II think many of the policies that we have around small business have been focused on what I’d consider to be social justice more than military advantage…
One of the incentives that unfortunately gets put into these policies is that if the goal is to do business with small businesses, then the incentive is for those small businesses to stay small businesses. Then I think that dovetails into the problem of execution. In my experience… the Department of Defense likes to make large numbers of really small bets on innovative companies. They want to sprinkle around small amounts of money to lots of different contractors. Then the added problem is that those small bets don’t transition into larger bets. So it shouldn’t come as a surprise that small businesses aren’t transitioning into larger businesses; that new entrants aren’t surviving. I think the problem here is that if you want small businesses to grow… you have to pay them. That is how they grow. That is how you go raise a larger round of investment. That provides the economic incentives. Investors aren’t investing in defense because they don’t think it is a good investment. And unfortunately the data shows that they are right… We have to concentrate our priorities, which means that from the Department, they can’t say, you know, here are 500 areas of research and development that we’re kind of interested in providing small amounts of money into…
Ultimately, getting a big contract is important. But it’s far more important for a small business in that it can then turn around to the investment community and go raise a round of funding that is a 10x valuation of what they had. That gives them years of runway to keep working…
I guess the main point I would make is, if in this period of time – you’re a software engineering coming out of college, or you’re an investor looking for the next bet that’s going to become a billion dollar company – why in the world would you join the defense world?… Since the end of the Cold War there’s been two companies that work in national security that have become billion dollar companies, where there are dozens in other sectors. At the end of the day, I think this is a problem with the customer.
That was a very on point Chris Brose on the CSIS podcast episode, “Surviving the Defense Industry: New Entrants and Small Business Graduation.”
I don’t have much to add, except the observation that Barry Watts made, that the financial industry essentially started exiting the defense business in the 1980s, well before the consolidation of the post-Cold War 1990s. Here’s a Defense Science Board article quote from 1988:
Investors believe that defense industries operate in a highly unstable and excessively complex business environment characterized by high risk, restricted cash flow, and low returns.
Investors’ skepticism has caused a virtual closure of the equity and debt markets to all but a few major contractors.
In other words, not a chance you’ll find defense startups able to IPO and get all sorts of cash to do great things like internet startups did back in the 1990s. There’s simply not any kind of exuberance, let alone the irrational kind.
The usual story about financial markets is that they help allocate capital to the highest valued use. But in defense, it is the bureaucracy that picks winners and losers through the acquisition process. It is a good question what the purpose the financial industry plays in defense, where companies are paid for R&D and have major capital costs often billed as a direct expense to the government. The company can’t raise private capital until it has a contract, and once the contract is won all relevant expenses are covered. Still, private capital isn’t forthcoming because small businesses have no path to transition to large businesses in defense.
Ultimately, the purpose of private capital is to place bets on technologies that are non-obvious, but could have huge upsides. These are the kinds of bets we do not find a risk adverse bureaucracy able to finance itself. Further, by putting skin in the game private investors suffer losses for being wrong and rewards for being right.
But with the DOD, there is little benefit to being “right.” First, it can take years to convince the bureaucracy that the right solution is indeed, right. Then, even if the government awards a contract, it is not clear how sunk costs can get reimbursed. The government will demand paying something close to marginal costs for the next increment of work. There is no “super profit” to compensate for the risk of being wrong, and to reimburse the sunk costs put in on the front end. There is no expected relation between the value that the innovation brings, and the cost of production of that technology.
And so, why would innovators and investors risk sinking their energy and capital into defense markets? The opportunity cost is simply too high. There has to be some avenue to scaling a new business across the “valley of death” and into a program of record, or else we’ll be stuck with the industrial base we have. Only having two defense companies reach billion dollar valuations over 30 years is simply abysmal. Certainly, as Brose states, it is due to the customer’s policies.
One last point, it’s not clear what the two defense companies to reach a billion were, or whether Chris Brose included Anduril in that list. Brose is now employed at Anduril, which recently reached a billion-dollar valuation. But that was largely on the back of DHS, itself relatively new.
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