Ok, I admit it. Uber is our darling here. We tend to go on and on both about valuation issues and what a unique business model it is. Here we have a company that is looking to raise capital at a $50bn valuation, and it’s core business model is to basically use other people’s idle assets to generate revenue. It’s growing gangbusters. Pretty slick.
But not everyone loves Uber. Aside from taxi medallion owners and stuck-in-the-past politicians, Uber also has a problem with it’s drivers. It seems that they want a piece of the pie too. The heart of the matter: drivers are 1099 contractors, and they want to be treated like employees.
How is this a Valuation Issue?
Ok, so you get it. Folks want to be employees and not contractors. How’s this come back to valuation though, right? Well consider that costs that a company is avoiding if they are mis-classifying employees. State and federal payroll tax, paid time off (PTO), fringe benefits such as healthcare… there’s a litany of costs that a company fails to incur by misclassifying employees.
Now let’s correlate back to value: consider you are such a company that employs an army of people that are tenuously termed contractors. For arguments sake, let’s use the following numbers:
- EBITDA: 1.0 million
- 1099 Expense – $1 million
Fringe and benefits often range 30% or so. This means that if we convert the above contractors to employees and pay full freight on fringe, we increase payroll to $1.3 million and decrease EBITDA to $700k. At a 5x multiple, the company just lost $1.5 million in valuation.
This isn’t just notional. Consider the above scenario in the context of an exit. What happens when a smart buyer, through the course of their due diligence, identifies this issue? Good bet that they are going to re-price the deal, lest they take on the future risk the the contractors being reclassified on their dime.
Avoiding Misclassification Issues
The contractor-or-not issue isn’t entirely black and white, but the IRS does helpfully lay out a “20 Factor” test to use as a guide. The application of these factors has evolved over time, but it’s a good starting point. (So is consulting legal counsel if you have concerns…).
Here’s the list:
- Instructions. Workers who must comply with your instructions as to when, where, and how they work are more likely to be employees than independent contractors.
- Training. The more training your workers receive from you, the more likely it is that they’re employees. The underlying concept here is that independent contractors are supposed to know how to do their work and, thus, shouldn’t require training from the purchasers of their services.
- Integration. The more important that your workers’ services are to your business’s success or continuation, the more likely it is that they’re employees.
- Services rendered personally. Workers who must personally perform the services for which you’re paying are more likely employees. In contrast, independent contractors usually have the right to substitute other people’s services for their own in fulfilling their contracts.
- Hiring assistants. Workers who are not in charge of hiring, supervising, and paying their own assistants are more likely employees.
- Continuing relationship. Workers who perform work for you for significant periods of time or at recurring intervals are more likely employees.
- Set hours of work. Workers for whom you establish set hours of work are more likely employees. In contrast, independent contractors generally can set their own work hours.
- Full time required. Workers whom you require to work or be available full time are likely to be employees. In contrast, independent contractors generally can work whenever and for whomever they choose.
- Work done on premises. Workers who work at your premises or at a place you designate are more likely employees. In contrast, independent contractors usually have their own place of business where they can do their work for you.
- Order or sequence set. Workers for whom you set the order or sequence in which they perform their services are more likely employees.
- Reports. Workers whom you require to submit regular reports are more likely employees.
- Payment method. Workers whom you pay by the hour, week, or month are more likely employees. In contrast, independent contractors are usually paid by the job.
- Expenses. Workers whose business and travel expenses you pay are more likely employees. In contrast, independent contractors are usually expected to cover their own overhead expenses.
- Tools and materials. Workers who use tools, materials, and other equipment that you furnish are more likely employees.
- Investment. The greater your workers’ investment in the facilities and equipment they use in performing their services, the more likely it is that they’re independent contractors.
- Profit or loss. The greater the risk that your workers can either make a profit or suffer a loss in rendering their services, the more likely it is that they’re independent contractors.
- Works for more than one person at a time.The more businesses for which your workers perform services at the same time, the more likely it is that they’re independent contractors.
- Services available to general public. Workers who hold their services out to the general public (for example, through business cards, advertisements, and other promotional items) are more likely independent contractors.
- Right to fire. Workers whom you can fire at any time are more likely employees. In contrast, your right to terminate an independent contractor is generally limited by specific contractual terms.
- Right to quit. Workers who can quit at any time without incurring any liability to you are more likely employees. In contrast, independent contractors generally can’t walk away in the middle of a project without running the risk of being held financially accountable for their failure to complete the project.
Evaluating 1099’s for conversion is often a good pre-diligence activity. Misclassification is fairly common on main street as small businesses seek an edge in highly competetive markets. Further, from an administrative standpoint it’s certainly easier to use 1099’s than employees. In the deeper end of the pool, Uber isn’t the only one to struggle with the issue – consider the issues that Fedex has grappled with over the last few years. In fact, last year the 9th Circuit ruled against the company which has steadfastly (and creatively) deemed their drivers contractors.
Regardless, classification of 1099’s / employees can be a major issue and bears scrutiny, especially in the context of exit planning.