From venture capital cycles to international relations, turbulence has seemingly become the norm. That’s caused tech startups to turn to a new fraternity of investors with some serious dollars to spend.
Enter the defense industrial base.
The billions-dollar industry, bearing some of the world’s biggest brands, has of late turned veritable venture capitalist for today’s most cutting-edge technology.
Spurred by wars abroad and rising tensions with China, federal contracting giants are pumping hundreds of millions into their venture capital operations in hopes of staying on top of the latest advancements in artificial intelligence, quantum computing, machine learning, cyber, 3D manufacturing and robotics — and staying ahead of U.S. adversaries. The likes of Lockheed Martin, Booz Allen and RTX are increasingly taking on new bets and backing smaller, emerging companies in Greater Washington and beyond with crucial dollars that are getting harder to find in the traditional VC world.
Locally and nationally, venture capital activity has ebbed from 2021 and 2022 highs — 2,715 deals were struck nationwide in the third quarter of 2023, about a third fewer than the same quarter last year — while rising interest rates and inflation have made private equity and venture capital firms even more conservative.
Corporate investors, however, have remained resilient through the lower funding cycles. In 2022, 26.2% of all U.S. venture funding rounds included an investment from a corporate venture capital investor (CVC), a record high, according to venture capital data firm PitchBook. In all, 634 CVC-led rounds last year totaled $22.4 billion in value, up more than a quarter from the prior year.
But it’s a strategy that’s just as beneficial to the big defense firms, too. Brian MacCarthy, senior vice president of ventures and managing partner of Booz Allen Ventures, the VC arm of McLean-based Booz Allen Hamilton Inc. (NASDAQ: BAH), explains why.
“Could we go find it faster and build better capability around it as opposed to trying to do it internally?” he said. “This is just a third lever where we can find and access critical technologies and then make an investment.”
What’s driving the shift
Booz Allen Ventures launched its $100 million fund in 2022. RTX Corp. also jumped on the VC bandwagon that year, launching RTX Ventures without disclosing dollar figures.
Daniel Ateya, president and managing director of RTX Ventures, told the Washington Business Journal it has set aside enough to seal five to 10 deals a year in its sweet spot: Series A and B rounds with check sizes ranging from $2 million to $10 million each.
“It’s not necessarily $100 million per se, but it’s in that range,” Ateya told us. “We have flexibility to work within that range.”
Lockheed Martin Corp. (NYSE: LMT) was among the first to experiment with the potential of such strategic investments, launching Lockheed Martin Ventures in 2007 with a $100 million fund for startups. Today, it stands as one of the largest such contractor VC arms with $400 million to invest in startups nationwide. It’s invested in 75 companies across 16 years, per PitchBook, with its most recent deal inked in late October as part of a $10 million injection in Herndon’s HawkEye 360 Inc., a company that specializes in space-based radio frequency data and analytics.
In 2016, Lockheed revamped its VC operation by hiring Chris Moran as vice president and the fund’s general manager. It’s grown from two investment managers in 2020 to four, one for each of Lockheed’s four business segments, with an associate under each to ensure its infusions are in step with the contractor’s tech needs. A year ago, Lockheed also announced LM Evolve, an initiative to form joint ventures or partnerships with midsized companies.
“In a nutshell, things have changed a lot,” Moran said in a recent interview. “We’ve tied ourselves much more closely to the future of the company than we were before.”
The war in Ukraine propelled more such investments from a defense industry that had realized the significant role that new tech could play, and the importance of being able to more directly guide it. Whether it be funding autonomous drones or the use of Elon Musk’s Starlink satellite internet service by Ukrainian soldiers, the battle was a watershed moment for defense contractors to start thinking of themselves as investors.
“The kind of things that Ukraine is using to prosecute this war are exactly the things in the wheelhouse of the venture community,” Moran said.
But one could think of this as a defensive posture, too. Federal contractors have increasingly seen traditional VC firms encroach on their territory, boosting a handful of heavily venture-backed industry players that could eventually be competitors or partners. Those include companies like Shield AI, HawkEye 360, Anduril, Rebellion Defense, Palantir and Epirus, better known in industry parlance as the “SHARPE” cohort.
The feds as inspiration
In any good business, the prevailing philosophy is that the customer is always right. And experts say the new VC divisions reflect as much a change of philosophy in the federal government as in the federal contractors themselves.
Since the dot-com boom, the feds believed they could build the secure technology solutions they needed themselves or pay an established government contractor to build it, said John Song, managing director for government technology analysis firm Baird and co-head of its government and defense investment banking practice. But that yearslong process has proven a liability as the pace of business has sped up.
“We don’t have years for these very quick, high-speed technologies that are being deployed by our adversaries,” Song said. “So we needed to find a different paradigm to tap into leading-edge technologies for the government space.”
Before this paradigm shift into VC, a contractor was largely a hardware company, a software company or a services company, and the feds were prone to getting locked into a single vendor for not just that product, but also its repairs and software updates for the subsequent 10 to 15 years, according to Mike Gozycki, partner at Capitol Meridian Partners, a D.C. investment firm focused on the government contracting sector. The cost, he said, would often be too high for federal agencies to switch vendors after a certain point.
To combat that, the government has since moved toward open architecture and open standards concepts, where anybody from a large systems integrator to a fledgling startup can build products that comply with federal standards, he said.
“Those open standards, it allows these smaller businesses to compete and develop a better mousetrap for a lower price,” Gozycki said.
And it’s made them considerably more attractive for bigger defense companies to back, sometimes uniting prior competitors. To that end, RTX Ventures and Lockheed Martin Ventures jointly contributed to a $12.5 million investment in a 3D printing company, Boston-based Fortify, in June to help push its tech forward in the broader national defense sphere.
Since its start, RTX Ventures has made 10 total investments, with the latest in Redondo Beach, California, aviation and aerospace design startup Impulse Space, according to PitchBook data. Lockheed Martin Ventures has made 21 investments this year alone, per PitchBook, including in CalypsoAI, an AI cybersecurity company based in D.C., as well as in a Los Altos, California, satellite design software company named Antaris Space.
Booz Allen Ventures has made six investments since its founding, including four in artificial intelligence companies, the most recent being Credo AI, a San Francisco startup whose software platform essentially helps put up guardrails around AI algorithms. It’s a conscious investment strategy for Booz Allen, where an executive recently dubbed AI “the most transformative technology since electricity.”
“Our focus on AI investments, specifically, is enabling us to provide government agencies with direct access to innovative technology that is transforming the next generation of national security and global defense and enabling the government to address urgent challenges at speed and scale,” said Susan Penfield, chief technology officer at Booz Allen.
Smaller companies like Science Applications International Corp., which invested $5 million in Morpheus Data in March, a Colorado cloud automation startup, also find they must strategically invest to stay ahead of the pack. It’s increasingly become a fourth route for SAIC to attain exclusive rights to new tech outside of the typical paths to build the tech in-house, partner with a company or acquire a company outright — particularly for expensive commercial tech, said Bob Genter, president of the company’s defense and civilian sector.
The company’s leadership will develop the roadmap and best paths forward depending on what it thinks its federal customers will most need in the years to come. The key, Genter said, is to make the right bets between those four options, before a rival finds a better product.
“We believe that we are, but you may not make the right bet because things change so often. Technology changes often,” he said. “You need to be able to pivot and be nimble. Being nimble is super critical, and our industry is not known for that.”
The price versus the payoff
While VC investments are unquestionably risky, Gozycki said defense contractors are hardly betting the farm. He said he doesn’t believe massive contractors will ever rank venture investments as a top priority.
“It’s somewhat outsourced R&D. This doesn’t really affect their earnings per share,” he said. “If Lockheed Martin makes an $11 million investment in a startup, that’s not going to move the needle from an earnings per share.”
While it may not take big financial hits, that doesn’t mean a VC arm doesn’t have to appease the larger contractor’s shareholders, justify quarterly expenses and show some financial returns, whether immediately within its business units or ultimately in its bottom line.
“One of the biggest challenges, to kind of answer that specific question, is showing short-term progress, but building towards long-term, bold wins,” said Ateya of RTX Ventures. “The bold wins and the big disruptive results — they’re going to take time. But we can show a lot of progress along the way in terms of the diversified portfolio we’re building and then the engagements that we’re generating and driving across our company with these portfolio companies.”
Certainly, every dollar counts for the startup, despite the fact that a defense contractor is rarely going to be the biggest investor on the cap table. Startups also get a new customer base out of the deal, and perhaps a subcontracting role to a larger contractor or insight to serve as a prime on their own government contracts. For a funding-hungry startup, that’s what sets the defense contractors apart from traditional VC or private equity money.
It’s what Garrett Smith, CEO of Reveal Technology, a Booz Allen Ventures portfolio company based in Silicon Valley, describes as the difference between “dumb money” and “smart and engaged money.”
Smith was quick to say that all of his investors add value to his company. But what attracted him to Booz Allen’s investment were clear metrics of success. Booz Allen wants Reveal Technology to deliver value to the former’s contract vehicles with its federal customers.
“They’ve said those things to me, and then we’ve seen it firsthand, and we’ve had that relationship play out materially and accelerating our engagement with customers like the Army and others,” Smith said. “I would say that Booz Allen is nothing if not smart and engaged.”
The knowledge goes both ways, said MacCarthy, who joined Booz Allen 13 years ago, initially recruiting for tech talent in San Francisco.
“It’s been really educational to see how they see the world,” MacCarthy said of startup CEOs. “They’re helping us to move faster as well.”
The danger can be going too fast in the wrong direction. Unlike startups, corporate giants like Lockheed Martin and Booz Allen involve a huge amount of bureaucracy and multiple billion-dollar business divisions beholden to their own goals and objectives. “Focus on specific areas is really the hardest thing that any of these companies, including us, need to do,” SAIC’s Genter said.
“The intent is to know the ingredients and know what you’re making and then explicitly go buy, build or partner on those individual ingredients,” Genter said. “But make one meal. Don’t try to make 15 different kinds of meals.”
In MacCarthy’s mind, these investments are only the beginning, given how quickly technology is moving. He said he’d be shocked if more defense contractors don’t start up their own VC arms in the next five or 10 years, but he does have a warning for those new entrants to the complicated worlds of both venture capital and government contracting.
“If you’re doing this predominantly for financial reasons, I don’t know if that really works as well as the strategic side, at least for the U.S. government,” MacCarthy said. “Just because of how patient you have to be to get these very complicated software and hardware systems into these much, much bigger legacy [government] programs. You can have the best software in the world to solve the problem. But if you can’t integrate it into the big machine of DOD, then it’s pointless.”
