New Overtime Regulations Could Harm Tech Startups and Small Businesses

The Department of Labor has just finalized their new overtime regulations, an update to the Fair Labor Standards Act of 1938 that will raise the salary threshold under which workers will qualify for overtime pay to about $47,476 beginning December 1, 2016. Previously, only workers making under $23,600 were subject to mandatory overtime pay regulation where employers track employee hours and pay them time-and-a-half for every hour worked over 40 hours a week. The Obama White House estimates that approximately 5 million workers could be affected by the law, 39% of whom are millennials between the ages of 16 and 34. 

It’s important to realize that this policy change is not an anti-poverty adjustment to the tax code, like a hypothetical expansion of the Earned Income Tax Credit (EITC), but rather a broad mandate for businesses to fundamentally change their business practices, a requirement that potentially comes with a handful of distortions. In part, the law means that millions of salaried workers will be reclassified to hourly, and many will be “back on the clock,” to use a 20th-century term that has almost fallen out of use.

Overtime pay regulations were originally designed for the working poor in the 20th century manufacturing economy

We understand the good intentions of the new regulation. But there are many factors that the Department of Labor did not consider when expanding an 80-year old law in the 21st century. Requiring employers to pay salaried employees by the hour and to pay overtime is more closely aligned with how work was tracked (by the hour) and compensated for in the 20th century manufacturing economy. Furthermore, workers on hourly wages tend to skew toward lower-income workers, so when mandatory overtime regulations were initially extended to those making less than $23,600 annually, the distortionary impact of compliance was mitigated.

By in large, the U.S. economy has since evolved into a services and information economy where more workers are salaried and paid not just in cash but also other forms of benefits such as equity compensation. The White House further estimates that 81.8% of workers affected by expanding the mandatory overtime threshold to $47,476 would have some college, a bachelor’s degree or some advanced degree.

For companies below a certain size or certain financing level that employ educated salaried employees, these sorts of rules could do serious harm. 

Tech startups, non-profits and institutions of higher education are likely to bear the worst brunt of new overtime regulations 

Non-profits and institutions of higher education have been vocal about how damaging such rules would be for them. 

Another highly impacted sector is the dynamic area of tech startups.

In their early phases, many tech startups are pre-revenue which constrains their ability to pay employees as they build a vision and a product depending on their access to financing. Even after crossing the hurdle of introducing their product to market, startups often continue to operate on a weak revenue stream. Although many associate tech startups as companies that pay their employees vastly above the $47,476 threshold, this is not the case for all roles in early startups.

Many startups have margins that remain very small, and that is one of the reasons they pay employees in equity instead of cash wages.

The unhindered start-up model with flexible compensation options has played a substantial role in what has often enabled tech startups to take-off. Adding even miniscule costs to their operations could seriously impact the start-up model and unlike large companies which can afford large compliance departments, start-ups cannot easily pass on the cost of this regulation.

Boots Dunlap, the CEO of RRA Capital, a small financial technology company in Scottsdale, Arizona illustrated this point to us in an interview, saying “This new rule will put so many small businesses like mine into cardiac arrest.” He further explained that “It was valiant to attack the Fat Cats of the 1920’s when a few heads of industry controlled the newspapers and politics; however, this rule is designed to continue to widen the gap between small business and big business; between struggling entrepreneurs and the heads of industry.”

Moreover, adjustments to comply with this law are not free. Most small startups do not have in-house counsel or compliance departments. Lawyers who work with start-ups typically charge between $350 and $800 per hour, and legal costs for non-complex matters (such as payroll and worker classification) are about $5,000 a year.

In New York, tech entrepreneur Dan Gelertner of Dittach explained to us how hard the new rules could be for his new company:

In a startup, where our margins are already so tight, where we enter this difficult and dangerous field knowing that the vast majority of us will fail, a small increase in operating cost – a fraction of a percent, even something that costs only a thousand dollars – can make us insolvent. It can mean that all the money and energy we spent up to that point was wasted. It can mean that instead of employing a half-dozen people we can now employ no one at all.

Major aspects of the overtime regulation are premised on a traditional view of what it means to work and on a traditional view of compensation structure. These factors are not easily applicable to the 21st century—in particular, to tech startups. While enhanced overtime regulations may make sense in some industries and some company sizes, it doesn’t for many others. In part, various updates to the original Fair Labor Standards Act of 1938 have acknowledged this by creating exemptions for various disciplines, however, technology jobs and small businesses remain non-exempt.

Alex Goldberg, a former tech entrepreneur and now a Managing Director of a New-York based venture capital fund, Canary Ventures, argues for why such a tech exemption would make sense:

I can imagine some contexts where the overtime regulations are important, with certain vulnerable populations in the workforce. But I do think there are certain types of companies, especially in tech, where a fluidity and variability of a policy would make more sense. In early phases of incubation, it’s quite usual for start-ups to drain their bank accounts, bit by bit. Money is extremely precious and salaries don’t look like what they are in corporate America. So you can imagine that when you have this type of government mandate on start-ups, the speed of innovation will be throttled.

Overtime Regulations Impacting Tech Startups and Innovation Could Further Hinder Productivity

The updated rules announced today unfortunately indicate that there will be no new exemption for tech companies. As real GDP growth continues to hover around 2%, largely driven by declining productivity, the new overtime rules and their negative impact on innovative tech startups are bound to exacerbate this trend more so than alleviate it.