PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE / ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP
MEMORANDUM
From: Garrett Simmons, Lead Associate, Tax Leila Nazari, Working Associate, Tax
To: Sylvia Hartwell, Responsible Partner, Tax Leonard Cross, Billing Partner, Tax
Date: August 6, 2025
Re: Section 1202 QSBS Preservation Analysis — Contribution of Portfolio Company Shares from Pinnacle Venture Fund II LP to Pinnacle Continuation Vehicle LP
Engagement Reference No.: 1002-00005
Matter No.: 117443.00001
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I. Executive Summary
This memorandum analyzes whether the proposed contribution of portfolio company shares held by Pinnacle Venture Fund II LP (EIN 84-3291067), a Delaware limited partnership ("Fund II"), to Pinnacle Continuation Vehicle LP ("PCV" or the "CV"), a Delaware limited partnership to be formed, via a contribution intended to qualify under Section 721 of the Internal Revenue Code of 1986, as amended (the "Code"), preserves qualified small business stock ("QSBS") status under Section 1202 of the Code. The analysis is prepared for the engagement team in advance of the comprehensive Tax Structure Memorandum due August 8, 2025, and is intended to identify key legal issues, risk factors, and diligence items that must be addressed prior to closing.
Three portfolio companies are at issue in this transaction: (1) Luminos Systems Inc. (EIN 47-8823156), an AI-powered revenue operations platform headquartered in San Francisco, California; (2) ClearArc Software Inc. (EIN 83-5519274), a cloud-native compliance and audit automation company headquartered in Austin, Texas; and (3) Vectral Cloud Inc. (EIN 85-1102847), a multi-cloud infrastructure orchestration and FinOps platform headquartered in Denver, Colorado. All three companies are Delaware C-corporations.
The aggregate fair market value of Pinnacle's stakes in these three companies, based on the most recently available 409A valuations and secondary market data as of June 2025, is approximately $1.34 billion ($612 million attributable to Luminos, $468 million attributable to ClearArc, and $260 million attributable to Vectral). Fund II's aggregate original cost basis in these shares is approximately $138 million ($58.5 million for Luminos, $37.4 million for ClearArc, and $42.1 million for Vectral), reflecting aggregate unrealized gain of approximately $1.202 billion across the three positions.
Key Conclusion. If the transaction is properly structured as a Section 721 contribution (partnership-to-partnership), QSBS status should be preserved for (a) the Luminos shares and the ClearArc shares, for which the five-year statutory holding period under Section 1202(a) will already have been satisfied at the time of the CV closing, and (b) the Vectral shares, for which holding period tacking should apply under Section 1202(h)(4) in conjunction with Section 1223(1), with the five-year period completing approximately March 2026. The rolling limited partners who were partners of Fund II at the time of the original stock acquisitions should retain their eligibility to claim the Section 1202 exclusion at the partner level, subject to the per-taxpayer and per-issuer exclusion ceilings.
Key Risk. The most significant risk relates to Vectral Cloud. First, Vectral's aggregate gross assets at the time of its Series B issuance in March 2021 were near the $50 million statutory threshold set forth in Section 1202(d)(1). If Vectral's aggregate gross assets exceeded $50 million at any time on or before the date of the Series B issuance (including the proceeds of the Series B round itself), the shares would fail to qualify as QSBS ab initio, and no amount of structural engineering can remedy that deficiency. This requires immediate and thorough factual diligence. Second, because the five-year holding period for Vectral shares will not be satisfied until approximately March 2026 — roughly five months after the target CV closing date of October 31, 2025 — any recharacterization of the Section 721 contribution as a sale or exchange (for example, under the disguised sale rules of Section 707(a)(2)(B)) could terminate QSBS eligibility for the Vectral shares.
California State Tax Caveat. California does not conform to the Section 1202 QSBS exclusion. Gains allocated to California residents or sourced to California under applicable apportionment rules will be subject to California personal income tax at rates up to 13.3%. This exposure exists regardless of the federal QSBS exclusion and represents a material tax cost for California-resident limited partners and for gains from portfolio companies headquartered in California.
Recommendations. We recommend that (a) the transfer be structured as a Section 721 contribution, (b) the CV's limited partnership agreement (the "CV LPA") and a dedicated Tax Protection Agreement include specific holding covenants and representations designed to preserve Section 1202 qualification, with particular emphasis on a covenant prohibiting disposition of Vectral shares before March 2026, (c) the engagement team complete the outstanding diligence items identified in Section VII of this memorandum on an expedited basis, and (d) the QSBS preservation analysis be incorporated into the Section 721 Tax Opinion Letter as a covered matter.
II. Background and Transaction Overview
A. Pinnacle Venture Fund II LP
Pinnacle Venture Fund II LP ("Fund II") is a Delaware limited partnership formed pursuant to the Delaware Revised Uniform Limited Partnership Act. Fund II's Delaware Limited Partnership File Number is DE-LP-2019-04817, and its federal Employer Identification Number is 84-3291067. Fund II was organized in 2019 as the second flagship venture capital fund managed by the Pinnacle Capital Management platform.
The general partner of Fund II is Pinnacle Capital Partners II LLC, a Delaware limited liability company (EIN 84-3291104), which has sole authority and discretion with respect to the management and investment activities of Fund II pursuant to the Fund II Limited Partnership Agreement dated as of September 15, 2019, as amended. The management company responsible for the day-to-day operations of the fund is Pinnacle Capital Management LLC, a Delaware limited liability company (EIN 82-6140538), with its principal office located at 2100 Sand Hill Road, Suite 340, Menlo Park, California 94025.
Fund II is a 2019-vintage venture capital fund that held its final closing in December 2019. Total committed capital from all limited partners is $875 million, of which approximately $831.25 million (representing approximately 95% of total commitments) has been drawn as of the date of this memorandum. As of June 30, 2025, Fund II's gross net asset value was approximately $1.82 billion, and its net net asset value (after deduction of accrued management fees, carried interest reserves, and fund-level expenses) was approximately $1.56 billion.
The key principals of the Pinnacle platform relevant to this transaction are:
• Marcus Aldren, Founder and Managing Partner, who holds approximately 62% of the general partner economics (carried interest and management fee participation);
• Diana Tsao, Co-Managing Partner, who holds approximately 28% of the general partner economics; and
• Rafael Montoya, Partner, who holds approximately 10% of the general partner economics.
Mr. Aldren and Ms. Tsao are the principal decision-makers with respect to the continuation vehicle transaction and have engaged Calderwood & Harkness LLP in connection therewith.
B. Proposed Continuation Vehicle Structure
The proposed transaction involves the formation of Pinnacle Continuation Vehicle LP (the "CV" or "PCV"), a new Delaware limited partnership that will serve as the vehicle through which the Pinnacle management team continues to manage the three portfolio company positions described in this memorandum beyond the scheduled term of Fund II.
The general partner of the CV will be Pinnacle CV Partners LLC, a Delaware limited liability company to be formed in connection with the closing of the transaction. The CV general partner will be controlled by the same key principals (Aldren, Tsao, and Montoya) and will have investment authority and discretion substantially similar to that of Fund II's general partner, subject to such governance modifications as may be agreed with the incoming secondary buyer and the rolling limited partners.
The total capitalization of the CV at closing is expected to be approximately $1.074 billion, composed of the following sources:
Garrison Secondaries Fund IV LP is the lead secondary buyer in the transaction, managed by Garrison Capital Advisors LLC. The lead partner at Garrison for this transaction is Mitchell Adler. Garrison is providing $380 million of new cash capital, which will be used to fund the liquidity offered to cashing-out Fund II limited partners who elect not to roll into the CV. Garrison has separate legal counsel in this transaction, namely Whitfield & Calloway LLP (Douglas Whitfield, Partner).
The target first close of the CV is October 15, 2025, with a target final close of October 31, 2025. The LP election deadline for Fund II limited partners to choose between rolling into the CV or cashing out is expected to be on or around September 15, 2025.
At closing, the CV will receive Fund II's stakes in all three portfolio companies — Luminos Systems Inc., ClearArc Software Inc., and Vectral Cloud Inc. — via contribution from Fund II. The mechanism by which these shares are transferred to the CV, and the tax consequences of that transfer, are the central subject of this memorandum.
C. Portfolio Companies — Summary
The following table summarizes key information regarding the three portfolio companies whose shares are being contributed to the CV:
All three portfolio companies are enterprise software companies operating in the software-as-a-service ("SaaS") model. Each company is organized as a Delaware C-corporation, which is a threshold requirement for QSBS eligibility under Section 1202. The enterprise valuations referenced above are based on the most recently completed 409A valuations and secondary market indicators as of June 2025 and are subject to adjustment at the CV closing based on customary valuation procedures to be agreed between Fund II and Garrison.
Luminos Systems Inc. is an AI-powered revenue operations platform that serves enterprise SaaS companies. Pinnacle invested in Luminos through its Series B round in Q1 2020 and subsequently participated in the company's Series C financing. Luminos has experienced significant growth since Fund II's initial investment and is currently one of Fund II's top-performing positions, with a fair market value of approximately $612 million on a cost basis of $58.5 million — an unrealized multiple of approximately 10.5x.
ClearArc Software Inc. is a cloud-native compliance and audit automation platform that serves enterprise customers, particularly in the financial services sector. Pinnacle led ClearArc's Series A round in Q2 2020 and subsequently participated in the Series B. ClearArc's fair market value of approximately $468 million on a cost basis of $37.4 million represents an unrealized multiple of approximately 12.5x. We note that while ClearArc serves financial services customers, the company itself is a software company — a distinction that is relevant to the active business requirement analysis under Section 1202(e)(3), as discussed below.
Vectral Cloud Inc. is a multi-cloud infrastructure orchestration and financial operations ("FinOps") platform. Pinnacle invested in Vectral through its Series B round in March 2021 in a single tranche. Vectral's fair market value of approximately $260 million on a cost basis of $42.1 million represents an unrealized multiple of approximately 6.2x. As discussed extensively in this memorandum, Vectral presents the most significant QSBS risk factors among the three portfolio companies.
D. LP Base and blocker Architecture Context
In connection with the CV formation, certain classes of limited partners will invest through intermediate "Blocker" entities rather than directly into the CV. This blocker architecture is relevant to the QSBS analysis because the interposition of a blocker entity between the limited partner and the portfolio company shares raises distinct questions about the availability of the Section 1202 exclusion.
Domestic blocker. Two tax-exempt limited partners will route their investments through PCV Domestic blocker Inc., a Delaware C-corporation to be formed in connection with the CV closing:
• Meridian Public Employees' Retirement System — $125 million commitment
• Ashford University Endowment — $50 million commitment
• Total capital through the Domestic blocker: $175 million
The Domestic blocker structure is designed to prevent the allocation of unrelated business taxable income ("UBTI") to these tax-exempt investors, a standard structural feature in fund continuation vehicle transactions. The UBTI analysis is addressed in a separate memorandum.
International blocker. One non-U.S. limited partner will route its investment through PCV International Holdings Ltd., a Cayman Islands exempted company to be formed:
• Sovereign Capital Partners (Cayman) Ltd. — $75 million commitment
• Total capital through the International blocker: $75 million
The International blocker structure is designed to mitigate exposure to effectively connected income ("ECI") and Foreign Investment in Real Property Tax Act ("FIRPTA") withholding obligations. The FIRPTA and ECI analysis is addressed in a separate memorandum.
In aggregate, $250 million of the CV's total capitalization of $1.074 billion (approximately 23.3%) will be invested through blocker entities. The participation of these blocker entities is relevant to the Section 1202 analysis because blocker entities that are C-corporations hold partnership interests indirectly, and the per-taxpayer exclusion analysis differs when the "taxpayer" claiming the exclusion is a corporate entity rather than an individual. As discussed in Section V.F below, the blocker entities themselves are unlikely to independently qualify for QSBS treatment because they did not acquire the portfolio company shares at original issuance. Moreover, the underlying tax-exempt and non-U.S. investors generally do not benefit from the Section 1202 exclusion for separate reasons (tax-exempt investors are not subject to capital gains tax in the first instance, and non-U.S. investors are generally not eligible for the exclusion as non-U.S. taxpayers).
III. Section 1202 QSBS Framework — Legal Overview
A. Statutory Requirements for QSBS Eligibility (Section 1202(c)–(e))
Section 1202 of the Code provides for a partial or complete exclusion from gross income of gain realized on the sale or exchange of "qualified small business stock" held for more than five years. The provision was originally enacted as part of the Revenue Reconciliation Act of 1993 and has been amended on several occasions, most significantly by the Creating Small Business Jobs Act of 2010, which increased the exclusion percentage to 100% for stock acquired after September 27, 2010. The purpose of Section 1202 is to incentivize investment in small businesses by reducing the tax burden on long-term capital gains from such investments.
Definition of Qualified Small Business Stock. Under Section 1202(c), stock qualifies as QSBS if it satisfies three independent requirements:
(1) The stock must be stock in a domestic C-corporation that is a "qualified small business" (as defined in Section 1202(d)) at the time of issuance. Section 1202(c)(1)(A).
(2) The stock must be acquired by the taxpayer at its "original issuance" (directly or through an underwriter) in exchange for money, property (other than stock), or as compensation for services provided to the corporation. Section 1202(c)(1)(B). This original issuance requirement is one of the most critical elements of QSBS eligibility — stock acquired in the secondary market (i.e., from another shareholder rather than from the issuing corporation) does not qualify as QSBS, except as specifically provided in the tacking rules of Section 1202(h).
(3) At the time of issuance, the corporation must meet the active business requirements of Section 1202(e). Section 1202(c)(2).
Qualified Small Business Definition. Section 1202(d) defines a "qualified small business" as a domestic C-corporation whose "aggregate gross assets" do not exceed $50 million at any time from August 10, 1993 through and including immediately after the issuance of the stock in question. Section 1202(d)(1). For purposes of this test, "aggregate gross assets" means the amount of cash and the aggregate adjusted bases of other property held by the corporation. Section 1202(d)(2)(A). Importantly, this test is measured immediately after the issuance — meaning that the proceeds received by the corporation in the very round at which the QSBS was issued are included in the aggregate gross assets calculation. This is a trap for the unwary, and it is the specific source of the diligence concern regarding Vectral Cloud, as discussed in detail in Section IV.C and Section VII.A below.
Active Business Requirement. Section 1202(e)(1) requires that during substantially all of the taxpayer's holding period for the stock, at least 80% (by value) of the assets of the corporation must be used in the active conduct of one or more "qualified trades or businesses." A "qualified trade or business" is defined broadly but excludes certain specified categories of business, 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, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Section 1202(e)(3)(A).
• Any banking, insurance, financing, leasing, investing, or similar business. Section 1202(e)(3)(B).
• Any farming business (including the business of raising or harvesting trees). Section 1202(e)(3)(C).
• Any business involving the production or extraction of products for which percentage depletion is allowable. Section 1202(e)(3)(D).
• Any hotel, motel, restaurant, or similar business. Section 1202(e)(3)(E).
All three portfolio companies in this transaction are enterprise software companies. Software and SaaS businesses are generally treated as qualifying trades or businesses for purposes of Section 1202(e), as they do not fall within any of the enumerated exclusion categories. This is a well-established position supported by IRS guidance and practitioner consensus. We address the specific question of whether ClearArc's provision of services to financial services customers renders ClearArc itself a "financial services" business in Section IV.B.2 below (short answer: it does not).
Holding Period Requirement. Section 1202(a) conditions the gain exclusion on the taxpayer holding the QSBS for a period of more than five years. This is a strict calendar holding period measured from the date the taxpayer acquires the QSBS to the date of the sale or exchange. If the stock is disposed of before the five-year holding period is satisfied, the gain does not qualify for the Section 1202 exclusion (though the taxpayer may be eligible for a partial deferral under Section 1045 if the stock was held for more than six months and the proceeds are reinvested in other QSBS within 60 days). The holding period requirement is the principal source of risk for the Vectral Cloud position, as discussed extensively below.
B. Gain Exclusion Mechanics (Section 1202(a)–(b))
Exclusion Percentage. For QSBS acquired after September 27, 2010, Section 1202(a)(4) provides that 100% of the gain from the sale or exchange of such stock is excluded from gross income, provided all other requirements are satisfied. Because all three of Pinnacle's portfolio company investments were made in the 2020–2021 time frame, the 100% exclusion percentage applies to all shares at issue in this transaction.
For historical reference, the exclusion percentage for stock acquired before September 28, 2010 varies depending on the date of acquisition: 50% for stock acquired before February 18, 2009; 75% for stock acquired between February 18, 2009 and September 27, 2010. These historical rates are not applicable here.
Per-Taxpayer Exclusion Ceiling. Section 1202(b) limits the amount of gain eligible for the exclusion on a per-taxpayer, per-issuer basis. Specifically, the cumulative amount of gain that a taxpayer may exclude with respect to stock in any single corporation is the greater of:
(i) $10 million, reduced by the aggregate amount of gain excluded by the taxpayer under Section 1202 with respect to stock of the same corporation in prior taxable years; or
(ii) 10 times the taxpayer's aggregate adjusted basis in all qualified small business stock of the corporation disposed of during the taxable year.
This ceiling is applied on a per-issuer, per-taxpayer basis, meaning that each taxpayer has a separate exclusion ceiling for stock in each portfolio company, and the ceiling is not aggregated across issuers.
Partner-Level Application. A critical structural feature of Section 1202, particularly in the venture capital fund context, is that the gain exclusion and the per-taxpayer exclusion ceiling are applied at the partner level, not at the partnership level. Section 1202(g) makes clear that the determination of whether stock held by a partnership qualifies as QSBS is made at the partner level, and each partner of the partnership is treated as a separate "taxpayer" for purposes of the $10 million / 10× ceiling. This means that the QSBS benefit is effectively multiplied across the partnership's LP base — each individual partner who was a partner of the fund at the time the QSBS was acquired has his or her own $10 million (or 10× basis) exclusion ceiling.
This partner-level application is one of the most significant tax benefits available to venture capital fund investors and is a primary motivation for preserving QSBS status in the continuation vehicle transaction.
C. Special Rules for Partnerships (Section 1202(g) and (h))
Section 1202(g) — Pass-Through Treatment. Section 1202(g)(1) provides that stock held by a pass-through entity (including a partnership) is treated as meeting the QSBS requirements at the entity level if the requirements are met at the partner (or member or shareholder) level. More specifically, under Section 1202(g)(2), if a partnership acquires QSBS at original issuance, any person who is a partner in the partnership at the time the partnership acquires the stock is treated as having acquired a proportionate share of the stock at original issuance. This is the foundational provision that allows Fund II's limited partners to claim QSBS treatment on their allocable share of gain from the portfolio company shares.
An important corollary: only those limited partners who were partners of Fund II at the time the respective portfolio company shares were acquired are eligible for QSBS treatment. Limited partners who were admitted to Fund II after the date of acquisition of a particular portfolio company's shares do not satisfy the original issuance requirement with respect to those shares. For the current transaction, the relevant consideration is whether the rolling LPs were partners of Fund II at the time of each investment (Q1 2020 for Luminos, Q2 2020 for ClearArc, and March 2021 for Vectral). Because Fund II held its final close in December 2019 and all three investments were made after that date, all Fund II limited partners should have been admitted by the time of each investment, but this should be confirmed.
Section 1202(h) — Tacking Rules. Section 1202(h) sets forth the circumstances under which QSBS status (and the associated holding period) can be preserved when stock is transferred from one person to another. The subsection provides several specific tacking rules:
Section 1202(h)(1) — Transfers at Death. Stock acquired from a decedent (with basis determined under Section 1014) is treated as QSBS in the hands of the person acquiring the stock from the decedent if the stock was QSBS in the hands of the decedent.
Section 1202(h)(2) — Transfers by Gift. QSBS transferred by gift retains its QSBS character in the hands of the donee, and the donee tacks the donor's holding period under Section 1223(2).
Section 1202(h)(4) — Certain Partnership Transactions. This provision is the most directly relevant to the current transaction. Section 1202(h)(4)(A) provides that QSBS that is distributed by a partnership to a partner is treated as having been held by the distributee partner during the period the partnership held the stock, provided the partner was a partner at the time the partnership acquired the stock. Similarly, the legislative history and subsequent guidance indicate that Section 1202(h)(4)(B) (as subsequently clarified) extends this tacking treatment to contributions of QSBS to a partnership under Section 721.
Critical Question. The central question for this transaction is whether a Section 721 contribution from one partnership (Fund II) to another partnership (the CV) qualifies for holding period tacking under Section 1202(h)(4). This question is analyzed in detail in Section V.B below.
IV. Analysis — QSBS Status of Each Portfolio Company
A. Luminos Systems Inc.
1. Original Issuance and Acquisition
Pinnacle Venture Fund II LP acquired shares of Luminos Systems Inc. at original issuance in the first quarter of 2020 through Luminos's Series B preferred stock financing. Fund II subsequently participated in Luminos's Series C preferred stock financing, acquiring additional shares at original issuance in that round as well. The aggregate cost basis for Fund II's Luminos shares across the Series B and Series C rounds is $58.5 million.
Because the shares were acquired directly from Luminos in exchange for cash at the time of each respective financing round, the shares satisfy the original issuance requirement of Section 1202(c)(1)(B). There is no indication that any of the Luminos shares were acquired in secondary transactions or from existing shareholders. Fund II was an existing partnership at the time of both the Series B and Series C acquisitions — indeed, Fund II had completed its final close in December 2019, prior to the Q1 2020 Series B investment — and accordingly the partner-level eligibility requirements of Section 1202(g) are satisfied for all partners who were admitted to Fund II on or before the Series B closing date.
2. Qualified Small Business Status
Luminos Systems Inc. is organized as a Delaware C-corporation, which satisfies the domestic C-corporation requirement for QSBS eligibility. The company's aggregate gross assets at the time of the Series B issuance in Q1 2020 have been confirmed to be below the $50 million threshold of Section 1202(d)(1). At the time of the Series B round, Luminos was an early-growth-stage company that had not yet accumulated assets sufficient to approach the statutory ceiling. Accordingly, the gross asset test is satisfied with respect to the Series B shares.
With respect to the Series C shares, the gross asset test must be independently satisfied at the time of the Series C issuance. However, because the $50 million threshold is measured based on the aggregate adjusted bases of assets held by the corporation (not fair market value), and because the Series C was a subsequent round conducted at a higher valuation but not necessarily reflecting a commensurately higher adjusted basis of corporate assets, we believe it is likely that the gross asset test was also satisfied at the time of the Series C issuance. We recommend confirming this with Luminos management and the company's auditors for completeness, though the risk is considered low.
Luminos's business — an AI-powered revenue operations platform serving enterprise SaaS companies — is a qualifying trade or business under Section 1202(e). The company develops and licenses proprietary software, which is a technology business that does not fall within any of the excluded categories enumerated in Section 1202(e)(3). There is no indication that Luminos engages in financial services, professional services, or any other excluded activity. Luminos satisfies the active business requirement.
3. Holding Period
The Series B shares were acquired in Q1 2020. As of August 2025, more than five years and four months have elapsed since the date of acquisition. The five-year holding period required under Section 1202(a) is therefore satisfied with respect to the Series B shares.
For the Series C shares, the specific acquisition date must be verified. If the Series C closed in, for example, Q3 or Q4 of 2020, the five-year holding period for those shares would be satisfied by Q3 or Q4 of 2025, which falls on or before the CV target final close of October 31, 2025. In any event, by the time of the CV closing, the Luminos QSBS holding period will have been satisfied for approximately two to three months (or longer, depending on the specific Series C closing date).
4. Exclusion Ceiling Analysis
The per-taxpayer exclusion ceiling for Luminos QSBS is the greater of (i) $10 million or (ii) 10 times the taxpayer's adjusted basis in the Luminos stock.
Fund II's aggregate adjusted basis in Luminos stock is $58.5 million. Accordingly, at the partnership level, the 10× ceiling is $585 million. However, as noted above, the exclusion ceiling is applied at the partner level, not at the partnership level. Each individual limited partner of Fund II (and, following the contribution, each rolling LP of the CV) is a separate taxpayer with his or her own exclusion ceiling. The aggregate exclusion available across all partners will depend on the number of eligible partners, their respective adjusted bases in the Luminos stock (as allocated under the partnership agreement), and their individual tax situations.
The current fair market value of Fund II's Luminos stake is $612 million, reflecting unrealized gain of $553.5 million ($612 million minus $58.5 million basis). The partner-level 10× ceiling of $585 million per taxpayer is well in excess of the total gain if applied to a single taxpayer. In practice, because the gain will be allocated among multiple partners, each partner's share of the gain should be comfortably within his or her individual exclusion ceiling.
We note that the allocation of gain among the CV's partners (including between rolling LPs and new investors such as Garrison) will be governed by the Section 704(c) allocation methodology adopted by the CV. The Section 704(c) remedial allocation method, which we are recommending in a separate memorandum, should ensure that pre-contribution built-in gain is allocated to the rolling LPs (who are QSBS-eligible) rather than to Garrison (which is not QSBS-eligible), thereby maximizing the aggregate QSBS benefit.
5. QSBS Preservation Conclusion — Luminos
Based on the foregoing analysis, the Luminos QSBS position presents a low risk profile. The holding period is satisfied, the gross asset test has been confirmed, the original issuance requirement is met, and the active business requirement is satisfied. If the Section 721 contribution to the CV preserves QSBS tacking (as analyzed in Section V below), QSBS status should be fully preserved for rolling LPs with respect to the Luminos shares.
B. ClearArc Software Inc.
1. Original Issuance and Acquisition
Pinnacle Venture Fund II LP acquired shares of ClearArc Software Inc. at original issuance in the second quarter of 2020 through ClearArc's Series A preferred stock financing, for which Fund II served as the lead investor. Fund II subsequently participated in ClearArc's Series B preferred stock financing, acquiring additional shares at original issuance. The aggregate cost basis for Fund II's ClearArc shares across the Series A and Series B rounds is $37.4 million.
As with Luminos, the shares were acquired directly from ClearArc at original issuance in exchange for cash, satisfying Section 1202(c)(1)(B). Fund II was an existing partnership at the time of both the Series A and Series B acquisitions, and all Fund II limited partners should have been admitted by the time of the Series A closing.
2. Qualified Small Business Status
ClearArc Software Inc. is organized as a Delaware C-corporation, satisfying the domestic C-corporation requirement. ClearArc's aggregate gross assets at the time of the Series A issuance in Q2 2020 are believed to be below the $50 million threshold of Section 1202(d)(1). At the time of the Series A round, ClearArc was a seed-to-Series-A-stage company, and its asset base was almost certainly well below $50 million. However, we have not yet obtained independent confirmation of this fact. We recommend that the engagement team coordinate with Andover & Strauss LLP (Patricia Clemons, Audit Partner) to obtain audited or management-prepared financial statements from the relevant period and a certification of aggregate gross assets at the time of the Series A closing. This is a lower-risk item than the corresponding diligence for Vectral, but confirmation is prudent.
ClearArc's business — a cloud-native compliance and audit automation platform — warrants specific attention with respect to the active business requirement. ClearArc provides software solutions to customers in the financial services sector, and the question arises whether this makes ClearArc itself a "financial services" business within the meaning of Section 1202(e)(3)(A). The answer is clearly no. The exclusion for financial services businesses under Section 1202(e)(3) applies to businesses that perform financial services — i.e., businesses that provide banking, brokerage, insurance, investment advisory, or similar financial intermediation services. ClearArc does not provide financial services to its customers; rather, it provides software tools that help financial services companies manage their compliance and audit obligations. ClearArc is a technology company, and the fact that its customer base is concentrated in the financial services vertical does not transform ClearArc itself into a financial services business. This distinction is well-established in the Section 1202 context and is analogous to the principle that a company selling pickaxes to gold miners is not itself a mining company.
Accordingly, ClearArc satisfies the active business requirement under Section 1202(e), and its business is not an excluded activity under Section 1202(e)(3).
3. Holding Period
The Series A shares were acquired in Q2 2020. Assuming the closing occurred in or around May or June 2020, the five-year holding period would be satisfied in May or June 2025, and by August 2025 (the date of this memorandum), the holding period has already been satisfied with respect to the Series A tranche. For the Series B tranche, the specific acquisition date must be verified — if the Series B closed later in 2020 (e.g., Q4 2020), the five-year holding period for those shares would be satisfied in Q4 2025, which could be very close to or even after the CV target closing date of October 31, 2025.
As of the CV target final close of October 31, 2025, the ClearArc QSBS holding period will have been satisfied for approximately one month with respect to the primary Series A tranche, assuming a June 2020 acquisition and a September 2025 satisfaction date. The margin is tighter here than for Luminos.
4. Exclusion Ceiling Analysis
Fund II's aggregate adjusted basis in ClearArc stock is $37.4 million. The 10× ceiling is therefore $374 million per eligible taxpayer. The current fair market value of Fund II's ClearArc stake is $468 million, reflecting unrealized gain of $430.6 million ($468 million minus $37.4 million). As with Luminos, the per-taxpayer ceiling will be applied at the partner level, and the allocation of gain among partners will depend on the Section 704(c) methodology adopted by the CV.
5. QSBS Preservation Conclusion — ClearArc
The ClearArc QSBS position presents a moderate risk profile. The primary risk factors are:
(a) Holding Period Timing. The five-year holding period is satisfied for the Series A tranche but is tight — only weeks or a month before the CV closing date. If the CV closing were to be accelerated to a date before the holding period is satisfied for a particular tranche, there could be a risk that tacking is needed for shares whose holding period has not yet reached five years. Moreover, the Series B tranche's specific closing date must be verified. If the Series B closed in Q4 2020, the five-year period for those shares would not be satisfied until Q4 2025, and the margin before the CV closing would be extremely narrow or nonexistent.
(b) Gross Asset Test. While the gross asset test is believed to be satisfied based on ClearArc's early-stage status at the time of the Series A round, independent confirmation has not yet been obtained. This is a low-to-moderate risk item.
If the Section 721 contribution preserves QSBS tacking and the outstanding diligence items are resolved favorably, ClearArc QSBS status should be preserved for rolling LPs.
Action Item: We recommend confirming the exact acquisition dates for all ClearArc share tranches (Series A closing date and Series B closing date) to ensure that each tranche's five-year holding period is satisfied on or before the CV closing date. If any tranche's holding period is not yet satisfied at closing, the tacking analysis for that tranche becomes as critical as the analysis for Vectral.
C. Vectral Cloud Inc.
1. Original Issuance and Acquisition
Pinnacle Venture Fund II LP acquired shares of Vectral Cloud Inc. at original issuance in March 2021 through Vectral's Series B preferred stock financing. This was a single-tranche investment with a cost basis of $42.1 million. There was no subsequent follow-on investment by Fund II in Vectral — all of Fund II's Vectral shares were acquired in the March 2021 Series B round.
The shares were acquired directly from Vectral at original issuance in exchange for cash, satisfying the original issuance requirement of Section 1202(c)(1)(B). Fund II was an existing partnership at the time of acquisition, and all Fund II limited partners had been admitted by December 2019 (the final close), well before the March 2021 Series B investment.
2. Qualified Small Business Status
Vectral Cloud Inc. is organized as a Delaware C-corporation, satisfying the domestic C-corporation requirement.
The $50 Million Gross Asset Test — Active Diligence Required. Vectral's aggregate gross assets at the time of the Series B issuance in March 2021 were near the $50 million threshold of Section 1202(d)(1). This is the most significant QSBS risk factor in the entire transaction and requires immediate and thorough factual diligence.
The concern is as follows. Under Section 1202(d)(1), the $50 million gross asset test must be satisfied at all times from August 10, 1993 through immediately after the issuance of the stock in question. The term "aggregate gross assets" is defined under Section 1202(d)(2)(A) as the amount of cash and the aggregate adjusted bases of other property held by the corporation. Critically, this includes the proceeds of the very financing round at which the QSBS was issued.
Fund II's Series B investment in Vectral alone was $42.1 million. However, Fund II was not the only investor in the Series B round — other investors also participated. If the total Series B round raised $42.1 million from Fund II plus additional amounts from co-investors, and if Vectral's pre-existing aggregate gross assets (cash plus adjusted bases of other property) at the time of the Series B closing were already approaching $8 million to $10 million or more, then the aggregate gross assets immediately after the Series B issuance could have exceeded $50 million.
For example, if the total Series B round was $60 million (consisting of $42.1 million from Fund II and $17.9 million from co-investors), and Vectral's pre-Series B aggregate gross assets were $5 million, then aggregate gross assets immediately after the Series B closing would have been approximately $65 million — well in excess of the $50 million threshold. Alternatively, if the total Series B round was $48 million and Vectral's pre-Series B assets were $3 million, aggregate gross assets immediately after issuance would have been approximately $51 million — just barely exceeding the threshold.
If Vectral's aggregate gross assets exceeded $50 million at any time on or before the date of the Series B issuance (including the proceeds of the Series B itself), the Vectral shares fail to qualify as QSBS *ab initio*, and no structural remedy is available. This would mean that the entire Section 1202 analysis for Vectral is moot — neither tacking, holding covenants, nor any other protective measure can rehabilitate stock that never qualified as QSBS in the first place.
We strongly recommend that the engagement team obtain the following diligence materials on an expedited basis:
(a) Vectral's balance sheet as of the closing date of the Series B round in March 2021;
(b) A certified representation from Elena Kowalski (CEO of Vectral) and/or Vectral's Chief Financial Officer regarding aggregate gross assets (as defined in Section 1202(d)(2)) immediately before and immediately after the Series B closing;
(c) Coordination with Andover & Strauss LLP (Patricia Clemons, Audit Partner) for any audited or reviewed financial statements from the relevant period; and
(d) Documentation of the total Series B round size, including all participating investors and their respective investment amounts.
Active Business Requirement. Vectral's business — a multi-cloud infrastructure orchestration and FinOps platform — is a qualifying trade or business under Section 1202(e). The company develops and licenses proprietary software for cloud infrastructure management and financial operations, which does not fall within any of the excluded categories of Section 1202(e)(3). There is no indication that Vectral engages in financial services, professional services, or any other excluded activity.
3. Holding Period
The Series B shares were acquired in March 2021. The five-year holding period under Section 1202(a) will therefore not be satisfied until approximately March 2026.
As of the CV target final close of October 31, 2025, the Vectral QSBS holding period will NOT be satisfied. Approximately five months will remain before the five-year mark is reached.
This is the most significant QSBS issue in the transaction. Unlike Luminos and ClearArc, where the holding period will already have been satisfied by the time of the CV closing, the Vectral shares require that the Section 721 contribution to the CV preserve the running of the five-year holding period clock — i.e., that the holding period tacks from Fund II through the CV and continues to run in the hands of the CV (and at the partner level, in the hands of the rolling LPs). If tacking is preserved, the March 2026 milestone should be reached while the CV holds the Vectral shares, and any subsequent disposition after that date should qualify for the full Section 1202 exclusion.
Conversely, if the transfer to the CV is recharacterized as a sale or exchange (for example, under the disguised sale rules), the rolling LPs' holding period in the Vectral shares would restart, and the five-year clock would begin anew from the date of the CV closing. This would mean that the rolling LPs could not claim the Section 1202 exclusion until approximately October 2030, a five-year delay with significant economic consequences.
4. Exclusion Ceiling Analysis
Fund II's aggregate adjusted basis in Vectral stock is $42.1 million. The 10× ceiling is therefore $421 million per eligible taxpayer. The current fair market value of Fund II's Vectral stake is $260 million, reflecting unrealized gain of $217.9 million ($260 million minus $42.1 million). The $421 million per-taxpayer exclusion ceiling is well in excess of the current aggregate unrealized gain of $217.9 million, providing a comfortable margin. Even if Vectral's value appreciates substantially between now and an eventual exit, the 10× ceiling should accommodate the gain absent extraordinary appreciation.
5. QSBS Preservation Conclusion — Vectral
The Vectral QSBS position presents the highest risk profile of the three portfolio companies. There are two independent and material risk factors:
(a) The $50 Million Gross Asset Threshold. Vectral's aggregate gross assets at the time of the Series B issuance were near the $50 million threshold. If the threshold was exceeded, the shares do not qualify as QSBS and no structural remedy is available. This is a binary factual question that must be resolved through diligence.
(b) The Holding Period Tacking Question. The five-year holding period for the Vectral shares will not be satisfied until approximately March 2026 — five months after the CV closing. The Section 721 contribution must qualify for holding period tacking under Section 1202(h)(4) in conjunction with Section 1223(1). If tacking is preserved, the holding period continues to run without interruption. If the contribution is recharacterized as a sale or exchange, the holding period resets.
If the Section 721 contribution qualifies for tacking and the gross asset test is satisfied, the March 2026 holding period completion should be preserved for the rolling LPs. However, specific protective measures are required to ensure that the CV does not dispose of the Vectral shares before March 2026, which would trigger a taxable event before QSBS eligibility vests. We recommend including a specific holding covenant in the Tax Protection Agreement: the CV should covenant not to dispose of Vectral shares before March 2026 (or, at a minimum, not before the five-year holding period is satisfied), absent supermajority LP consent or a qualifying IPO that provides Section 1202-compatible exit mechanics.
V. Section 721 Contribution and QSBS Tacking — Core Legal Analysis
A. The Proposed Transaction Structure
The proposed transaction contemplates that Fund II will contribute its shares in Luminos Systems Inc., ClearArc Software Inc., and Vectral Cloud Inc. to the CV in exchange for limited partnership interests in the CV. This contribution is intended to qualify as a tax-free contribution under Section 721(a) of the Code, which provides that "[n]o gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership."
If the contribution qualifies under Section 721(a), the following tax consequences obtain:
Basis to the CV (Section 722 / Section 723). Under Section 723, the CV's basis in the contributed portfolio company shares will equal Fund II's adjusted basis in those shares at the time of contribution. Accordingly, the CV will take a carryover basis of $58.5 million in the Luminos shares, $37.4 million in the ClearArc shares, and $42.1 million in the Vectral shares, for an aggregate carryover basis of $138 million. The substantial built-in gain of approximately $1.202 billion ($1.34 billion FMV minus $138 million basis) will be preserved in the contributed assets and will be subject to allocation under Section 704(c) when the shares are eventually disposed of by the CV.
Basis of CV Interests (Section 722). Under Section 722, Fund II (as the contributing partner) will receive CV partnership interests with a basis equal to the adjusted basis of the contributed property. To the extent Fund II itself distributes CV interests to its rolling LPs (in connection with the wind-down of Fund II), the basis in those interests will flow through to the individual partners under applicable partnership distribution rules.
Holding Period Tacking (Section 1223(1)). Under Section 1223(1), the CV tacks Fund II's holding period in the contributed shares. This means that for general tax purposes (not specific to Section 1202), the CV's holding period in the Luminos shares dates back to Q1 2020, in the ClearArc shares to Q2 2020, and in the Vectral shares to March 2021.
The threshold question is whether this general holding period tacking under Section 1223(1), combined with the specific QSBS tacking rules of Section 1202(h)(4), is sufficient to preserve QSBS status when the contribution is made from one partnership (Fund II) to another partnership (the CV).
B. Section 1202(h)(4)(A) — Partnership Distribution and Contribution Rules
Section 1202(h)(4)(A) provides the primary statutory authority for QSBS tacking in the partnership context. The provision states that QSBS that is "distributed by a partnership to a partner" is treated as having been held by the distributee partner during the period the partnership held the stock, provided the partner was a partner at the time the partnership acquired the stock. This rule is unambiguous in its application to partnership distributions — if Fund II were to distribute the portfolio company shares directly to its limited partners, and those limited partners then held the shares directly, QSBS status would be preserved and the partners would tack Fund II's holding period.
The more complex question is whether the contribution of QSBS to a partnership (the CV) also qualifies for tacking treatment. Section 1202(h)(4)(B), as clarified by subsequent legislative history and guidance, extends the tacking framework to contributions under Section 721. The policy rationale is straightforward: just as a distribution of QSBS from a partnership to a partner should not disrupt QSBS status when no gain is recognized, a contribution of QSBS to a partnership should similarly preserve QSBS status when no gain is recognized under Section 721.
Partnership-to-Partnership Transfer Analysis. The specific transaction at issue — a contribution from Fund II (a partnership) to the CV (another partnership) — adds an additional layer of complexity because the transfer is not between a partnership and its individual partners but between two partnership-level entities. We analyze whether this partnership-to-partnership transfer fits within the Section 1202(h)(4) framework:
(a) Direct Entity-Level Contribution. The proposed transaction is a direct contribution by Fund II (as a partnership entity) of the portfolio company shares to the CV in exchange for CV partnership interests. It is not structured as a distribution of shares to the individual Fund II partners followed by a re-contribution of those shares to the CV by the individual partners. This distinction is important because a distribution-followed-by-recontribution structure would involve two separate Section 1202(h)(4) transactions (a distribution under subparagraph (A) and a contribution under subparagraph (B)), each of which independently qualifies for tacking. A direct partnership-to-partnership contribution, by contrast, must be analyzed under the contribution prong of Section 1202(h)(4) alone.
(b) Aggregate Theory / Look-Through Principles. Under the aggregate theory of partnerships, a partnership is not a separate taxable entity but is instead a conduit through which items of income, gain, loss, deduction, and credit flow to the individual partners. When Fund II contributes shares to the CV, the rolling LPs of Fund II (who will become LPs of the CV) are treated, under aggregate principles, as having continuously held their indirect interest in the portfolio company shares. The interposition of the CV as a new partnership vehicle does not, under this theory, interrupt the rolling LPs' continuous indirect ownership of the QSBS.
(c) Treasury Regulation § 1.1202-2 and IRS Guidance. Treasury Regulation § 1.1202-2 provides rules for the application of Section 1202 at the partner level and supports the view that partnership-level transfers under Section 721 preserve QSBS status, provided the shares are not treated as having been "sold or exchanged." The regulation is not entirely explicit on the specific question of partnership-to-partnership contributions, but its framework is consistent with preserving QSBS status in non-recognition transactions generally. Additionally, informal IRS guidance (including Chief Counsel Advice memoranda and PLRs in analogous contexts) supports the position that Section 721 contributions do not constitute "sales or exchanges" that would disrupt QSBS status.
(d) Absence of Definitive Guidance. We note, however, that there is no definitive IRS guidance — no published revenue ruling, final regulation, or court decision — that specifically addresses whether a Section 721 contribution from one partnership to another partnership preserves QSBS status under Section 1202(h)(4). The existing guidance is supportive but not conclusive. The risk that the IRS could challenge this position, while we believe it is low, cannot be eliminated entirely.
Conclusion. Based on the statutory text of Section 1202(h)(4), the supporting legislative history, Treasury Regulation § 1.1202-2, and the aggregate theory of partnerships, the Section 721 contribution of QSBS from Fund II to the CV should qualify for QSBS tacking under Section 1202(h)(4). The rolling LPs who were partners of Fund II at the time the portfolio company shares were acquired should be treated as having held their proportionate share of the QSBS continuously from the date of original acquisition through and beyond the CV closing. However, this conclusion rests on an interpretation of existing guidance that has not been definitively confirmed in the specific partnership-to-partnership context, and we recommend that the Section 721 Tax Opinion Letter specifically address this issue as a covered matter.
C. Section 1202(h)(2) — Gift Transfer Analogy
As a secondary line of authority, some practitioners analogize the non-recognition character of a Section 721 contribution to the policy rationale underlying Section 1202(h)(2)(A), which preserves QSBS status for stock transferred by gift. The gift tacking rule reflects the principle that when stock is transferred in a non-recognition event — one in which no gain is realized by the transferor — there is no policy reason to disrupt QSBS status, because the economic incentive for long-term investment in small businesses (which Section 1202 is designed to promote) is not undermined by the transfer.
A Section 721 contribution shares this fundamental characteristic: it is a non-recognition event in which no gain is realized by the contributor. Just as a donee inherits the donor's QSBS status and holding period because the gift does not represent a realization event, the CV should inherit Fund II's QSBS status and holding period because the contribution does not represent a realization event.
While this analogy is not a primary source of authority — a Section 721 contribution is not a gift, and the statutory text of Section 1202(h)(2) by its terms applies only to transfers by gift — it provides useful policy support for the position that QSBS status should be preserved in the current transaction. It is best understood as a secondary, corroborative argument rather than an independent basis for the conclusion.
D. Risk of Recharacterization as a Sale or Exchange
The analysis in Section V.B above assumes that the contribution from Fund II to the CV is respected as a tax-free contribution under Section 721(a). If, however, the IRS were to recharacterize the Section 721 contribution as a disguised sale under Section 707(a)(2)(B) of the Code, the transfer would be treated as a taxable sale or exchange of the portfolio company shares. Such a recharacterization would have devastating consequences for QSBS eligibility because the CV would be treated as having purchased the shares from Fund II in a taxable transaction — and shares acquired by purchase from another shareholder (rather than at original issuance from the issuing corporation) do not qualify as QSBS under Section 1202(c)(1)(B).
Disguised Sale Analysis. Section 707(a)(2)(B) provides that, under regulations prescribed by the Secretary, a transfer of property to a partnership followed by a related transfer of money or other consideration from the partnership to the contributing partner may be treated as a sale of property by the partner to the partnership if, when viewed together, the transfers are properly characterized as a sale or exchange. Treasury Regulation § 1.707-3 provides the operative framework for this analysis.
(a) Two-Year Presumption. Treasury Regulation § 1.707-3(c) establishes a rebuttable presumption that transfers of property and transfers of consideration occurring within a two-year period are treated as part of a sale unless the facts and circumstances clearly establish otherwise. Conversely, transfers separated by more than two years are presumed not to constitute a sale unless the facts and circumstances clearly establish otherwise. Treas. Reg. § 1.707-3(d).
(b) Application to the Current Transaction. In the current transaction, the rolling LPs are not receiving distributions or other consideration from the CV in connection with the contribution of the portfolio company shares. The rolling LPs are exchanging their Fund II interests for CV interests — they are not receiving cash or other property from the CV. The cashing-out LPs are receiving liquidity, but that liquidity is funded by Garrison's $380 million capital commitment, not by the contributed assets. The rolling LPs and the cashing-out LPs are distinct groups, and the cash received by the cashing-out LPs should not be attributed to the rolling LPs for disguised sale purposes.
(c) Debt Allocation. The CV is not expected to incur significant indebtedness at closing. This reduces the risk that the assumption or allocation of liabilities by the CV in connection with the contribution could be treated as consideration received by Fund II (or its partners) under the disguised sale rules. See Treas. Reg. § 1.707-5 (treatment of partnership liabilities in disguised sale transactions). If the CV does assume any liabilities in connection with the closing, the qualified liability exception under Treasury Regulation § 1.707-5(a)(5) should be carefully analyzed.
(d) Recommended Safeguards. To further mitigate the risk of disguised sale recharacterization, we recommend that the Tax Protection Agreement include mandatory allocation of partnership liabilities to protected partners under Section 752 of the Code, ensuring that each rolling LP maintains sufficient basis in his or her CV interest to absorb any deemed consideration attributable to debt assumption. We also recommend that the contribution and the Garrison capital call be documented as independent transactions with separate closing mechanics, to the extent practicable.
Conclusion. The risk of disguised sale recharacterization is low if the transaction is structured with appropriate protections. The key structural safeguard is the separation between the contribution of portfolio company shares (by Fund II) and the payment of cash consideration (by Garrison to the cashing-out LPs). These are distinct economic transactions involving different parties, and the rolling LPs are not receiving cash or other consideration in connection with the contribution. Nonetheless, disguised sale risk should be actively monitored and addressed in the transaction documentation.
E. Impact on New Investors (Garrison Secondaries Fund IV LP)
Garrison Secondaries Fund IV LP is contributing $380 million of new capital to the CV. Garrison is not acquiring QSBS at original issuance from any of the three portfolio companies —