Tech startups have traditionally relied heavily on contract developers, freelance engineers, and consulting firms. AB5 significantly impacts this model. This guide helps tech companies understand compliance requirements.
The Core Problem for Tech Companies
Prong B Almost Always Fails
If your company builds software, and you hire contractors to write software, you almost certainly fail Prong B of the ABC Test. Software development IS the "usual course" of a software company's business.
Common Scenarios Analyzed
Scenario 1: Contractor Building Core Product Features
Situation: SaaS startup hires a React developer to build new dashboard features.
ABC Test Result:
- Prong A: Maybe pass (works remotely, sets hours)
- Prong B: FAILS - Dashboard is core product
- Prong C: Depends on developer's other clients
Conclusion: Likely employee under AB5
Scenario 2: Design Agency for Marketing Website
Situation: Same startup hires a design agency to rebuild marketing site.
ABC Test Result:
- Prong A: Pass - Agency controls how work is done
- Prong B: PASS - Marketing site design is outside software development
- Prong C: Pass - Agency has multiple clients, own business
Conclusion: Valid contractor (but B2B exemption provides extra protection)
Scenario 3: Offshore Development Team via Agency
Situation: Startup contracts with offshore dev shop for feature development.
Analysis: The B2B exemption may apply if the agency is a legitimate business entity meeting all 12 criteria. However, individual developers within the agency aren't your concern - they're the agency's employees.
Compliance Strategies for Tech Startups
1. Use the B2B Exemption
Contract with incorporated development agencies/consultancies rather than individual freelancers. The agency should:
- Have its own business entity (LLC, Corp)
- Have a separate business location
- Have multiple clients
- Set its own rates
- Use its own tools/equipment
2. Hire Employees (Even Part-Time)
California W-2 employees can work part-time. Consider:
- Part-time employment with benefits pro-rated
- Using PEOs (Professional Employer Organizations) for HR/payroll
- Employer of Record (EOR) services
3. Hire Out-of-State
AB5 applies to California-based work. Remote workers in other states may not be covered. However:
- Other states have their own classification rules
- Some states are adopting ABC-like tests
- Tax nexus implications exist
4. True Ancillary Services Only
Use contractors only for work truly outside your business:
| Software Company | Safe to Contract | Risky to Contract |
|---|---|---|
| SaaS Platform | Legal, accounting, office cleaning, HR | Feature development, QA, DevOps |
| Mobile App | Photography, copywriting (non-core), legal | iOS/Android development, UX design |
| E-commerce | Warehouse, shipping, tax prep | Platform development, product photography |
The Professional Services Exemption
Some tech roles may qualify under professional services exemptions:
- Graphic Designers: May qualify if they have specialized training and control work
- Marketing Professionals: Specific requirements for marketing exemption
- Data Analysts: Generally NOT exempt - analysis is core to many tech businesses
Best Practice
Build an in-house team for core development work. Use contractors through proper B2B relationships or agencies for specialized, non-core projects. Document everything.
Startup-Specific Considerations
- Equity Compensation: Contractors can receive equity, but this doesn't change classification
- Accelerator/Incubator: Program requirements don't override employment law
- Investor Due Diligence: VCs increasingly ask about contractor classification
- M&A Risk: Misclassification creates liability in acquisitions