There's A Looming Threat To The Way Uber And Other Rich New Startups Do Business

New York Magazine's Kevin Roose just wrote a story exposing a big threat to a whole host of successful startups.

Lately, there's been a rise in a new type of startup: "on demand" startups.

Basically they are like Uber, but instead of summoning taxi drivers, they summon other service providers - food deliverers, people who do laundry, people who clean homes, flower deliverers, and so on.

Like Uber, many of these startups do not actually employee the people who provide those "on demand" services. The startups hire contractors.

Roose even says there is a term for this trend. It's the "1099 economy" named after the tax form companies fill out when they hire contractors - 1099 MISCs, not the W2s companies have to fill out for full time employees.

The reason Uber, Homejoy, Instacart, Washio, SpoonRocket, and other startups are hiring contractors is simple: contractors are a lot cheaper than employees. For example, the companies don't have to worry about withholding taxes or paying into social security.

New York-based "on demand" housekeeper company MyClean used to use contractors. When it switched to full time cleaners, its labor costs went up 40%.

MyClean chose to switch to full time employees because it felt the quality of its product went up.

Some startups may not get to make the choice. They may be forced to hire their contractors on full time.

It turns out its against the law to treat contractors the same way you would treat employees.

Roose explains:

In June, a group of Uber drivers joined a class-action lawsuit against the company in California and Massachusetts. The drivers, represented by Boston attorney Shannon Liss-Riordan, alleged that Uber misclassified them as independent contractors, thereby requiring them to bear upkeep and maintenance costs that normal employees wouldn't be liable for. (Uber, in a statement to the Boston Globe, said it would "vigorously defend the rights of riders to enjoy competition and choice, and for drivers to build their own small business.")

Start-ups aren't the only companies being targeted for worker Misclassification. But they are the most vulnerable to a change in the law. Require a 1099 start-up to reclassify its workers as W-2 employees, and you radically change its ability to lower prices and undercut the competition - which was, in many cases, a key reason investors were interested in the first place.

"If their drivers are classified as employees then that suddenly makes their business model untenable," Denise Cheng, a research assistant at the MIT Center for Civic Media, told the Globe.

One warning shot for 1099-dependent start-ups came in an August rulingby a federal appeals court, which found that 2,300 FedEx delivery drivers in California were being misclassified as independent contractors, since FedEx exercised broad control over their schedules and methods. "The drivers must wear FedEx uniforms, drive FedEx-approved vehicles, and groom themselves according to FedEx's appearance standards," Judge William Fletcher said. The three-judge panel ultimately ruled that since the contractors were being treated like employees, they were entitled to employee benefits such as overtime pay and reimbursement of expenses.

The implicit threat to start-ups like Homejoy, Spoonrocket, and Uber couldn't have been clearer. If you want to use independent contractors, the judges told FedEx, you've got to give them real independence.

The threat to lots of rich startups is this: if they lean on cheap contractors too much, and require them to act like full time employees too much, they may have to start paying them like full time employees.

That could seriously spike costs for many startups - at a time when prominent VCs are already worried about how much money startups are spending.