Hire an employee when the work is ongoing, central to your product, and you want to direct how it’s done. Hire a contractor when you’re buying a defined deliverable with an end date from someone who runs their own business. The label in the contract doesn’t decide it. The actual working relationship does, and when in doubt, hire the employee.
Key takeaways
- A full-time “contractor” doing core work on your product is the most common startup misclassification.
- Contractors own what they create unless a written agreement assigns it to you.
- Federal and state tests differ. California, Massachusetts and New Jersey use the strict ABC test.
- When you convert a contractor to an employee, paper the IP, sign a CIIAA, and grant equity on or after the start date at the current 409A price.
When is a contractor the right choice?
A contractor fits a defined project with a clear end: a brand identity, a landing page, a security audit, or a three-month MVP build by an agency. The contractor brings their own tools, sets their own hours and methods, and usually works for other clients too. You’re buying a result, not managing a person.
An employee fits anyone you expect to still be there in six months doing core work: building the product, selling it, or running operations. If you want to set their schedule, train them in your process, give them equity and make them part of the team, that’s an employee.
| Situation | Better fit |
| Defined deliverable with an end date | Contractor |
| Specialist skill needed for a few weeks or months | Contractor |
| Ongoing work on your core product or sales | Employee |
| You set the hours, tools and process | Employee |
| Same work your employees already do | Employee |
How do the law’s tests decide?
Federal and state agencies look past the contract to the relationship. Under the federal economic reality test, the most important questions are how much control the company has over the work, and whether the worker has a real opportunity for profit or loss through their own initiative and investment. Other factors include the skill involved, how permanent the relationship is, and whether the work is an integral part of the business. How the parties actually work matters more than what the contract says.
The federal rule has been in flux. The Department of Labor stopped enforcing its 2024 contractor rule in 2025 and in 2026 proposed replacing it with a test close to its 2021 version. Either way, the core questions are the same.
Many states are stricter. California, Massachusetts and New Jersey apply an ABC test for at least some purposes, under which a worker is an employee unless the company shows that (A) the worker is free from its control, (B) the work is outside the usual course of its business, and (C) the worker is independently established in that trade. Prong B alone makes it very hard to treat a software developer as a contractor at a software company. The IRS and state tax agencies apply their own tests as well. See Independent Contractor vs Employee for the penalties for getting it wrong.
What does each really cost?
An employee costs meaningfully more than their salary once you add the employer’s share of payroll taxes, workers’ compensation and unemployment insurance, benefits and payroll administration. A contractor’s higher hourly rate can still be cheaper for a short project, because you pay only for the work. But if the role is really permanent, the savings disappear the moment the worker is reclassified, and you owe back taxes, overtime and penalties on top.
Employees also aren’t required to work only for you. Most startup employees have no exclusivity obligation beyond the conflict-of-interest and outside-activities terms in their offer letter and CIIAA, and California limits restrictions on lawful off-duty work. Contractors simply have more freedom to take other clients.
Who owns the work?
This is the headline contractor risk. An employee’s work product generally belongs to the company, and the CIIAA confirms it. A contractor’s work product generally belongs to the contractor unless a written agreement assigns it to you. Investors check this in diligence, and a missing assignment from an early contractor who wrote your code is a real problem. Every contractor should sign an agreement with a present assignment of IP and confidentiality terms before starting. See Startup Contractor Agreement and Independent Contractor Agreement.
Can I run a mixed team of employees and contractors?
Yes, if the contractors do genuinely different, project-scoped work. Problems start when a contractor sits alongside employees doing the same job, on the same schedule, under the same manager. That fails the control and integration tests and exposes the whole group. Keep contractors on defined projects with their own deliverables, don’t manage their hours, and don’t give them employee benefits or titles.
How do I convert a contractor to an employee?
Converting a contractor who has become core to the team is common and straightforward if you do it in order:
- Sign an offer letter and CIIAA effective on the conversion date. See Startup Employment Contract Guide.
- Clean up the IP. Check that the contractor agreement assigned everything they built. If it didn’t, or there was no agreement, have them sign a catch-up assignment of prior work.
- Grant equity correctly. The board approves the grant on or after the start date, at the current 409A price. You can set the vesting start date back to when they began as a contractor, as a business decision, but don’t backdate the grant itself. See Promising Equity vs Issuing Equity.
- Move them to payroll and close out the contractor invoices.
If the person was really an employee all along, talk to counsel about past exposure before you convert.
For related reading, see How Much Should I Pay My First Startup Employees?, Who Owns Startup IP? and Employment Agreements. If you’d like help deciding how to structure a hire, contact us.
