What Every Defense Start-Up Should Know About Government Contracts
After months of pursuing one of the most demanding customers out there, you finally made it: your defense start-up was awarded a SBIR grant by the U.S. Government. Congratulations! This probably took months of hard work, and it is a big milestone to celebrate.
However, not all government contracts are alike; in fact, there are some that you may be better off refusing. Here are some tips on understanding various types of contracts, and how to decide whether they are right for your business.
Types of U.S. Government Contracts for Dual-Use and Defense Start-Ups
There are two types of contracts you can win with the Government and, specifically, the DoD: cost-plus and firm-fixed.
A cost-plus contract is a form of cost-reimbursement contract wherein the Government reimburses the contractor for costs incurred within the scope of the contract. If costs exceed the plan, the Government must reimburse the contractor for overruns and determine if the contract should continue. Cost-plus contracts are used when there is uncertainty or complexity that makes it challenging to know, with certainty, what the total costs of the effort will be. (Example: developing a teleportation device)
In firm-fixed contracts, the Government provides a total budget amount for the scope of the effort and provides progress payments as the contractor executes the scope. Any overruns are the responsibility of the contractor. These contract types are used when there is more certainty in the effort and the steps to achieve the end state are known. (Example: building a house)
Historically, SBIR grants and contracts are most similar to firm fixed price contracts in that the startup must deliver the milestones agreed to, and any savings are treated as margin. Conversely, the Government owns the risk on cost-plus contracts because they must pay for overruns or terminate the contract.
Compliance Burdens: The Fine Print in Cost-Plus Defense Contracts
On the surface, the idea of having the Government reimburse additional costs incurred might sound compelling to defense tech start-ups.
However, these come with fine print: because the threat of overruns exists on cost-plus contracts, the Government will want to exact controls on the contractor’s performance. In order to get reimbursed, the start-up will need to fulfill additional requirements. These will likely include earned-value management (EVM) reporting, and compliance tracking through audits from the Defense Contracting Audit Agency (DCAA). DCAA requires a certified cost accounting system for reviewing and approving each expense on every invoice, dividing them into categories like labor, overhead, materials, administrative costs, etc.
In principle, the Government has many strong reasons to require EVM and DCAA. R&D is risky for any industry, but this is especially important for dual-use and defense projects where lives may be on the line. The government customer is likely to argue that the technology is “risky,” that they need “accountability” for their investment, and that they need a reporting system that measures the startup’s contract performance against a codified plan.
For precisely that reason, EVM and DCAA are legally required for contracts over $50 million. The Government is used to applying these requirements to contracts with large Prime contractors, who have well-developed systems, network infrastructure, and resources to apply towards reporting and compliance. However, for a start-up competing for grants below the $20 million amount, costs associated with meeting these requirements can far outweigh the amount of the award itself.
Unfortunately, in the vast majority of cases, it’s best for early VC-backed defense start-ups to “swipe left” on cost-plus DoD contracts and awards. Understanding the terms of the contract before spending valuable resources on preparing an application is paramount. A startup may communicate the undue burden of EVM and DCAA to the customer ahead of time — but, unlike most commercial contracts, there will not be room to negotiate terms after a contract is awarded. If the cost-plus terms cannot be waived, the start-up should decide whether to accept the contract. For example, a SBIR contract value of $2M may not be enough to execute the technical scope of the contract while meeting the compliance and reporting requirements. The start-up should request a long-term contract with a higher contract value to justify the costs and ensure it has a committed partner for follow-on production efforts.
Defense Start-Ups Need Government Champions
Start-ups should apply discernment when courting government customers, who can be challenging due to their bureaucracy. One of the best things a founder can do is find a “champion” within the Department of Defense, who believes in the start-up’s technology, advocates for its adoption, and helps the company navigate the complexities of government contracting.
Red 6, a Moonshots Capital portfolio company, took extensive measures to secure government sponsors and a Senior Leader champion to continue their development of advanced AR flight training tools for the Department of Defense. Most recently, this collaboration and advocacy led to a recent STRATFI award of $30M.
Another Moonshots portfolio company, Proteus Space, aims to flip the satellite design process on its head by slashing the timeline to design a satellite from years to hours. Proteus spent extensive time identifying the right government customers to approach, and developing a thoughtful customer engagement strategy is paying off through recent SBIR awards. Revolutionary solutions like Red 6, Proteus, and many other start-ups in the dual-use and defense space should be met by the DoD with inquiry, not hesitation.
Securing consistent and reliable government advocacy can be challenging for a defense tech startup given the rate of personnel changeover within key DoD positions. However, start-ups pursuing similar strategies should keep in mind that the Government can become a fickle customer when a company’s government champion moves to a new role.
DoD’s Seed Investments: The Purpose of SBIRs
The terms of a contract pose implications that could have far-reaching impacts on the partnership between the Government and defense-tech startups.
SBIRs are intended as seed funds for innovation that help strengthen the defense industrial base by giving innovative small businesses the opportunity to partner with the Government on small scope R&D prototyping efforts that may benefit the DoD. As with any seed investment, risks are more substantial, but the defense industry needs revolutionary capabilities that come from start-up innovation and must continue to take the right risks.
When the government customer is asking for burdensome level of insight and requirements on contracts, they simply fail to understand the objective of SBA grants. If a SBIR contract or grant comes with strings attached and costly reporting requirements, start-ups will return to the commercial marketplace and rue the day they pursued the defense market. If the Government deems such requirements necessary for grants under $20 million, it should offset the start-up’s costs by making a long-term and higher value commitment.
Ultimately, resolving the problems posed by cost-plus terms on small government contracts requires engagement from both sides. On the other hand, an accurate understanding of contract terms make start-ups better equipped to communicate their own needs and secure better partnership conditions for the industry overall. In response, the DoD should act proactively to understand the needs and constraints of defense tech start-ups to make them more inclined to ‘swipe right’ on partnerships that stand to greatly benefit the nation.
Authored by: Moonshots Capital Defense Ventures Fellow Lt. Col. Allen Varghese, and General Partners Kelly Perdew and Craig Cummings.
Moonshots Capital is a military veteran-founded venture capital firm that invests in early-stage startups with extraordinary leaders.
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*This article has been amended since the time of its publication. The original version stated that EVM and DCAA are legally required for contracts over $20 million; however, that amount has recently been raised to $50 million.
