Technology

Military leaders talk incessantly about innovation. Why don’t they buy more of it?

Published reports detail how little DoD actually spends on new or start-up companies, even ones that have what the military says its looking for.

Tom Temin@tteminWFED

March 14, 2024 12:40 pm

12 min read

For a decade, the nation’s military leadership have talked about the need for innovative technology, and how to inject it faster into doctrine and operations. Published reports detail how little the Defense Department actually spends on new or start-up companies, even ones that have what the military says its looking for. For some insight, the Federal Drive with Tom Temin turned to people with experience at the Pentagon and in startups. Lisa Hill is the director of investor relations and engagement at Shield Capital. Michael Brown is a partner at Shield Capital, and former director of the Defense Innovation unit.

Interview Transcript:

Tom Temin And you are both former employees. And Michael, you as a director of the Defense Innovation Unit. So, you know where of you speak. Let’s begin a little bit. Just give us a brief summary of what Shield Capital is all about. Sounds like the name shield puts you in that space.

Lisa Hill Sure. So, you know, Shield Capital is really set up to capitalize on the convergence of these market trends in both commercial technology and national security, and really able to leverage the specialists approach to venture capital investing, which is deep understanding in a technical domain, and also the value added advantage that we’re able to bring to our portfolio companies within their market strategies. And so, Shield Capital is really at the forefront of looking into what are the companies building and what are the applications in both markets, and will they be able to scale? How will we be able to be part of that success for those young companies?

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Tom Temin And Michael, putting on your former DIUX hat, you dealt with a lot of these companies. They brought things to you. There was OTA, you know, other transaction authority money to maybe get prototypes. What’s your experience with the degree to which they ended up doing business with the Pentagon? And how did you try to inculcate them both in the procurement system and in what it takes to deliver at military scale, let’s say?

Michael Brown Yeah. Well, I think you’re right Tom, using the other transaction authority, we’re able to bring folks in quickly and put them on contract and then start to test their solution in a military application. So, let’s test and see how they work. And then those that were successful got put on a contract, I think a pretty good success rate. I think DIU was able to at the time, I left a year and a half ago, achieve a 50% transition rate. That means for every project you start, 50% result in a production contract for one of the vendors. So, we were able to bring in over 100 new vendors to DoD. The question is, okay, how big are those production contracts? And to your point, starting out in your introduction, what percentage of that is of Pentagon spending is that? So that’s where I think we still have some room to room to grow, but DIU was able to prove that we could bring new vendors in, and they could begin to scale.

Tom Temin Well, would it also be accurate to say that even a small amount of spending could have a lot of, I don’t know, catalyzing effect? For example, the startups aren’t building battleships at $12 billion apiece, but there is something that for $1 million, could completely change the way a battleship operates, or a carrier operates. I’m making that example up, but I think that’s probably what was more in mind. Fair to say.

Michael Brown It’s exactly right. So, the Replicator program, which wants to deliver thousands of attritable autonomous systems to ENDOPACOM, you could get 2.6 million drones for the cost of one aircraft carrier. So, you’re right, it’s a completely different scale in terms of what you can buy for taxpayer dollars. And we saw a number of vendors, whether it was C3.ai, Shield ai, separate from Shield Capital, obviously Anduril, we saw a number of vendors start to scale, and now they’ve gone on to do large contracts beyond what we were able to help them achieve at DIU.

Tom Temin Yeah. So, then the aggregate sales of this industry, I guess no one can really tell for sure. It’s hard to pull that data out, but one published report said it was only 1% of DoD spending. Do you feel that’s accurate, or could it be more than that?

Michael Brown I think it’s pretty accurate. I think, you know, the vendors that DIU was able to introduce were achieving around $5 billion in contract value at the same time that the Pentagon would have bought $1 trillion worth of gear. Now, to your earlier point, it’s much more expensive to buy an aircraft carrier fighter aircraft, but there’s still a lot of room to move for these new innovative capabilities from nontraditional vendors. So, 1% is too small. It will never be 50%. But that shows that there’s quite a bit of headroom to bring in new capabilities at lower prices for DoD.

Tom Temin We’re speaking with Michael Brown. He’s a partner at Shield Capital and with Lisa Hill, the director of investor relations and engagement at Shield Capital. Both are formerly with the Defense Innovation Unit. And Lisa, what’s your criteria? What do you look for specifically in a company, not just the technology that they’re developing? And by the way, is it only software or is it also hardware types of items? And beyond the technology itself, what does it take for you to say, yeah, this is worth investing in.

Lisa Hill So I think, so Shield Capital looks at four domains specifically. So, we. We are in artificial intelligence, autonomy, cybersecurity, and space that just earlier this week we had one of our portfolio companies, Ace Apex Space Manufacturing, had a successful launch on the Space-x transporter ten, breaking a world record for speed from design sheet into orbit. And so, we are in both software and also hardware. And I think that that diversity is really important because hardware is capital intensive. If you have that balanced portfolio with the software, the SAS opportunities, the enablement opportunities, and then that’s a really important strategy for us. And that’s the way that we sort of think about that, that balance. But that’s not why we would make decisions. And I think and I’ll, I’ll turn it over to Mike here. But, you know, even in the way that we look at investing and in the way that we are approach in three real ways, the team, the technology, and the timing, and that is, is this team the right team to solve this problem? Have they worked together? Do they understand what it takes to start a business to really take this innovation to the next level? And the timing, is the market right? This might be a really great idea. Is the market right to be able to take this and scale it? Is there a customer? Are there customers? Customer traction is critical for our evaluation. And then technology. Is this technology innovative? Is this a science project? Is this a feature or a product? And I think that when you really look at that in that holistic way and you evaluate in the way that our investment committee is really looking deeply into these opportunities, that is that you come up with a productive outcome and a path to success for these founders. And our portfolio runs the breadth of Pre-seed, Seed, series A. That’s really where we like to focus because we are able to be part of those companies approaching those dual market opportunities and that within the government and within commercial markets. And I would also say that, you know, the DoD is not a great customer in the very beginning, particularly for software companies. If you do not have great commercial customer traction on the commercial side, it’s going to be a harder sell to the government customer who wants to see that validation. However, if you look to maybe a hardware company that early DoD partner in the testing and evaluation phase, and the construction phase is a much better partner because of all of the resources that are available to, say, the Air Force.

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Tom Temin Sure.

Lisa Hill Rather building the model on your own then going on as a young company. But so, I’ll leave it there.

Tom Temin Let me pull on that thread for a moment because I wanted to ask about hardware. One of the other issues besides innovation and startups is just the shrinking defense industrial base. The Dib small businesses are maybe getting a bigger share of the money, but there’s fewer of them, and there’s sole sources for many of the critical parts. What about if a company said, you know, we have a much better way of making gyroscopes? I’m making that up. Or roller ball bearings for jet engines. And this technology uses this type of metallurgy instead of that type, this type of manufacturing process instead of that type. We think we can deliver roller ball bearings to the Air Force maintenance facilities for 30% less than Timken. Again, I’m making this up, but would that also attract, do you think, venture capital nowadays? That’s old-line hardware metal pounding?

Michael Brown Yeah. Well, I think it really would depend. Lisa really hit the nail on the head. It really would depend on the team, the confidence in the team. How differentiated is their technology? You mentioned a new process or maybe use new materials. So how significant is that in terms of the performance and cost of what you’re looking for? And then what’s their path to market for components like that? Probably the path to market is with a prime or major defense contractor. One of the differentiating factors for social capital is we have a strategic partnership with L3 Harris. And so that allows us not only some vast resources for tech due diligence of companies to see a differentiated or tech is but also that’s the fastest path to government revenue. So L3 Harris already has the contract. So, if they have a new vendor to evaluate and that vendor is interested, then they have a quick path to revenue different. If you’re talking about kind of a finished product versus a component okay. Well now there’s more opportunity to use DIU AFWERX other pathways into DoD. And of course, that’s where some of us at Shield have some experience. Are we able to help a potential portfolio company?

Tom Temin Sure. I guess it’s easier to make a better chocolate bar. The problem is distribution of shelf space, which is what is going to stop you no matter how good it is.

Michael Brown Yes.

Tom Temin And while I was going to ask the same mistakes that a company or a team would make in trying to sell their product, I’m imagining are similar to the mistakes they make in trying to sell themselves to get money. So, what should they do in general? Better? What’s the most common error you see from startups or would be startups with respect to how they talk to the people that are going to fund and buy from them.

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Lisa Hill You know, I would actually sort of turn that around and say that the incentives are not aligned within the department to be able to go out to these commercial opportunities and have real learning conversation. We are mired in conflicts of interest or non-compete, noncompetitive environments, and it’s almost a question mark. Why are you having a conversation with a venture capitalist? It doesn’t seem to be aligned. And, you know, even the way that we think about budgeting, you know, the PPBE reform report just came out with a host, I think, over 40 recommendations for how to really think about resourcing. So, when we think about companies coming to the department, first of all, who would you even call to say, hey, I have this cool thing. So, understanding how to access is the first problem that many young companies find themselves in, which is why the Defense Innovation Unit was established, was to be able to open the aperture of opportunity and be able to speak in both the early startup language and also acquisition language. And that is why you see so many people and so many leaders, like Mike and Raj leaving the Pentagon to go into venture capital because they are bilingual venture capitalist who speak DoD acquisition and startup founder language. And that’s really the inhibitor. It’s not the sell yourself better. It is who do you call? How do you access it? And then what are the real opportunities that are worth my time for what I’m building? That’s a two-way conversation.

Tom Temin 703695 5000 won’t get you very far, Michael.

Michael Brown That’s right. You were asking, what would we say to potential startup companies that would help them as they’re selling to us to potentially get money? I think a lot of founders are focused on the technology, and that’s very important. That really is something that obviously allows companies to differentiate, and its ultimately what DoD might be interested in. However, just as important, and Lisa pointed this out, is the team itself. So what experience are you bringing that ideally makes you suited to bring this technology to market? Experience there is pretty important. And your go to market your point Tom, just now about distribution, it’s one thing to have, you know, the best widget in the world, but figuring out how were you actually going to get that to the customer is important. And that’s a complex chain at DoD. And it’s also important in the businesses we invest in it. We’re looking for dual use. So, what’s your plan to be a successful commercial company is very reliant on what your go to market is. So, we’re at evaluating all of those. So, I think the mistake would be a founder that comes in, is very excited about the technology, but hasn’t really thought about who the team is, how relevant their experience is to what they’re trying to accomplish, and then they go to market or distribution channel.