Uber’s Pioneering Business Model Is Under Attack in the Courtroom

Like seagulls following a trawler, lawyers predictably trail in the wake of a pioneering business such as Uber. The latest attack on the ride-share company — a class-action lawsuit is under way in California — focuses on the payment of drivers as 1099 contractors rather than W2 employees. Similar lawsuits are pending against the ride-share company Lyft. Shannon Liss-Riordan, a lawyer representing the plaintiffs against Uber and a pioneer of this type of case, recently rebuked Uber in an interview with the Recorder: “The most highly valued startup in the world right now . . . can afford to pay for workers’ comp and unemployment.”

The central allegation is that Uber and Lyft (and many other on-demand economy companies) pay their “partners” as 1099 independent contractors while treating them as W2 employees. The distinction might seem academic, but it has substantial economic and legal implications: 1099 contractors do not receive benefits and have to cover their business expenses; in return, they are supposed to have greater freedom in the terms and conditions of how they perform their services. Businesses also do not pay Social Security, Medicare, and unemployment taxes on 1099 contractors.

This criticism about hiring workers as 1099 contractors feeds into a broader narrative about the evils of flexible work contracts and the supposedly exploitive practices of on-demand new business models such as Uber, Lyft, and Task Rabbit. According to Robert Reich, secretary of labor in the Clinton administration, these upstarts are not contributing to a growing economy, but to a “share-the-scraps economy.” This patronizing epithet ignores the preferences of workers themselves, many of whom would rather have flexible schedules than be yoked to a nine-to-five job. Even worse, in the case of Uber and Lyft the drive to recategorize drivers as W2 employees would probably lower their income; it’s the drivers’ status as 1099 contractors — free to switch between apps — that enables them to capture a relatively high share of passenger revenues.

Many workers would rather have flexible schedules than be yoked to a nine-to-five job.

Although switching to W2 classification sometimes benefits employees — while raising costs for all consumers — in this case, the driver-partners benefit from their independent status because it gives them leverage vis-à-vis their app overlords. Ride-share companies operate two-sided marketplaces, meaning that they have to attract passengers in order to bring drivers into the system; and, simultaneously, they must attract drivers to create passenger demand. Uber and Lyft exist in brutal competition with one another (and, to a lesser extent, with Sidecar), and the services are not meaningfully distinct in quality or price. As a result, driver availability is the primary difference between them. As with most two-sided marketplaces, there is a virtuous (or vicious) cycle: Passengers gravitate toward the service with more drivers (faster pickup times), causing drivers to increasingly serve that app, which in turn causes even more passengers to switch to that app.

Because the availability of drivers with cars is the main difference between the services, both companies are in a perpetual war for drivers. The companies focus on increasing driver availability, and additional demand from passengers becomes a positive by-product of having a proliferation of drivers. Uber and Lyft bombard drivers with incentives to switch to their side; both companies have fought hard to attract and retain their partners.

Unfortunately from Uber’s or Lyft’s perspective, once they’ve captured a driver, they have no means of retaining his loyalty; the drivers are 1099 contractors and can switch to the other service. Many even operate both services simultaneously, increasing their income by taking the closest available passenger. If drivers were W2 employees, Uber and Lyft could more easily restrict them from working for their competitor. Under the looser 1099 rules, however, there’s little to prevent the drivers from switching. As long as there are at least two companies in the marketplace, drivers have the option of leaving, which helps ensure that they capture a decent share of the passenger revenue (about 80 percent).

In the absence of this leverage, the drivers would be locked in and the relationship would be more like that between New York City taxi drivers and medallion owners. Historically, medallion owners have captured the majority of the income from passenger fares because drivers have little power and are easily substituted. If you want to drive a taxi in NYC, you either have to buy a medallion or lease one from a medallion owner. But medallion owners have no incentive to compete for drivers, because they don’t have a broader market-building incentive to increase driver availability. As a result, it’s a take-it-or-leave-it offer from the medallion owner. In this dynamic, unsurprisingly, the driver’s average share of passenger revenues is much lower than it is with Uber or Lyft — nearer to 50 percent in NYC.

This is born out in the driver-income data. A study by Jonathan Hall and Alan Krueger, “An Analysis of the Labor Market for Uber’s Driver-Partners in the United States,” found that Uber drivers make substantially more per hour than local taxi drivers in most markets, with a gap of almost $15 per hour in NYC. Uber sponsored the study, but the income data stands on their own and Alan Krueger, former chairman of Obama’s Council of Economic Advisers, is hardly a pro-business apparatchik. Uber drivers who are 1099 employees have to pay their expenses, of course, such as gas, but that’s also true for many taxi drivers in NYC who are likewise independent contractors (and not only pay for gas but also to lease a medallion).

This raises the question of why Lyft and Uber, if it’s in their long-term interest, have not switched to W2 employment to lock in drivers. Besides the short-term expense (increased taxes and benefits, much of which goes to the government and not the drivers), the problem is coordination: Neither company can make the move without the other for fear of provoking a mass migration of drivers to its competitor. With the class-action lawsuit, however, drivers may have handed their employers just the tool to solve this problem.

Uber drivers make substantially more per hour than local taxi drivers in most markets, with a gap of almost $15 per hour in NYC.

Moreover, reclassification as W2 employees would jeopardize the very flexibility and lifestyle qualities that attracted most drivers to the job in the first place. In their study, Hall and Kreuger found that more than 60 percent of Uber drivers have another job, and 87 percent of drivers said that “to be my own boss and set my own schedule” was either a major or minor motivation for signing up. Similarly, 85 percent listed as a motivation the desire “to have more flexibility in my schedule and balance my work with my life and family.” The flexibility of Uber work is a feature, not a defect.

This is true for independent contractors more generally as well: Although the benefits might seem less attractive than those offered by a traditional job, 82 percent of independent contractors preferred their work arrangement to a traditional job, according to a 2005 survey by the Bureau of Labor Statistics on “contingent and alternative work arrangements.” Conversely only 9 percent would prefer a traditional work arrangement. Flexible work contracts can allow people to tailor the terms and conditions of their work to the uneven contours of their life rather than suffering in a one-size-fits-all regime. To the extent that new technologies make this more feasible, we should celebrate them, not fear them.

The class-action lawsuits will now play out before a jury, which, as Judge Vince Chhabria of the Northern District of California put it, “will be handed a square peg and asked to choose between two round holes.” According to Reuters, Chhabria “acknowledged the difficulty of parsing the status of Lyft’s drivers, who share common characteristics with both full-time employees and contractors.” Uber and Lyft drivers do not look like typical 1099 contractors — after all, they provide a service that’s integral to the business (Uber wouldn’t exist without its drivers) and are screened and monitored by the company, which exerts both financial and behavioral control.

But these cases are different from the widely cited FedEx lawsuit, which, after a decade of litigation, resulted in the company’s being forced to take on its independent contractors as W2 drivers. One distinction is that FedEx required its drivers to buy FedEx uniforms and set their delivery days, times, and methods. By contrast, Uber drivers have no set uniform and, more important, no set schedule; drivers work when and where they want to work, which doesn’t look very much like the life of a typical W2 employee.

For the drivers’ sake, let’s hope that jurors place this square ride-share peg in a 1099-shaped hole.

— Piotr Brzezinski is a partner at Velos Partners, a Los Angeles–based venture-capital fund; the fund does not own shares in any of the companies mentioned in this article.