a founder’s right to payment or deferring compensation is useless.Although the California Department of Labor could bring a proceeding against a company for not paying its employees in accordance with wage and hour laws, the more likely scenario is that a disgruntled founder will decide to leave the company and sue for unpaid wages. If the founder was working normal start-up hours of 60+ hours per week, between unpaid minimum wage and overtime, missed meal and rest breaks, and penalties for all of these violations (plus the time and expense of a lawsuit), the amount of money claimed by the founder can add up very quickly. This is especially true for a start-up that still hasn’t generated much (or any) revenue. Additionally, if the start-up is planning to approach investors to raise capital, a lawsuit will look bad during due diligence and the investors will likely be turned off by the prospect of their investment money being used to pay the debt of the company from the lawsuit.

Personal Liability of Directors

One reason why we recommend forming a corporation is to protect the people involved from personal liability for the actions of the corporation. However, California statute specifically carves out an exception from such personal liability protection for officers and directors for wage and hour violations. Section 558.1 of the California Labor Code states that any employer, or any person acting on behalf of the employer (which includes any owner, director, officer, or managing agent of the employer) may be held liable for the employer’s violations of any provision regulating minimum wages and other directives in Wage Orders, such as unpaid overtime and denied meal or rest breaks.The language in accompanying portions of the Labor Code suggests that such personal liability can only be enforced by the Labor Commissioner during a proceeding, not in a private lawsuit against a company by an ex-founder. However, this limitation is not explicit in the Labor Code. There is a risk that an ex-founder may still use it as another claim in a private lawsuit brought for other reasons. Otherwise, if the ex-founder knows that the company is insolvent, they may instead opt to bring a proceeding before the Labor Commissioner where this provision can be enforced. Then the officers and directors of the company may be forced to personally pay for the unpaid wages, penalties, and violations of the ex-founder.

What You Can Do

California has a reputation for being an employee-friendly state, and has crafted its wage and hour laws so that people get paid for the work that they perform. Unfortunately, no exception or defense has been created for the broke start-up that is formed with all of the founders voluntarily agreeing not to be paid until the company can generate revenue. Thus, the options to avoid the risks of a wage and hour lawsuit or proceeding are limited.First, companies can pay their workers at least minimum wage and pay careful attention to whether the workers are non-exempt employees to whom overtime and meal and rest breaks are owed. At the very least, founders can limit the number of founders or other employees who are working for the company without pay to minimize the risk that someone will become disgruntled and pursue a suit for unpaid wages.Second, the founders can wait to incorporate their company until they are further along in building the company’s product or services. While there may be an argument at some stage of a project that someone working on an unincorporated venture is an employee of that venture, at least initially two friends working towards building an idea together will likely not be seen as creating an employer-employee relationship and so wage and hour laws would not yet apply. However, incorporation has many important tax and liability benefits. Additionally, attracting investors and additional talent requires an established legal entity, so this strategy may only be viable in the initial stages of an idea. A legal entity also owns the IP and other work that the founders are creating instead of each founder individually owning the IP that they create. If founders own IP individually, they could take it with them if they decided to leave the venture.Founder compensation is seldom discussed until it is too late and the wage and hour violations have already occurred, giving a departing founder significant leverage to demand a large pay-out or equity stake in the company. Such risks should be weighed by founders when starting a company and should impact decisions about how money is allocated, how many hours are worked by each employee, and how to best expand the team.The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.^{1 Anthony Zaller, "Five Exempt Employee Classifications All California Employers Should Understand," 2015.}