Effective June 30, 2027, Washington state law will prohibit noncompetition covenants in most employment and independent contractor relationships.

What can you do if you have an employee or contractor who could walk away with a significant portion of your business or profits? One potential solution is to grant an ownership interest coupled with a new noncompetition covenant. This approach works because the law does not prohibit noncompetition covenants when they relate to the purchase or sale of an ownership interest of 1% or more of a business.

This strategy is appropriate only for employees whose departure and competition could materially harm the business.

If a business determines that granting ownership may be worthwhile to support a noncompetition covenant, the first step is to value the company as a whole, and the specific interest to be transferred. Although these values are related, discounts may apply to the value of the interest to be transferred.

Discounts reflect the reduced value of an ownership interest due to a lack of control and marketability. For example, if a closely held company is valued at $1 million, a 1% ownership interest is typically worth less than $10,000 because minority interests in closely held businesses lack control and are difficult to sell.

Valuation is critical for determining the tax consequences to both the business and the employee. The structure of the transfer will also have tax implications.

Businesses must be prepared to treat new owners as true owners. Courts are likely to disregard arrangements that constitute “ownership in name only.” Key indicators of genuine ownership include access to records and participation in profits. Actions designed to deprive minority owners of their share of earnings — for example, adjusting owner compensation to eliminate distributable profits — are also likely to create issues. If the arrangement does not reflect a legitimate ownership interest and relationship, a court may set it aside and invalidate the related noncompetition covenant.

Having appropriate governing documents — such as an LLC agreement or corporate bylaws — is critical. Businesses with a single owner will likely need new or updated documents. Those documents must then be followed, including requirements for annual meetings, recordkeeping, communications, and financial reporting. Consistent adherence to these rules reinforces the legitimacy of the ownership structure.

Governing documents should also include provisions addressing involvement with competing businesses, company opportunities, trade secrets, intellectual property, and related matters.

Likely, a business will not want a key employee’s spouse involved in managing the business. So, the governing documents should require a spousal consent confirming that the involved spouse has full management authority over any marital interest in the company.

At the time of the ownership transfer, the company and the key employee should enter into a new employment agreement. It's important to carefully coordinate this agreement with the other governing documents to avoid inconsistencies or ambiguity. The agreements should also specify which document controls in the event of a conflict.

When transferring an ownership interest to a key employee, it's essential to establish clear repurchase terms. These terms are typically set out in a buy-sell agreement. The agreement should provide that if the employee leaves the company or is terminated, the company will have the right — or in some cases the obligation — to repurchase the ownership interest. It should also address contingencies such as death, disability, divorce, or bankruptcy. The agreement may include a defined method or formula for determining the repurchase price, along with financing terms, if any. Buy-sell provisions are a critical component of the overall arrangement and should not be treated as an afterthought.

It's unwise to attempt to transfer an ownership interest to a key employee without qualified legal and tax advice. While some transactions may be suitable for self-help or the use of artificial intelligence tools, this is not one of them. The legal and tax implications are significant and warrant the involvement of experienced legal and accounting professionals.

There is also the practical challenge of how to approach the key employee — how to assess their perception of value and develop a proposal likely to be well received. The approach and proposal should be developed with an understanding that employees’ bargaining positions have improved under the new law.

Given the number of moving pieces — from valuation to negotiation to document preparation — now is the time to evaluate whether a key employee ownership strategy is appropriate and to begin the valuation and document preparation process necessary for implementation before July 2027.

 Shea Meehan is an attorney and the director of planning at Cornerstone Wealth Strategies, headquartered in Washington state and servicing clients nationwide.