Silicon Valley is laying the groundwork for what could be an unintended financial consequence from the war
With all of the geopolitical conflicts in the news today, as well as the newfound attention heaped on Defense technology by Silicon Valley, the aforementioned quote could be run in any number of financial or tech industry content outlets. The rapprochement between the Valley and the Pentagon after 30+ years of estrangement has generated electricity and optimism not seen in years.
The reality is that quote was uttered not this year, but 20 years ago, during the post-9/11 pivot from Internet investing to the newly christened "Homeland Security" sector. Overnight, emerging VC managers created new firms with the specific intent to capitalize on what would undoubtedly become a very lucrative sector: a wave of new technologies designed around protecting the homeland from AQ-backed terrorism. In parallel, some of the most storied VC firms of the time created thematic funds and tasked senior partners with their stewardship, all in an attempt to capture some of the $38B in spending allocated to the Department of Homeland Security (DHS).
I was one of those swept up in the wave of patriotism, a sense of duty, and national purpose. I left a lucrative career in venture capital to lead a startup commercializing technology for explosive detection, as there was a very credible threat of suicide bombers on American soil. With Oklahoma City not too far in the distant past, many of us feared a domestic campaign of terrorism targeting shopping malls, critical infrastructure, and cultural centers of importance.
What happened next was less of a bang, and more of a whimper.
In a previous post, I detailed some of the problems I encountered when running that company. Most significantly, I found that unlike the tech industry, where new technology tends to be absorbed relatively quickly, in the sectors most vulnerable and in need of advanced technology for Homeland Security, that rate of absorption is rather low. In fact, it's so much lower/slower than one is used to in tech that the problem of investment duration pops up.
With Homeland Security, after the rush into the sector in 2002, by 2005, the investment boom had largely petered out. With the exception of the acquisition of InVision by GE for $900M, there were no "unicorn" IPOs or exits of note. In fact, much of the government spending in the sector was absorbed by the defense primes with less-technologically-breakthrough-but-more-easily-procured systems. The standout winner from this period that even loosely resembled a startup company was Palantir, which raised $3B over its 17-year journey to go public at a $16B market cap (multiples/IRR more akin to private equity than venture capital).
The VC firms that launched with a Homeland Security focus either weren't able to fully close Fund I, became zombies before raising Fund II, or morphed into private equity firms/funds. The name-brand firms with Homeland Security thematic sub-funds "rebranded" those vehicles around cybersecurity, which enabled them to fund startups targeting the enterprise market.
Candidly, I see many of the same issues today with Defense Tech. Instead of DHS as the "buyer," DOD serves that purpose.
So what can be done to avoid the same boom/bust outcome for Defense Tech that we saw with Homeland Security?
If I were launching a VC firm/fund or starting a company in Defense Tech, here's what I would do:
#1: Focus on Dual-Use capabilities:
As much as I love the sound of a 25mm chain gun going "chockachockachoka" (I worked on the Bradley Fighting Vehicle back in the day), in order to reduce reliance on DOD or Government Systems Integrator (GSI) acquisitions, the investment has to have dual-use applications for the civilian market. Dual-use creates a path to revenue during normal commercial cycles and opens up a universe of non-defense-related acquirers. The best example that comes to mind is Keyhole, an IQT-funded startup eventually acquired by Google, and the basis for Google Earth.
#2 Nurture Multiple Exit Opportunities:
So many of the companies I see in Defense Tech are so niche-focused that they can only exit and return capital to investors through acquisition by a handful of defense primes. Having that small a universe of buyers in a market where it's very difficult to take a company public is a risk to both investors and entrepreneurs. Rather than focus on exit through defense acquisition, I suggest that Defense Tech companies need to intentionally appeal to not only the vertical market of defense but also to a horizontal market of additional acquirers.
#3 Develop alternative funding structures:
Much like the Cleantech market, there's a problem with investment duration in Defense Tech. Basically, the time period from launch through procurement could exceed the life of a 10-year VC fund. My recommendation is that VC firms entering this market change the fund life to 15 years and arrange "permanent capital" funding sources that don't follow the standard VC fund life.
#4 Adjust multiple expectations
As mentioned earlier, even a successful company in Defense Tech doesn't have the multiples attributed to Power Law winners in the VC market. My recommendation is that funds investing in the sector be willing to accept a lower multiple in exchange for longer-term customer relationships for their portfolio companies and build that into the model.
I'm a true believer that Silicon Valley-style technology investing can play a great part in evolving our national security to face modern threats. A close study of the Homeland Security investment rush would serve both investors and entrepreneurs as they pursue this noble goal.
Comments
You can follow this conversation by subscribing to the comment feed for this post.