A current trend in business right now is shifting from employees to self-employed freelancers, or contractors.
There are tremendous benefits, some disadvantages, and risks too. You must structure things correctly, and the main thing is that the freelancer must share in the benefits of gain as well as the risk of loss.
The main benefits (which I will expand on later in this blog) are:
- Shared risk
- More focused results
- Flexible overhead
The risks are:
- Poorly structured contracts that Canada Revenue Agency will come back and say you have employees, not contractors, and then you lose all the benefits;
- Higher initial costs per person (due to shared risk);
- Loss of control of workloads;
- Possibly higher turnover
Let’s look at shared risk…
Sharing the Risk with Your People
When you hire an employee, there is an underlying expectation that your job is to provide them work and they are there to fulfill on the job requirements.
If you lose clients or customers, then your job, as owner, is to “fill the gap” for them. In the short-term you will keep them on, and that adds to your costs. An employee can have a more passive attitude towards the overall business risk you are in, just by being in business!
What I mean is your employees generally speaking are looking for something that you, as a business owner, had to become more adept at living without – security.
You know that you are dependent on your own efforts to generate results for your customers/clients and you also know that there are things outside your control. Things like economic trends, changes in laws, changes in technology, client behavioural changes, and so on.
Employees are (again I am speaking generally, there are many exceptions) usually risk averse. They want the comfort and stability of a regular pay cheque.
With a contractor, they are sharing the risk with you.
Here’s an example – assume you have a law firm and you have a fixed price agreement with a freelance lawyer for the work on a job. If you lose that client, they lose the fee.
That is what I call shared risk. You are in this game of business together. Not partners, yet sharing the risk of loss.
The contractor must also have the benefit of gain, not just shared risk of loss.
They gain by being super efficient within their fixed fee contract. Perhaps they, in turn, sub-contract (this would have to be discussed in their agreements and allowed for) the work. Or, they just are efficient at delivering results. They also must provide some investment – usually working with their own equipment, supplies, and tools.
You see, you cannot, as the business owner control your free-lancers. They control the process, you tell them the results you want. If they produce the deliverables as per the contract you have with your clients, and they deliver them in a shorter time frame, great! That time is their own, not yours to dictate to them extra work.
If they take longer, then that is their loss, not yours. You see, again, it is shared risk.
So, what is the main benefit here?
With fixed fees, your costs have moved from Fixed to Variable, and that is a great thing for a business.
When you hire employees, the costs tend to be very fixed and very sticky. Even when your business declines you will need to keep paying your employees. You will not want to lay them off. And if you do, and they have been with you for a long time, then you could have a lot of severance to pay out.
Let’s look at the next benefit….
More Focused Results
When you put the onus on your contractors to produce certain results within a fixed fee, they learn to be efficient and not waste time. When an employee knows (subconsciously it is there) that they get paid regardless of outcomes, the sharp edge can be lost.
This is great for your clients as they get the better results! And, your job is to ensure those deliverables are being met as per your contracts or expectations with your clients.
Another benefit, as I mentioned above, is more flexible overhead costs…
From Fixed to Variable Costs
Here is an irony of costing behaviour – when you fix your fees with your contractors, they become variable to you.
How does that work?
Imagine you are a technology company, and you have a fixed contract with your client to produce a particular result for a fixed fee. Let’s say, it is for $3,000 a month to manage all their servers and computers.
Further, let us say you have one contractor assigned to that client, and you have a fixed fee contract with her to work on that client and she charges you $1,500 per month.
Even though your fees are fixed you have just converted a fixed fee to a variable cost!
It works like this – you have fixed revenue of $3,000, less the now variable cost of $1,500 to your contractor, for a gross profit before overhead of $1,500, or 50%.
If that person was an employee (fixed salary) and you lost that client, then you would very likely still keep that employee on.
In the contractor example, as above, if you lose that client, then you stop paying the $1,500 immediately. No revenue, no cost. 100% variable.
This is shared risk, as when the business goes up everyone wins, and if it goes down, everyone shares in the loss, you and your contractors.
And, if you are a smart businessperson, then, if that happens, you will want to quickly get new work for your valued contractor, or you run the risk of losing them!
Now You Can Scale Your Growth
When you don’t burden yourself with fixed overhead by hiring long-term employees then you can scale up or down according to your marketing efforts with a lot more flexibility.
You won’t be worrying about all those employees that you need to “take care of”.
You will have created a Team synergy with shared responsibility – shared gains and shared risks, shared effort to make each client a raving fan.
There Are Risks…
Canada Revenue Agency looks for a number of fact patterns in assessing whether you really do have contractors, or employees.
They would like every business to have only employees. They want this because then they are assured that you, as the employer will be remitting their tax deductions monthly.
If you have contractors, Canada Revenue Agency (CRA) will have to wait for them to pay their taxes annually. And, some contractors will be negligent and either not report all their income, or just not pay their taxes owing.
Here is what CRA will look for (I have cut and pasted this from the CRA website as related to this area):
“These questions relate to the following elements:
- the level of control the payer has over the worker’s activities
- whether the worker or payer provides the tools and equipment
- whether the worker can subcontract the work or hire assistants
- the degree of financial risk the worker takes
- the degree of responsibility for investment and management the worker holds
- the worker’s opportunity for profit
- any other relevant factors, such as written contracts
We look at the answers separately for each element and then together.
We consider whether they reflect the stated intention and we decide if the actual working conditions are more consistent with a contract of service or with a contract for services.” (**Canada Revenue Agency)
You cannot just create a nice agreement with your contractors if the fact pattern does not follow the above actual elements – control, risk, investment of tools and equipment by the contractor, opportunity to profit, risk of loss, level of responsibility, written contracts in place.
So, the biggest risk for you as a businessperson is by structuring your relationship with your contractors with agreements that sound great, yet you still treat them like employees.
You must give up control, sharing the risks and the rewards.
Your Costs Will Go Up
You will pay more per contractor as a rule than with an employee relationship.
The reason for this is the shared risk.
You may be thinking – “why would I want to increase my costs?? What could possibly be the benefit to me?”
I want to bring you back to fixed versus variable costs. When you can convert a fixed cost to a variable cost you remove a significant amount of uncertainty from your business. Your profits actually become almost virtually fixed and predictable, provided the volume is enough to cover overhead plus planned profit.
Let me explain.
As already mentioned, when you have employees they tend to be fixed in nature. I will share an example from our business. When we worked strictly with fixed salary employees, and they were working directly on client work (that was fixed as well), and we lost a client, then our costs did not decline.
For example, assume we had $20,000 in billings and $8,000 (40%) in direct labour. Our gross profit would be $12,000 (60%). So far, so good.
If we lost a client that we were billing $5,000 per month on, then our revenue is now $15,000, costs are still $8,000 and our new gross profit is only $7,000, not $12,000. Ouch!
Further, the employee who is now waiting for new work gets used to a lower workload for the same salary. And, this was the corker for us, they would then complain when “new” work was added, even though we had carried them for a few months. ☹
If that contractor was sharing the risk, their fees would go down. In the example above, if we lost $5,000 in billings to our client, and we would then reduce the contractors fee by $2,000 (40%), so our new Gross Profit is $9,000, not $7,000!
Then because we do not want to lose that great contractor, we will work hard to fill the gap quickly for them.
Risk of Loss of Control and Turnover
Another risk, using contractors, is that they become “little businesspeople” and if there is that gap in their income, they may rush out to fill their workload with other clients not connected to your business. They also could become competitors.
Personally, I do not fear the risk of competition, for three reasons:
- If you treat your contractors like gold, they will stay.
- If you pay them more than they could ever earn in the marketplace as an employee, why would they leave?
- Employees can leave and compete with you too, and this is just as frequent as with contractors. When you do (1) and (2) right, you virtually ensure loyalty long-term.
In our firm, I have sometimes questioned myself on the fees we pay bookkeepers (significantly higher than the marketplace, some of the highest in Canada).
Yet, what we have gotten in return is awesome business results for our clients, loyal and happy team members, a culture of shared responsibilities, and respect for each team member’s strengths!
Thanks for reading….