PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
January 7, 2022
MEMORANDUM
From: Sylvia Hartwell, Partner, Tax Group, Calderwood & Harkness LLP
To: Robert Adeyemi, Responsible Partner, Capital Markets Group, Calderwood & Harkness LLP; Audrey Zhou, Lead Associate, Capital Markets Group, Calderwood & Harkness LLP
CC: Jennifer Kwon, Billing Partner; Brendan Walsh, Working Associate
Re: Tax Structure Memorandum — Lumos Analytics Inc. Proposed Initial Public Offering of Class A Common Stock
Matter Number: 1008-00002
Client: Lumos Analytics Inc.
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I. Executive Summary and Purpose
A. Purpose
This memorandum has been prepared by the Tax Group of Calderwood & Harkness LLP to analyze the principal federal and state income tax implications arising from the proposed initial public offering (the "IPO") of Class A Common Stock of Lumos Analytics Inc. ("Lumos," the "Company," or the "Issuer") on the Nasdaq Global Select Market. Lumos is a Delaware C-corporation headquartered at 450 Folsom Street, Suite 1200, San Francisco, California 94105. This memorandum is intended to inform and support the Capital Markets Group's structuring and disclosure work in connection with the Company's Registration Statement on Form S-1, as well as to identify areas requiring ongoing tax compliance planning for the Company and its stockholders.
B. Scope of Analysis
The analysis contained herein covers the following principal areas:
(a) Section 351 and Section 368 Considerations. Whether the IPO and related recapitalization transactions give rise to taxable events under Sections 351 and 368 of the Internal Revenue Code of 1986, as amended (the "Code");
(b) State Income and Franchise Tax Nexus Analysis. State-level corporate income and franchise tax implications for the Company in California, New York, Texas, and Illinois, and state-level tax consequences for stockholders in each of those jurisdictions;
(c) Qualified Small Business Stock (QSBS) Analysis Under Section 1202. Whether shares of Lumos stock held by founders, early investors, and employees qualify as "qualified small business stock" under Section 1202 of the Code, and whether such status is preserved through and after the IPO;
(d) Payroll Tax Implications of Employee Stock Option Exercises. Federal and state payroll tax consequences arising from the exercise of employee stock options in connection with or following the IPO; and
(e) Other Federal Tax Considerations. Deductibility of underwriting discounts and offering expenses, Section 162(m) limitations on executive compensation, and Section 280G golden parachute considerations.
C. Key Conclusions
The key conclusions of this memorandum are summarized as follows:
(i) IPO Primary Issuance. The IPO itself is not expected to constitute a reorganization under Section 368 or an exchange subject to non-recognition treatment under Section 351. The issuance of primary shares in a firm-commitment underwriting will not result in adverse federal income tax consequences to the Company, and the gross proceeds received by the Company are not taxable income.
(ii) Preferred Stock Conversion. The automatic conversion of all outstanding Series A through Series D Preferred Stock into shares of Class A Common Stock upon the effectiveness of the IPO is expected to qualify as a tax-free recapitalization under Section 368(a)(1)(E) of the Code. No gain or loss should be recognized by the converting stockholders. Basis and holding period in the surrendered preferred stock will carry over to the Class A Common Stock received.
(iii) Dual-Class Recapitalization. The establishment of the Class A Common Stock and Class B Common Stock dual-class structure, including the reclassification of founders' existing common stock as Class B Common Stock (carrying ten votes per share), should similarly qualify as a tax-free recapitalization under Section 368(a)(1)(E). No taxable event is expected for the founders.
(iv) QSBS Preservation. Qualified small business stock status for eligible stockholders holding stock acquired at or before the Series A round (and certain early employees whose options were exercised before aggregate gross assets exceeded $50 million) may be preserved through the IPO by operation of Section 1202(h)(4)(A), subject to the Company's continued satisfaction of the active business requirement post-IPO. Stock issued in the Series B, Series C, and Series D rounds does not qualify as QSBS because the Company's aggregate gross assets exceeded $50 million at the time of those issuances.
(v) State Tax Nexus. Lumos has established nexus and is qualified to do business in California, New York, Texas, and Illinois, with varying state income and franchise tax consequences. Notably, California does not conform to the federal Section 1202 QSBS gain exclusion, which has significant implications for the Company's California-resident founders.
(vi) Payroll Tax Exposure. Significant payroll tax exposure arises from the potential exercise of approximately 11,300,000 outstanding non-qualified stock options by Company employees, with estimated aggregate compensation spread of approximately $137.6 million at the midpoint IPO price. The Company should plan for substantial payroll tax obligations in the quarters following the IPO.
D. Proposed Offering Structure
The proposed IPO is structured as follows, based on the draft Registration Statement on Form S-1 and term sheet provided by Pinnacle Securities LLC, the lead book-running manager:
•  Primary Shares: 12,941,176 newly issued shares of Class A Common Stock to be sold by the Company.
•  Preliminary Price Range: $16.00 to $18.00 per share, with a midpoint of $17.00 per share.
•  Gross Proceeds to Company (at midpoint): Approximately $220,000,000.
•  Net Proceeds to Company (at midpoint): Approximately $205,700,000, after deduction of the underwriting discount of approximately $14,300,000 (representing 6.5% of gross proceeds).
•  Secondary Shares: 3,500,000 shares of Class A Common Stock to be sold by selling stockholders, comprised of (a) 2,000,000 shares from Velthryn Venture Partners Fund IV, L.P. ("Velthryn") and (b) 1,500,000 shares from Arclight Equity Group Fund VII, L.P. ("Arclight").
•  Overallotment Option: Up to 2,466,176 additional shares of Class A Common Stock, at the option of the underwriters, exercisable for 30 days following the date of the final prospectus.
•  Lead Book-Running Manager: Pinnacle Securities LLC, 399 Park Avenue, New York, New York 10022.
E. Company Identification
•  Employer Identification Number (EIN): 82-3194567
•  Delaware File Number: 6281934
•  Date of Incorporation: March 14, 2016, in the State of Delaware
II. Background: Capital Structure and Recapitalization
II.A. Pre-IPO Capital Structure
The following description of the Company's pre-IPO capital structure is based upon the Company's Amended and Restated Certificate of Incorporation currently in effect, the draft Registration Statement on Form S-1, stockholder agreements, and the capitalization table prepared by Brendan Walsh in November 2021 (see Appendix A for the complete capitalization table).
1. Authorized Capital Stock
As of the date of this memorandum, the Company's certificate of incorporation authorizes the issuance of up to 500,000,000 shares of common stock, par value $0.0001 per share, and such additional shares of preferred stock as have been designated pursuant to the various certificates of designation filed in connection with each preferred stock financing. The Company does not currently have a separate class of authorized but undesignated preferred stock available for future issuance; this will be addressed in the Amended and Restated Certificate of Incorporation to be filed in connection with the IPO.
2. Class B Common Stock (Founders)
The Company's two co-founders hold the entirety of the outstanding common stock of the Company as of the date hereof, which will be reclassified as Class B Common Stock (ten votes per share) upon the effectiveness of the IPO. The Class B Common Stock holdings are as follows:
These shares were issued to the founders in connection with the formation of the Company in 2016 and are currently the only outstanding shares of common stock. All shares are fully vested and outstanding.
3. Preferred Stock Outstanding (Series A Through Series D)
The Company has completed four rounds of preferred stock financing since its incorporation. The aggregate number of shares of preferred stock outstanding is 62,400,000 shares, consisting of the following series:
The Series D round closed at a price per share of $12.50, implying a post-money valuation of approximately $1.478 billion. Ridgeline Capital Partners Fund II, L.P. ("Ridgeline") is the primary holder of Series A Preferred Stock. Arclight holds a portion of both the Series B and Series C Preferred Stock. Velthryn holds portions of the Series C and Series D Preferred Stock. The precise share allocations among holders by series are set forth in the capitalization table attached as Appendix A and in the stockholder records maintained by Broadleaf Transfer Services.
4. Employee Stock Option Pool
The Company's 2016 Stock Incentive Plan (the "2016 Plan") authorizes the issuance of up to 14,800,000 shares of common stock pursuant to stock option grants and other equity awards. As of December 31, 2021, there are 11,300,000 options outstanding under the 2016 Plan, with a weighted-average exercise price ("WAEP") of $4.82 per share. The remaining 3,500,000 shares are available for future grants or have been forfeited and returned to the pool. A summary of the outstanding options, including the breakdown between incentive stock options ("ISOs") and non-qualified stock options ("NQSOs"), is set forth in Appendix C. We are awaiting confirmation of the ISO/NQSO classification from Naomi Feinberg, General Counsel.
5. Fully Diluted Pre-IPO Share Count
On a fully diluted basis (including all outstanding common stock, all outstanding preferred stock on an as-converted basis, and all outstanding stock options), the Company has approximately 118,200,000 shares outstanding as of the date of this memorandum, calculated as follows:
We note that the fully diluted share count is approximately 118.2 million shares and that additional dilution will occur upon the issuance of 12,941,176 primary shares in the IPO (and potentially up to 2,466,176 overallotment shares).
II.B. IPO Recapitalization Transactions
In connection with the IPO, the Company will effect the following recapitalization transactions, all of which are described in the draft Registration Statement and are conditioned upon the effectiveness of the Registration Statement:
1. Automatic Conversion of Preferred Stock
Upon the closing of the IPO, all 62,400,000 shares of outstanding Series A through Series D Preferred Stock will automatically convert into shares of Class A Common Stock on a one-for-one basis (subject to any applicable anti-dilution adjustments, none of which are expected to be triggered). This automatic conversion is mandated by the terms of the applicable certificates of designation governing each series of preferred stock, which provide for mandatory conversion upon the closing of a "Qualified IPO" (generally defined as an underwritten public offering resulting in gross proceeds to the Company of at least $75,000,000). The proposed IPO, with anticipated gross proceeds of approximately $220,000,000, satisfies this threshold.
2. Establishment of Dual-Class Structure
Concurrently with the IPO, the Company will adopt an Amended and Restated Certificate of Incorporation (the "Restated Certificate") that establishes a dual-class common stock structure:
(a) Class A Common Stock (one vote per share): Issued to public investors in the IPO, to converting preferred stockholders, and in connection with the exercise of stock options.
(b) Class B Common Stock (ten votes per share): Held exclusively by the founders, Priya Subramanian and Marcus Henley. The existing common stock held by the founders will be reclassified and redesignated as Class B Common Stock under the Restated Certificate.
3. Sunset Provision
The Restated Certificate includes a sunset provision pursuant to which all outstanding shares of Class B Common Stock will automatically convert into shares of Class A Common Stock on a one-for-one basis upon the earliest to occur of:
(i) the seventh anniversary of the closing of the IPO;
(ii) the transfer of any share of Class B Common Stock to any person or entity that is not a "Permitted Transferee" (as defined in the Restated Certificate, generally limited to the other founder, certain family trusts, and entities controlled by a founder); or
(iii) the date on which the founders collectively hold fewer than 10% of the total number of shares of common stock then outstanding (on an as-converted basis).
4. Post-IPO Capitalization Summary
Following the consummation of the IPO (assuming no exercise of the overallotment option and no exercise of stock options), the Company's outstanding shares of common stock will be approximately as follows:
Note: The approximately 27,300,000 shares of Class A Common Stock from existing non-founder common stock includes shares held by investors and employees who previously received common stock or exercised options. This figure is derived from the difference between the estimated post-IPO Class A total and the sum of the converted preferred shares and new primary shares, and should be confirmed against the final capitalization table.
5. Post-IPO Voting Power
The dual-class structure will result in the following approximate voting power distribution:
•  Class B Common Stock (founders): 28,500,000 shares × 10 votes per share = 285,000,000 votes
•  Class A Common Stock: ~102,641,176 shares × 1 vote per share = ~102,641,176 votes
•  Total votes: ~387,641,176
•  Founders' voting percentage: 285,000,000 / 387,641,176 ≈ 73.5%
The founders will collectively control approximately 73.5% of the total voting power of the Company's outstanding capital stock immediately following the IPO, notwithstanding holding only approximately 21.7% of the total economic interest. This voting concentration has significant implications for the Section 351 analysis discussed in Part III below.
III. Section 351 Analysis — Issuance of Primary Shares
III.A. Applicability of Section 351
1. General Rule
Section 351(a) of the Code provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and if, immediately after the exchange, such person or persons are in "control" of the corporation. For purposes of Section 351, "control" is defined by reference to Section 368(c) as ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.
2. Application to a Typical IPO
In a typical initial public offering, public investors transfer cash (which constitutes "property" for Section 351 purposes) to the issuer in exchange for newly issued shares of stock. Theoretically, this transaction could be characterized as a Section 351 exchange. However, in practice, Section 351 is rarely applicable to an IPO for two principal reasons:
First, in a firm-commitment underwriting, the underwriters (rather than the ultimate public investors) purchase the shares directly from the issuer and then resell them to the investing public. The investing public thus acquires shares from the underwriters in the secondary market and is not treated as "transferors" of property to the issuer for purposes of Section 351. The underwriters themselves, acting as dealers in securities, are not treated as transferors of "property" because they are in the business of buying and selling securities and are not making a capital contribution.
Second, even if the public investors were treated as transferors of property to the issuer, they would need to constitute a "control" group holding at least 80% of the total combined voting power immediately after the exchange. In most IPOs, public investors do not acquire 80% of the voting power, and this is especially true in dual-class structures where founders retain disproportionate voting control.
3. Analysis Specific to the Lumos IPO
The Lumos IPO is structured as a firm-commitment underwriting led by Pinnacle Securities LLC. Under the terms of the underwriting agreement, Pinnacle Securities and the other underwriters will purchase 12,941,176 shares of Class A Common Stock directly from the Company at the public offering price less the underwriting discount, and will then resell those shares to the investing public. The key Section 351 considerations are as follows:
(a) Transferor Status. Because the IPO is structured as a firm-commitment underwriting, the public investors who ultimately purchase the shares on the Nasdaq Global Select Market will not be treated as "transferors" of property to the Company for purposes of Section 351. They will acquire their shares from the underwriters, not directly from the Company. The underwriters themselves, purchasing and reselling shares in their capacity as dealers, are similarly not treated as Section 351 transferors. Accordingly, the primary issuance does not constitute an exchange to which Section 351 applies.
(b) Control Requirement — Alternative Analysis. Even assuming, arguendo, that the public investors were treated as transferors of property to the Company in exchange for Class A Common Stock, they would not satisfy the 80% "control" requirement of Section 368(c). Immediately after the IPO, the public investors would hold 12,941,176 shares of Class A Common Stock. The total combined voting power of the Company immediately after the IPO would be approximately 387,641,176 votes (as calculated in Part II.B.5 above). The public investors' voting power would be approximately 12,941,176 / 387,641,176, or approximately 3.3% — far short of the 80% threshold. The founders' Class B Common Stock, carrying ten votes per share, ensures that the dual-class structure precludes any possibility of the public investors constituting a "control" group.
4. Conclusion.  Section 351 is not expected to apply to the primary issuance of Class A Common Stock in the IPO. No adverse federal income tax consequences are expected to arise for the Company from the issuance of primary shares.
The Company will receive gross proceeds of approximately $220,000,000 (approximately $205,700,000 net of the underwriting discount of approximately $14,300,000). These proceeds are not taxable income to the Company. For federal income tax purposes, the receipt of cash in exchange for the issuance of common stock is treated as a capital contribution that increases the Company's additional paid-in capital. The Company will not recognize gain or loss upon the issuance of its own stock. See Code § 1032(a) ("No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation.").
III.B. Tax Basis and Holding Period for New Shares
1. Public Investors
Each public investor who purchases shares of Class A Common Stock in the IPO will have a tax basis in such shares equal to the purchase price paid (i.e., between $16.00 and $18.00 per share, depending on the final pricing determined at the time of the offering). The holding period for such shares will begin on the date of purchase (i.e., the settlement date of the IPO). Public investors should consult their own tax advisors regarding the tax consequences of their investment.
2. The Company
As noted above, the Company will not recognize gain or loss upon the issuance of the primary shares. The Company's receipt of IPO proceeds will increase its additional paid-in capital on its balance sheet and will increase its cash and cash equivalents. No adjustment to the Company's tax basis in its assets or tax attributes results from the primary share issuance.
IV. Section 368(a)(1)(E) Analysis — Recapitalization
IV.A. Conversion of Preferred Stock to Class A Common Stock
1. Characterization of the Transaction
Upon the effectiveness of the IPO, all 62,400,000 outstanding shares of Series A through Series D Preferred Stock will automatically convert into shares of Class A Common Stock on a one-for-one basis. For federal income tax purposes, this conversion constitutes an exchange by each preferred stockholder of shares of preferred stock of the Company for shares of common stock of the same Company. The central question is whether this exchange qualifies as a tax-free "recapitalization" under Section 368(a)(1)(E) of the Code.
2. Requirements for a Tax-Free Recapitalization
A "recapitalization" is defined under Section 368(a)(1)(E) as a "reorganization" for purposes of the Code's non-recognition provisions. Although the Code does not define the term "recapitalization" with specificity, the Treasury Regulations, case law, and IRS guidance establish that a recapitalization involves a reshuffling of the capital structure of a single corporation. To qualify as a tax-free recapitalization, the following requirements must generally be satisfied:
(i) Stock-for-Stock Exchange of Same Corporation. The transaction must involve an exchange of stock (or securities) of a corporation for stock (or securities) of the same corporation. An exchange of preferred stock for common stock of the same corporation is a paradigmatic recapitalization. See Bazley v. Commissioner, 331 U.S. 737 (1947); Treas. Reg. § 1.368-2(e)(1).
(ii) Plan of Reorganization. There must be a plan of reorganization. Here, the plan is embodied in the Amended and Restated Certificate of Incorporation, the board resolutions authorizing the recapitalization, and the terms of the certificates of designation governing the preferred stock, which provide for mandatory conversion upon a Qualified IPO. Taken together, these documents constitute a plan of reorganization.
(iii) Business Purpose. The transaction must be motivated by a legitimate business purpose. The conversion of the Company's complex multi-series preferred stock structure into a simple common stock structure is a standard step taken in connection with a public offering to simplify the Company's capital structure, satisfy listing requirements of the Nasdaq Global Select Market, and facilitate public trading of a single class of voting common stock. These objectives constitute valid business purposes.
3. Analysis.  The Series A through Series D Preferred Stock constitutes "stock" for federal income tax purposes. Although preferred stock with certain debt-like features can in some circumstances be treated as debt rather than equity (under the principles of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972), and related authority), the Lumos preferred stock has standard venture capital features — liquidation preferences, conversion rights, protective provisions, and voting rights — that are consistent with equity characterization. The preferred stock does not have mandatory redemption features, fixed maturity dates, or other characteristics that would suggest debt treatment. Accordingly, the preferred stock is properly classified as equity.
The Class A Common Stock received in exchange for the preferred stock is also "stock" of the same corporation. The exchange is solely stock-for-stock — no cash, debt instruments, or other property ("boot") is distributed to the converting stockholders in connection with the conversion. There are no accrued but unpaid dividends that would be treated as boot, as the preferred stock does not bear cumulative dividends and no dividends have been declared.
4. Conclusion.  The automatic conversion of 62,400,000 shares of Series A through Series D Preferred Stock into shares of Class A Common Stock upon the effectiveness of the IPO should qualify as a tax-free recapitalization under Section 368(a)(1)(E) of the Code. No gain or loss should be recognized by the converting stockholders, including Velthryn Venture Partners Fund IV, L.P., Arclight Equity Group Fund VII, L.P., Ridgeline Capital Partners Fund II, L.P., and all other holders of preferred stock.
5. Basis and Holding Period
Basis. Under Section 358(a)(1), each converting stockholder will take a "substituted basis" in the Class A Common Stock received equal to the stockholder's adjusted tax basis in the surrendered preferred stock. For example, a Series A holder who acquired shares at $1.96 per share will have a basis of $1.96 per share in the Class A Common Stock received upon conversion, and a Series D holder who acquired shares at $12.50 per share will have a basis of $12.50 per share.
Holding Period. Under Section 1223(1), the holding period of the Class A Common Stock received in the recapitalization includes the holding period of the surrendered preferred stock. This "tacking" of the holding period is critically important for two purposes: (a) determining whether gain on a subsequent sale of the Class A Common Stock qualifies for long-term capital gains treatment (requiring a holding period of more than one year), and (b) determining whether the stock qualifies for the Section 1202 QSBS gain exclusion (requiring a holding period of more than five years). The tacking of the holding period is discussed further in connection with the QSBS analysis in Part V below.
IV.B. Dual-Class Reclassification
1. Characterization of the Transaction
In connection with the adoption of the Restated Certificate, the existing common stock held by the founders (28,500,000 shares) will be reclassified and redesignated as Class B Common Stock carrying ten votes per share. This reclassification constitutes an exchange by the founders of their existing common stock for a new class of common stock (Class B) of the same corporation.
2. Analysis.  Like the preferred-to-common conversion, the reclassification of the founders' common stock as Class B Common Stock constitutes a recapitalization under Section 368(a)(1)(E). The transaction involves an exchange of stock of the Company for a different class of stock of the same Company. The only substantive change is the creation of a differential voting right — Class B shares carry ten votes per share, whereas Class A shares carry one vote per share. The economic rights (dividends, liquidation distributions) of the two classes are otherwise identical.
No boot is paid or received in the reclassification. The founders do not receive any cash, debt instruments, or other property in addition to the Class B Common Stock. The transaction is solely a stock-for-stock exchange.
3. Potential Issue: Constructive Distribution From Voting Differential
A potential concern arises from the fact that the founders' shares will carry enhanced voting rights (ten votes per share) relative to the Class A shares held by other stockholders. One could argue that the enhancement of the founders' voting power constitutes a disproportionate benefit that should be treated as a constructive distribution or constructive dividend to the founders, potentially giving rise to taxable boot.
However, under established precedent and IRS guidance, a mere change in voting rights in a recapitalization — where no property other than stock is received and where the economic rights of the stock are not materially altered — does not give rise to boot or a constructive distribution. The IRS has consistently treated dual-class recapitalizations as tax-free, provided that the transaction is structured as a stock-for-stock exchange and that no property other than stock is distributed. See, e.g., Rev. Rul. 84-114, 1984-2 C.B. 90 (reclassification of single class of stock into two classes with different voting rights is a recapitalization under Section 368(a)(1)(E)); Treas. Reg. § 1.305-7(c) (addressing changes in conversion ratios, which is not directly on point but supports the general principle that changes in relative rights among stockholders in the context of a recapitalization do not give rise to Section 305(c) deemed distributions where the recapitalization is tax-free).
Moreover, the enhanced voting rights granted to the founders are consistent with industry practice for technology company IPOs and serve the legitimate business purpose of preserving founder control during the Company's transition to a public company. The Restated Certificate includes a sunset provision that limits the duration of the Class B voting advantage.
4. Conclusion.  The dual-class reclassification should qualify as a tax-free recapitalization under Section 368(a)(1)(E). No taxable event is expected for Priya Subramanian or Marcus Henley. The founders will take a substituted basis in their Class B Common Stock equal to their basis in the surrendered common stock, and their holding period will tack.
IV.C. Implications for Selling Stockholders
1. Secondary Offering Component
In addition to the primary shares offered by the Company, the IPO includes a secondary component in which certain existing stockholders will sell shares of Class A Common Stock to the public:
•  Velthryn Venture Partners Fund IV, L.P.: Selling up to 2,000,000 shares of Class A Common Stock. These shares will be received by Velthryn upon the automatic conversion of its Series C and Series D Preferred Stock immediately prior to the IPO closing.
•  Arclight Equity Group Fund VII, L.P.: Selling up to 1,500,000 shares of Class A Common Stock. These shares will be received by Arclight upon the automatic conversion of its Series B and Series C Preferred Stock immediately prior to the IPO closing.
2. Tax Consequences of Secondary Sales
The sale of shares by Velthryn and Arclight in the secondary component of the IPO is a taxable event. Each selling stockholder will recognize capital gain (or, theoretically, capital loss) equal to the difference between the sale price per share and the selling stockholder's adjusted tax basis in the shares sold.
3. Character of Gain
The character of the gain — long-term or short-term — depends on the selling stockholder's holding period in the shares sold. Because the conversion of preferred stock to Class A Common Stock qualifies as a tax-free recapitalization (as discussed in Part IV.A above), the holding period of the Class A Common Stock includes the holding period of the surrendered preferred stock. All series of Lumos preferred stock were acquired more than one year before the anticipated IPO date:
•  Series B Preferred Stock: acquired September 10, 2019 (more than two years prior)
•  Series C Preferred Stock: acquired February 18, 2020 (approximately two years prior)
•  Series D Preferred Stock: acquired August 24, 2020 (approximately seventeen months prior)
Accordingly, long-term capital gains treatment should apply to the gain recognized by both Velthryn and Arclight on the sale of their secondary shares, assuming the IPO closes on or after the anticipated date in early 2022. We note that for the Series D shares, the holding period is close to the one-year threshold, and the selling stockholders should confirm the precise IPO closing date relative to the Series D acquisition date to ensure that the one-year holding period requirement is satisfied.
4. Tax Basis for Selling Stockholders
The adjusted tax basis for each selling stockholder is the substituted basis from the preferred stock conversion — generally, the original investment cost per share paid in the applicable preferred series. For example:
•  Velthryn's Series C shares: basis of approximately $7.20 per share
•  Velthryn's Series D shares: basis of approximately $12.50 per share
•  Arclight's Series B shares: basis of approximately $3.75 per share
•  Arclight's Series C shares: basis of approximately $7.20 per share
The precise basis per share may vary depending on any adjustments made by the selling stockholders (e.g., for transaction costs incurred in connection with the original investment). Each selling stockholder should confirm its basis with its own tax advisors.
5. Company Consequences
The Company will not receive any proceeds from the sale of secondary shares and will not recognize any gain, loss, or income in connection with the secondary component of the IPO.
V. Qualified Small Business Stock (QSBS) — Section 1202 Analysis
V.A. Overview of Section 1202 Benefits
1. Federal Gain Exclusion
Section 1202 of the Code provides a significant tax benefit for eligible holders of "qualified small business stock" ("QSBS"): a partial or complete exclusion from federal income tax on gain from the sale or exchange of QSBS that has been held for more than five years. The exclusion percentage depends on the date the QSBS was acquired:
•  50% exclusion for stock acquired after August 10, 1993 and before February 18, 2009
•  75% exclusion for stock acquired after February 17, 2009 and before September 28, 2010
•  100% exclusion for stock acquired after September 27, 2010
Because Lumos was incorporated on March 14, 2016, all Lumos stock was necessarily acquired after September 27, 2010. Accordingly, if the QSBS requirements are satisfied, eligible stockholders may qualify for a 100% exclusion of gain on the sale of their Lumos QSBS.
2. Per-Issuer Gain Exclusion Limit
The amount of gain eligible for the Section 1202 exclusion is limited, on a per-issuer basis, to the greater of:
(a) $10,000,000 ($10 million), reduced by the aggregate amount of gain excluded with respect to prior sales of the same issuer's QSBS; or
(b) ten times the taxpayer's adjusted basis in the QSBS disposed of during the taxable year.
For founders and early investors with low basis in their Lumos stock, the 10× basis alternative may provide a significantly higher exclusion limit than the $10 million fixed cap, but the specific limit must be calculated on a case-by-case basis.
3. Significance for Lumos Stockholders
The potential availability of the Section 1202 exclusion is a matter of significant financial consequence for Lumos's founders, early investors, and employees. If founders Priya Subramanian and Marcus Henley are able to exclude 100% of federal capital gains tax on the sale of their Lumos shares (after holding for five or more years), the tax savings could be substantial, given the founders' low basis in their shares and the anticipated market capitalization at and following the IPO. Similarly, Ridgeline Capital Partners Fund II, L.P. (through its individual limited partners) and early employees who exercised options at low exercise prices may benefit from the exclusion.
V.B. QSBS Eligibility Requirements — Application to Lumos
To qualify as QSBS, stock must satisfy several requirements at the time of issuance and on an ongoing basis. We analyze each requirement below as applied to Lumos.
1. Domestic C-Corporation Requirement
Section 1202(c)(1) requires that the issuer be a "domestic corporation" that is a "C corporation" during substantially all of the taxpayer's holding period for the stock. Lumos is a corporation organized under the laws of the State of Delaware, a domestic jurisdiction, and has been taxed as a C-corporation since its incorporation on March 14, 2016. The Company has never elected S-corporation status and has not been treated as a partnership or disregarded entity for federal income tax purposes. This requirement is satisfied.
2. Active Business Requirement
Under Section 1202(e), at least 80% of the corporation's assets (by value) must be used in the active conduct of one or more "qualified trades or businesses." Certain trades or businesses are excluded from qualifying, including:
•  Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services (Section 1202(e)(3)(A));
•  Any banking, insurance, financing, leasing, investing, or similar business (Section 1202(e)(3)(B));
•  Any farming business (Section 1202(e)(3)(C));
•  Any business involving the production of natural resources (Section 1202(e)(3)(C));
•  Any hotel, motel, restaurant, or similar business (Section 1202(e)(3)(D)).
Lumos Analytics Inc. is a technology and software company that develops and licenses a cloud-based SaaS analytics platform for data visualization, predictive modeling, and business intelligence. The Company's customers include financial institutions, insurance companies, and other enterprises. A critical distinction must be drawn between a company that provides financial services (which is an excluded category) and a company that provides technology products to financial services companies (which is not excluded). Lumos does not itself perform financial services, brokerage services, or investment advisory services for its customers. Rather, it provides enterprise software tools that its customers use to conduct their own businesses. This distinction is well-supported by IRS guidance and legislative history, and we conclude that Lumos's business is a qualified trade or business for purposes of Section 1202.
Based on publicly available information and management representations, the substantial majority of the Company's assets are used in the active conduct of its software business (including intellectual property, computer equipment, office space and leasehold improvements, accounts receivable, and working capital necessary to fund operations). The 80% active business threshold should be satisfied.
3. Original Issuance Requirement
Section 1202(c)(1)(B) requires that the stock be acquired by the taxpayer at original issuance (directly or through an underwriter) in exchange for money, other property (not including stock), or as compensation for services. This requirement is satisfied for:
•  Founders (Subramanian and Henley): Stock issued directly by the Company in 2016 in exchange for cash and/or services.
•  Series A–D Investors: Stock purchased directly from the Company at original issuance in each financing round in exchange for cash.
•  Employees: Options exercised under the 2016 Plan, with stock issued directly by the Company upon exercise in exchange for the exercise price (cash).
We note that QSBS status is determined on a holder-by-holder basis. Stock acquired on the secondary market (e.g., in a private secondary transaction from an existing stockholder rather than from the Company) would not satisfy the original issuance requirement. We are not aware of any significant secondary transactions involving Lumos stock, but this should be confirmed with management.
4. Aggregate Gross Assets Test (the "$50 Million Test")
Section 1202(d)(1) provides that a corporation is a "qualified small business" only if its aggregate gross assets at all times from the date of the corporation's incorporation through the date of the stock issuance in question (and immediately after the issuance, taking into account amounts received in the issuance) do not exceed $50,000,000.
For purposes of this test, "aggregate gross assets" means the amount of cash and the aggregate adjusted tax bases of other property held by the corporation. See Section 1202(d)(2). This is a cumulative test — the corporation must never have had aggregate gross assets exceeding $50 million at any point from inception through the date of the issuance in question. Once the $50 million threshold is exceeded, any stock issued thereafter does not qualify as QSBS (though previously issued stock that was QSBS at the time of issuance retains its QSBS status).
We have analyzed the Company's aggregate gross assets at each significant stock issuance date, using the audited and unaudited financial statements provided by Meridian & Howe LLP (Gregory Simmons, Audit Partner) and management representations provided by David Lau, CFO. The detailed analysis is set forth in Appendix B. The key conclusions are as follows:
(a) At Founding/Initial Capitalization (March 2016). The Company's aggregate gross assets at inception were minimal — limited to the founders' initial capital contributions. The $50 million threshold was not approached.
(b) At Series A Close (June 20, 2018; $18 million raised). The Company's aggregate gross assets immediately after giving effect to the Series A proceeds were approximately $18 million (Series A cash proceeds) plus the adjusted tax bases of existing assets (estimated at less than $5 million, consisting primarily of cash, computer equipment, and leasehold improvements). Total aggregate gross assets were approximately $20–23 million. The $50 million threshold was not exceeded.
(c) At Series B Close (September 10, 2019; $45 million raised). The Company's aggregate gross assets immediately after giving effect to the Series B proceeds were approximately $63 million or more, consisting of $45 million in new Series B cash proceeds plus existing cash on hand and other assets accumulated since the Series A round. Based on our analysis, the Company's aggregate gross assets likely exceeded $50 million immediately after the Series B close, or very shortly thereafter. This is a close determination, and the precise figure depends on the Company's cash burn rate between the Series A and Series B rounds and the adjusted tax basis of assets acquired during that period. However, the weight of the evidence suggests that the $50 million threshold was crossed at or around the Series B close.
(d) At Series C Close (February 18, 2020; $72 million raised). The Company's aggregate gross assets were well in excess of $50 million, and would have been so even without the Series C proceeds.
(e) At Series D Close (August 24, 2020; $110 million raised). The Company's aggregate gross assets were significantly in excess of $50 million. As of December 31, 2021, the Company had $94.3 million in cash alone, which by itself exceeds the $50 million threshold.
5. Conclusion on QSBS Eligibility by Stockholder Category
Based on the foregoing analysis, the QSBS eligibility of Lumos stock varies by stockholder category:
Practical Impact:
•  Ridgeline Capital Partners Fund II, L.P. (Series A investor, 9,200,000 shares acquired June 2018): May hold QSBS. However, Ridgeline is a limited partnership, and the Section 1202 exclusion is available only to non-corporate taxpayers. The exclusion would flow through to Ridgeline's individual limited partners, each of whom would apply the Section 1202 requirements at the partner level. The five-year holding period from June 2018 would be satisfied by June 2023 — this holding period has not yet been satisfied at the time of the proposed IPO. Ridgeline is not a selling stockholder and is subject to the 180-day lock-up, so no immediate sale is contemplated.
•  Founders (shares issued 2016): Likely hold QSBS. The five-year holding period from March 2016 was satisfied by March 2021, and the founders' stock has been held for more than five years as of the date of this memorandum. The founders' Class B Common Stock will be subject to the lock-up period, and no immediate sale is contemplated. Upon a future sale following the lock-up expiration, the founders may be eligible for the 100% federal QSBS gain exclusion, subject to the per-issuer gain limit.
•  Early Employees: Employees who exercised stock options before the Company's aggregate gross assets exceeded $50 million (i.e., before approximately September 2019) may hold QSBS. A case-by-case analysis is required, based on the specific exercise date of each employee's options and the Company's aggregate gross assets at that time. The five-year holding period runs from the date of exercise, not the date of grant.
•  Velthryn and Arclight: Stock acquired by Velthryn (Series C and D) and Arclight (Series B and C) does not qualify as QSBS because the Company's aggregate gross assets exceeded $50 million at the time of those issuances. No Section 1202 exclusion is available to these investors.
V.C. Effect of the IPO on Existing QSBS Status
1. Key Question
A critical question for eligible QSBS holders is whether the IPO — and in particular, the recapitalization transactions occurring in connection with the IPO — causes previously issued QSBS to lose its qualification.
2. IPO Does Not Destroy Existing QSBS Status
The IPO itself does not cause existing QSBS to cease being QSBS. Section 1202 does not require that the issuer remain a private company or that the stock remain unlisted on a national securities exchange. As long as the Company continues to satisfy the active business requirement and other ongoing conditions after the IPO, existing QSBS retains its qualification. The aggregate gross assets test is applied only at the time of stock issuance; it is not an ongoing requirement. Thus, the fact that the Company's aggregate gross assets will increase significantly following the IPO (due to the influx of approximately $205.7 million in net proceeds) does not retroactively disqualify previously issued QSBS.
3. Effect of Preferred-to-Common Conversion (Recapitalization)
Under Section 1202(h)(4)(A), stock acquired by a taxpayer through a conversion described in Section 1036 or by reason of a reorganization described in Section 368 is treated as QSBS in the hands of the taxpayer if the stock so converted or exchanged was QSBS in the hands of the taxpayer immediately before such conversion or exchange. The conversion of preferred stock to Class A Common Stock in connection with the IPO qualifies as a recapitalization under Section 368(a)(1)(E), as discussed in Part IV.A above. Accordingly, for holders of Series A Preferred Stock whose shares qualified as QSBS at the time of issuance, the Class A Common Stock received upon conversion should be treated as QSBS under Section 1202(h)(4)(A). The holding period of the surrendered preferred stock tacks to the Class A Common Stock received.
4. Effect of Dual-Class Reclassification on Founders' QSBS
Similarly, the reclassification of the founders' common stock as Class B Common Stock in the dual-class recapitalization qualifies as a recapitalization under Section 368(a)(1)(E). Under Section 1202(h)(4)(A), the founders' Class B Common Stock should retain QSBS status if the original common stock qualified as QSBS at the time of its issuance in 2016. The holding period tacks.
5. Post-IPO Active Business Requirement Concern
While existing QSBS is not retroactively disqualified by the IPO, the Company must continue to satisfy the active business requirement (the 80% asset test) on an ongoing basis during each stockholder's holding period. The influx of approximately $205.7 million in net IPO proceeds in cash raises a potential concern: if the Company holds excessive cash or passive investments (such as marketable securities held for investment) rather than deploying the proceeds in its active business, the 80% active business asset threshold could be jeopardized.
The IRS has acknowledged that a corporation may hold cash and other liquid assets as "reasonable working capital" without those assets being treated as passive assets that count against the 80% threshold, provided the cash is held in connection with a specific, definite, and feasible plan for the use of such amounts in the active business. See Section 1202(e)(6) (providing a two-year safe harbor for working capital held for specific business purposes). However, the safe harbor has limitations, and the general rule is that cash and investments not actively used in the business may jeopardize QSBS status if they cause passive assets to exceed 20% of total corporate assets.
6. Recommendation: QSBS-Compliant Use of Proceeds
We recommend that Calderwood & Harkness advise Lumos management on QSBS-compliant use of IPO proceeds. The draft S-1 states that the Company intends to use the net proceeds for general corporate purposes, including working capital, research and development investment, and potential strategic acquisitions. This intended use of proceeds is generally consistent with the active business requirement, but formal QSBS compliance planning is advisable to ensure that:
(a) IPO proceeds are deployed in the active business within a reasonable period of time;
(b) The Company maintains documentation of specific, definite, and feasible plans for the use of any cash held as working capital, in order to avail itself of the Section 1202(e)(6) safe harbor;
(c) Any investments of idle cash are made in a manner consistent with the working capital safe harbor (e.g., short-term, liquid investments rather than long-term passive investments); and
(d) The Company monitors its asset composition on a quarterly basis to confirm ongoing compliance with the 80% active business threshold.
V.D. Selling Stockholders and QSBS
The QSBS implications for the selling stockholders in the secondary component of the IPO are as follows:
•  Velthryn Venture Partners Fund IV, L.P. (selling up to 2,000,000 shares): Velthryn acquired its Lumos stock in the Series C round (February 2020) and the Series D round (August 2020). At both issuance dates, the Company's aggregate gross assets exceeded $50 million. Accordingly, Velthryn's stock does not qualify as QSBS, and no Section 1202 gain exclusion is available with respect to the secondary shares being sold.
•  Arclight Equity Group Fund VII, L.P. (selling up to 1,500,000 shares): Arclight acquired its Lumos stock in the Series B round (September 2019) and the Series C round (February 2020). For the Series B shares, the determination is a close call — the Company's aggregate gross assets likely exceeded $50 million immediately after the Series B close, though the precise figure is subject to some uncertainty (see Appendix B). For the Series C shares, the $50 million threshold was clearly exceeded. On balance, no QSBS exclusion is expected to be available to Arclight with respect to the secondary shares being sold.
•  Ridgeline Capital Partners Fund II, L.P.: Ridgeline is not a selling stockholder and is subject to the 180-day lock-up agreement. Ridgeline's Series A stock (acquired June 2018) may qualify as QSBS, and the five-year holding period will be satisfied by June 2023 at the earliest. The Section 1202 exclusion would be available to Ridgeline's individual limited partners upon a future sale after the holding period is satisfied, subject to the per-issuer gain limits and other requirements. We note that as a partnership, Ridgeline itself does not claim the Section 1202 exclusion — the exclusion flows through to its individual partners.
V.E. QSBS Recommendations
Based on the foregoing analysis, we recommend the following actions:
1.  QSBS Compliance Memorandum for Management. Calderwood & Harkness should prepare a separate, detailed QSBS compliance memorandum for Lumos management, setting forth: (a) a complete list of stockholders who hold potential QSBS, with the applicable issuance dates and estimated aggregate gross assets at each issuance; (b) the applicable five-year holding periods for each eligible stockholder; (c) the ongoing QSBS compliance requirements that must be maintained post-IPO, including the active business requirement and working capital safe harbor procedures; and (d) recommended use-of-proceeds monitoring procedures to be implemented by the CFO.
2.  Founder Advisory. Advise Priya Subramanian and Marcus Henley that their Class B Common Stock should retain QSBS treatment following the dual-class reclassification, by operation of Section 1202(h)(4)(A). Additionally, advise the founders that a transfer of Class B shares to a non-permitted transferee (which triggers automatic conversion to Class A under the sunset provision) should not destroy QSBS status, as such conversion would also be treated as a recapitalization within the meaning of Section 1202(h)(4)(A). However, the founders should be aware that any sale of shares within the first five years of the original holding period (now satisfied) or in excess of the per-issuer gain exclusion limit would not benefit from the exclusion.
3.  General Stockholder Advisory. All eligible stockholders should be advised to consult their own tax advisors regarding individual QSBS eligibility, per-issuer gain limits, and the interaction of Section 1202 with state tax law (particularly California, as discussed in Part VI.B below).
VI. State Tax Nexus Analysis
VI.A. Overview
Lumos is qualified to do business and files tax returns in four states: California, New York, Texas, and Illinois. The state tax implications of the IPO must be analyzed from two perspectives: (1) the impact on the Company's state-level corporate income and franchise tax obligations, and (2) the impact on individual and entity-level stockholders who are residents of, or have nexus with, these states.
The following analysis addresses the principal state tax considerations in each jurisdiction. This is not a comprehensive state tax analysis and does not cover all possible state and local tax implications. We recommend that Lumos engage a state and local tax specialist to perform a detailed nexus study and apportionment analysis in connection with the IPO and on an ongoing basis thereafter.
VI.B. California
1. Company Nexus and Tax Obligations
Lumos is headquartered at 450 Folsom Street, Suite 1200, San Francisco, California 94105, and the majority of the Company's employees are located in California. California is the Company's principal place of business, and the Company is subject to the California franchise tax under the California Revenue and Taxation Code ("CRTC"). As a C-corporation doing business in California, Lumos is subject to the California franchise tax at a rate of 8.84% on its net income apportioned to California.
California employs a single-sales-factor apportionment formula for most business types, pursuant to CRTC § 25128.7. Under this formula, the Company's California-source income is determined by multiplying its total business income by the ratio of its California sales to its total sales everywhere. As a SaaS company, the sourcing of Lumos's revenue to California depends on the location of its customers and the market-based sourcing rules applicable to sales of services and intangibles under CRTC § 25136.
2. Impact of IPO Proceeds
The gross proceeds received by the Company from the IPO (approximately $220 million) are not income for California franchise tax purposes. The receipt of cash in exchange for the issuance of the Company's own stock is a capital contribution, not taxable income. There is no California franchise tax consequence to the Company from the receipt of IPO proceeds.
3. California Non-Conformity With Section 1202 (QSBS)
This is a critical issue for California-resident stockholders, including the founders. California does not conform to the federal Section 1202 QSBS gain exclusion. CRTC § 18152.5 provides a much more limited California-specific exclusion for qualified small business stock, and that exclusion has been effectively suspended for taxable years beginning on or after January 1, 2012 (pursuant to CRTC § 18152.5(i)). Accordingly, California stockholders — including founders Priya Subramanian and Marcus Henley, who are presumed to be California residents — will not receive any state-level gain exclusion on the sale of QSBS, even if they qualify for the 100% federal exclusion under Section 1202.
The practical consequence is significant: even if the founders pay zero federal income tax on gain from a future sale of their Lumos shares (by virtue of the Section 1202 exclusion), they will owe California personal income tax at the highest marginal rate (currently 13.3%) on the full amount of the gain. Given the founders' substantial holdings and low basis, the California tax liability on a future sale could be tens of millions of dollars.
We recommend that this non-conformity be noted in the S-1 risk factors and investor communications as appropriate, and that the founders be advised to consult with personal tax counsel regarding California tax planning strategies, including the potential implications of any change of residence prior to a sale of shares.
4. Employee Stock Option Exercises
California sources income from stock option exercises based on an allocation of the employee's service period between the grant date and the exercise date (or vesting date, for ISOs). If an employee was employed in California during the period from the option grant date to the exercise date, a portion (or all) of the option exercise income will be sourced to California. For employees who have been employed in California for the entire period from grant to exercise, 100% of the option exercise income will be California-source income. California personal income tax ("PIT") withholding and state disability insurance ("SDI") obligations apply. This issue is discussed further in Part VII.
VI.C. New York
1. Company Nexus and Tax Obligations
Lumos is qualified to do business in the State of New York and maintains nexus with New York through its business activities, employee presence, and customer relationships in the state. Additionally, several key parties to the IPO are located in New York, including Calderwood & Harkness LLP (New York office at 425 Lexington Avenue, 42nd Floor, New York, New York 10017), Arclight Equity Group (780 Third Avenue, 22nd Floor, New York, New York 10017), and Pinnacle Securities LLC (399 Park Avenue, New York, New York 10022).
As a corporation doing business in New York, Lumos is subject to the New York corporate franchise tax under Article 9-A of the New York Tax Law. New York imposes a tax on the greater of apportioned business income, the business capital base, or a fixed dollar minimum. New York uses a single-receipts-factor apportionment formula for purposes of the business income base.
2. Impact of IPO Proceeds
The gross proceeds received by the Company from the IPO are not taxable income for New York corporate franchise tax purposes. As with the federal analysis, the receipt of cash in exchange for the Company's own stock is a capital contribution and not subject to tax. There is no New York franchise tax consequence from the receipt of IPO proceeds.
3. New York QSBS Treatment
New York does not fully conform to the federal Section 1202 QSBS gain exclusion. New York Tax Law § 612(c)(28) provides a partial exclusion from New York personal income tax for gain from the sale of QSBS, but the exclusion is subject to limitations and is generally less generous than the federal exclusion. Specifically, New York's exclusion is based on the pre-2003 version of Section 1202, which provided only a 50% exclusion (rather than the 100% exclusion available under current federal law). Moreover, the excluded gain may be subject to the New York alternative minimum tax.
Selling stockholders who are New York residents or New York-based entities should be aware of these limitations and should consult their own tax advisors regarding the New York treatment of any QSBS gain.
4. Capital Gains Tax for New York-Resident Stockholders
Selling stockholders who are New York residents (or who are subject to New York taxation on their capital gains) will be subject to New York personal income tax on the gain recognized from the sale of their secondary shares. The New York personal income tax rate for high-income individuals is currently as high as 10.9% (including the temporary surcharge enacted in 2021). In addition, New York City residents are subject to New York City personal income tax at rates up to 3.876%. Capital gains on stock sales by New York-resident entities (such as partnerships and LLCs) are generally taxed at the partner/member level.
VI.D. Texas
1. Company Nexus and Tax Obligations
Lumos is qualified to do business in the State of Texas. Texas does not impose a personal income tax