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Servicing payroll for startups? Here are 6 key challenges to expect

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The startup world is a wonderful place to be in. Their success continues to amaze and inspire us in many ways. However, in their single-minded pursuit to get off the ground and move as fast as possible, startups often do not grant enough focus to HR and statutory compliance elements so as to ensure that there are no problems in the long run.  

Here, I share the learnings from my experience of working with several startups as their payroll service provider (PSP). Highlighted below are some of the crucial matters that startups have to take care of to ensure that they are properly safeguarded. When looked at from the perspective of the PSP, the points will also bring to light some of the common challenges faced and how we can avoid/overcome them.

Let’s begin...

1. Pay first… decide later?

We have often seen that startups pay their employees without having given much thought to the salary structure. It so happens that one’s CTC is misinterpreted as ‘net pay’. The startup would agree to give the employee salary of, let’s say, Rs.35,000 per month and happily transfers the amount to his account.

Unfortunately, the happiness is short lived. Statutory deductions in the form of professional tax, income tax (TDS) and labor contributions have to be considered before making payments to employees. Non-deduction of such taxes or contributions will result in the startup bearing its burden, often with interest and penalty.

2. Minimalistic payroll data

In addition to employment agreements, the employer should maintain records of increments, bonuses, leaves and loans given to employees. Again, it’s common for these to be communicated orally to the employee which results in much hair splitting at the time of execution. We have started seeing a trend of startups not maintaining leave records. Whilst this is beneficial to the employee, its rampant misuse results in the loss of the startup’s most crucial asset - cash. Startups should define their HR policies clearly. These policies, while being flexible, should not compromise on the startup’s own business interest.

3. Getting too creative

Startups are a creative lot; they have to be, it’s in their DNA. Unfortunately, we cannot afford to be too creative when it comes to statutes. We need to abide by the law and have to ensure that our operations function within its framework. Startups tend to get creative with salary structures, working hours, leave policies and other HR matters.

For instance, consider salary structuring. A typical salary structure has several components, some taxable and others tax-free. However, the scope of the latter is fairly limited. To overcome this limitation, tax-free components such as the uniform allowance (offered to factories, etc., where employees have to be dressed in prescribed uniforms) are expanded by startups to include formal wear such as suits and coats!

There is also a genuine problem surrounding leaves in the startup space. For example, in Karnataka, whereas 24 days/annum of leave (including sick leaves) are to be granted to employees working 5 days a week, startups often offer only a lesser number of leaves. This is done upon the pretext that they are offering other benefits, such as a work-from-home option, compensatory offs, etc. That notwithstanding, the requirements vis-a-vis leaves under the Shops & Commercial Establishment Law will have to be complied with.

Often, such scenarios lead to penal consequences. Further, non-compliance will lead to unsavory comments on the due diligence report.

4. Pending statutory dues… will pay it out of investor money?

This is a remark that’s often quoted by startups when PSPs ask them to settle statutory dues. PSPs are often viewed as harbingers of bad news as they keep highlighting issues - startups don’t like issues; they like solutions. Sadly, other than the payment of statutory dues, PSPs have no solution to offer. Cash is too crucial to be ‘wasted’ on paying these dues. They would rather pay employee salaries (it’s another matter that it’s CTC they pay and not net salary - refer point 1 above). They would prefer to settle these dues using investor money. Investor money is for the growth of the startup and not for cleaning up its mistakes. Every rupee invested into the startup is with the faith that it will be used well. Correcting a mismanaged financial position is not one of them. It’s best that statutory dues are settled in time.

5. Going completely paperless is not always a good idea

Startups love going paperless; some to go green, some to save costs. However, when it comes to employment contracts, this is not a very good idea. We have often seen that the understanding between the employee and the employer is oral or, at best, on emails (WhatsApp is a close competitor now!). There is little regard given to the good old fashioned way - to have things in writing and to have the contracts signed off. The absence of a written contract often leads to misunderstandings and eventually to disputes. Contracts not only define the terms of employment, but are key documents to protect the interests of the startup. Intellectual property protection, non-disclosure clauses, etc., are sine qua non in any employee engagement. It’s best to have all employee contracts in writing.

6. Facing a cash crunch to afford talent? No problem… ESOPs to your rescue!

Startups have given ESOPs a whole new meaning. In a public limited company (PLC), ESOPs make sense only when there is the possibility of converting these shares to cash, which usually happens during acquisition or funding. Until then, ESOPs exist on paper. Further, ESOPs have a huge tax impact on their exercise which many startups are clueless about. The employee is required to pay tax on the difference between the fair value of the stock and the money paid to acquire it (which is usually very low). This comes to a head especially for employees who leave an organization before a liquidity event with their vested shares, these stock options need to be exercised at that time. The tax has to be paid in the year the employee exercises the option and not in the year when it is converted to cash. In the year of such exercise, employees often come back to the employer to discuss as to who bears the tax liability; it’s often the employer who ends up bearing the burden. A clear understanding of how ESOP operates and its tax impact will help startups structure this policy better.

We would like to emphasize here that startups should, in addition to the humongous pile of tasks on their table, start looking at labor compliances with renewed interest. It’s in their long term benefit to be on the right side of the law. Further, documentation vis-a-vis employee engagement at its birth (e.g. employment contracts), its life (e.g. leave records) and its termination (e.g. full & final settlement letter) need to be tightened.

Payroll service providers are here to help startups improve their processes and startups should not hesitate to reach out to experts whenever they feel the need to do so.

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