1042-00002 · Client 1042 · Diligence/Tax

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CALDERWOOD & HARKNESS LLP

Internal Memorandum

Privileged & Confidential Attorney-Client Privilege / Attorney Work Product

TO: George Trujillo, Responsible Partner Christy Bauer, Lead Associate

FROM: Garrett Simmons, Working Associate, Tax Practice Group

DATE: March 18, 2022

RE: Federal Income Tax Characterization of Post-Money SAFEs — Brightfield Cloud Services Inc.

MATTER NO.: 1042-00002

CLIENT: Brightfield Cloud Services Inc. ("BCS" or the "Company")

I. Executive Summary

Calderwood & Harkness LLP represents Brightfield Cloud Services Inc. in connection with the Company's issuance of Post-Money Simple Agreements for Future Equity ("SAFEs") to five angel investors in an aggregate principal amount of $1,850,000. The SAFEs carry a post-money valuation cap of $12,000,000 and no discount rate. Each SAFE was executed between March 1 and March 15, 2022, and the aggregate proceeds have been deposited into the Company's operating account at Harborview Savings Bank.

This memorandum analyzes the federal income tax characterization of the SAFEs, addressing the threshold question of whether the instruments constitute equity, debt, or a derivative instrument for United States federal income tax purposes. The characterization of these instruments has significant implications for both the Company and the investors, including whether income is recognized at issuance, whether interest deductions are available, and how basis and holding periods are determined going forward.

Our principal conclusions are as follows:

1. The SAFEs should not be treated as debt instruments under Section 385 of the Internal Revenue Code or under general federal income tax principles. The instruments lack all material indicia of indebtedness: they have no stated maturity date, bear no interest or coupon, impose no unconditional obligation on the Company to repay the Purchase Amount, and provide no creditor remedies to the holders. Under the multi-factor debt-equity analysis articulated by the courts and referenced in Section 385(b), the SAFEs fall squarely on the equity side of the spectrum.

2. No taxable event occurs upon issuance of the SAFEs to the investors or upon the Company's receipt of funds. The investors' payment of the Purchase Amount in exchange for a contingent right to receive equity at a future date does not give rise to current income recognition by any party.

3. The SAFEs are most appropriately characterized as either open-transaction equity contracts or as prepaid forward contracts. Under the open-transaction doctrine, as articulated in Burnet v. Logan, 283 U.S. 404 (1931), the right received by each investor is too contingent and uncertain in value to be currently taxed. Similarly, under a prepaid forward contract analysis, consistent with the principles of Revenue Ruling 2003-7, no income is recognized at the time of the investor's prepayment. Under either characterization, no current income recognition is triggered at issuance, the investor's basis in the SAFE equals the Purchase Amount, and recognition of gain or loss is deferred until a settlement event occurs.

4. The tax treatment upon conversion in a future Equity Financing, Liquidity Event, or Dissolution will depend on the specific facts of that triggering event. This memorandum identifies the general framework applicable to each triggering event but does not provide a definitive analysis of conversion-event tax consequences, which should be undertaken at the time of the relevant transaction based on the facts then available.

This memorandum also briefly addresses the Section 83(b) election status of the founders' restricted stock, confirming that all three co-founders timely filed their elections and that the SAFE round does not affect those elections. In addition, we address the Company's state tax posture in Texas and Delaware, confirming that no material state tax liabilities arise from the SAFE issuance.

The analysis set forth herein is based on the Internal Revenue Code of 1986, as amended (the "Code"), Treasury Regulations promulgated thereunder, published revenue rulings, and applicable judicial precedent, all as in effect on the date of this memorandum. We note at the outset that the Internal Revenue Service has not issued formal guidance — whether in the form of a revenue ruling, temporary or final regulation, or published notice — specifically addressing the federal income tax characterization of SAFEs. Accordingly, our conclusions are based on general tax principles, analogies to instruments sharing characteristics with SAFEs, and the available body of authority addressing similar contingent-equity instruments.

II. Factual Background

A. The Company

Brightfield Cloud Services Inc. is a Delaware corporation, incorporated on September 14, 2021, under Delaware General Corporation Law. The Company's Employer Identification Number is 87-3294156, and its Delaware File Number is 6198274. BCS maintains its principal offices at 4710 East Riverside Drive, Suite 210, Austin, Texas 78741.

BCS develops and markets a cloud-based infrastructure monitoring platform branded "BrightWatch." The BrightWatch platform combines proprietary Internet of Things ("IoT") sensor hardware with a Software-as-a-Service ("SaaS") analytics dashboard, enabling real-time monitoring of building systems including HVAC, electrical, plumbing, and fire suppression infrastructure. The Company's target market consists of mid-market commercial building operators — primarily owners and managers of office, retail, and light industrial properties with between 50,000 and 500,000 square feet of leasable space.

As of the date of this memorandum, BCS employs three full-time employees (the three co-founders described below) and engages two independent contractors providing software engineering services. The Company reported approximately $47,000 in monthly recurring revenue ("MRR") as of February 2022, representing an annual run-rate revenue of approximately $564,000. The Company's monthly burn rate is approximately $68,000, consisting primarily of personnel costs, cloud hosting expenses, and general and administrative overhead. The SAFE proceeds of $1,850,000 provide the Company with an estimated runway of approximately twenty-two to twenty-four months at current expenditure levels, absent additional revenue growth.

B. Capitalization

The Company's Certificate of Incorporation, as filed with the Delaware Secretary of State on September 14, 2021, authorizes 10,000,000 shares of Common Stock, par value $0.0001 per share. No shares of Preferred Stock are currently authorized. As of the date of this memorandum, 7,500,000 shares of Common Stock are issued and outstanding, held by the Company's three co-founders as follows:

All founder shares were acquired pursuant to Restricted Stock Purchase Agreements, each dated September 14, 2021, and are subject to a four-year vesting schedule with a one-year cliff. The vesting commencement date for all three founders is September 14, 2021. Under the terms of the Restricted Stock Purchase Agreements, the Company holds a right to repurchase unvested shares at the original purchase price (par value) upon a founder's cessation of service. As of the date of this memorandum, no founder shares have vested (the one-year cliff does not expire until September 14, 2022), and no shares have been repurchased by the Company.

No shares of Preferred Stock have been authorized or issued. The Company has not adopted an equity incentive plan and has not established a stock option pool. The Board of Directors has indicated an intention to adopt an equity incentive plan in connection with a future Series A financing round, but no action has been taken as of the date hereof.

C. The SAFE Round

Between March 1 and March 15, 2022, BCS executed five Post-Money SAFEs with five angel investors. Each SAFE was modified from a standard post-money SAFE template to include a Most Favored Nation ("MFN") provision and to clarify certain dissolution-waterfall mechanics. The material terms of all five SAFEs are identical, except for the individual Purchase Amounts. The SAFEs carry a post-money valuation cap of $12,000,000 and no discount rate. The individual SAFEs are summarized in the table below:

The aggregate SAFE Percent of 15.4167% is calculated by dividing the aggregate Purchase Amount ($1,850,000) by the post-money valuation cap ($12,000,000). This percentage represents the portion of the Company's fully-diluted capitalization (calculated on a post-money basis) that the SAFE holders would collectively own upon conversion. The implied fully-diluted share count upon conversion is approximately 8,866,995 shares (calculated as 7,500,000 ÷ (1 – 0.154167)), yielding approximately 1,366,995 implied SAFE conversion shares.

The SAFEs contain the following key triggering events and conversion mechanics:

Equity Financing. The SAFEs define "Equity Financing" as a bona fide transaction or series of transactions in which the Company issues and sells shares of Preferred Stock with aggregate gross proceeds to the Company of at least $1,000,000, excluding any conversion of SAFEs and other convertible instruments. Upon an Equity Financing, each SAFE automatically converts into shares of the Preferred Stock issued in that round, at a price per share equal to the quotient obtained by dividing the post-money valuation cap ($12,000,000) by the Company Capitalization (as defined in the SAFE). The number of shares issued upon conversion is determined by dividing the Purchase Amount by the applicable conversion price.

Liquidity Event. Upon a "Liquidity Event" — defined as a Change of Control or an Initial Public Offering — each SAFE holder is entitled to receive, at the holder's election, the greater of (a) the Purchase Amount, or (b) the amount payable on the number of shares of Common Stock into which the SAFE would convert if the SAFE were treated as having converted at the Valuation Cap price immediately prior to the Liquidity Event.

Dissolution Event. Upon a "Dissolution Event" — defined as a voluntary or involuntary liquidation, dissolution, or winding up of the Company — each SAFE holder is entitled to receive a return of the Purchase Amount out of the Company's remaining assets, but only after satisfaction of all creditor claims and only in priority to distributions to holders of Common Stock. The SAFE holders' recovery in dissolution is limited to the Purchase Amount and is subject to the availability of assets; they have no right to pursue claims against the Company or its assets as creditors.

Most Favored Nation (MFN) Provision. The SAFEs include an MFN provision pursuant to which, if the Company issues any subsequent SAFE or convertible instrument on terms more favorable than those set forth in the existing SAFEs (e.g., a lower valuation cap, a discount rate, or other investor-favorable provisions), the existing SAFEs will be automatically amended to incorporate the more favorable terms.

Pro Rata Rights. The Company has entered into pro rata rights side letters with the three investors whose individual commitments equal or exceed $350,000: Lorraine Chastain ($500,000), marshall Huang / Jade Peak Ventures LLC ($400,000), and Dr. Nneka Adeyemi-Foster / Ariel Crest Capital LLC ($350,000). The side letters grant these investors the right to participate pro rata in future equity financings to maintain their percentage ownership.

Securities Law Exemption. The SAFEs were issued in reliance on the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended, and Rule 506(b) of Regulation D promulgated thereunder. All five investors (or, in the case of entity investors, the controlling persons thereof) have been verified as accredited investors within the meaning of Rule 501(a) of Regulation D. The Company intends to file a Form D with the Securities and Exchange Commission within fifteen days of the first SAFE closing date.

D. Key SAFE Attributes Relevant to Tax Characterization

In evaluating the federal income tax characterization of the SAFEs, the following attributes are of particular significance:

• No stated maturity date. The SAFEs do not mature on any specified date. There is no date by which the Company is required to convert the SAFEs or return the Purchase Amount. The SAFEs remain outstanding indefinitely until a triggering event occurs.

• No interest rate, coupon, or periodic payments. The SAFEs bear no interest, whether stated or imputed. The investors are not entitled to any periodic payments — whether denominated as interest, dividends, or otherwise — at any time during the term of the SAFEs.

• No unconditional obligation to repay the Purchase Amount. The Company is not obligated to return the Purchase Amount to the investors under any circumstances other than a Dissolution Event, and even then, only to the extent of available assets after satisfaction of creditor claims. There is no fixed obligation to repay; the investors bear the full risk that the Company may fail and that no assets will be available for distribution.

• No creditor remedies. The SAFE holders have no right to accelerate the obligations under the SAFEs, no security interest in any Company assets, no right to declare a default, and no ability to force the Company into involuntary bankruptcy or receivership. The absence of creditor remedies distinguishes the SAFEs fundamentally from a debt obligation.

• Conversion is contingent upon uncertain future events. Conversion of the SAFEs into equity is triggered only by the occurrence of an Equity Financing, a Liquidity Event, or a Dissolution — none of which is certain to occur, and the timing of which is inherently unpredictable. The investors have no unilateral right to demand conversion or to force a triggering event.

• Equity-linked economic return. Upon an Equity Financing, the SAFEs convert into shares of the Preferred Stock issued in that round at a price per share determined by the Valuation Cap. The economic return to the investors is thus entirely dependent on the Company's equity value — precisely the same type of return that an equity holder would expect.

• Priority in Dissolution. Upon Dissolution, SAFE holders receive a return of their Purchase Amount (to the extent of available assets), but only in priority to holders of Common Stock and not as a creditor claim. This priority is analogous to a liquidation preference on preferred stock, not to a creditor's right to repayment.

III. Analysis of Federal Income Tax Characterization

A. The Threshold Question: Equity, Debt, or Derivative?

The federal income tax consequences of the SAFE issuance — and, ultimately, the consequences upon conversion or settlement — depend fundamentally on the characterization of the SAFEs as one of three types of instruments: (1) an equity instrument or equity contract (including an open transaction), (2) a debt instrument, or (3) a derivative financial instrument (such as a prepaid forward contract or an option).

As a threshold matter, we note that the Internal Revenue Service has not issued formal guidance — whether in the form of a revenue ruling, revenue procedure, temporary or final regulation, technical advice memorandum, private letter ruling, or published notice — that specifically addresses the federal income tax characterization of SAFEs. The SAFE instrument was developed by Calderon Partners LLC in 2013 and has since become widely used in early-stage venture capital financing. Despite its prevalence, the IRS has not provided authoritative guidance on the classification question. Accordingly, our analysis must proceed under general tax principles, judicial precedent, Treasury Regulations, and analogies to instruments that share one or more characteristics with SAFEs.

The three possible characterizations and their respective tax frameworks are as follows:

Equity Instrument / Open Transaction. If the SAFEs are treated as equity instruments — or, more precisely, as contracts for the future issuance of equity — no taxable event occurs at issuance. The investors hold a basis in the SAFEs equal to their Purchase Amounts, and gain or loss recognition is deferred until a settlement event (conversion, Liquidity Event, or Dissolution) occurs. The Company treats the proceeds as a deferred equity contribution, not as borrowings, and does not claim interest deductions.

Debt Instrument. If the SAFEs were treated as debt, the instruments would be subject to the original issue discount ("OID") rules of Sections 1271 through 1275 of the Code, the imputed interest rules, and the Section 163 interest deduction limitations. The Company would be required to accrue and deduct interest (or OID), and the investors would be required to include OID in gross income on a current basis, even absent cash payments. As discussed below, we conclude that debt characterization is not appropriate.

Derivative Financial Instrument. If the SAFEs are treated as derivative instruments — specifically, as prepaid forward contracts — the tax treatment is substantially similar to the open-transaction analysis: no income recognition at issuance, basis equal to the Purchase Amount, and deferred recognition until settlement. Alternatively, if the SAFEs were characterized as options, different rules would apply; however, as discussed in Section III.E below, option characterization is inapt and is not recommended.

We analyze each of these characterizations in detail below.

B. Debt vs. Equity Analysis Under Section 385 and Case Law

1. Section 385 Framework

Section 385 of the Internal Revenue Code authorizes the Secretary of the Treasury to prescribe regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness, or as in part stock and in part indebtedness, for purposes of the Code. Although the Treasury Department's regulatory efforts under Section 385 have had a complicated history — the most recent final regulations under Section 385, promulgated in 2016 (T.D. 9790), address only certain related-party transactions and documentation requirements — Section 385(b) itself sets forth a non-exclusive list of factors to be considered in making the debt-equity determination.

The five factors enumerated in Section 385(b), derived from decades of judicial precedent and incorporated into the statute, are as follows:

(i) Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and whether there is a fixed rate of interest.

The SAFEs contain no such promise. There is no maturity date — whether fixed, determinable, or contingent — by which the Company is required to pay any amount to the holders. There is no "sum certain" payable at any time. The Company's obligation under the SAFE is not to pay money but to issue shares of stock upon the occurrence of a qualifying Equity Financing, or to pay amounts in connection with a Liquidity Event or Dissolution, none of which is unconditional. This factor weighs heavily in favor of equity characterization.

(ii) Whether there is subordination to or preference over any indebtedness of the corporation.

The SAFEs do not rank as indebtedness of the Company. In a Dissolution Event, SAFE holders recover their Purchase Amounts (to the extent of available assets) only after satisfaction of all creditor claims. The SAFEs are subordinated to all indebtedness and general creditor claims. Their priority is only over Common Stock — a priority that is functionally identical to a liquidation preference on preferred stock. This factor weighs in favor of equity characterization.

(iii) The ratio of debt to equity of the corporation.

BCS has minimal liabilities. As of December 31, 2021, the Company's balance sheet reflected total liabilities of approximately $41,600 (consisting of accrued expenses and accounts payable) against stockholders' equity of approximately $247,800. The SAFE investment of $1,850,000 does not create a leveraged capital structure; to the contrary, it substantially increases the Company's capital base. If the SAFEs themselves were treated as equity (as we recommend), the Company's debt-to-equity ratio would remain negligible. Even if the SAFEs were hypothetically treated as debt, the resulting debt-to-equity ratio (approximately 7.5:1) would be unusual for a transaction that both parties intend and structure as an equity investment. This factor weighs in favor of equity characterization, though the debt-to-equity ratio is generally considered less probative in the context of an early-stage startup.

(iv) Whether there is convertibility into the stock of the corporation.

The SAFEs are convertible — indeed, conversion into Preferred Stock upon an Equity Financing is the primary intended outcome. Convertibility is a feature found in both convertible debt and convertible equity instruments, and courts have recognized that this factor can cut either way. In the context of the SAFEs, however, the convertibility feature reinforces the equity characterization rather than detracting from it: the SAFEs are designed as a path to equity ownership, not as a debt instrument with an equity "kicker." The conversion is not at the holder's option (as is typical with convertible notes) but is triggered automatically by the occurrence of an Equity Financing, further underscoring the equity nature of the instrument.

(v) The relationship between holdings of stock in the corporation and holdings of the interest in question.

The SAFE holders are unrelated third-party investors who do not hold Common Stock in BCS. The SAFEs are not held in proportion to existing stock ownership. This factor is essentially neutral but does not suggest the kind of proportionate-to-equity-holdings debt issuance that courts have found indicative of disguised equity contributions by existing shareholders.

Taken together, the five Section 385(b) factors overwhelmingly support the conclusion that the SAFEs should be characterized as equity, not debt, for federal income tax purposes.

2. Multi-Factor Case Law Analysis

Beyond the statutory factors enumerated in Section 385(b), courts have developed multi-factor tests for distinguishing debt from equity in cases where the classification is disputed. The most commonly cited formulation is the thirteen-factor test articulated by the Third Circuit in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), and adopted or adapted in substantially similar form by other circuits. While no single factor is dispositive, courts evaluate the totality of the circumstances. We apply the principal factors below:

Name or label of the instrument. The instrument is denominated a "Simple Agreement for Future Equity." The use of the word "equity" in the instrument's name, while not controlling, reflects the parties' understanding and intent that the instrument is equity-linked, not debt. Courts have recognized that the label given by the parties, while entitled to some weight, is not determinative. See, e.g., Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980). Here, however, the label is consistent with the substance of the arrangement.

Intent of the parties. Both the Company and the investors intend and represent the SAFEs as equity-linked instruments. The Company's Board of Directors approved the SAFEs as an equity financing mechanism. The investors understood that they were making equity-like investments — bearing full downside risk with upside tied to the Company's equity value. The Form D to be filed with the SEC will classify the SAFEs as equity securities. The parties' subjective intent, while not dispositive standing alone, is consistent with equity characterization.

Fixed maturity date. The SAFEs have no maturity date, fixed or otherwise. The absence of a maturity date is one of the most significant factors distinguishing these instruments from debt. A creditor lending money to a borrower expects repayment by a date certain; the SAFE holders have no such expectation. See Litton Business Systems, Inc. v. Commissioner, 61 T.C. 367 (1973) (absence of maturity date indicative of equity).

Source of repayment. The SAFE holders' economic return is derived from the same source as the Common Stock holders' return: the Company's equity value. In an Equity Financing, the SAFEs convert into Preferred Stock — the holders receive their return through appreciation of the Company's equity. In a Liquidity Event, the holders receive the greater of the Purchase Amount or the value of their implied equity stake. In a Dissolution, the holders participate in the distribution of residual assets — the same asset pool from which equity holders are paid. There is no dedicated revenue stream, segregated account, or specific asset pledged as the source of repayment, as one would expect with a debt obligation.

Right to enforce payment. The SAFE holders have no right to accelerate the Company's obligations, no right to declare a default, no right to a security interest in Company assets, and no ability to compel the Company to undertake an Equity Financing, Liquidity Event, or Dissolution. The absence of enforcement rights is a hallmark of equity: a stockholder cannot force a corporation to pay dividends or to liquidate. By contrast, a creditor typically has a panoply of remedies upon default, including acceleration, foreclosure, and involuntary bankruptcy. The SAFEs provide none of these remedies.

Participation in management. The SAFEs do not confer voting rights, Board representation, or any right to participate in the management of the Company. The pro rata rights side letters granted to three of the five investors confer only the right to participate in future equity financings on a pro rata basis — a protective anti-dilution right, not a management right. The absence of management participation rights is neutral in the debt-equity analysis, as both preferred equity holders and holders of certain debt instruments may lack such rights.

Thin capitalization / adequacy of capitalization. As noted above, BCS is not thinly capitalized. The SAFE proceeds of $1,850,000 substantially strengthen the Company's balance sheet and provide operating runway of approximately twenty-two to twenty-four months. There is no indication that the SAFE investment was structured as debt to exploit the interest deduction or to create an artificially leveraged capital structure.

Identity of interest between creditors and shareholders. The SAFE holders are unrelated third-party investors. None of them holds Common Stock in BCS. None of them is a related party to any of the founders. There is no overlap between the creditor class and the equity class that might suggest a disguised equity contribution. This factor is neutral or slightly supportive of equity characterization.

Ability to obtain financing from outside lending institutions. An early-stage technology company such as BCS, with less than $600,000 in annual revenue and a limited operating history, would be unlikely to obtain traditional debt financing from a commercial bank on terms comparable to the SAFE investment. The fact that the investors provided capital through SAFEs rather than through a traditional loan reflects the economic reality that this is risk capital, not a creditworthy borrower's arm's-length debt.

Use of funds. The SAFE proceeds are being used for general corporate purposes — product development, customer acquisition, and working capital — rather than for the acquisition of a specific asset that could serve as collateral. This usage pattern is more consistent with equity investment than with asset-backed lending.

Conclusion under Section 385 / debt-equity analysis. Applying the totality of the relevant factors, the SAFEs lack virtually all indicia of debt. They should not be classified as debt instruments for federal income tax purposes. The instruments have no maturity date, no interest, no unconditional repayment obligation, no creditor remedies, and no priority over creditor claims. The parties intend and structure the instruments as equity-linked investments, and the economic substance of the arrangement is entirely consistent with equity. We are confident that this conclusion would be sustained if challenged by the Internal Revenue Service.

3. Implications If SAFEs Were Treated as Debt (for Completeness)

Although we conclude that debt characterization is not appropriate, we briefly note the implications that would arise if the SAFEs were, contrary to our analysis, treated as debt instruments:

Original Issue discount. Because the SAFEs bear no stated interest and have no stated redemption price at maturity, they would be treated as having been issued with original issue discount ("OID") under Sections 1271 through 1275 of the Code. The OID rules require the holder to accrue OID as ordinary income on a constant-yield basis over the life of the instrument and require the issuer to deduct the corresponding amount. However, application of the OID rules to the SAFEs would be highly problematic: the absence of a maturity date makes it impossible to calculate a yield to maturity or to determine the accrual period, and the absence of a stated redemption price makes it impossible to calculate the amount of OID. The OID rules are fundamentally designed for instruments with fixed terms and ascertainable economic characteristics — precisely the characteristics that the SAFEs lack.

Imputed Interest Under Section 7872. Section 7872 imputes interest on certain "below-market loans." However, Section 7872 applies to "loans" — a term that implies an obligation to repay. Because the SAFEs do not create an unconditional obligation to repay the Purchase Amount, Section 7872 is arguably inapplicable. Moreover, Section 7872 is primarily targeted at gift loans, compensation-related loans, corporation-shareholder loans, and tax-avoidance loans — none of which describes the arm's-length, third-party SAFE transactions at issue here.

Inconsistency with Economic Substance. Classification of the SAFEs as debt would be inconsistent with the economic substance of the arrangement. The investors bear full equity risk: they may lose their entire investment if the Company fails, and their upside is tied entirely to the Company's equity value. No rational creditor would accept these terms. The economic substance doctrine, as codified in Section 7701(o) of the Code, requires that the tax treatment of a transaction reflect its economic substance. Treating the SAFEs as debt would elevate form over substance in a manner that the doctrine is designed to prevent.

For these reasons, we are confident that debt characterization is not appropriate and that any such characterization, if asserted by the IRS, would not be sustained.

C. Open-Transaction Doctrine / Equity Contract Characterization

1. Analytical Framework

Having concluded that the SAFEs are not debt, we turn to the affirmative characterization of the instruments. The first and most straightforward characterization treats the SAFEs as equity contracts — that is, as agreements for the future issuance of equity — under the open-transaction doctrine.

The open-transaction doctrine originates in the Supreme Court's decision in Burnet v. Logan, 283 U.S. 404 (1931). In Logan, the taxpayer sold stock in a mining company in exchange for a right to receive future payments based on the mine's output. Because the value of the mine's future output was inherently uncertain and could not be fairly ascertained at the time of the sale, the Court held that the transaction remained "open" — the taxpayer was not required to recognize gain at the time of the sale but could instead recover her basis before recognizing gain as payments were received. The open-transaction doctrine has been applied in numerous subsequent cases involving contingent consideration, installment sales, and other transactions where the value of the consideration received is too uncertain to be ascertained at the time of the transaction.

A SAFE can be analogized to an open transaction in which the investor pays cash in exchange for a contingent right to receive equity at a future date, subject to the occurrence of an uncertain triggering event. At the time of SAFE issuance, the investor receives no stock, no fixed right to stock, and no guarantee that stock will ever be issued. The right is entirely contingent on the occurrence of one of three triggering events — an Equity Financing, a Liquidity Event, or a Dissolution — each of which is uncertain both as to timing and as to whether it will occur at all. The Company may never raise a qualifying round of Preferred Stock financing. The Company may never undergo a Change of Control or Initial Public Offering. The Company may continue to operate indefinitely without triggering any conversion event, in which case the SAFEs would remain outstanding indefinitely with no economic return to the holders.

This uncertainty is precisely the type of contingency that the open-transaction doctrine is designed to address. At the time of issuance, the SAFEs have no ascertainable value separate from the Purchase Amount paid by the investors. The right to receive future equity is too contingent and too dependent on uncertain future events to be valued with any degree of reliability. Accordingly, the transaction should remain "open" — no gain or loss should be recognized at issuance — until a closing event occurs that permits a reliable determination of the value received.

We note that the IRS has historically disfavored the open-transaction doctrine, viewing it as an exception to be narrowly applied. See Treas. Reg. § 1.1001-1(a) (providing that "only in rare and extraordinary cases" will the value of property received in an exchange be considered not reasonably ascertainable). However, this skepticism is directed primarily at situations where a taxpayer seeks to use the open-transaction doctrine to defer recognition of gain on the sale of appreciated property. In the SAFE context, the open-transaction analysis does not serve as a deferral mechanism for recognized gain; rather, it reflects the economic reality that the investor has exchanged cash for a contingent right whose value cannot be determined until a triggering event occurs. The application of the open-transaction doctrine here is not aggressive or extraordinary — it is the natural consequence of the instrument's contingent and uncertain character.

2. Tax Consequences Under Open-Transaction Characterization

Under the open-transaction characterization, the tax consequences of the SAFE issuance and subsequent events are as follows:

At issuance. No taxable event occurs for either the Company or the investor. The investor has a basis in the SAFE equal to the Purchase Amount paid. The Company has received capital — cash — but has not issued any stock. The amount received by the Company is treated as a deferred equity contribution: it is not includible in the Company's gross income, is not treated as a loan or borrowing, and does not give rise to any deduction.

Upon conversion in an Equity Financing. When an Equity Financing occurs and the SAFEs convert into shares of Preferred Stock, the investor's basis in the SAFE (equal to the Purchase Amount) carries over to the shares of Preferred Stock received upon conversion. No gain or loss is recognized at conversion. The conversion is treated as an exchange of one equity right (the SAFE) for another (the Preferred Stock), analogous to a tax-free exchange under Section 1036 of the Code (exchange of common stock for common stock of the same corporation) or, more precisely, as a tax-free recapitalization under Section 368(a)(1)(E), depending on the specific mechanics of the conversion and the terms of the Preferred Stock issued. The investor's holding period for the Preferred Stock may tack back to the date of the SAFE acquisition, depending on the applicable characterization of the conversion transaction.

Upon a Liquidity Event. If the SAFE holder receives cash or other consideration in connection with a Liquidity Event (whether a Change of Control or an Initial Public Offering), gain or loss is recognized at that time. The amount of gain or loss is measured by the difference between the amount realized (the cash or fair market value of other consideration received) and the investor's adjusted basis in the SAFE (the Purchase Amount). The character of the gain — ordinary income or capital gain — will depend on the facts of the Liquidity Event and the applicable provisions of the Code, including whether the SAFE constitutes a "capital asset" in the hands of the investor and whether the holding period is sufficient to qualify for long-term capital gain treatment.

Upon Dissolution. If the Company undergoes a Dissolution Event and the SAFE holder receives a distribution of the Company's remaining assets (up to the Purchase Amount), gain or loss is recognized to the extent that the amount received exceeds or falls short of the investor's adjusted basis in the SAFE. If the Company dissolves with no assets available for distribution to SAFE holders, the investor recognizes a loss equal to the full Purchase Amount.

D. Prepaid Forward Contract Characterization

1. Analogy to Variable Prepaid Forward Contracts

An alternative — and, in some respects, more technically precise — characterization treats the SAFE as a prepaid forward contract. Under this characterization, the investor has prepaid the purchase price for a variable number of shares of stock to be delivered in the future upon the occurrence of a triggering event. The investor's prepayment (the Purchase Amount) is the consideration paid for the right to receive shares at a later date, and the number of shares to be received is determined by a formula applied at the time of the triggering event (specifically, the Purchase Amount divided by the conversion price, which is derived from the Valuation Cap).

This characterization finds support in Revenue Ruling 2003-7, 2003-1 C.B. 363, which addresses the tax treatment of prepaid forward contracts on stock. In Revenue Ruling 2003-7, the IRS considered a taxpayer who entered into a forward contract to purchase shares of stock, making a prepayment of the full purchase price at the time the contract was entered into, with delivery of the shares deferred to a later date. The ruling held that the taxpayer did not recognize income at the time of the prepayment. Instead, the taxpayer was treated as having a basis in the forward contract equal to the prepayment amount, and recognition of gain or loss was deferred until the forward was settled — that is, until shares were delivered or the contract was settled in cash.

The SAFEs share several key characteristics with the variable prepaid forward contracts addressed in Revenue Ruling 2003-7:

• Upfront payment. The investor makes a full upfront payment (the Purchase Amount) at the time the SAFE is executed, just as the taxpayer in Revenue Ruling 2003-7 prepaid the full purchase price of the forward contract.

• Variable number of shares. The number of shares to be received by the investor is not fixed at the time of payment but is determined by a formula at the time of the triggering event. In the case of the SAFEs, the number of shares is determined by dividing the Purchase Amount by the conversion price, which is itself derived from the Valuation Cap and the Company Capitalization at the time of the Equity Financing. This variability is analogous to the variable delivery obligation in a variable prepaid forward.

• Deferred delivery. Delivery of shares is deferred until the occurrence of a triggering event. The investor does not receive any shares at the time of payment and may not receive shares for months or years — or, in the event that no triggering event occurs, may never receive shares at all.

There are, however, certain differences between the SAFEs and a classic prepaid forward contract:

• No fixed settlement date. A typical prepaid forward contract specifies a fixed settlement date — a date certain on which the shares will be delivered. The SAFEs have no such date; settlement occurs only upon the occurrence of an Equity Financing, a Liquidity Event, or a Dissolution, none of which is scheduled or certain to occur.

• Contingent settlement. In a typical prepaid forward, settlement is mandatory — the forward will be settled on the specified date, one way or another. In the case of the SAFEs, settlement is contingent: if no triggering event ever occurs, the SAFEs remain outstanding indefinitely, and the investor never receives shares or any other consideration. This makes the SAFE more uncertain than a typical prepaid forward.

These differences, however, do not undermine the prepaid forward characterization; if anything, they strengthen the case for non-recognition at issuance. The greater the uncertainty of settlement, the more compelling the argument that the transaction should remain open and that no income should be recognized until the uncertainty is resolved. The absence of a fixed settlement date and the contingent nature of delivery make the SAFEs, if anything, less appropriate for current income recognition than the prepaid forward contract addressed in Revenue Ruling 2003-7.

2. Tax Consequences Under Prepaid Forward Characterization

The tax consequences under the prepaid forward characterization are substantially identical to those under the open-transaction analysis:

• At issuance: No income is recognized by either the Company or the investor. The investor's basis in the SAFE equals the Purchase Amount. The Company treats the proceeds as a deferred equity contribution, not as income.

• Upon conversion or settlement: Gain or loss is recognized when the forward is settled — that is, when shares are delivered (upon an Equity Financing), when cash or other consideration is received (upon a Liquidity Event), or when a distribution is made or the instrument becomes worthless (upon Dissolution). The amount of gain or loss is determined by the difference between the amount realized and the investor's basis.

• No imputation of interest or OID. The characterization as a prepaid forward contract, like the open-transaction characterization, avoids the imputation of interest or original issue discount. Because the contract is not debt and the investor's return is entirely contingent on the Company's equity value (not on the passage of time or the use of money), there is no time-value-of-money component to impute. The investor is not lending money to the Company; the investor is prepaying the purchase price for a contingent equity interest.

The prepaid forward characterization thus provides the same practical result as the open-transaction characterization. The choice between the two characterizations is largely a matter of analytical framework rather than substantive tax consequence. We believe that either characterization is defensible, and we recommend that the Company and the investors adopt a consistent position based on the open-transaction / equity contract framework as the primary characterization, with the prepaid forward analysis as a well-supported alternative.

E. Option Characterization (Considered and Rejected)

For completeness, we have considered whether the SAFEs could be characterized as options to acquire equity at a capped price. Under this characterization, the Purchase Amount would be treated as a premium paid for the right to acquire shares of Preferred Stock at a price determined by the Valuation Cap.

We reject this characterization for two principal reasons:

First, an option typically requires the holder to make an additional payment — an exercise price — at the time of exercise in order to acquire the underlying property. The holder pays a premium for the option and then, upon exercise, pays the exercise price to acquire the stock. The SAFEs do not operate this way. The Purchase Amount is fully paid upfront, and no additional payment is required upon conversion. When the SAFEs convert in an Equity Financing, the investor receives shares automatically, without tendering any additional consideration. The economic mechanics of the SAFE are thus fundamentally different from those of an option.

Second, an option is typically exercisable at the holder's election — the holder decides whether and when to exercise. The SAFEs do not give the holder any unilateral exercise right. Conversion is triggered automatically by external events (an Equity Financing, a Liquidity Event, or a Dissolution) that are outside the holder's control. The holder cannot elect to convert the SAFE at a time of the holder's choosing; conversion occurs only when, and if, a qualifying event takes place. This automatic, externally triggered conversion mechanism is inconsistent with option characterization.

For these reasons, option characterization is inapt for the SAFEs, and we do not recommend it.

F. Company-Side Tax Treatment

BCS receives cash in the aggregate amount of $1,850,000 in exchange for the SAFEs. Under either the open-transaction or prepaid forward characterization, the receipt of cash is not taxable income to the Company. The cash is treated as a contribution to capital or a deferred equity issuance — essentially, the Company has received an advance payment for equity that it will issue at a future date upon the occurrence of a triggering event.

This treatment is consistent with well-established principles governing corporate capital contributions. Under Section 118 of the Code, a corporation's gross income does not include contributions to its capital. While Section 118 is most commonly applied to contributions by existing shareholders, the principle that a corporation does not recognize income upon the receipt of equity capital is fundamental to the corporate tax system and extends to contributions by persons who will become shareholders upon conversion.

The SAFEs do not generate an interest deduction for BCS. Because the instruments are not debt, there is no interest — whether stated, imputed, or in the form of OID — for the Company to deduct under Section 163 of the Code. This is consistent with the characterization of the SAFEs as equity instruments: equity investments are funded with after-tax dollars and do not give rise to deductions for the issuing corporation.

No amortizable premium or discount arises in connection with the SAFEs. These concepts are applicable to debt instruments under Sections 171 and 1276 of the Code and have no application to equity contracts or prepaid forward contracts.

G. Most Favored Nation (MFN) Provision

The MFN provision in the SAFEs provides that if the Company issues any subsequent SAFE or convertible instrument on terms more favorable to the holder than those contained in the existing SAFEs (e.g., a lower valuation cap, a discount rate, additional protective provisions, or other investor-favorable terms), the existing SAFEs will be automatically amended to incorporate the more favorable terms. This provision is a standard protective mechanism designed to ensure that earlier SAFE investors are not disadvantaged relative to later investors.

The triggering of the MFN provision does not, in itself, create a taxable event. An amendment to the terms of an outstanding financial instrument may, under certain circumstances, be treated as a taxable exchange of the old instrument for a new instrument if the amendment results in a "significant modification" of the instrument's terms. See Treas. Reg. § 1.1001-3 (addressing modifications of debt instruments). However, the regulations under Section 1.1001-3 apply by their terms to "debt instruments," which, as we have concluded, the SAFEs are not.

Even if the significant-modification regulations were applied by analogy, the triggering of the MFN provision would adjust the economic terms of the existing SAFE (e.g., by reducing the valuation cap) but would not constitute a disposition, exchange, or constructive receipt of income by the investor. The investor would continue to hold the same SAFE, with the same Purchase Amount and the same basis, subject to adjusted conversion terms. The adjusted terms (e.g., a lower valuation cap, resulting in a greater number of shares upon conversion) would be taken into account at the time of conversion or settlement, not at the time of the MFN amendment.

We note that if the MFN provision results in a materially different instrument — for example, if a subsequent SAFE includes an interest component, a maturity date, or other debt-like features that are incorporated into the existing SAFEs via the MFN provision — the characterization analysis would need to be revisited at that time. Based on the terms of the current SAFEs and the Company's stated intention to issue only post-money SAFEs without interest or maturity provisions, we do not anticipate that the MFN provision will alter the equity characterization of the instruments.

IV. Founders' Restricted Stock — Section 83(b) Elections

A. Background

The three co-founders of BCS — Devin Mallory, Priya Raghavan, and Tomás Guerrero-Vidal — each acquired shares of BCS Common Stock pursuant to Restricted Stock Purchase Agreements dated September 14, 2021, the date of the Company's incorporation. As described in Section II.B above, the founder shares are subject to four-year vesting schedules with one-year cliffs. The vesting commencement date for all three founders is September 14, 2021. Under the Restricted Stock Purchase Agreements, the Company holds a right to repurchase unvested shares at the original purchase price (par value of $0.0001 per share) upon a founder's cessation of service with the Company. This repurchase right constitutes a "substantial risk of forfeiture" within the meaning of Section 83(c)(1) of the Code.

Under Section 83(a) of the Code, when property is transferred to any person in connection with the performance of services, the service provider must include in gross income the excess of the fair market value of the property (determined without regard to any restriction other than a restriction that by its terms will never lapse) over the amount paid for the property, at the first time that the property is either transferable or no longer subject to a substantial risk of forfeiture. In the case of the founder shares, this would mean that absent a Section 83(b) election, each founder would recognize ordinary income as the shares vest over the four-year period, with the amount of income measured by the fair market value of the shares at the time each tranche vests, less the par value paid.

B. Section 83(b) Elections

Section 83(b) of the Code provides an alternative: a service provider who receives property subject to a substantial risk of forfeiture may elect, within 30 days of the transfer, to include in gross income for the year of transfer the excess of the fair market value of the property at the time of transfer (determined without regard to any restriction other than a nonlapse restriction) over the amount paid for the property. By making this election, the service provider accelerates income recognition to the date of transfer, when the fair market value of the property may be minimal, and avoids recognizing ordinary income as the shares vest at potentially higher values.

All three BCS co-founders timely filed Section 83(b) elections within 30 days of the September 14, 2021, grant date. The elections were filed with the Internal Revenue Service in October 2021, within the mandatory 30-day window prescribed by Section 83(b)(2) and Treasury Regulation § 1.83-2(b). Copies of the elections were also provided to the Company, as required by Treasury Regulation § 1.83-2(d).

The effect of the Section 83(b) elections is as follows:

• Each founder included in gross income for the 2021 taxable year the excess of the fair market value of the Common Stock at the time of transfer (September 14, 2021) over the amount paid (par value of $0.0001 per share). At the time of the Company's incorporation on September 14, 2021, the fair market value of the Common Stock was nominal — essentially equal to par value — as the Company had no operations, no revenue, no customers, and no assets other than the founders' intellectual contributions. Accordingly, the income recognized upon the Section 83(b) elections was minimal or zero for each founder.

• Going forward, the founders will not recognize additional ordinary income as their shares vest over the four-year period. The substantial risk of forfeiture — the Company's repurchase right on unvested shares — is disregarded for income recognition purposes once the Section 83(b) election is made. Instead, any appreciation in the value of the shares between the grant date and a future sale or other disposition will be treated as capital gain (long-term capital gain if the shares are held for more than one year from the grant date).

• The founders' holding period for purposes of determining long-term versus short-term capital gain treatment begins on the grant date, September 14, 2021, regardless of the vesting schedule. As of the date of this memorandum, the founders have held their shares for approximately six months; they will satisfy the one-year holding period requirement for long-term capital gain treatment on or after September 14, 2022.

If a founder's employment with BCS terminates before all shares are vested and the Company exercises its repurchase right to reacquire unvested shares at par value, the departing founder will recognize a capital loss equal to the amount previously included in income under the Section 83(b) election with respect to the forfeited shares (which, as noted, was minimal or zero). However, under Section 83(b)(1)(B), no deduction is allowed for a loss resulting from a forfeiture of shares for which a Section 83(b) election was made, except to the extent that the amount paid for the shares exceeded the amount received upon forfeiture.

C. SAFE Round Impact on Fair Market Value of Founder Shares

The issuance of the SAFEs at a $12,000,000 post-money valuation cap does not retroactively affect the Section 83(b) elections filed by the founders in October 2021. The elections were based on the fair market value of the Common Stock at the time of transfer — September 14, 2021 — and subsequent changes in the Company's valuation do not alter the income recognized under those elections. The Section 83(b) election is a one-time, irrevocable election that fixes the amount of income at the time of transfer; subsequent appreciation or depreciation does not give rise to additional income or to a refund of the amount previously recognized.

However, the issuance of SAFEs at a $12,000,000 post-money valuation cap may be relevant to future valuations of the Common Stock for other purposes. In particular:

• Section 409A Valuations. If BCS adopts an equity incentive plan and grants stock options or other compensatory equity awards to employees or service providers, Section 409A of the Code requires that the exercise price of incentive stock options (and the fair market value used for other purposes) be determined in accordance with a reasonable valuation methodology. The SAFE Valuation Cap of $12,000,000 will be one data point — though not the sole or necessarily the most probative data point — in any future 409A valuation. A 409A valuation typically applies significant discounts to the preferred stock price to arrive at the fair market value of common stock, reflecting the differences in rights, preferences, and economic characteristics between the two classes of stock.

• Future Financings. The SAFE Valuation Cap establishes a market-derived reference point for the Company's pre-money valuation in future equity financings. This may influence the pricing of a future Series A round and, consequently, the fair market value of the Common Stock following that round.

The SAFE issuance does not affect the founders' Section 83(b) elections or their vesting schedules in any respect. The SAFEs are issued by the Company, not by the founders, and do not constitute a transfer of founder shares. The founders' equity ownership is diluted on a fully-diluted basis by the SAFE Percent (15.4167%), but this dilution does not trigger a taxable event for the founders.

V. State Tax Considerations

A. Texas Franchise Tax

BCS is a Delaware corporation qualified to do business in the State of Texas. The Company's Texas Secretary of State filing number is 804217635. As a corporation doing business in Texas, BCS is subject to the Texas franchise (margin) tax, imposed under Chapter 171 of the Texas Tax Code.

The Texas franchise tax applies to taxable entities with total revenue exceeding the no-tax-due threshold, which for reports originally due in 2022 (based on the 2021 tax year) is $1,230,000. "Total revenue" for Texas franchise tax purposes is generally defined as the amount reported on the entity's federal income tax return as gross receipts or gross sales, less returns and allowances, plus certain other items of income specified by the Texas Tax Code. Importantly, capital contributions, equity issuances, and other non-revenue receipts are not included in "total revenue" for franchise tax purposes.

BCS's annualized run-rate revenue as of February 2022 is approximately $564,000 (based on approximately $47,000 in monthly recurring revenue). The Company's actual total revenue for the 2021 reporting period — which covers only the period from incorporation on September 14, 2021, through December 31, 2021, approximately three and a half months — was approximately $130,000 to $165,000, well below the $1,230,000 no-tax-due threshold.

Accordingly, BCS has no Texas franchise tax liability for the 2021 tax year. The Company is, however, required to file a no-tax-due information report (Form 05-163) with the Texas Comptroller of Public Accounts, together with the Public Information Report (Form 05-102), by the applicable filing deadline (generally May 15, 2022, for the initial report year).

Receipt of the SAFE proceeds ($1,850,000) is not "revenue" for Texas franchise tax purposes. The SAFE proceeds represent a capital contribution or deferred equity issuance, not income from the Company's operations. Accordingly, the SAFE proceeds do not count toward the $1,230,000 no-tax-due threshold and do not create a franchise tax liability.

We recommend that the Company engage its tax return preparer to timely file the no-tax-due information report and Public Information Report with the Texas Comptroller. Failure to file, even when no tax is due, may result in the forfeiture of the Company's right to transact business in Texas.

B. Delaware Franchise Tax

As a Delaware corporation, BCS is subject to the annual Delaware franchise tax imposed under Title 8, Section 503 of the Delaware Code. The Delaware franchise tax may be calculated under one of two methods: the Authorized Shares Method or the Assumed Par Value Capital Method. The Company's annual report and franchise tax payment are due on or before March 1 of each year.

For the 2021 tax year, BCS paid the minimum Delaware franchise tax of $400, based on the Authorized Shares Method. Under this method, the franchise tax for a corporation with up to 5,000 authorized shares is $175, and for a corporation with 5,001 to 10,000 authorized shares is $250. However, a minimum payment of $400 applies to all corporations regardless of share count when the annual report filing fee is included. BCS, with 10,000,000 authorized shares, would owe a substantially higher amount under the Authorized Shares Method but may benefit from using the Assumed Par Value Capital Method, which typically produces a lower tax liability for corporations with high

CALDERWOOD & HARKNESS LLP
Internal Memorandum
Privileged & Confidential Attorney-Client Privilege / Attorney Work Product
TO: George Trujillo, Responsible Partner Christy Bauer, Lead Associate
FROM: Garrett Simmons, Working Associate, Tax Practice Group
DATE: March 18, 2022
RE: Federal Income Tax Characterization of Post-Money SAFEs — Brightfield Cloud Services Inc.
MATTER NO.: 1042-00002
CLIENT: Brightfield Cloud Services Inc. ("BCS" or the "Company")
I. Executive Summary
Calderwood & Harkness LLP represents Brightfield Cloud Services Inc. in connection with the Company's issuance of Post-Money Simple Agreements for Future Equity ("SAFEs") to five angel investors in an aggregate principal amount of $1,850,000. The SAFEs carry a post-money valuation cap of $12,000,000 and no discount rate. Each SAFE was executed between March 1 and March 15, 2022, and the aggregate proceeds have been deposited into the Company's operating account at Harborview Savings Bank.
This memorandum analyzes the federal income tax characterization of the SAFEs, addressing the threshold question of whether the instruments constitute equity, debt, or a derivative instrument for United States federal income tax purposes. The characterization of these instruments has significant implications for both the Company and the investors, including whether income is recognized at issuance, whether interest deductions are available, and how basis and holding periods are determined going forward.
Our principal conclusions are as follows:
1. The SAFEs should not be treated as debt instruments under Section 385 of the Internal Revenue Code or under general federal income tax principles. The instruments lack all material indicia of indebtedness: they have no stated maturity date, bear no interest or coupon, impose no unconditional obligation on the Company to repay the Purchase Amount, and provide no creditor remedies to the holders. Under the multi-factor debt-equity analysis articulated by the courts and referenced in Section 385(b), the SAFEs fall squarely on the equity side of the spectrum.
2. No taxable event occurs upon issuance of the SAFEs to the investors or upon the Company's receipt of funds. The investors' payment of the Purchase Amount in exchange for a contingent right to receive equity at a future date does not give rise to current income recognition by any party.
3. The SAFEs are most appropriately characterized as either open-transaction equity contracts or as prepaid forward contracts. Under the open-transaction doctrine, as articulated in Burnet v. Logan, 283 U.S. 404 (1931), the right received by each investor is too contingent and uncertain in value to be currently taxed. Similarly, under a prepaid forward contract analysis, consistent with the principles of Revenue Ruling 2003-7, no income is recognized at the time of the investor's prepayment. Under either characterization, no current income recognition is triggered at issuance, the investor's basis in the SAFE equals the Purchase Amount, and recognition of gain or loss is deferred until a settlement event occurs.
4. The tax treatment upon conversion in a future Equity Financing, Liquidity Event, or Dissolution will depend on the specific facts of that triggering event. This memorandum identifies the general framework applicable to each triggering event but does not provide a definitive analysis of conversion-event tax consequences, which should be undertaken at the time of the relevant transaction based on the facts then available.
This memorandum also briefly addresses the Section 83(b) election status of the founders' restricted stock, confirming that all three co-founders timely filed their elections and that the SAFE round does not affect those elections. In addition, we address the Company's state tax posture in Texas and Delaware, confirming that no material state tax liabilities arise from the SAFE issuance.
The analysis set forth herein is based on the Internal Revenue Code of 1986, as amended (the "Code"), Treasury Regulations promulgated thereunder, published revenue rulings, and applicable judicial precedent, all as in effect on the date of this memorandum. We note at the outset that the Internal Revenue Service has not issued formal guidance — whether in the form of a revenue ruling, temporary or final regulation, or published notice — specifically addressing the federal income tax characterization of SAFEs. Accordingly, our conclusions are based on general tax principles, analogies to instruments sharing characteristics with SAFEs, and the available body of authority addressing similar contingent-equity instruments.
II. Factual Background
A. The Company
Brightfield Cloud Services Inc. is a Delaware corporation, incorporated on September 14, 2021, under Delaware General Corporation Law. The Company's Employer Identification Number is 87-3294156, and its Delaware File Number is 6198274. BCS maintains its principal offices at 4710 East Riverside Drive, Suite 210, Austin, Texas 78741.
BCS develops and markets a cloud-based infrastructure monitoring platform branded "BrightWatch." The BrightWatch platform combines proprietary Internet of Things ("IoT") sensor hardware with a Software-as-a-Service ("SaaS") analytics dashboard, enabling real-time monitoring of building systems including HVAC, electrical, plumbing, and fire suppression infrastructure. The Company's target market consists of mid-market commercial building operators — primarily owners and managers of office, retail, and light industrial properties with between 50,000 and 500,000 square feet of leasable space.
As of the date of this memorandum, BCS employs three full-time employees (the three co-founders described below) and engages two independent contractors providing software engineering services. The Company reported approximately $47,000 in monthly recurring revenue ("MRR") as of February 2022, representing an annual run-rate revenue of approximately $564,000. The Company's monthly burn rate is approximately $68,000, consisting primarily of personnel costs, cloud hosting expenses, and general and administrative overhead. The SAFE proceeds of $1,850,000 provide the Company with an estimated runway of approximately twenty-two to twenty-four months at current expenditure levels, absent additional revenue growth.
B. Capitalization
The Company's Certificate of Incorporation, as filed with the Delaware Secretary of State on September 14, 2021, authorizes 10,000,000 shares of Common Stock, par value $0.0001 per share. No shares of Preferred Stock are currently authorized. As of the date of this memorandum, 7,500,000 shares of Common Stock are issued and outstanding, held by the Company's three co-founders as follows:
All founder shares were acquired pursuant to Restricted Stock Purchase Agreements, each dated September 14, 2021, and are subject to a four-year vesting schedule with a one-year cliff. The vesting commencement date for all three founders is September 14, 2021. Under the terms of the Restricted Stock Purchase Agreements, the Company holds a right to repurchase unvested shares at the original purchase price (par value) upon a founder's cessation of service. As of the date of this memorandum, no founder shares have vested (the one-year cliff does not expire until September 14, 2022), and no shares have been repurchased by the Company.
No shares of Preferred Stock have been authorized or issued. The Company has not adopted an equity incentive plan and has not established a stock option pool. The Board of Directors has indicated an intention to adopt an equity incentive plan in connection with a future Series A financing round, but no action has been taken as of the date hereof.
C. The SAFE Round
Between March 1 and March 15, 2022, BCS executed five Post-Money SAFEs with five angel investors. Each SAFE was modified from a standard post-money SAFE template to include a Most Favored Nation ("MFN") provision and to clarify certain dissolution-waterfall mechanics. The material terms of all five SAFEs are identical, except for the individual Purchase Amounts. The SAFEs carry a post-money valuation cap of $12,000,000 and no discount rate. The individual SAFEs are summarized in the table below:
The aggregate SAFE Percent of 15.4167% is calculated by dividing the aggregate Purchase Amount ($1,850,000) by the post-money valuation cap ($12,000,000). This percentage represents the portion of the Company's fully-diluted capitalization (calculated on a post-money basis) that the SAFE holders would collectively own upon conversion. The implied fully-diluted share count upon conversion is approximately 8,866,995 shares (calculated as 7,500,000 ÷ (1 – 0.154167)), yielding approximately 1,366,995 implied SAFE conversion shares.
The SAFEs contain the following key triggering events and conversion mechanics:
Equity Financing. The SAFEs define "Equity Financing" as a bona fide transaction or series of transactions in which the Company issues and sells shares of Preferred Stock with aggregate gross proceeds to the Company of at least $1,000,000, excluding any conversion of SAFEs and other convertible instruments. Upon an Equity Financing, each SAFE automatically converts into shares of the Preferred Stock issued in that round, at a price per share equal to the quotient obtained by dividing the post-money valuation cap ($12,000,000) by the Company Capitalization (as defined in the SAFE). The number of shares issued upon conversion is determined by dividing the Purchase Amount by the applicable conversion price.
Liquidity Event. Upon a "Liquidity Event" — defined as a Change of Control or an Initial Public Offering — each SAFE holder is entitled to receive, at the holder's election, the greater of (a) the Purchase Amount, or (b) the amount payable on the number of shares of Common Stock into which the SAFE would convert if the SAFE were treated as having converted at the Valuation Cap price immediately prior to the Liquidity Event.
Dissolution Event. Upon a "Dissolution Event" — defined as a voluntary or involuntary liquidation, dissolution, or winding up of the Company — each SAFE holder is entitled to receive a return of the Purchase Amount out of the Company's remaining assets, but only after satisfaction of all creditor claims and only in priority to distributions to holders of Common Stock. The SAFE holders' recovery in dissolution is limited to the Purchase Amount and is subject to the availability of assets; they have no right to pursue claims against the Company or its assets as creditors.
Most Favored Nation (MFN) Provision. The SAFEs include an MFN provision pursuant to which, if the Company issues any subsequent SAFE or convertible instrument on terms more favorable than those set forth in the existing SAFEs (e.g., a lower valuation cap, a discount rate, or other investor-favorable provisions), the existing SAFEs will be automatically amended to incorporate the more favorable terms.
Pro Rata Rights. The Company has entered into pro rata rights side letters with the three investors whose individual commitments equal or exceed $350,000: Lorraine Chastain ($500,000), marshall Huang / Jade Peak Ventures LLC ($400,000), and Dr. Nneka Adeyemi-Foster / Ariel Crest Capital LLC ($350,000). The side letters grant these investors the right to participate pro rata in future equity financings to maintain their percentage ownership.
Securities Law Exemption. The SAFEs were issued in reliance on the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended, and Rule 506(b) of Regulation D promulgated thereunder. All five investors (or, in the case of entity investors, the controlling persons thereof) have been verified as accredited investors within the meaning of Rule 501(a) of Regulation D. The Company intends to file a Form D with the Securities and Exchange Commission within fifteen days of the first SAFE closing date.
D. Key SAFE Attributes Relevant to Tax Characterization
In evaluating the federal income tax characterization of the SAFEs, the following attributes are of particular significance:
• No stated maturity date. The SAFEs do not mature on any specified date. There is no date by which the Company is required to convert the SAFEs or return the Purchase Amount. The SAFEs remain outstanding indefinitely until a triggering event occurs.
• No interest rate, coupon, or periodic payments. The SAFEs bear no interest, whether stated or imputed. The investors are not entitled to any periodic payments — whether denominated as interest, dividends, or otherwise — at any time during the term of the SAFEs.
• No unconditional obligation to repay the Purchase Amount. The Company is not obligated to return the Purchase Amount to the investors under any circumstances other than a Dissolution Event, and even then, only to the extent of available assets after satisfaction of creditor claims. There is no fixed obligation to repay; the investors bear the full risk that the Company may fail and that no assets will be available for distribution.
• No creditor remedies. The SAFE holders have no right to accelerate the obligations under the SAFEs, no security interest in any Company assets, no right to declare a default, and no ability to force the Company into involuntary bankruptcy or receivership. The absence of creditor remedies distinguishes the SAFEs fundamentally from a debt obligation.
• Conversion is contingent upon uncertain future events. Conversion of the SAFEs into equity is triggered only by the occurrence of an Equity Financing, a Liquidity Event, or a Dissolution — none of which is certain to occur, and the timing of which is inherently unpredictable. The investors have no unilateral right to demand conversion or to force a triggering event.
• Equity-linked economic return. Upon an Equity Financing, the SAFEs convert into shares of the Preferred Stock issued in that round at a price per share determined by the Valuation Cap. The economic return to the investors is thus entirely dependent on the Company's equity value — precisely the same type of return that an equity holder would expect.
• Priority in Dissolution. Upon Dissolution, SAFE holders receive a return of their Purchase Amount (to the extent of available assets), but only in priority to holders of Common Stock and not as a creditor claim. This priority is analogous to a liquidation preference on preferred stock, not to a creditor's right to repayment.
III. Analysis of Federal Income Tax Characterization
A. The Threshold Question: Equity, Debt, or Derivative?
The federal income tax consequences of the SAFE issuance — and, ultimately, the consequences upon conversion or settlement — depend fundamentally on the characterization of the SAFEs as one of three types of instruments: (1) an equity instrument or equity contract (including an open transaction), (2) a debt instrument, or (3) a derivative financial instrument (such as a prepaid forward contract or an option).
As a threshold matter, we note that the Internal Revenue Service has not issued formal guidance — whether in the form of a revenue ruling, revenue procedure, temporary or final regulation, technical advice memorandum, private letter ruling, or published notice — that specifically addresses the federal income tax characterization of SAFEs. The SAFE instrument was developed by Calderon Partners LLC in 2013 and has since become widely used in early-stage venture capital financing. Despite its prevalence, the IRS has not provided authoritative guidance on the classification question. Accordingly, our analysis must proceed under general tax principles, judicial precedent, Treasury Regulations, and analogies to instruments that share one or more characteristics with SAFEs.
The three possible characterizations and their respective tax frameworks are as follows:
Equity Instrument / Open Transaction. If the SAFEs are treated as equity instruments — or, more precisely, as contracts for the future issuance of equity — no taxable event occurs at issuance. The investors hold a basis in the SAFEs equal to their Purchase Amounts, and gain or loss recognition is deferred until a settlement event (conversion, Liquidity Event, or Dissolution) occurs. The Company treats the proceeds as a deferred equity contribution, not as borrowings, and does not claim interest deductions.
Debt Instrument. If the SAFEs were treated as debt, the instruments would be subject to the original issue discount ("OID") rules of Sections 1271 through 1275 of the Code, the imputed interest rules, and the Section 163 interest deduction limitations. The Company would be required to accrue and deduct interest (or OID), and the investors would be required to include OID in gross income on a current basis, even absent cash payments. As discussed below, we conclude that debt characterization is not appropriate.
Derivative Financial Instrument. If the SAFEs are treated as derivative instruments — specifically, as prepaid forward contracts — the tax treatment is substantially similar to the open-transaction analysis: no income recognition at issuance, basis equal to the Purchase Amount, and deferred recognition until settlement. Alternatively, if the SAFEs were characterized as options, different rules would apply; however, as discussed in Section III.E below, option characterization is inapt and is not recommended.
We analyze each of these characterizations in detail below.
B. Debt vs. Equity Analysis Under Section 385 and Case Law
1. Section 385 Framework
Section 385 of the Internal Revenue Code authorizes the Secretary of the Treasury to prescribe regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness, or as in part stock and in part indebtedness, for purposes of the Code. Although the Treasury Department's regulatory efforts under Section 385 have had a complicated history — the most recent final regulations under Section 385, promulgated in 2016 (T.D. 9790), address only certain related-party transactions and documentation requirements — Section 385(b) itself sets forth a non-exclusive list of factors to be considered in making the debt-equity determination.
The five factors enumerated in Section 385(b), derived from decades of judicial precedent and incorporated into the statute, are as follows:
(i) Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and whether there is a fixed rate of interest.
The SAFEs contain no such promise. There is no maturity date — whether fixed, determinable, or contingent — by which the Company is required to pay any amount to the holders. There is no "sum certain" payable at any time. The Company's obligation under the SAFE is not to pay money but to issue shares of stock upon the occurrence of a qualifying Equity Financing, or to pay amounts in connection with a Liquidity Event or Dissolution, none of which is unconditional. This factor weighs heavily in favor of equity characterization.
(ii) Whether there is subordination to or preference over any indebtedness of the corporation.
The SAFEs do not rank as indebtedness of the Company. In a Dissolution Event, SAFE holders recover their Purchase Amounts (to the extent of available assets) only after satisfaction of all creditor claims. The SAFEs are subordinated to all indebtedness and general creditor claims. Their priority is only over Common Stock — a priority that is functionally identical to a liquidation preference on preferred stock. This factor weighs in favor of equity characterization.
(iii) The ratio of debt to equity of the corporation.
BCS has minimal liabilities. As of December 31, 2021, the Company's balance sheet reflected total liabilities of approximately $41,600 (consisting of accrued expenses and accounts payable) against stockholders' equity of approximately $247,800. The SAFE investment of $1,850,000 does not create a leveraged capital structure; to the contrary, it substantially increases the Company's capital base. If the SAFEs themselves were treated as equity (as we recommend), the Company's debt-to-equity ratio would remain negligible. Even if the SAFEs were hypothetically treated as debt, the resulting debt-to-equity ratio (approximately 7.5:1) would be unusual for a transaction that both parties intend and structure as an equity investment. This factor weighs in favor of equity characterization, though the debt-to-equity ratio is generally considered less probative in the context of an early-stage startup.
(iv) Whether there is convertibility into the stock of the corporation.
The SAFEs are convertible — indeed, conversion into Preferred Stock upon an Equity Financing is the primary intended outcome. Convertibility is a feature found in both convertible debt and convertible equity instruments, and courts have recognized that this factor can cut either way. In the context of the SAFEs, however, the convertibility feature reinforces the equity characterization rather than detracting from it: the SAFEs are designed as a path to equity ownership, not as a debt instrument with an equity "kicker." The conversion is not at the holder's option (as is typical with convertible notes) but is triggered automatically by the occurrence of an Equity Financing, further underscoring the equity nature of the instrument.
(v) The relationship between holdings of stock in the corporation and holdings of the interest in question.
The SAFE holders are unrelated third-party investors who do not hold Common Stock in BCS. The SAFEs are not held in proportion to existing stock ownership. This factor is essentially neutral but does not suggest the kind of proportionate-to-equity-holdings debt issuance that courts have found indicative of disguised equity contributions by existing shareholders.
Taken together, the five Section 385(b) factors overwhelmingly support the conclusion that the SAFEs should be characterized as equity, not debt, for federal income tax purposes.
2. Multi-Factor Case Law Analysis
Beyond the statutory factors enumerated in Section 385(b), courts have developed multi-factor tests for distinguishing debt from equity in cases where the classification is disputed. The most commonly cited formulation is the thirteen-factor test articulated by the Third Circuit in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), and adopted or adapted in substantially similar form by other circuits. While no single factor is dispositive, courts evaluate the totality of the circumstances. We apply the principal factors below:
Name or label of the instrument. The instrument is denominated a "Simple Agreement for Future Equity." The use of the word "equity" in the instrument's name, while not controlling, reflects the parties' understanding and intent that the instrument is equity-linked, not debt. Courts have recognized that the label given by the parties, while entitled to some weight, is not determinative. See, e.g., Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980). Here, however, the label is consistent with the substance of the arrangement.
Intent of the parties. Both the Company and the investors intend and represent the SAFEs as equity-linked instruments. The Company's Board of Directors approved the SAFEs as an equity financing mechanism. The investors understood that they were making equity-like investments — bearing full downside risk with upside tied to the Company's equity value. The Form D to be filed with the SEC will classify the SAFEs as equity securities. The parties' subjective intent, while not dispositive standing alone, is consistent with equity characterization.
Fixed maturity date. The SAFEs have no maturity date, fixed or otherwise. The absence of a maturity date is one of the most significant factors distinguishing these instruments from debt. A creditor lending money to a borrower expects repayment by a date certain; the SAFE holders have no such expectation. See Litton Business Systems, Inc. v. Commissioner, 61 T.C. 367 (1973) (absence of maturity date indicative of equity).
Source of repayment. The SAFE holders' economic return is derived from the same source as the Common Stock holders' return: the Company's equity value. In an Equity Financing, the SAFEs convert into Preferred Stock — the holders receive their return through appreciation of the Company's equity. In a Liquidity Event, the holders receive the greater of the Purchase Amount or the value of their implied equity stake. In a Dissolution, the holders participate in the distribution of residual assets — the same asset pool from which equity holders are paid. There is no dedicated revenue stream, segregated account, or specific asset pledged as the source of repayment, as one would expect with a debt obligation.
Right to enforce payment. The SAFE holders have no right to accelerate the Company's obligations, no right to declare a default, no right to a security interest in Company assets, and no ability to compel the Company to undertake an Equity Financing, Liquidity Event, or Dissolution. The absence of enforcement rights is a hallmark of equity: a stockholder cannot force a corporation to pay dividends or to liquidate. By contrast, a creditor typically has a panoply of remedies upon default, including acceleration, foreclosure, and involuntary bankruptcy. The SAFEs provide none of these remedies.
Participation in management. The SAFEs do not confer voting rights, Board representation, or any right to participate in the management of the Company. The pro rata rights side letters granted to three of the five investors confer only the right to participate in future equity financings on a pro rata basis — a protective anti-dilution right, not a management right. The absence of management participation rights is neutral in the debt-equity analysis, as both preferred equity holders and holders of certain debt instruments may lack such rights.
Thin capitalization / adequacy of capitalization. As noted above, BCS is not thinly capitalized. The SAFE proceeds of $1,850,000 substantially strengthen the Company's balance sheet and provide operating runway of approximately twenty-two to twenty-four months. There is no indication that the SAFE investment was structured as debt to exploit the interest deduction or to create an artificially leveraged capital structure.
Identity of interest between creditors and shareholders. The SAFE holders are unrelated third-party investors. None of them holds Common Stock in BCS. None of them is a related party to any of the founders. There is no overlap between the creditor class and the equity class that might suggest a disguised equity contribution. This factor is neutral or slightly supportive of equity characterization.
Ability to obtain financing from outside lending institutions. An early-stage technology company such as BCS, with less than $600,000 in annual revenue and a limited operating history, would be unlikely to obtain traditional debt financing from a commercial bank on terms comparable to the SAFE investment. The fact that the investors provided capital through SAFEs rather than through a traditional loan reflects the economic reality that this is risk capital, not a creditworthy borrower's arm's-length debt.
Use of funds. The SAFE proceeds are being used for general corporate purposes — product development, customer acquisition, and working capital — rather than for the acquisition of a specific asset that could serve as collateral. This usage pattern is more consistent with equity investment than with asset-backed lending.
Conclusion under Section 385 / debt-equity analysis. Applying the totality of the relevant factors, the SAFEs lack virtually all indicia of debt. They should not be classified as debt instruments for federal income tax purposes. The instruments have no maturity date, no interest, no unconditional repayment obligation, no creditor remedies, and no priority over creditor claims. The parties intend and structure the instruments as equity-linked investments, and the economic substance of the arrangement is entirely consistent with equity. We are confident that this conclusion would be sustained if challenged by the Internal Revenue Service.
3. Implications If SAFEs Were Treated as Debt (for Completeness)
Although we conclude that debt characterization is not appropriate, we briefly note the implications that would arise if the SAFEs were, contrary to our analysis, treated as debt instruments:
Original Issue discount. Because the SAFEs bear no stated interest and have no stated redemption price at maturity, they would be treated as having been issued with original issue discount ("OID") under Sections 1271 through 1275 of the Code. The OID rules require the holder to accrue OID as ordinary income on a constant-yield basis over the life of the instrument and require the issuer to deduct the corresponding amount. However, application of the OID rules to the SAFEs would be highly problematic: the absence of a maturity date makes it impossible to calculate a yield to maturity or to determine the accrual period, and the absence of a stated redemption price makes it impossible to calculate the amount of OID. The OID rules are fundamentally designed for instruments with fixed terms and ascertainable economic characteristics — precisely the characteristics that the SAFEs lack.
Imputed Interest Under Section 7872. Section 7872 imputes interest on certain "below-market loans." However, Section 7872 applies to "loans" — a term that implies an obligation to repay. Because the SAFEs do not create an unconditional obligation to repay the Purchase Amount, Section 7872 is arguably inapplicable. Moreover, Section 7872 is primarily targeted at gift loans, compensation-related loans, corporation-shareholder loans, and tax-avoidance loans — none of which describes the arm's-length, third-party SAFE transactions at issue here.
Inconsistency with Economic Substance. Classification of the SAFEs as debt would be inconsistent with the economic substance of the arrangement. The investors bear full equity risk: they may lose their entire investment if the Company fails, and their upside is tied entirely to the Company's equity value. No rational creditor would accept these terms. The economic substance doctrine, as codified in Section 7701(o) of the Code, requires that the tax treatment of a transaction reflect its economic substance. Treating the SAFEs as debt would elevate form over substance in a manner that the doctrine is designed to prevent.
For these reasons, we are confident that debt characterization is not appropriate and that any such characterization, if asserted by the IRS, would not be sustained.
C. Open-Transaction Doctrine / Equity Contract Characterization
1. Analytical Framework
Having concluded that the SAFEs are not debt, we turn to the affirmative characterization of the instruments. The first and most straightforward characterization treats the SAFEs as equity contracts — that is, as agreements for the future issuance of equity — under the open-transaction doctrine.
The open-transaction doctrine originates in the Supreme Court's decision in Burnet v. Logan, 283 U.S. 404 (1931). In Logan, the taxpayer sold stock in a mining company in exchange for a right to receive future payments based on the mine's output. Because the value of the mine's future output was inherently uncertain and could not be fairly ascertained at the time of the sale, the Court held that the transaction remained "open" — the taxpayer was not required to recognize gain at the time of the sale but could instead recover her basis before recognizing gain as payments were received. The open-transaction doctrine has been applied in numerous subsequent cases involving contingent consideration, installment sales, and other transactions where the value of the consideration received is too uncertain to be ascertained at the time of the transaction.
A SAFE can be analogized to an open transaction in which the investor pays cash in exchange for a contingent right to receive equity at a future date, subject to the occurrence of an uncertain triggering event. At the time of SAFE issuance, the investor receives no stock, no fixed right to stock, and no guarantee that stock will ever be issued. The right is entirely contingent on the occurrence of one of three triggering events — an Equity Financing, a Liquidity Event, or a Dissolution — each of which is uncertain both as to timing and as to whether it will occur at all. The Company may never raise a qualifying round of Preferred Stock financing. The Company may never undergo a Change of Control or Initial Public Offering. The Company may continue to operate indefinitely without triggering any conversion event, in which case the SAFEs would remain outstanding indefinitely with no economic return to the holders.
This uncertainty is precisely the type of contingency that the open-transaction doctrine is designed to address. At the time of issuance, the SAFEs have no ascertainable value separate from the Purchase Amount paid by the investors. The right to receive future equity is too contingent and too dependent on uncertain future events to be valued with any degree of reliability. Accordingly, the transaction should remain "open" — no gain or loss should be recognized at issuance — until a closing event occurs that permits a reliable determination of the value received.
We note that the IRS has historically disfavored the open-transaction doctrine, viewing it as an exception to be narrowly applied. See Treas. Reg. § 1.1001-1(a) (providing that "only in rare and extraordinary cases" will the value of property received in an exchange be considered not reasonably ascertainable). However, this skepticism is directed primarily at situations where a taxpayer seeks to use the open-transaction doctrine to defer recognition of gain on the sale of appreciated property. In the SAFE context, the open-transaction analysis does not serve as a deferral mechanism for recognized gain; rather, it reflects the economic reality that the investor has exchanged cash for a contingent right whose value cannot be determined until a triggering event occurs. The application of the open-transaction doctrine here is not aggressive or extraordinary — it is the natural consequence of the instrument's contingent and uncertain character.
2. Tax Consequences Under Open-Transaction Characterization
Under the open-transaction characterization, the tax consequences of the SAFE issuance and subsequent events are as follows:
At issuance. No taxable event occurs for either the Company or the investor. The investor has a basis in the SAFE equal to the Purchase Amount paid. The Company has received capital — cash — but has not issued any stock. The amount received by the Company is treated as a deferred equity contribution: it is not includible in the Company's gross income, is not treated as a loan or borrowing, and does not give rise to any deduction.
Upon conversion in an Equity Financing. When an Equity Financing occurs and the SAFEs convert into shares of Preferred Stock, the investor's basis in the SAFE (equal to the Purchase Amount) carries over to the shares of Preferred Stock received upon conversion. No gain or loss is recognized at conversion. The conversion is treated as an exchange of one equity right (the SAFE) for another (the Preferred Stock), analogous to a tax-free exchange under Section 1036 of the Code (exchange of common stock for common stock of the same corporation) or, more precisely, as a tax-free recapitalization under Section 368(a)(1)(E), depending on the specific mechanics of the conversion and the terms of the Preferred Stock issued. The investor's holding period for the Preferred Stock may tack back to the date of the SAFE acquisition, depending on the applicable characterization of the conversion transaction.
Upon a Liquidity Event. If the SAFE holder receives cash or other consideration in connection with a Liquidity Event (whether a Change of Control or an Initial Public Offering), gain or loss is recognized at that time. The amount of gain or loss is measured by the difference between the amount realized (the cash or fair market value of other consideration received) and the investor's adjusted basis in the SAFE (the Purchase Amount). The character of the gain — ordinary income or capital gain — will depend on the facts of the Liquidity Event and the applicable provisions of the Code, including whether the SAFE constitutes a "capital asset" in the hands of the investor and whether the holding period is sufficient to qualify for long-term capital gain treatment.
Upon Dissolution. If the Company undergoes a Dissolution Event and the SAFE holder receives a distribution of the Company's remaining assets (up to the Purchase Amount), gain or loss is recognized to the extent that the amount received exceeds or falls short of the investor's adjusted basis in the SAFE. If the Company dissolves with no assets available for distribution to SAFE holders, the investor recognizes a loss equal to the full Purchase Amount.
D. Prepaid Forward Contract Characterization
1. Analogy to Variable Prepaid Forward Contracts
An alternative — and, in some respects, more technically precise — characterization treats the SAFE as a prepaid forward contract. Under this characterization, the investor has prepaid the purchase price for a variable number of shares of stock to be delivered in the future upon the occurrence of a triggering event. The investor's prepayment (the Purchase Amount) is the consideration paid for the right to receive shares at a later date, and the number of shares to be received is determined by a formula applied at the time of the triggering event (specifically, the Purchase Amount divided by the conversion price, which is derived from the Valuation Cap).
This characterization finds support in Revenue Ruling 2003-7, 2003-1 C.B. 363, which addresses the tax treatment of prepaid forward contracts on stock. In Revenue Ruling 2003-7, the IRS considered a taxpayer who entered into a forward contract to purchase shares of stock, making a prepayment of the full purchase price at the time the contract was entered into, with delivery of the shares deferred to a later date. The ruling held that the taxpayer did not recognize income at the time of the prepayment. Instead, the taxpayer was treated as having a basis in the forward contract equal to the prepayment amount, and recognition of gain or loss was deferred until the forward was settled — that is, until shares were delivered or the contract was settled in cash.
The SAFEs share several key characteristics with the variable prepaid forward contracts addressed in Revenue Ruling 2003-7:
• Upfront payment. The investor makes a full upfront payment (the Purchase Amount) at the time the SAFE is executed, just as the taxpayer in Revenue Ruling 2003-7 prepaid the full purchase price of the forward contract.
• Variable number of shares. The number of shares to be received by the investor is not fixed at the time of payment but is determined by a formula at the time of the triggering event. In the case of the SAFEs, the number of shares is determined by dividing the Purchase Amount by the conversion price, which is itself derived from the Valuation Cap and the Company Capitalization at the time of the Equity Financing. This variability is analogous to the variable delivery obligation in a variable prepaid forward.
• Deferred delivery. Delivery of shares is deferred until the occurrence of a triggering event. The investor does not receive any shares at the time of payment and may not receive shares for months or years — or, in the event that no triggering event occurs, may never receive shares at all.
There are, however, certain differences between the SAFEs and a classic prepaid forward contract:
• No fixed settlement date. A typical prepaid forward contract specifies a fixed settlement date — a date certain on which the shares will be delivered. The SAFEs have no such date; settlement occurs only upon the occurrence of an Equity Financing, a Liquidity Event, or a Dissolution, none of which is scheduled or certain to occur.
• Contingent settlement. In a typical prepaid forward, settlement is mandatory — the forward will be settled on the specified date, one way or another. In the case of the SAFEs, settlement is contingent: if no triggering event ever occurs, the SAFEs remain outstanding indefinitely, and the investor never receives shares or any other consideration. This makes the SAFE more uncertain than a typical prepaid forward.
These differences, however, do not undermine the prepaid forward characterization; if anything, they strengthen the case for non-recognition at issuance. The greater the uncertainty of settlement, the more compelling the argument that the transaction should remain open and that no income should be recognized until the uncertainty is resolved. The absence of a fixed settlement date and the contingent nature of delivery make the SAFEs, if anything, less appropriate for current income recognition than the prepaid forward contract addressed in Revenue Ruling 2003-7.
2. Tax Consequences Under Prepaid Forward Characterization
The tax consequences under the prepaid forward characterization are substantially identical to those under the open-transaction analysis:
• At issuance: No income is recognized by either the Company or the investor. The investor's basis in the SAFE equals the Purchase Amount. The Company treats the proceeds as a deferred equity contribution, not as income.
• Upon conversion or settlement: Gain or loss is recognized when the forward is settled — that is, when shares are delivered (upon an Equity Financing), when cash or other consideration is received (upon a Liquidity Event), or when a distribution is made or the instrument becomes worthless (upon Dissolution). The amount of gain or loss is determined by the difference between the amount realized and the investor's basis.
• No imputation of interest or OID. The characterization as a prepaid forward contract, like the open-transaction characterization, avoids the imputation of interest or original issue discount. Because the contract is not debt and the investor's return is entirely contingent on the Company's equity value (not on the passage of time or the use of money), there is no time-value-of-money component to impute. The investor is not lending money to the Company; the investor is prepaying the purchase price for a contingent equity interest.
The prepaid forward characterization thus provides the same practical result as the open-transaction characterization. The choice between the two characterizations is largely a matter of analytical framework rather than substantive tax consequence. We believe that either characterization is defensible, and we recommend that the Company and the investors adopt a consistent position based on the open-transaction / equity contract framework as the primary characterization, with the prepaid forward analysis as a well-supported alternative.
E. Option Characterization (Considered and Rejected)
For completeness, we have considered whether the SAFEs could be characterized as options to acquire equity at a capped price. Under this characterization, the Purchase Amount would be treated as a premium paid for the right to acquire shares of Preferred Stock at a price determined by the Valuation Cap.
We reject this characterization for two principal reasons:
First, an option typically requires the holder to make an additional payment — an exercise price — at the time of exercise in order to acquire the underlying property. The holder pays a premium for the option and then, upon exercise, pays the exercise price to acquire the stock. The SAFEs do not operate this way. The Purchase Amount is fully paid upfront, and no additional payment is required upon conversion. When the SAFEs convert in an Equity Financing, the investor receives shares automatically, without tendering any additional consideration. The economic mechanics of the SAFE are thus fundamentally different from those of an option.
Second, an option is typically exercisable at the holder's election — the holder decides whether and when to exercise. The SAFEs do not give the holder any unilateral exercise right. Conversion is triggered automatically by external events (an Equity Financing, a Liquidity Event, or a Dissolution) that are outside the holder's control. The holder cannot elect to convert the SAFE at a time of the holder's choosing; conversion occurs only when, and if, a qualifying event takes place. This automatic, externally triggered conversion mechanism is inconsistent with option characterization.
For these reasons, option characterization is inapt for the SAFEs, and we do not recommend it.
F. Company-Side Tax Treatment
BCS receives cash in the aggregate amount of $1,850,000 in exchange for the SAFEs. Under either the open-transaction or prepaid forward characterization, the receipt of cash is not taxable income to the Company. The cash is treated as a contribution to capital or a deferred equity issuance — essentially, the Company has received an advance payment for equity that it will issue at a future date upon the occurrence of a triggering event.
This treatment is consistent with well-established principles governing corporate capital contributions. Under Section 118 of the Code, a corporation's gross income does not include contributions to its capital. While Section 118 is most commonly applied to contributions by existing shareholders, the principle that a corporation does not recognize income upon the receipt of equity capital is fundamental to the corporate tax system and extends to contributions by persons who will become shareholders upon conversion.
The SAFEs do not generate an interest deduction for BCS. Because the instruments are not debt, there is no interest — whether stated, imputed, or in the form of OID — for the Company to deduct under Section 163 of the Code. This is consistent with the characterization of the SAFEs as equity instruments: equity investments are funded with after-tax dollars and do not give rise to deductions for the issuing corporation.
No amortizable premium or discount arises in connection with the SAFEs. These concepts are applicable to debt instruments under Sections 171 and 1276 of the Code and have no application to equity contracts or prepaid forward contracts.
G. Most Favored Nation (MFN) Provision
The MFN provision in the SAFEs provides that if the Company issues any subsequent SAFE or convertible instrument on terms more favorable to the holder than those contained in the existing SAFEs (e.g., a lower valuation cap, a discount rate, additional protective provisions, or other investor-favorable terms), the existing SAFEs will be automatically amended to incorporate the more favorable terms. This provision is a standard protective mechanism designed to ensure that earlier SAFE investors are not disadvantaged relative to later investors.
The triggering of the MFN provision does not, in itself, create a taxable event. An amendment to the terms of an outstanding financial instrument may, under certain circumstances, be treated as a taxable exchange of the old instrument for a new instrument if the amendment results in a "significant modification" of the instrument's terms. See Treas. Reg. § 1.1001-3 (addressing modifications of debt instruments). However, the regulations under Section 1.1001-3 apply by their terms to "debt instruments," which, as we have concluded, the SAFEs are not.
Even if the significant-modification regulations were applied by analogy, the triggering of the MFN provision would adjust the economic terms of the existing SAFE (e.g., by reducing the valuation cap) but would not constitute a disposition, exchange, or constructive receipt of income by the investor. The investor would continue to hold the same SAFE, with the same Purchase Amount and the same basis, subject to adjusted conversion terms. The adjusted terms (e.g., a lower valuation cap, resulting in a greater number of shares upon conversion) would be taken into account at the time of conversion or settlement, not at the time of the MFN amendment.
We note that if the MFN provision results in a materially different instrument — for example, if a subsequent SAFE includes an interest component, a maturity date, or other debt-like features that are incorporated into the existing SAFEs via the MFN provision — the characterization analysis would need to be revisited at that time. Based on the terms of the current SAFEs and the Company's stated intention to issue only post-money SAFEs without interest or maturity provisions, we do not anticipate that the MFN provision will alter the equity characterization of the instruments.
IV. Founders' Restricted Stock — Section 83(b) Elections
A. Background
The three co-founders of BCS — Devin Mallory, Priya Raghavan, and Tomás Guerrero-Vidal — each acquired shares of BCS Common Stock pursuant to Restricted Stock Purchase Agreements dated September 14, 2021, the date of the Company's incorporation. As described in Section II.B above, the founder shares are subject to four-year vesting schedules with one-year cliffs. The vesting commencement date for all three founders is September 14, 2021. Under the Restricted Stock Purchase Agreements, the Company holds a right to repurchase unvested shares at the original purchase price (par value of $0.0001 per share) upon a founder's cessation of service with the Company. This repurchase right constitutes a "substantial risk of forfeiture" within the meaning of Section 83(c)(1) of the Code.
Under Section 83(a) of the Code, when property is transferred to any person in connection with the performance of services, the service provider must include in gross income the excess of the fair market value of the property (determined without regard to any restriction other than a restriction that by its terms will never lapse) over the amount paid for the property, at the first time that the property is either transferable or no longer subject to a substantial risk of forfeiture. In the case of the founder shares, this would mean that absent a Section 83(b) election, each founder would recognize ordinary income as the shares vest over the four-year period, with the amount of income measured by the fair market value of the shares at the time each tranche vests, less the par value paid.
B. Section 83(b) Elections
Section 83(b) of the Code provides an alternative: a service provider who receives property subject to a substantial risk of forfeiture may elect, within 30 days of the transfer, to include in gross income for the year of transfer the excess of the fair market value of the property at the time of transfer (determined without regard to any restriction other than a nonlapse restriction) over the amount paid for the property. By making this election, the service provider accelerates income recognition to the date of transfer, when the fair market value of the property may be minimal, and avoids recognizing ordinary income as the shares vest at potentially higher values.
All three BCS co-founders timely filed Section 83(b) elections within 30 days of the September 14, 2021, grant date. The elections were filed with the Internal Revenue Service in October 2021, within the mandatory 30-day window prescribed by Section 83(b)(2) and Treasury Regulation § 1.83-2(b). Copies of the elections were also provided to the Company, as required by Treasury Regulation § 1.83-2(d).
The effect of the Section 83(b) elections is as follows:
• Each founder included in gross income for the 2021 taxable year the excess of the fair market value of the Common Stock at the time of transfer (September 14, 2021) over the amount paid (par value of $0.0001 per share). At the time of the Company's incorporation on September 14, 2021, the fair market value of the Common Stock was nominal — essentially equal to par value — as the Company had no operations, no revenue, no customers, and no assets other than the founders' intellectual contributions. Accordingly, the income recognized upon the Section 83(b) elections was minimal or zero for each founder.
• Going forward, the founders will not recognize additional ordinary income as their shares vest over the four-year period. The substantial risk of forfeiture — the Company's repurchase right on unvested shares — is disregarded for income recognition purposes once the Section 83(b) election is made. Instead, any appreciation in the value of the shares between the grant date and a future sale or other disposition will be treated as capital gain (long-term capital gain if the shares are held for more than one year from the grant date).
• The founders' holding period for purposes of determining long-term versus short-term capital gain treatment begins on the grant date, September 14, 2021, regardless of the vesting schedule. As of the date of this memorandum, the founders have held their shares for approximately six months; they will satisfy the one-year holding period requirement for long-term capital gain treatment on or after September 14, 2022.
If a founder's employment with BCS terminates before all shares are vested and the Company exercises its repurchase right to reacquire unvested shares at par value, the departing founder will recognize a capital loss equal to the amount previously included in income under the Section 83(b) election with respect to the forfeited shares (which, as noted, was minimal or zero). However, under Section 83(b)(1)(B), no deduction is allowed for a loss resulting from a forfeiture of shares for which a Section 83(b) election was made, except to the extent that the amount paid for the shares exceeded the amount received upon forfeiture.
C. SAFE Round Impact on Fair Market Value of Founder Shares
The issuance of the SAFEs at a $12,000,000 post-money valuation cap does not retroactively affect the Section 83(b) elections filed by the founders in October 2021. The elections were based on the fair market value of the Common Stock at the time of transfer — September 14, 2021 — and subsequent changes in the Company's valuation do not alter the income recognized under those elections. The Section 83(b) election is a one-time, irrevocable election that fixes the amount of income at the time of transfer; subsequent appreciation or depreciation does not give rise to additional income or to a refund of the amount previously recognized.
However, the issuance of SAFEs at a $12,000,000 post-money valuation cap may be relevant to future valuations of the Common Stock for other purposes. In particular:
• Section 409A Valuations. If BCS adopts an equity incentive plan and grants stock options or other compensatory equity awards to employees or service providers, Section 409A of the Code requires that the exercise price of incentive stock options (and the fair market value used for other purposes) be determined in accordance with a reasonable valuation methodology. The SAFE Valuation Cap of $12,000,000 will be one data point — though not the sole or necessarily the most probative data point — in any future 409A valuation. A 409A valuation typically applies significant discounts to the preferred stock price to arrive at the fair market value of common stock, reflecting the differences in rights, preferences, and economic characteristics between the two classes of stock.
• Future Financings. The SAFE Valuation Cap establishes a market-derived reference point for the Company's pre-money valuation in future equity financings. This may influence the pricing of a future Series A round and, consequently, the fair market value of the Common Stock following that round.
The SAFE issuance does not affect the founders' Section 83(b) elections or their vesting schedules in any respect. The SAFEs are issued by the Company, not by the founders, and do not constitute a transfer of founder shares. The founders' equity ownership is diluted on a fully-diluted basis by the SAFE Percent (15.4167%), but this dilution does not trigger a taxable event for the founders.
V. State Tax Considerations
A. Texas Franchise Tax
BCS is a Delaware corporation qualified to do business in the State of Texas. The Company's Texas Secretary of State filing number is 804217635. As a corporation doing business in Texas, BCS is subject to the Texas franchise (margin) tax, imposed under Chapter 171 of the Texas Tax Code.
The Texas franchise tax applies to taxable entities with total revenue exceeding the no-tax-due threshold, which for reports originally due in 2022 (based on the 2021 tax year) is $1,230,000. "Total revenue" for Texas franchise tax purposes is generally defined as the amount reported on the entity's federal income tax return as gross receipts or gross sales, less returns and allowances, plus certain other items of income specified by the Texas Tax Code. Importantly, capital contributions, equity issuances, and other non-revenue receipts are not included in "total revenue" for franchise tax purposes.
BCS's annualized run-rate revenue as of February 2022 is approximately $564,000 (based on approximately $47,000 in monthly recurring revenue). The Company's actual total revenue for the 2021 reporting period — which covers only the period from incorporation on September 14, 2021, through December 31, 2021, approximately three and a half months — was approximately $130,000 to $165,000, well below the $1,230,000 no-tax-due threshold.
Accordingly, BCS has no Texas franchise tax liability for the 2021 tax year. The Company is, however, required to file a no-tax-due information report (Form 05-163) with the Texas Comptroller of Public Accounts, together with the Public Information Report (Form 05-102), by the applicable filing deadline (generally May 15, 2022, for the initial report year).
Receipt of the SAFE proceeds ($1,850,000) is not "revenue" for Texas franchise tax purposes. The SAFE proceeds represent a capital contribution or deferred equity issuance, not income from the Company's operations. Accordingly, the SAFE proceeds do not count toward the $1,230,000 no-tax-due threshold and do not create a franchise tax liability.
We recommend that the Company engage its tax return preparer to timely file the no-tax-due information report and Public Information Report with the Texas Comptroller. Failure to file, even when no tax is due, may result in the forfeiture of the Company's right to transact business in Texas.
B. Delaware Franchise Tax
As a Delaware corporation, BCS is subject to the annual Delaware franchise tax imposed under Title 8, Section 503 of the Delaware Code. The Delaware franchise tax may be calculated under one of two methods: the Authorized Shares Method or the Assumed Par Value Capital Method. The Company's annual report and franchise tax payment are due on or before March 1 of each year.
For the 2021 tax year, BCS paid the minimum Delaware franchise tax of $400, based on the Authorized Shares Method. Under this method, the franchise tax for a corporation with up to 5,000 authorized shares is $175, and for a corporation with 5,001 to 10,000 authorized shares is $250. However, a minimum payment of $400 applies to all corporations regardless of share count when the annual report filing fee is included. BCS, with 10,000,000 authorized shares, would owe a substantially higher amount under the Authorized Shares Method but may benefit from using the Assumed Par Value Capital Method, which typically produces a lower tax liability for corporations with high

CALDERWOOD & HARKNESS LLP

MATTER NO.: 1042-00002

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