Should VCs stop shunning investments in DefenseTech?

Venture capital firms have shied away from DefenseTech investments in the past. With the war in Ukraine, VCs can no longer afford to ignore it

By Uwe Horstmann

VCs have shied away from DefenseTech investments in the past. Is this because DefenseTech is not a venture capital case? And, more importantly, should it be one at all? The war in Ukraine has led to a paradigm shift in the way we think about the defense sector. Russia’s unprovoked war against its sovereign neighbor has sparked debate among technology companies, investors, and governments on how to do more for Defense. In fact, even NATO seems to have joined the ranks of tech investors in recent times.

Not just in Europe but around the world, people suddenly realize that we have taken for granted the security we have enjoyed over the last few decades as countries start to look at how they can better defend themselves in the future. So, when it comes to entering the DefenseTech space, what do generalist venture capital firms need to consider?

What are DefenseTech startups?

There are three fields of application for DefenseTech. Some of the technology solutions are civilian in nature. For example, digital health and mental well-being for those involved, including military personnel. Other companies offer solutions with a dual-use function, either for commercial or military purposes, such as observation tools, sensors for object recognition, or cybersecurity countermeasures. And then there are the purely military use cases, like active counter-drone systems, autonomous weapons, and ammunition.

When we talk about defense, it is important to make these distinctions and be very clear about what kind of technology we mean – where it simply gives us the means to protect ourselves better or where it can actively be used against other people.

Venture investing in DefenseTech

The parameters for looking at investing in such companies are 1) the technology involved, 2) its primary users, 3) what the exit scenario is, 4) whether it deals with weapons or ammunition, 5) if special laws or export regulations apply, and 6) what ESG considerations have to be taken into account. Let’s look at some examples:

Parameters for investing in DefenseTech
  • A start-up in the healthcare sector, for example, in telemedicine or mental health, is contracted by the military to provide care for its thousands of soldiers in peacetime. The primary use is civilian; it’s not a weapon or ammunition, no special regulations apply, and the exit case is a broad universe of mostly civilian actors.
  • AI technology that improves object recognition based on AI sensor fusion is a dual-use case, as it cannot be used as a weapon but for surveillance (civilian or law enforcement/military), and it is allowed under regulation. The exit case could be other technology players or security companies.
  • A drone defense startup: Kinetic projectiles that can be used for the destruction of unauthorized drones in restricted airspace. The primary use is for military or law enforcement purposes; it is a type of munition, special export regulations apply, and the exit case is likely to be in the aerospace or military industry. Systems like Iron Dome could be cited as an example of further development of this technology.

VC funds have rules

Investors have to asses what to invest in and evaluate whether the technology is for civil, dual-use, or military applications.

In terms of how they can invest, most VCs have strict rules. These are set and specified together with the limited partners of the fund. These partners, whether institutional investor, family office, or private individual, also have their own set of rules. For the generalist VC, a lot of topics like gambling, drugs, weapons, or ammunition are off the table. It’s best to openly discuss with the LPs what is possible and what is not. Having said that, it’s also important to take into consideration ESG implications for the funds.

Selling to governments is complicated, to say the least, but not impossible

Another thing to think about is how to scale DefenseTech. Coming out of R&D and taking into account government procurement cycles for either civilian or military purposes, you are looking at a potential sales period of 18 months. Startups in this space need to have a long breath. You are usually dealing with strong incumbent players. So selling to a single customer — the government — becomes very difficult when you are competing with large industry players with deep lobbying pockets.

However, despite the longer government sales cycles, government customers tend to stay with the same supplier for a longer period of time than enterprises. In addition, the transparent, open bidding process for government procurement allows startups and scaleups with real technological advances to have a fair chance of winning a defense category against larger incumbents. These factors, combined with the dual commercial use cases, tend to provide a balanced revenue model to sustain VC investment over the long term.

Tread lightly because technology can always be misused

We must always remember that technology can be used for good and bad. The elephant in the room when investing in DefenseTech is the ethical implications. We have seen how using commercially available drones on the battlefield has enabled an outnumbered army to turn the tide of a conflict against a superior enemy. However, we have also seen how technology can be manipulated and used against those who cannot defend themselves.

There is the perennial threat of governments and big companies using our own data against us. Palantir may help catch the bad guys, but if you live in a country where the leadership considers it a crime to disagree with them, you’re going to be in big trouble.

Another perspective is the impact of this kind of investment on the people who work in the tech industry or its customers.

Spotify founder Daniel Ek made headlines when he invested in the German defense AI company Helsing. The result was a shitstorm from artists active on Spotify, who had their work removed from the platform in protest. On several occasions, the tech scene has been vocal about these issues. Microsoft-owned GitHub faced criticism from its own developers when it collaborated with ICE, the US Immigration and Customs Enforcement agency.

DefenseTech is complicated, but VCs can’t afford to ignore it

There are many concerns about VCs investing in DefenseTech, both ethical and financial. Ultimately, it is up to VCs and tech investors to decide whether their investment in defense technology is in line with their values and their LPs.

In hindsight, there is potential, especially in dual-use concepts. There you are dealing with a multi-purpose role with different angles in terms of customers, use cases, and exit opportunities. How the technology is used and how these future exit scenarios unfold, however, needs to be strictly monitored. The European Union has adopted a dual-use regulation that sets out common licensing requirements and procedures for all EU member states for the export, brokering, technical assistance, transit, and transfer of dual-use items.

Industry pledges can also help prevent investment in dual-use companies from going in the wrong direction: A group of robotics companies, including Boston Dynamics, recently declared that they would not support the weaponization of their products and encouraged others in the industry to do the same. This could also be a prerequisite before a VC commits to investing.

It is becoming increasingly clear that the military can be a huge and relevant market for startups. In the long run, DefenseTech will have a major impact on the way we protect our democracy, our values, and our way of living against new threats. Simply ignoring the issue is not an option, also not for VCs. February 24, 2022, has sparked a constructive and open debate, and that’s a start.