Brutal Honesty Over Hype Since 2008
Assembly Bill 5, signed into law in September 2019, is the most consequential piece of employment legislation California has passed in a generation — and for early-stage entrepreneurs, it is one of the most operationally significant constraints they face. Understanding AB 5’s actual requirements, not the political characterization of them from either direction, is essential for anyone building a California-based team.
The law fundamentally changed how California determines whether a worker is an employee or an independent contractor. Prior to AB 5, California used a multi-factor “economic realities” test that gave employers meaningful flexibility in structuring working relationships. AB 5 replaced that test with the “ABC test” for most industries — a three-part standard that presumes all workers are employees unless the hiring entity can satisfy all three prongs.
The ABC Test
To classify a worker as an independent contractor under AB 5, the hiring entity must prove: (A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract and in fact; (B) that the worker performs work that is outside the usual course of the hiring entity’s business; and (C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Prong B is the one that creates the most significant problems for startups. If you are a technology company and you want to contract with a software developer, AB 5 presumes that developer is an employee — because software development is within the usual course of your business. You can satisfy Prong A by giving the developer genuine autonomy. But Prong B requires that the work be outside your usual course — which it is not, by definition, if the developer is building the product you sell.
The Practical Consequences for Startups
For early-stage companies that historically relied on contractors to access specialized skills without the overhead of full employment, AB 5 created immediate compliance exposure. The common startup model — hire contractors for design, development, marketing, and legal work while keeping the core team minimal — became legally precarious for California-based companies engaging California-resident contractors in work central to the business. The penalty structure for misclassification is severe: back wages, payroll taxes, penalties, and potential exposure under California’s PAGA statute, which allows workers to bring representative claims on behalf of all similarly situated employees.
Many California startups responded to AB 5 by: converting contractor relationships to employment (increasing fixed costs significantly), restructuring relationships to use out-of-state contractors or staffing agencies (introducing intermediary costs), or simply ceasing to engage California residents for certain categories of work (reducing access to local talent). None of these responses is cost-free. All of them represent overhead that startups in other states do not face to the same degree.
The Exemption Maze
AB 5 includes dozens of industry-specific exemptions — doctors, dentists, lawyers, architects, engineers, accountants, insurance agents, real estate agents, and many others can still be engaged as independent contractors under certain conditions. The exemption list has expanded since the law’s passage as affected industries lobbied successfully for carve-outs. But navigating the exemption structure requires legal analysis for every contractor relationship, adding compliance cost to every engagement that a California startup makes.
Prop 22 and Its Lessons
In November 2020, California voters passed Proposition 22, exempting gig economy companies (Uber, Lyft, DoorDash) from AB 5 for their driver relationships. The initiative was heavily funded by the gig companies themselves and passed with 58% of the vote. The Prop 22 experience illustrates both the political mechanism through which AB 5 exemptions are obtained — expensive ballot campaigns — and the underlying tension between the law’s worker protection goals and economic reality. The same tension exists across many industries; most lack the financial resources to run a ballot campaign to resolve it.
For entrepreneurs, the AB 5 lesson is straightforward: California employment law requires legal review of every contractor relationship, and the cost of misclassification is high enough that the review is not optional overhead. Build that cost into your hiring and compliance budget from day one.
— The Hedge | Brutal Honesty Over Hype Since 2008
The Hedge 