Uber does it. Lyft does it. So did Sprig and Homejoy until recently.

Besides being members of the on-demand economy, these startups classify, or classified, their workers as contractors rather than employees. It is an unconventional approach to hiring and has been a hit with venture capitalists and workers alike.

According to  a report by Sherpa Ventures, a Silicon Valley-based VC firm, investments in on-demand economy startups more than doubled to $1.6 billion by 2013. Part of the reason for the cash infusion was the startups' business model, which relied on an army of freelance workers providing services and ensuring customer traction. The report referred to this employment model as a “freelance marketplace” and stated that a “perpetual hourly employment is deeply inefficient for all parties involved.” The so-called contractors for on-demand economy startups also liked the labor classification because it enabled them to earn cash in a depressed economy by using their existing resources or assets.  

What was once an accepted business model  is now changing. A number of startups, such as Sprig and Instacart, have adopted conventional labor classifications. But, mega-valuation startups Uber and Lyft are holding out and fighting court cases to preserve their right to classify drivers as contractors. This article will look at startup motivations for this approach and its future. (For more, see 4 Challenges Uber Will Face In The Next Years.)

Why Classify Workers As Contractors?  

Unlike the traditional Silicon Valley startup model where scale is achieved by the genius of a couple of engineers working with constrained resources, on-demand startups require a massive infusion of resources in the form of service providers and infrastructure. For example, Uber had 160,000 drivers in the U.S. at the end of 2014. This translates to an equivalent number of cars. On its own, it would be impossible for Uber to buy or lease so many cars.

In addition to this, classifying workers as employees burdens startups with additional costs and liabilities such as overtime, vehicle insurance and health insurance. Cumulatively, these costs add up to a substantial number and negatively affect profit margins. To recoup their costs, on-demand economy startups would need to increase the price of their services. In turn, this could affect their revenue run rates.  

But their current strategy of hiring freelancers flouts the IRS's existing regulations for labor classification. IRS guidelines specify three controls that make an individual an independent contractor: behavioral control, financial control and relationship of employee to workers. In other words, the business owner must enable workers to work at their own pace, use their own resources and establish their own code of conduct with customers.

The training and guidelines for service provided by many startups amount to behavioral control, however. Lyft's directions to its drivers to fist bump passengers is equivalent to behavioral control. Similarly, Postmates and Instacart employees, as well as employees at a number of other startups, are required to wear uniforms while interacting with customers.

Journey From Contractor To Employee

Sustained pressure from the media, politicians and the threat of a wave of lawsuits could result in a change to the current business model. Uber recently lost a lawsuit related to the labor classification of a driver at the California Commission of Labor. Based on the commission's ruling, Uber owes $4,000 to the driver for working overtime. Uber is appealing the decision as it could potentially open the floodgates for additional lawsuits regarding employee compensation.

Other startups caved in before being threatened with contractor lawsuits. Instacart and Sprig have converted their contractors to employees. The CEOs of both companies claim that while the move may hurt their bottom line, they hope to make up for the shortfall through higher customer satisfaction, and, subsequently, increased revenues, in the long term. The record on that front, however, is mixed. For example, two startups – Zirtual and Homejoy – folded recently due to worker misclassification problems. But other startups claim to have had a positive experience with reclassifying contractors as employees.

Sprig and Instacart are small enough to make the transition with limited impact to their bottom lines. Uber – the most well-known on-demand economy startup in the world – is too far down the road to make the change. In an appeal against the California Labor Commission's ruling, the startup's lead outside counsel stated that the company would have to change its business model to comply with the ruling. “There would be no rigid schedules and this autonomy and flexibility (for Uber's drivers) couldn't exist,” he said. (For more, see How Do Ridesharing Companies Like Uber Make Money?)

According to Arun Sundarajan, an NYU professor who studies the on-demand economy, current labor classifications are “out of date” and the move away from employees to contractors is a paradigmatic shift from an industrial era of monolithic organizations to a networked society. Sundarajan says labor laws should be based on “fine-grained distinctions” of employment, and salary entitlements, such as health coverage, insurance against workplace injuries etc., should be universal. “They should not become exclusive perks for a dwindling band of salaried employees,” he wrote in a Financial Times editorial.

But the employee band referenced in Sundarajan's editorial is hardly dwindling. A majority of workers in the United States are employees instead of freelancers. Incidentally, this number also includes employees of major technology corporations such as Google Inc. (GOOG) and Facebook Inc. (FB). Dismantling the entire apparatus and system of employee benefits is not feasible given the numbers. And defining a new class of workers exclusively for the on-demand economy really depends on the amount of traction and users gained by platform apps in the economy.

The Bottom Line  

The on-demand economy became popular during the economic recession as a means to earn extra income. It has since established itself as a valid and substantial source of work for many; however, current labor classification rules do not recognize participating in the on-demand economy as legitimate contract work. Commentators and experts have suggested that the creation of a new class of employee – one who shifts between gigs in the freelance economy – under labor laws might solve the problem.