Key to defense innovation -- making the 21st century institutionally legible

Luke Constable: I don’t know how deep into accounting you are, there is a metric that’s really commonly used called EBITDA. And effectively, it is a free cash flow proxy metric. And it was invented by some people in the cable industry who wanted to raise a lot of money to go roll out cable systems all across the US. And they wanted to be able to quickly raise debt to go buy these sort of small cable operators and then put them all together. And with this metric that they invented, all of these other investors suddenly had a Schelling point. Suddenly, all of these investors had a new unit of measurement to look at this type of business. And because they accepted it, they were willing to go fund those purchases. Suddenly, a whole wave of those purchases were done, and basically a whole wave of these projects were financed because someone figured out a way to make that institutionally legible. [emphasis added]

And a similar thing has happened in the last 10 or 15 years with what we call enterprise SaaS companies, where we now have a new set of metrics that weren’t really in use 20 years ago. These are metrics, I’m not sure if you’re familiar with them, these are metrics like CAC, gross churn, net dollar retention. And if I went to someone today and I said, “Oh, I’m investing in a business that has an average customer life time of six years, an LTV to CAC of 4:1, it has 98% gross retention and 127% net dollar retention, and I think those numbers are going to persist for the next four or five years, that is something that I almost wouldn’t even have to explain what the product is. If something met those metrics and truly met those metrics, it’s a company that would get a huge valuation in today’s markets. And it’s again, it’s because it’s now institutionally legible. Someone has basically convinced the world of that. So then the question should probably be, why do these things get institutionally legible? …

Ben Reinhardt: You could almost think of it as someone coming in being really good at sales and arguably like marketing, and basically changing taste and creating a new product category

That was Luke Constable on a great episode of Ben Reinhardt’s Idea Machines podcast, “Your equity is a product.” The whole conversation revolved around how projects get funded, and Luke has tons of outstanding insights.

I thought this part on financial metrics was important because it is exactly the question facing innovative military programs. Oversight agencies and Congress have a particular Schelling point for evaluating new weapons systems. If new paradigms for weapon systems do not meet those criteria, then they will not get funded.

Just like traditional financial metrics (e.g., net income, free cash flow) fail to indicate the investment potential for Software-as-a-Service companies, fixed requirements and lifecycle cost estimates fail to indicate the military value of new programs that use modern approaches like agile and devsecops. The challenge of defense leadership is to define new metrics that are consistent with information era processes, and then get Congress to embrace it all.

Unfortunately, the DoD doesn’t have the trial-and-error experimentalism that exists in the market to go and find out what works. In the market, institutional legibility is arrived at gradually. Even if traditional money managers didn’t invest in SaaS in the early years, there were venture funds that took the risk. This provided information and a feedback cycle that drew traditional investors into the new metrics.

For defense programs all the oversight agencies and Congress have to be convinced before it gets funds — unless firms privately fund developments themselves. One approach is a massive lobbying effort to redefine the elements in an Acquisition Program Baseline. Another approach is to cut Congress out of detailed project-level allocation decisions by justifying budgets at a portfolio level. But then there still needs to be some type of program reporting… and a certain level of trust.

I’ll leave you with some words of wisdom from Luke: