Due Diligence of a Target Company’s Independent Contractor Misclassification Risks by ‎Private Equity Firms

Private equity firms regularly conduct due diligence of legal risks that could impact potential investments. Yet when considering whether to invest in a target company structured in whole or in part on an independent contractor (IC) business model, few PE firms consider IC misclassification exposure with a sufficient degree of knowledge and insight needed to make well-informed decisions. Further, it is not enough to assess the current liability risks of acquiring a target company operating on an IC business model and then to decide if those risks still make it a  worthwhile investment. Rather, meaningful measures can usually be taken, post-closing, to minimize such risks by substantially elevating the target company’s current level of compliance with applicable IC laws – and doing so in a sustainable and profitable manner. With an enhanced understanding of the current risks and the tools that can be used to minimize such risks going forward, PE firms can obtain a far better appreciation whether to invest in, and how to value, a contemplated acquisition of a target company operating on an IC business model.

The current landscape of IC business arrangements in the U.S.

Independent contractor business models have become far more prevalent. In a study just released in November 2024 by the Bureau of Labor Statistics of the U.S. Department of Labor, individuals in the U.S. workforce who identified their main working relationship as “independent contractor” increased in the past six years from 10.6 million in 2017 to 11.9 million in 2023 – a jump of over 12%. One of the more telling aspects of the study is that 80.3% of such individuals preferred their status as ICs to a traditional employment arrangement. Thus, it is hardly surprising that there are an increasing number of companies using an IC business model – and a great number of those companies have been and continue to be targeted by PE firms.

At the same time, claims for IC misclassification continue to be prevalent, and seven- and eight-figure settlements and judgments are increasingly common, as we have reported each month on this blog in our round-up of the prior month’s legal developments. Despite the fact that litigation and legislative initiatives over IC status has been and remains front-page news, especially in the on-demand gig economy, there are few in the business world (or for that matter, in the field of law) that can articulate what makes a worker a legitimate IC or a misclassified employee. That is because there are different IC tests under most federal laws, and most states have IC tests that not only vary from the federal laws but also differ from the laws in other states. This creates a challenge for companies operating nationwide or in a number of different states. That in turn contributes to challenges faced by PE firms in assessing whether a target company operating on an IC business model is a worthwhile investment.

Initial assessment of IC compliance

The first step in assessing a company’s current state of IC compliance is a review of applicable legal tests for IC status. While some tests have over 20 factors that are considered and other tests have as few as two or three, oftentimes one or more of the factors themselves take into account a host of additional considerations. For example, some state law tests for IC status are called ABC tests with three prongs, all of which must be met. But the first prong of an ABC test determines whether  the business directs and controls the manner by which the workers under contract perform their services. In determining direction and control, however, courts and administrative agencies have identified dozens of factors. So, even a test that seems abbreviated can lead to a consideration of many factors bearing on the IC status of the workers in question.

Not all IC business models are capable of becoming compliant with applicable IC laws. If the target company does not appear to be IC-compliant currently, a PE firm may well abandon its interest in acquiring the company. But that approach may be shortsighted if the target company’s business model is capable of becoming compliant with applicable IC laws after closing, with the types of adjustments discussed below. In that event, three considerations come to mind: how should the target be valued; what provisions can or should be included in an acquisition agreement to protect the PE firm after closing; and what steps can be implemented post-closing to minimize ongoing IC misclassification risk and transform the target company into one that maximizes compliance with applicable IC laws – and does so in a sustained and profitable manner.

One process that some PE firms have used to assess IC misclassification risk initially and then to minimize such risk post-closing is IC Diagnostics (TM). This type of process examines dozens of factors to determine whether the target company has already achieved a minimal level of IC compliance and then focuses on modifications that can be made post-closing to restructure, re-document, and re-implement the IC relationship to achieve an enhanced level of compliance with IC laws.  

Some re-structuring of the IC relationship may be useful post-closing

Most companies using an IC business model only need a modest amount of restructuring of their IC relationships, while some may need a bit more – but in either case the objective is not to change the business model post-closing, but rather to retain its essential components so that the return on investment will meet the expectations of PE firm.

Re-documenting the IC relationship post-closing in a state-of-the-art manner

The next step is re-documenting the IC relationship of the new portfolio company in a sophisticated manner that substantially elevates the company’s IC compliance. This is typically a comprehensive undertaking intended to assure that the IC relationship is customized for the particular business and documented with a host of factors supporting IC status.

A state-of-the-art approach to documenting the IC relationship avoids merely reciting in a contract the factors in the applicable tests for IC status. Such recitals are sometimes disregarded by administrative agencies and courts, using the legal principle that contract terms can be ignored if they differ from the facts in actual practice.  Further, standard, model, one-size-fits-all and other “form” IC agreements tend to cause businesses to overlook the importance of customizing the structuring, documentation, and implementation of the IC relationship in a manner that fosters a company’s business model and promotes anticipated profitability. Customization requires a collaborative approach between management of the portfolio company and IC counsel – a process that results in retaining the profitable aspects of the business model while at the same time elevating IC compliance.

Re-implementing the IC relationship to elevate and maintain compliance 

Companies should also take steps to ensure that what is set forth in a re-documented IC agreement is then implemented in practice on both a short-term and long-term basis. As part of the implementation phase, internal company communications with ICs and about them should be articulated in a compliant manner using IC-centric wording instead of language that suggests an employment relationship.

Websites and marketing materials should be reviewed as part of the implementation phase and revised to articulate the IC relationship in a compliant manner. Few things can be more upsetting to companies than if their own words are used against them in court or before an administrative agency in an effort to challenge a legitimate IC relationship.

Because a number of the key legal requirements for a legitimate IC relationship are counter-intuitive, some businesses using IC Diagnostics (TM) have found a short round of management training to be valuable. This maximizes the likelihood that the company’s enhanced level of IC compliance is understood, carried out, and maintained by all those who interact with the independent contractors.

Adding well-drafted arbitration clauses with class action waivers

Once a portfolio company has elevated its IC compliance by the above steps, it is far less likely to be sued or audited by a government agency for IC misclassification, and if sued or audited, far more likely to prevail in such proceedings or to settle for a far smaller amount. But class action lawsuits can still occur, unless the portfolio company, post-closing, effectively eliminates these types of legal actions by use of a well drafted arbitration clause with class action waiver.

These types of clauses can lead to a class member being compelled to arbitrate his or her case on an individual basis. But an ineffectively drafted arbitration clause or one that is out of date may result in the company having to defend itself in a class action. Years ago we published a blog post entitled “How to Effectively Draft Arbitration Clauses with Class Action Waivers in IC Agreements.” Since that time, the law has evolved considerably. While the law generally favors arbitration, class action lawyers continue to vigorously challenge such contractual provisions – and they succeed more often than they should by focusing on language in arbitration clauses that do not meet current legal standards. As part of the re-documentation process, a portfolio company should include an effective and up-to-date arbitration clause in their IC agreements.

Conclusion

Target companies utilizing an IC business model can produce a considerable return on investment for PE firms, but there are legal issues that can lead to IC misclassification exposure unless IC compliance is closely examined. But any such exposure, which can be costly and lead to litigation or governmental audits, can oftentimes be reduced and minimized after closing by the type of process described above.

By Richard Reibstein

The post Due Diligence of a Target Company’s Independent Contractor Misclassification Risks by ‎Private Equity Firms appeared first on Independent Contractor Compliance.