war on the rocks

Renewing Defense Innovation: Five Incentives for Forming Pentagon-Startup Partnerships

May 3, 2018

At confirmation hearings on Capitol Hill on Nov. 7, 2017, Sen. John McCain was serving up a heaping of the straight talk for which he’s become known: “The DoD’s relationship with Silicon Valley … will be one of these disgraceful chapters that will be written about. That’s where the innovators are, sir.”

Time will tell whether James “Hondo” Geurts takes McCain’s advice and heads out to Silicon Valley in his capacity as the new assistant secretary of the Navy for research, development, and acquisition. But make no mistake, time is of the essence.

The commanding technological lead the United States possessed over its adversaries during much of the 20th century has, by Secretary of Defense Jim Mattis’ own admission, eroded in every domain of warfare. Today, the United States struggles to keep pace with foes capable of rapid progress. If it does not triage the technological slippage and begin attracting new partnerships in the commercial sector, the highest-budgeted defense force in the world will be outmaneuvered by adversaries with fewer resources who leverage commercial research with speed and agility.

An innovative pivot inside the Pentagon would be best served by engaging startups early to shape the development of cutting-edge, and often dual-use, technologies. Past American defense success with commercial sector partnerships and recent Chinese successes with startup investments provide anecdotal evidence that defense partnerships are best formed directly. Moreover, a wide body of academic literature indicates that direct relationships between the Defense Department and the commercial industrial are critical to defense innovation.

To regain America’s technological superiority, the Defense Department should harness the power of U.S. startups by developing an understanding of the startup landscape and aligning defense incentives to help these companies achieve their goals. This will position the Pentagon to gain early access to game-changing technologies before its adversaries while positioning startups to gain access to the Defense Department’s unrivaled resources.

A Historical Advantage Lost

In the past, the Department of Defense was highly effective at sourcing innovation and innovative minds from the non-defense world. During World War II, when the U.S. government realized it needed an external innovation pipeline to secure force-multiplying capabilities, it did something unprecedented: It hired civilian scientists to work on defense-related problems. While the United States has contracted civilians since the Revolutionary War, the establishment of Vannevar Bush’s Office of Scientific Research and Development was the first formalized effort to inject civilian scientist technological know-how into the Defense Department. Bush’s office was responsible for nearly all wartime military R&D including starting the Manhattan Project, and effectively establishing electronic warfare. Civilian scientists were so successful in helping the government achieve its objectives that the Office of Scientific Research and Development became the National Science Foundation in 1950. Later, during the Cold War, the government once again sourced outside innovation by mobilizing commercial industry to develop satellites and precision-guided munitions enabling the United States to see and accurately hit targets beyond the horizon. This “deep strike” capability was insurmountable by other countries and renewed America’s strategy of deterrence against the numerically preponderant Soviet Union.

Today, the Defense Department undervalues the commercial sector. To illustrate, the Defense Department spent roughly $62 billion on defense R&D and $101 billion on procurements in 2015. In comparison, U.S. businesses spent $345 billion on commercial R&D in 2015, supplemented by the roughly $70 billion U.S. venture capitalists put up in funding. In the 21st century, American adversaries have made better use of the commercial sector than the United States resulting in parity and overmatch.

After witnessing the United States employ commercial technologies such as GPS, satellites, and precision-guidance components during the Cold War, China, Russia, and North Korea followed suit, enabling them to match America’s once-insurmountable “deep strike” capability. More recently, Russia employed commercial drones to great advantage against Ukraine while China uses commercial products for digital radio frequency memory jamming. Even non-state actors like ISIL use commercial off-the-shelf drones and encryption software to gain an asymmetric advantage against U.S. forces.

The savviest adversaries have gone beyond merely acquiring and deploying cutting-edge commercial technologies by investing in early-stage startups to shape the development of those products before they even make it to market. The Chinese government, for example, committed $150 billion dollars toward developing artificial intelligence (AI) technologies such as image recognition, natural language processing, and predictive analytics. Consequently, China has become the world’s largest investor in AI, investing in Silicon Valley startups with the aim of using American commercial innovations to advance its own national security agenda.

Chinese companies bolster the government’s effort as Baidu, Alibaba, Tencent, and JD.com alone have invested $5.6 billion in 48 U.S. startups over the past two years. Some of the U.S. startups they invested in are Airbnb, Uber, and Lyft, as well as lesser known Magic Leap, a virtual reality startup, the mobile safety company TrustGo, and mapping company Atlas. Chinese investment in American startups working on defense-related technologies has sent the Trump Administration, Congress, and the Intelligence Community into a collective frenzy. Senator Mark Warner has been especially vocal about China’s use of the U.S. commercial sector to accelerate its technological progress, and the ramifications such engagement could have for American national security.

While China is busy influencing product development through early investments, the Defense Department remains focused on acquiring products. The Pentagon has established several organizations over the last decade to do just that including the Army’s Rapid Equipping Force and the Defense Innovation Unit Experimental (DIUx). These organizations have made significant progress in expediting government acquisitions. Although a faster acquisitions process is necessary to meeting battlefield needs, these efforts are insufficient for renewing the department’s technological superiority because they emphasize commercial acquisition, while China has a head-start by shaping commercial technology.

The Defense Department needs a pivot on the magnitude of the OSRD during World War II. Understanding the startup landscape and aligning defense incentives to startup needs is critical to realizing the relatively untapped opportunity that startups represent to national security

In a previous War on the Rocks article, Joshua Israel made a compelling argument that the Department of Defense should forge relationships with startup accelerators to gain access to early-stage startup ideas and technologies. It’s true that such engagement can be fruitful, but accelerators are a relatively new phenomenon. There is little empirical analysis on the impacts accelerators have on the startups and the broader ecosystem. The scant research that does exist is mixed, arguing that accelerators can have both positive and negative impacts on startup growth.

Understanding the Startup Landscape

A startup, by definition, is “a human institution designed to create new products and services under conditions of extreme uncertainty.” “Uncertainty” is a critical word here that represents both risk and opportunity since startups are working on unproven products. A Defense Department that can dampen risk and intensify opportunity for startups working on defense-relevant products will gain access to technologies before its competitors. Although early investment is risky for the Defense Department to take on, small early investments may be less risky and costly than acquiring technologies through the lengthy acquisitions process that may render the capabilities obsolete by the time they are deployed.

With early access to paradigm-shifting technologies, the department will be better able to influence how the products are developed and ultimately employed for defense purposes. Done correctly, a startup-Defense Department partnership would be mutually beneficial. The Pentagon would capture more commercial innovation earlier than any other actor, which will allow it to renew its technological superiority. Meanwhile, startups would gain access to incentives they could find nowhere else. To facilitate this partnership, the Defense Department must understand the startup ecosystem and the resources startups need to form viable companies.

The simplest way for the Defense Department to understand the needs of startups is to understand the first four rounds of startup funding: Seed, Series A, Series B, and Series C. The earlier the round, the less mature the company, which translates to greater risk and opportunity for the Pentagon.

The Seed round is where startups have what they believe to be a good idea and little else. A Seed round startup strives to prove that its idea solves a problem customers are willing to pay for. This is called “product-solution fit.” Series A startups move beyond product-solution fit, seeking to demonstrate that their product’s value meets the needs of targeted customers, or “product-market fit.” Product-market fit is signaled through growth in the number of users a product has and the amount of revenue it generates. To succeed, Series A startups search for early customers (a.k.a. “early adopters”) who are willing to use early, often incomplete or faulty, versions of their product to gain the feedback needed to improve that product. Startups in the Series B round aim to do three things: 1) solidify product-market fit; 2) expand into new market segments; and 3) experiment with different revenue streams. Critical to accomplishing each of these three tasks is providing evidence, gained through test cases, that the product is effective. Startups then perfect their product and focus on large-scale growth to new markets in the Series C round.

Aligning Defense Incentives with Startup Needs

Funding round stages indicate which milestones startups are working to overcome and the resources needed to overcome them. The key to making the Defense Department valuable to startups is recognizing which stage companies are in and aligning defense incentives to helping startups overcome the obstacles they face during that stage. Recently, a Sand Hill Road venture capitalist told me that he advises his portfolio companies against going to the Defense Department because success is a “crapshoot” due to lengthy award schedules and an obscure process. However, the value that DIUx has added to early-stage startups (less than 5 percent of its award portfolio), like Saildrone, Joby Aviation, and SHIELD AI, suggests that an alignment of incentives with a startups lifecycle would be highly valuable for both defense and startups. A Defense Department that can help startups through the funding rounds will be viewed as a valuable partner, which in turn will incentivize startups to pursue the defense marketplace.

The Pentagon can use five important incentives to target technology startups at different stages of the funding process.

First, it can offer early-stage startups non-dilutive financial support, or support that doesn’t involve taking an equity stake in the company. In private funding, investors seek to minimize risk by investing in startups and taking equity. If the startup succeeds, so do the investors. As such, private investment comes with an ownership cost. A Defense Department investment is different in that it does not equate to “buying” a portion of the company. Success for defense is developing a quality product that solves warfighter needs, not generating revenue, so government funding does not dilute the startup’s equity. Non-dilutive defense investment is a huge deal for startups because it signals an increase in valuation without affecting ownership. Working with the department early could also drive down risk for startups as high governmental switching costs make it likely that the government would give repeat business to companies already initiated into its system.

Second, the Defense Department has unparalleled resources and qualifications that could accelerate a startup’s growth, especially in the Seed and Series A rounds. For example, the government has ranges where drones and counter-drone products can be tested safely, which are tough to come by in the commercial sector. The department also possesses unique resources such as massive datasets that could be used to train cybersecurity algorithms and vast mock networks in which they can be tested. In addition, the government can accelerate the 3- to 5-year patent application process to less than a year by labeling the patent application as being a national security priority. Possessing patents is valuable for attracting private funding.

Third, the Pentagon can serve as an early adopter and a test case to demonstrate the value of a startup’s product. This is valuable for Series A and B startups. The department’s large budget and mission focus make it less sensitive to early failures than commercial customers and private investors. Startups often have difficulty finding customers to test their product and provide meaningful feedback that is used to improve it. The military is well positioned to provide feedback at a scale much larger than the commercial sector, which can accelerate the time needed to produce a valuable product. Data from a Defense Department test case along with a partnership with the Pentagon will together amount to a government “seal of approval,” which dampens risk and signals viability and market demand to commercial investors like venture capitalists.

Fourth, working with the U.S. military can help truly innovative startups get a head start on future commercial markets before they emerge. The Defense Department often faces problems before they become commercial concerns. Cybersecurity, drones, and counter drones were all relevant to the defense sector before the commercial markets for them were established. For example, Boeing subsidiary Insitu helped the Defense Department tackle intelligence, surveillance, and reconnaissance challenges with its drone ScanEagle and now has a leg up in the commercial market monitoring wildfires to help firefighters. Similarly, SHIELD AI was only able to raise funding from venture capitalists after a 2016 DIUx award signaled that there was a potential market for autonomous drones capable of mapping the interior of structures.

Finally, the Department of Defense represents a huge and lucrative market which can be critical to later-stage startups, like those in Series C, looking for large-scale growth in new customer segments and markets. The department is the largest employer in the world and has a budget greater than the total revenue of all Fortune 50 companies combined. The defense marketplace will give startups more access to people with the authority to write large checks. An added benefit is that the Defense Department offers larger margins to suppliers than commercial enterprises do. Additionally, the Pentagon can serve as a stepping stone to the broader U.S. government, and allied countries, where budgets are even larger.

How Can the ‘Disgraceful Chapter’ Be Rewritten?

In a word: partnership. Startups and the Defense Department are both hell-bent on surviving. The Pentagon needs innovative technology to bolster national defense. Startups need to raise capital to develop a valuable product. Both can use each other’s needs and comparative advantages for mutual gain, which will tie startups’ progress — and therefore, their success — to Defense Department innovation. Framing the startup-defense relationship around a partnership forces the Pentagon to consider the value it can add to the commercial sector while also giving clear, revenue-driven motivation for engaging with the defense marketplace.

History has shown that the commercial sector is vital to defense innovation. This remains the case in the 21st century. Initiating commercial partnerships with startups is a good place for the Pentagon to start, especially since early-stage, capital-hungry startups are unlikely to experience the existential crises that hinder Silicon Valley partnerships with the major tech giants today (e.g. Google and Project Maven). The Pentagon should begin reaching out to defense-relevant startups and forming partnerships immediately. It has worked for China. It will work for the United States. Time is of the essence.

 

Jeff Decker, PhD is the Program Manager for the Hacking for Defense Project at Stanford University’s Precourt Institute for Energy and an instructor for the Hacking for Defense course. He is an Army Second Ranger Battalion veteran. He can be reached at jmdecker@stanford.edu.

 Image: U.S. Army