Shadow HR: The Risks of a Patchwork Approach to Contractor Management

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If you’re losing sleep over finding top talent for your organization, you should know you’re not alone. The world has changed more in the past several months than many of us have seen in our entire lifetimes. With huge portions of the workforce furloughed, laid off, or working from home, companies now find themselves in uncharted waters.

Before the COVID-19 crisis hit, executives and HR leaders in every industry were under pressure to accelerate delivery, drive growth, and increase business efficiency. Now, many organizational leaders are wondering how they can meet those objectives in such a volatile economy.

It’s no wonder businesses are thinking outside the box when it comes to sourcing top talent today. They’re leaning heavily on freelancers and on-demand workers  to fill skill gaps at a time when many companies can’t find — or afford — the full-time talent they need.

The problem, however, is that few organizations have formal systems in place for managing these freelancers. This issue even predates the pandemic itself, as Forbescontributor Elaine Pofeldt covered in 2018. 

The common slapdash, piecemeal approach to freelancer management — which we at Stoke call “shadow HR” — opens an organization up to a host of threats. These include the risk of lawsuits and audits, overspending on freelance workers, and much more.

What Is Shadow HR?

If you’ve heard of “shadow IT,” shadow HR is similar: It’s a network of practices and platforms used to hire and manage workers within an organization, but a network that is not formally managed by standard organizational policies and procedures. Shadow HR sometimes uses the organization’s HR and human capital management tools to hire, onboard, manage, and pay on-demand workers; sometimes, these things happen outside formal channels without the organization’s explicit approval. 

Shadow HR typically governs everyone who’s doing work for a company without being on the company’s payroll — e.g, workers hired via Fiverr or Upwork, freelance designers, contract developers, etc. Because shadow HR runs in parallel to the company’s officially sanctioned HR policies, these contract workers often have very little visibility into the organization’s operations. The company, too, has next to no visibility into how these contract workers are being managed.

The problem is more dire than you might think. According to informal data we’ve collected here at Stoke, most of the companies we work with underestimate their number of non-payroll workers by up to 300 percent.

How Shadow HR Impacts Your Organization

The question is not whether shadow HR exists in an organization, but to what extent. Almost every business we work with has some issue with shadow HR, whether it’s the fact that on-demand workers aren’t being monitored properly, or that the HR department — or legal, or finance, or any other department for that matter — doesn’t have a clear understanding of how many freelancers are employed at any given time.

Often, the culprits responsible for the perpetuation of shadow HR in an organization are its top performers. These workers want to get things done, and they feel frustrated by the company’s cumbersome, heavily bureaucratic hiring processes. So, they’ll sidestep traditional avenues of hiring and take it upon themselves to find, onboard, manage, and pay on-demand workers. While the intention is noble, the result is that the entire organization is at greater risk of legal, financial, and HR issues.

1. Legal Issues

More than a few legal risks accompany shadow HR, including: failure to file the proper paperwork, filing incorrect tax documents, lack of liability insurance, intellectual property disputes, security breaches, and more.

2. Financial Issues

Overspending, underspending, and improper filing of tax documents are just a few financial risks posed by shadow HR. For example, if an employer fails to properly file 1099 forms, it could incur thousands — even millions — of dollars in fines and penalties.

3. HR Issues

Obviously, shadow HR has a huge impact on the officially sanctioned HR functions of an organization. Shadow HR often leads to misclassification of employees, a growing concern now that federal legislators are considering tightening classification criteria. Chaotic processes and pay cycles are also common in shadow HR, which puts the company at risk of incurring penalties. For example, in certain jurisdictions, companies face legal consequences if they don’t pay contractors in a timely manner.

Avoiding Shadow HR

While shadow HR presents its share of potential problems, it simply reflects an organizational need that isn’t being met. In short: Company leaders haven’t given their people the tools and best practices they need to manage on-demand workers through proper HR channels.

While there are no quick fixes for shadow HR, the good news is that avoiding it simply comes down to adopting the right systems, solutions, and strategies to help various stakeholders — hiring managers, legal, finance, HR — better manage freelance and on-demand workers. 

As Deloitte’s 2019 Human Capital Trends report puts it, “Organizations that take [the on-demand] workforce seriously can build strategies and programs to access and engage talented people wherever they may sit in the labor pool, driving business growth and extending the diversity of the workforce.”

Your company has the chance to play a role in addressing the problem of shadow HR for good and shaping a better future for all workers. It might take some effort, but it’s worth it.

Shahar Erez is cofounder and the CEO of Stoke .

By Shahar Erez