Diving Deeper into the Defense Innovation Ecosystem
by Patrick Collins
The first article in this series introduced the defense innovation ecosystem, discussed what makes it unique compared to other sectors of the economy, and explored cooperation between the government and the largest defense firms. This article will look at how the government engaged with small and medium sized firms and their challenges, including the legendary valley of death.
The Bottom of the Ecosystem
On the opposite end of the spectrum from the mature, large scale programs of record is the innovative basic research phase. This is usually laboratory work done at universities, federal research labs, or federally funded research centers. Here again, the government plays an active role as an early-stage investor. Most technologies at this stage are so new that there is no clear path to market for them. Federal grants may be the only form of financing available. Schools of all sizes participate in this government funded research, but some are particularly famous for some of their work supporting defense science and technology (S&T) such as the Massachusetts Institute of Technology (MIT), Stanford, Caltech, and many others.
Again, we see that DARPA is one government agency investing early on. Others include the Office of Naval Research (ONR) and Air Force Research Lab (ARFL). In addition to defense agencies, there’s also NASA and Department of Energy labs, like Lawrence Livermore. Federal funding here is truly a long-term investment. It may take 20 years or more before a theoretical concept develops to a fielded capability.
The Massive Middle
Between these two extremes lies the largest and most dynamic part of the innovation ecosystem, and government investment in this portion is different than the other two. In both the top and bottom strata, federal funding is intended to reduce technical risk, meaning the chance that the technology doesn’t prove viable. When DARPA covers the costs of a prototype jet, or funds a grant for a university research project, it is financing technical risk. In the middle strata, investments often also bear the burden of market risk — the potential that the technology works but the company lacks the staff, management, marketing, processes, and other things needed to be successful. This funding is used to help small and medium enterprises (SMEs) cross the infamous “valley of death” on their path to commercial success and sustainability. This is the difficult journey where a company transitions from start-up to scale-up and tries to move from earning small contracts in a range of hundreds of thousands of dollars into revenue levels in the tens or hundreds of millions of dollars annually.
Where do these SMEs come from?
There are three primary ways a company ends up in this massive middle segment of the ecosystem. The first is progressing linearly from the bottom up, a firm could grow out of a university or laboratory after research proves an experimental technology performs well enough to create a minimum viable product and transition into the commercial market.
A second avenue of approach is from the top down, when someone working within a large defense prime sees an opportunity the firm is not pursuing and decides to break off and make an entrepreneurial go at that market themselves. Dive Technologies is one example. Its founders left General Dynamics’ Bluefin Robotics business after working on small unmanned underwater vehicles to pursue a novel manufacturing process that leverages 3D printing to target the large and extra-large unmanned underwater vehicle market.
Finally, a company can move laterally from the commercial sector into defense. Software provides ample examples of this civilian-to-defense transition with new firms like Rebellion Defense, plus established ones like Amazon Web Services and Microsoft, entering the defense industry. It might seem odd to think of Amazon and Microsoft as medium sized firms, but they are not (yet) major players in the defense sector.
Where do they go?
Small or medium sized companies almost never grow into whales. If they survive, they tend to stay mid-sized by occupying niches or become acquisition targets for one of the prime defense contractors. Probably more than in-house R&D projects, mergers and acquisitions (M&A) are how the established giants of the defense sector innovate. In other words, they let others take on both the technical and market risk for them. Once a smaller firm has experimented and succeeded, then the intellectual property, staff, and book of work already won are purchased.
I’ll let others debate the wisdom of this, but from a systemic point of view, it means that prime defense companies are outsourcing part of the trial-and-error process to the broader innovation ecosystem. They might have to pay a higher premium to purchase a successful firm compared to building a capability organically, but they are not funding failures along the way. Overall, it is lower risk. Plus, it may be easier to convince a board to buy already proven, successful innovations, which will likely produce profits in the short term, than to gamble on long term R&D projects. Northrop Grumman’s Global Hawk program is a perfect example. The now famous unmanned aerial vehicle is a mainstay of Northrop’s aeronautical systems sector, but it was first built by Ryan Aeronautical, a sub-division within Allegheny Teledyne Incorporated. Northrop Grumman bought Ryan Aeronautical for $140 million in 1999. More recently, Forbes magazine cited data showing that in 2019, the defense and aerospace sector in the US disclosed 80 M&A deals at a value of $98.5 billion, a 33% increase from 2018. Innovation driven M&A is part of an overall trend of consolidation in the defense sector and, I suspect, part of the reason there is almost no turnover in the major defense firms. What is happening is churn within those firms as they jettison or retire legacy programs and acquire new ones.
In keeping with the pattern of concluding with questions for the DEF community, can someone shed additional light onto if there is a relationship between R&D and acquisition by the major defense firms? For those in a small or medium sized firm, how do you view the prospect of being acquired?
Patrick Collins was a DIA intelligence officer for ten years and holds a master’s degree in security studies from Georgetown and an MBA from the University of Cambridge. He joined DEF in the spring of 2020 and is interested in defense innovation. The views expressed here are his own and do not represent those of any department or agency.
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