It’s time for new incentives for defense primes to invest in startups

It’s time for new incentives for defense primes to invest in startups
Future artificial intelligence robot and cyborg.

New technologies will continue to come from the commercial sector. (Getty images)

While there have been some high-profile entrant startups that have successfully worked with the Pentagon, the majority of these small firms have found the bureaucracy too difficult to pierce — and the funding too sporadic. In this new op-ed, Chip Walter, a retired Navy captain now in the venture capital space, offers up a solution: look to the defense primes. 

The rules governing most markets can usually be boiled down to simple principles. Real estate, for example, is about “location, location, location.” On Capitol Hill, it’s “power of the purse.”  For mission impact in defense contracting, most would agree it’s “follow the money.”

On October 27th, the Department of Defense published [PDF] its 2022 National Defense Strategy (NDS). The NDS, released every four years, summarizes the key strategic principles that will guide national security priorities for the DoD. This year, the NDS clearly placed emphasis on innovation and technology investment in an era characterized by the Great Power Competition with China. The report directs DoD to “act urgently to sustain and strengthen U.S. deterrence, with the People’s Republic of China (PRC) as the Department’s pacing challenge” and Russia as the “acute threat.”

The NDS contained a powerful signal for industry as well — DoD is seeking to institutionalize technological innovation, going so far as to say “We [DoD] will be a fast-follower where market forces are driving commercialization of militarily-relevant capabilities … and speed their delivery to the warfighter.” The NDS goes on to state that DoD must transform the foundation of the future by “incorporating emerging technologies in the commercial and military sectors that solve our key operational challenges.”

The 2022 NDS language follows work that has been going on for several years. In 2021, federal agencies obligated $3.8 billion to nearly 7,000 companies under Small Business Innovation Research (SIBR) programs, which test technologies for feasibility for US Government applications. Of that, DoD alone awarded $1.6 billion. While this is positive, accelerating technological dynamism is not simply about making federal dollars flow to startups — it’s about making sure those startups evolve into sustainable businesses and their technology transitions into DoD programs.

There’s an easy, clear path for that to happen: by turning to the biggest defense contractors and providing them the right incentives to invest their cash towards non-traditional defense firms, especially those making big bets with little safety net.

In 2021 alone, the top six Defense Primes received over $120 billion in defense contracts. Those same six companies invested over $6 billion of Independent Research and Development (IRAD) funding — just five percent of their massive collective income. Even a small portion of that could money move mountains for tech startups if it was applied externally.

There are a few critical differences in how early-stage funding works in the defense industry vs other markets. Defense is a market many VC firms have historically avoided. Reputational concerns, an unfamiliarity with the ecosystem, longer time horizons, and regulatory fears all play a role in suppressing the availability of private capital. Despite government programs that attempt to fill the gap, notably SIBR grants and Other Transactional Authority (OTA), technologies repeatedly fail to move beyond proof-of-concept and demonstration to transition, often due to the inconsistency of DoD interest (finding a committed champion) and the complexity of navigating the regulatory environment.

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The primes do invest in startups, but they tend to use a partnership model instead of direct investments in the companies themselves because a portion of IRAD is reimbursable and direct investing is not. (Several primes have established corporate venture capital programs, Lockheed Martin being the leader; however, transitioning innovative technology into DoD programs still lags.) The format for a partnership can be as basic as a teaming agreement where two companies jointly pursue a given customer, or it could be a complicated strategic partnership with intertwined funding and development.

Unless the startup is already generating sufficient revenues through commercial traction, to survive it must attempt to raise money from third parties. But the focus of primes on these partnerships leads them to avoid investing with companies in their critical early phases, thus doing little to help early-stage technologies avoid the “Valley of Death” or more prosaic hazards, like bankruptcy.

In contrast, a VC-style investment channels money to a startup company, which then allocates it as needed to operating expenses, product development, and R&D. In the VC model, the investor has a stake in the startup’s success; in the prime partnership model, the prime is focused on securing a single piece of product or intellectual property (IP) and has little reason to support the company which created it. The result is that many of the prime’s partnerships are formed not with startups pioneering new technologies, but more likely with companies working on relatively incremental improvements to existing programs. This results in, essentially, exquisite variations on what DoD already has. This is antithetical to the goals of the NDS and not in line with the DoD’s recent support for low-cost attritable solutions.

Make no mistake: primes are a critical part of the national security apparatus and have a long and storied history of providing top-tier capabilities to DoD. Defense innovation would receive an incredible boost were we able to direct the prime’s expertise and resources to support the disruptive companies more fulsomely.  If we are to meet the innovation goals of the NDS, we must incentivize the primes to move beyond the short-term partnership model and encourage them to form more holistic relationships with promising early-stage companies, including investment into operating businesses. This will give the primes “skin in the game,” a real interest in supporting the startup’s success, and increase funding for companies during the phases they most need it.

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While I suspect there are many ways to incentivize the primes, two possible solutions could be through giving the prime tax incentives for investing while the startup remains private, or by allowing a portion of the investment to be an allowable expense if the startup’s solution migrates into a program-of-record. To seek the most appropriate solution, I recommend DoD establish a working group to include members from several primes (ones with and without a Corporate Venture Capital program) to work through intended and limit unintended consequences of the incentives.

Now, it takes two to tango, and startups have expressed concerns in the past about whether working with a prime would mean they would lose their IP. Let’s be clear: Intellectual property of both the startup and prime must be protected for this to work. As such, each investment should establish a product development partnership not to limit the commercial application of the startup company, but to codify IP protections and define shared or collaborative development as the partnership moves forward.

The 2022 NDS highlights why accelerating the transition of emerging technologies to the warfighter matters: China is relentlessly pursuing rapid scientific and technological advancements and its achievements are mounting. If we want to deliver the world’s most disruptive technology into the hands of the warfighter, we need to disrupt the parts of the acquisition system that are stifling it.

Capt. Chip Walter USN (ret.) served 28 years in the USN as a P-3 pilot, 8 years in CIA, the last 5 years leading a Science and Technology innovation center. Prior to joining Marlinspike Partners, he led Northrop Grumman’s Venture and Partnership Office as Senior Director.