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- [00:00]
Host
Why is everyone in Silicon Valley suddenly investing into defense tech?
- [00:04]
Defense Tech Investor
If you zoom out, venture is a trend driven business. Before defense tech it was maybe crypto, and before crypto it was creator economy and before that it was solo mo or something. Right. So defense just happens to be the trend today. But I think the meat of your question is why is defense the thing of the day? And I think there's a lot of reasons for it. One is just the people can look at the world today and just see there's conflict sort of everywhere brewing. You've got this big macro competition between the US And China. You've got the war in Ukraine. Northern Africa is sort of a mess. Obviously we're fighting over the Strait of Hormuz with Iran. And so there's big macro trends driving interest in defense. And then I think you also saw in the last few years just a change in the attitude around whether or not defense could be a successful investment sector, largely driven by three companies. I think, you know, Palantir, SpaceX and Anduril really proved that there was some meat on that bone and that brought a lot of interest to the space.
- [01:09]
Host
When I think about this, I think about it as self reinforcing. A lot of these spaces, they become hot because there's one or two or in this case three winners. And now capital gets returned. Now founders pursue that space and now suddenly there's a market. How much of that is what's driving defense?
- [01:29]
Defense Tech Investor
There's definitely a fair amount of that. So you have a lot of companies being founded today in aerospace and defense with former SpaceX engineers. Certainly former Palantir engineers are out there now. There's a mafia developing and I think you'll start seeing former Anduril engineers doing the same thing as they're hitting the scale they're hitting now. There's definitely some truth to that. The ecosystem has a flywheel effect that's taking place.
- [01:56]
Host
There's also a Department of War angle to this too. Their policy have changed. Tell me about that.
- [02:02]
Defense Tech Investor
A lot of changes happening in the Trump administration. So Department of Defense, Department of War, depending on who you ask, has been a really challenging customer to work with for decades for a hundred different reasons, which we can dive into in the last administration, the first Trump administration, a little bit in Biden, and certainly now in Trump too. A lot of effort has been made to make them a better customer. And so that's things like aligning the R and D funding with future acquisitions so companies don't get lost between the two sides of the House. The department is broadly split between research and development, and then acquisitions on one side are on another side. It's getting rid of sort of regulations in red tape that make it very expensive or challenging for companies to work with the department. Just yesterday, actually, the government suspended or eliminated something called cmmc, which was a cybersecurity requirement that imposed hundreds of thousands of dollars in costs on startups. And it was driven by a real desire to solve some cybersecurity challenges in the defense industrial base. But it made it almost impossible for young companies to do business with the government. That requirement is now gone. So some pluses and minuses there, but I think generally a net positive for the ecosystem. So a lot of things like that are happening.
- [03:27]
Host
Everybody realizes defense investing is hot right now. How has that evolved over the last couple years?
- [03:33]
Defense Tech Investor
I'll talk a little bit about the size of the market and then we can talk about the investment dollars going into it. So the Department of Defense's budget is, when I started investing in defense back in like 2019, 2020 was around 800 billion, maybe a little shy of that, maybe a little over last year it was over 900 billion. This year they're talking about a $1.5 trillion budget. I don't think they'll quite get there, but quite large. Put that in perspective, the global SaaS industry is something like 250 billion a year. You can add on to the US's defense budget the allied and partner defense budgets. That's probably another trillion ish dollars, maybe a little shy, depends on whether or not Europe meets its NATO commitments. And then you can layer on the domestic law enforcement budgets, federal, so you think like the homeland security budgets, you layer on the intelligence community budgets, you layer on black budgets, and you end up with the defense ecosystem being probably fairly well over a $2 trillion a year market, not a lot of markets of that size. So pretty impressive. If you go back to 2019, 2020, I would say there were single digit billions in venture or private equity, early stage growth dollars going into defense, and now it's well over a hundred billion a year. Remains to be seen if that investment is met with actual acquisitions from the government. But certainly it's starting to ramp up.
- [05:03]
Host
How much of this is driven by a new type of warfare, whether it's drones, what some call asymmetric warfare, where you have these very expensive equipment being attacked by these very cheap drones.
- [05:17]
Defense Tech Investor
Certainly a lot of the new investment, a lot of the venture investment is going into that side of the equation. Ultimately a lot of the Budget still goes to large legacy programs or what are called exquisite systems. So sort of the other end of the spectrum. So your F35s and aircraft carriers, that's starting to change. And more of the budget is moving towards the asymmetric side of the equation. Small drones, cyber electronic warfare systems, things like that. And a lot of that is being driven by what we've seen in Ukraine. So what's been effective there? I think something like 70% of the casualties in Ukraine, maybe higher, maybe more like 80%, are caused by FPV drones. So not artillery, not guns, but drones.
- [06:00]
Host
80% probably a decade ago. Zero.
- [06:02]
Defense Tech Investor
Newer drones in Iraq and Afghanistan dropping a stray grenade here or there, ISIS or the Taliban piloting those. But we're talking like onesies, twosies, nothing like what's happening in Ukraine today.
- [06:17]
Host
Is defense also going through this evolution where it seemed like five years ago everybody was going for these relatively low capital intensive challenges like drones. And today you have companies like Castilian going for hypersonic missiles and much more capital intensive projects.
- [06:35]
Defense Tech Investor
Even several years ago, there were lots of companies trying to build the capital intensive things. I think that there were fewer investors willing to take risks on those companies. And so what those companies were doing in like, sort of the traditional processes, they were receiving a lot of government R and D dollars, grants to help build those technologies. And we're basically locked out of the capital markets because most venture investors were not willing to put $10 million into a company trying to build hypersonic missiles, because that company would probably need to raise, let's say, $200 million or $300 million over 10 years to get to a program of record and start actually selling to the government. And that's a hard bet to make, especially when you could make good money on a SaaS investment. AI is driving a lot of people out of sectors that they perceive as pretty vulnerable to AI and sectors that they see as a little bit safer or harder for AI to marginalize. And deep tech is certainly one of those places. I got into investing in defense partially for like family history reasons and personal passion, but also because I was doing a lot of deep tech investing and realized all of the companies I was investing in had national security applications, but none of them were thinking about selling to the government. They had no idea that that was really a viable market for them. And so I started like digging into that market and how I could help them bridge that gap. That's really what got me into the space.
- [08:02]
Host
Jeremy Giffen has this pretty hot take on why there's more capital going after these capital intensive startups. And essentially as venture capital firms get bigger, now you have these large mega funds raising billions of dollars, sometimes over $10 billion per vintage. Only 15 years ago, the largest venture fund in the world, NEA, was $3 billion. But now you have entire vintages being over $10 billion. And the second order effect of that is you now have to go after capital intensity. You have to justify, why am I raising $10 billion? It can't be to invest into SaaS, startups or mobile applications. You have to go after hard problems and capital intensive problems. So it's in some ways the capital that's driving the capital intensive projects, not
- [08:48]
Defense Tech Investor
the other way around, a hundred percent. And I think that's in defense. It's also why you see some companies have the valuations they have. Anduril is a great company. One of the reasons I think their valuation is what it is is because if you are T. Rowe Price and you have interest, your investors want you to be investing in sort of the new style of defense. You don't have a lot of options at that scale where you have to write a hundred million dollar two hundred fifty million check. That makes sense. And so you have a lot of demand and not a ton of companies yet that are scaled to absorb that demand. And so valuations shoot up. So, yeah, I think you're right. Same dynamic is playing out where you've got an Andreessen that has 50 billion under management and how do you put that money to work? You need to find some capital intensive projects.
- [09:37]
Host
Taking back to 2019, you had left your previous firm and you launched Mark. First of all, tell me about the name. Why choose that name?
- [09:47]
Defense Tech Investor
It's Mark M A R Q U E. And so we violated the first rule of marketing, which is you should never have to spell your name for anybody. And I always have to spell it. So we named the firm after a letter of Mark and reprisal, which appears in the US Constitution in Article 1, Section 8, Clause 11, which grants Congress the right to issue these letters. Um, so a letter of mark is the document that Congress can give you. The President signs it, that allows you or turns a ship captain traditionally into a privateer. So you were allowed to go fight your ship basically on behalf of the US government or at the time the colonies during the Revolutionary War. And then any thing you captured you could take back to a prize court and it was ruled legal capture. So you're not a pirate. You were in fact a privateer. You'd sell it and you'd keep some of the proceeds and you'd pay taxes on that. And so this was one of the first historical uses of private capital. Both literally, money being invested in the ships and the crews, but the crews and the ships themselves are also capital for national security. And so we sort of adopted that as our name. Private capital for national security.
- [10:56]
Host
And these were outside investors that were backing these privateers?
- [11:00]
Defense Tech Investor
Yes. So sometimes it was the ship captains would own the ships and have a letter and go out, but often it was private investors would get the letter, find a crew, find the ship, hire everybody and send them out. And so in a lot of ways, this is like also early stage American venture capital, because you've got the financiers taking a very high risk bet, but then you also have the crew and the captain who are out there fighting their ships, much like founders, taking very high risk bets, but for a lot of payoff. If you landed a fat merchantman and brought it back and sold it at the price court, you might be set for life or at least for several years. So similar dynamics to venture today.
- [11:41]
Host
There was power law outcomes. Power law outcomes, yeah.
- [11:44]
Defense Tech Investor
You certainly could have ended up in an English jail or at the bottom of the sea.
- [11:47]
Host
There's both upside and downside. It reminds me of the Dutch traders and the origins of carry and private equity funds. A lot of people don't realize private equity funds and venture capital. Actually, the concept of carry goes back to the Dutch traders in the 11th century. They would come and take different goods and they would carry them back. And they also had private investors. And they would get 20%. Literally 20% of goods that they brought back would be given to the GPS and 80% would be given to, effectively, their LPs.
- [12:19]
Defense Tech Investor
Yeah, interesting. I mean, the whaling industry had similar dynamics too. So it's like venture really came out of a maritime tradition. Yeah, Total tangent, but I think just as an interesting side note related to privateers. So the pirates of the Caribbean were real. And the reason the pirates of the Caribbean existed as a force was the Europeans were funding privateers. So same thing we did with letters of market reprisal in the New World, basically to hunt treasure ships of the other European powers. And at some point they all got together and they decided that they were going to stop fighting each other in the New World, and so they outlawed privateering. So what happened is you had all of these privateers in the Caribbean with warships, a bunch of young men, and they all get a letter from their respective kings saying, no more privateering. But what do you expect these guys to do now? They're out of a job, but they have a bunch of guns and warships. They have a certain skill set going
- [13:19]
Host
back to defense and the space. What ending are we in when it comes to defense in this?
- [13:26]
Defense Tech Investor
I'm supposed to say early innings. That's what's good for my business, but I think it's true. And I don't want to be an ambulance chaser here, but the world is changing dramatically. The world order, right? So we had the post World War II World Order Where America was really first. We had a bipolar world between the US and the Soviets. And then we had sort of a unipolar world where the US had complete hegemony. That's changing. We don't know exactly what it's going to look like. And I think it's probably a 20 or 30 year process to play out. And we are in very early innings of that process. And I think if you look at the conflicts that are going on in the world today, you can look at them all as discrete conflicts, but they're not. They're much more like proxy wars between us and China and that competition that's just getting started. So I think we have 20 or 30 years before we see what emerges on the other side. And I'm hoping that when we emerge, it looks a lot like the mid-90s, but we'll see.
- [14:23]
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- [15:36]
Host
You mentioned earlier that it was very difficult to deal with the government in terms of as procurement. Why was it difficult and what's changing today?
- [15:48]
Defense Tech Investor
Hundreds of challenges in selling to the government. I think if you zoom way out, one of the major challenges is it's rife with principal agent issues. So what do I mean by that? The end user, we'll call them the war fighter. But it could just be someone sitting at a desk who needs a new piece of software to make their job a little bit easier. The warfighter almost never has budget or purchasing authority. Right? So you need them to be on board. Like they need to like the product you built and give you feedback and want to buy it and advocate for you. But that's not nearly enough in defense. So once you've got the war fighter on board, then you need to find a requirement that you fit with. So requirement is a bureaucratic process that the government runs where they basically determine whether or not a problem they have requires them to pay for a solution. So first what they want is they say, okay, so we've got this problem you've surfaced to us. Can we solve this by doing business slightly differently? So it's a new concept of operation, a new con op. If not, then can we solve it with something we already buy? Okay, if not, then maybe we'll buy something. Now that we know that we need to buy something, we're going to define exactly what it is that we need to buy. And that gets packaged into a series of documents. Once you have a requirement, now you need to get it funded. And so that means going to Congress.
- [17:08]
Host
Right?
- [17:09]
Defense Tech Investor
There's four committees in Congress that matter for defense. There's two in the Senate, two in the House. Two of those committees set policy. Those are the House Armed Services and the Senate Armed Services Committees. And then two of those committees actually set the budget. The defense budget, like I said, is massive budget, but it's the most constrained of all federal agencies in terms of how they spend their money. So there's thousands of line items in that budget and accounts and sub accounts. Very specific. And it's basically the only place in the budget where earmarks still exist. So the budget won't say here's a hundred million dollars to Raytheon, but it'll say, here's a hundred million dollars to buy SM6 missiles. Well, there's one company that makes them. Guess who it is right. And so it's like you have to understand now the sort of the Congressional budgeting and their interests, which means like district and constituent interests, factor into this. And then after all of that process gets run, you still have to find the right buyer in the DoD. So the person with contract authority, the office who's supposed to be serving that requirement, all of these players are required to be aligned to have a procurement go through successfully. So it's far from straightforward. And at each stage there's a lot of red tape and some traps that
- [18:22]
Host
you have to run. Right.
- [18:23]
Defense Tech Investor
And so like, none of that, I think makes sense to a investor who is not really focused on defense because you just look and you say this is the best technology solving this problem.
- [18:34]
Host
Of course they'll find a customer. Right. It's a great team.
- [18:36]
Defense Tech Investor
That's not how the government works.
- [18:38]
Host
Is this process the main reason there's been an oligopoly with these large defense primes, or is there something else underlining
- [18:45]
Defense Tech Investor
that there's a chicken and an egg issue here? I think that certainly the primes would argue, and I think they've got a fair argument to make, that the oligopoly exists because the systems were set up, not that the oligopoly set up the systems. So Congress basically shaped the incentives and then the Primes built their businesses around those incentive structures and we ended up with what we have now. When you create a lot of bureaucratic hurdles in red tape and you require people to build things that are capital intensive and you make budgeting processes take multi year efforts, you end up with companies that look like the Primes because you have to build a company that can survive that, where you have a small subset of engineers and relatively small internal R and D funding, but giant teams of lobbyists and lawyers and capture specialists to go after contract vehicles. They become financial firms basically.
- [19:41]
Host
And then it encourages these economies of scale and then they figure out they're an UN market where they could now keep new entrants from coming in. They hire the lobbyists. And regardless how it started, it always ends up in this recursive thing where the oligopolic nature of it is driven by the government and the defense contractors are furthering it. That's right. Tell me about the Last Supper.
- [20:05]
Defense Tech Investor
Last Supper? This is not the biblical Last Supper, but this is the apocryphal. Although it's not really apocryphal. This is the story of how the defense industrial base consolidated. So post World War II, there are tens of thousands of companies Working for the Department of Defense as private contractors building things. Right. And so some of them are mom and pop. Most of them are mom and pop shops building bolts and widgets that then get put into other, other aircraft. And some consolidation and verticalization starts to happen Post World War II, but not a lot. And so you still have like dozens of large firms, hundreds of medium sized firms, and then tens of thousands of small mom and pop shops. Fast Forward to the 90s. We win the Cold War and there is a great deal of pressure on Congress to reduce defense budgets so we don't have any more enemies. It turns out that that was not true. That was the thinking. We had sort of won the future and there should be a peace dividend. So Instead of spending 5% of GDP or 7% of GDP on defense, we want to bring that way down. We decided to bring that down, I guess to about 3% or 2 1/2% of GDP. And what the department realized was if we were going to slash defense budgets, a lot of these companies are going to go out of business. Makes sense. We are their only customer. But we can't afford to not have any American companies that make fighter jets or aircraft carriers. So what do we do? And what they decided was that they were going to summon all of the CEOs to the Pentagon for a dinner. And over the course of that dinner, they explained to them what was going to happen and basically said, look to your left, look to your right. One of you is going to be out of business at least. And so we highly encourage you to consolidate. And the result of that was exactly what they had requested was major consolidation. I had a chance to chat with the CEO of Lockheed. He was the CEO of Lockheed at the time, Norm Augustine, Absolutely like brilliant human being who was in that dinner and he was telling us before he went to the dinner, all the CEOs were like calling each other because they had never been summoned to the Pentagon for a dinner before. And so they had no idea what was coming. But he took that talk to heart and he went, and at the time, I think he was the CEO of Martin. And then they acquired Marietta and then Lockheed. And so now it's Lockheed. Martin was Lockheed, Martin, Marietta. They all started to consolidate. And so now we have a half dozen major defense primes and then a couple dozen sort of medium sized primes. But these are your Lockheeds, Raytheons, Northrop Grumman's General Dynamics. This is the, the result of the Last Supper.
- [22:50]
Host
And then today you have the Neoprimes Anduril, Saranic. I mentioned Castilian trying to enter the space. How are they able to enter a market where there seems to be such barriers to entry?
- [23:02]
Defense Tech Investor
The barriers are starting to come down as part of the answer I'll take from Anduril's perspective. So Anduril, like one of their major business insights, was instead of relying on government funding for research and development or product development, we are going to fund our own product development and then we are going to go try and just like compete in the market. So this is like following somewhat on the SpaceX and Paler model. And to do that requires a lot of capital. So they assembled a team, sort of like a super band. Palmer Lucky and Trey Stevens and all the folks they brought in raised a lot of capital at a hefty valuation even relatively early on to survive how long it would take to win the government over as a customer, started internal development, built great products and went from there. That's not a model that the average founder could have done five years ago or even two or three years ago. It is becoming a model that is slightly more viable as the barriers get knocked down and as more capital has rushed into the space.
- [24:07]
Host
I'm always fascinated by these category makers like SpaceX. There was no real space tech before they started SpaceX Anduril. There was no real Neoprimes. How are they able to go from 0 to 1 double click on the founding story?
- [24:23]
Defense Tech Investor
I think extremely challenging. So always a little bit of luck involved. They found, I think, a market that not a lot of people were competing in where they could sort of get a foot in the door they began. I was not a founding investor in Andrew, so this is maybe an apocryphal story, but I think they started with the Century Tower product. They started working with the Department of Homeland Security, putting Century Tower sort of on the border to monitor crossings and that an area where they didn't have a ton of competition at the time. And then they've horizontalized from there and expanded into new markets.
- [25:01]
Host
They found a beachhead and they executed really well, which gave them the right to go after other products. How would you go about mapping the defense technology market today? What are the different categories that are most compelling, both for entrepreneurs as well as investors?
- [25:17]
Defense Tech Investor
So there's definitely categories that I think are over invested in. The quintessential one there being small drones. There's a thousand small drone companies. We probably need four of the, you know, Group 1 drone companies and there's a couple of really good ones. Out there already. Neros announced, I think yesterday I saw a $500 million contract to make small FPV style drones. But there's a million companies out there building those. I think areas that are under invested in right now manufacturing. A lot of money going into advanced manufacturing. But it will be a 20 year effort to onshore or friendshore a lot of what's left over the last 30 or 40 years. It'll require trillions of dollars. People think of advanced manufacturing as one category, but there are so many different things that go into it. Tooling and die, forging, foundry work. There's a lot of space in manufacturing still to go and that's really critical to American national security. Most founders and investors are investing in tactical technologies, right? Small drones, battlefield tech, something that a soldier might use. Almost nobody is investing in strategic technologies. The quintessential strategic technology being a nuclear weapon or weapons of mass destruction. But there are other ways of thinking about strategic weapons or technologies. Those are things that like are almost political in their use. They really reshape the battlefield and I think lend themselves to venture. Since in venture you really are looking for kind of home run technologies. Home run wins. Not a lot of companies working in that space. Ew. So electronic warfare, very interesting. Space cyber. And we'll see how all these things get impacted by AI. Cyber for sure being heavily impacted right now.
- [27:06]
Host
The intersection of cybersecurity and defense.
- [27:09]
Defense Tech Investor
That's right, yeah. The Mythos release where they sort of pump the brakes because it was discovering a bunch of zero days. So what does that mean for the traditional cyber defense firms? What does that mean for cyber offense? Can you build a sustainable business if the frontier models are able to sort of fairly easily work in the cyber domain in ways that humans really can't. So you have like the, if you're going to segment defense, you have like those areas. So you've got tactical technologies, you have strategic technologies, you have sort of your software, your hardware. And then you have companies that are building sort of in a specific vertical and then you have companies that are building platform plays.
- [27:49]
Host
Right.
- [27:50]
Defense Tech Investor
So Anduril being the largest of the platform plays today, I think Mock industries being another one trying to build sort of a very horizontally integrated defense prime contractor, someone who can compete with a Lockheed or a Raytheon. Not a lot of companies building that today. Almost always when we're chatting with LPs, they'll ask like how do you find the next and role? And my answer is usually you don't like you look for a company that's building a great product that has a wedge and you just hope that the team is smart enough and sharp enough to eventually build up a platform company. But very hard to start out on day one with the intent of building
- [28:30]
Host
a platform company side of technology and the quality of the product. What are the other characteristics of things that make the best new defense technology companies?
- [28:44]
Defense Tech Investor
Obviously technology market for it, like demand, future demand. Use the Wayne Gretzky quote, you got to skate to where the puck is going, not to where it is today. Founding teams like all the things you look for normally when you're doing venture investments. But I would say for us, it really goes back to what I talked about earlier. The way government acquisitions work, we look to see. We talk to the war fighters, right? Who are the end users that are using your product. Which means that we don't normally do precede. Right. Like we were looking for companies that have a product, maybe not in the market, but prototype, they put in a customer's hands usually. So we talk to those folks. We go to exercises here in the States and then abroad, see how the products are actually getting used and how they work. We talk to the requirements writers. A lot of that is classified. We all hold clearances at the firm. It's crazy to be investing in this space. Maybe not at Precis, but almost anywhere else. If you don't have anyone with clearances at your firm, there's actual information asymmetry in defense and it's institutionalized through the security clearance process. Requirements are often classified. Some exercises are classified where the technology is getting used to. The results of exercises can be classified. Just because you have clearances doesn't mean you get access to that information. But if you don't have clearances, you're definitely not getting access to that information. The budgets are classified other than like this year's budget. It's a very like, odd space to be investing in.
- [30:10]
Host
When you say all this classified information, I think about competitive advantage, I think about information Alpha. How does it work?
- [30:17]
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- [33:10]
Host
a venture capitalist would have access to this information.
- [33:14]
Defense Tech Investor
The old trope that like you don't have a need to know is true in the clearance world. Like you could have a clearance, it could be top secret clearance with sort of the special tickets attached to it. That doesn't mean that you get access to information unless you have a need to know that information. So I'll start out by saying that. So just because you have clearances doesn't mean you get to know where the bodies are buried or the aliens are being hidden. But the government over classifies things. Some of the things they classify routinely as policy are the requirements. Like I said, they run that process. So the actual requirements are often classified. Now they might come out publicly and say we need to buy something that does X and Y. Really what they're looking for is something that does Z. And like they're analogizing Z to X and Y so they don't have to tell you what the classified requirement is. But if you want to know what they're actually trying to do that might be classified. The Department of Defense is actually quite communist in how they set their budgets. They do like five year plans, the extended spends are classified. So you can see what this year's budget is because Congress is passing it. Other than sort of like the black budgets, but like where the money's going to go long term they have a plan and not everybody gets to see that plan. So being able to have a frank conversation with the government customer, whether it's about how a company performed at an exercise, what it is they need to buy or how much money is going to go to, it might require you to have access to that information that is not available to the general public. There's like probably a dozen firms that have clearances, but not very many.
- [34:50]
Host
How do the founders that you look for in defense tech differ from world class non defense founders?
- [34:57]
Defense Tech Investor
The trope of like the 20something Stanford GSB grad, certainly that founder archetype can be successful in defense, but I think defense has a lot of characteristics. Kind of like pharma, where it pays to have some folks with gray hair on your team that have been in the industry for a long time, have really good industry contacts. And that is both contacts within the government and with the prime contractors early on for a new defense company, if you're cautious and you protect your IP and you sort of Know what you're getting into. It's great to work with the Primes. The Primes have done the hard work of landing large multibillion dollar contract vehicles to produce a product. And their job as a prime contractor is to go hire subcontractors to perform a lot of the work on that contract. So having relationships with the Primes, knowing how they do business, having relationships inside the government, knowing how they do business, very important. That usually means a slightly older founder who's coming from the sector. I think it's a very hard space to just have a bright idea and a cool tech and build it and break in.
- [36:06]
Host
And part of that is the R and D part of the government and the acquisitions. They don't really talk to each other, they don't collaborate as closely.
- [36:15]
Defense Tech Investor
So it used to be one organization and then it was split between research and development rdtne. So research, development, testing and evaluation. So all of the work that goes into early stage prototyping and then the organization that is designed to acquire stuff at scale. So it used to be one organization, now it's two. Five years ago, the research and development organizations often did not talk to the acquisitions organizations and vice versa. And so you might have a lab, we'll say a lab that's working on Alt pnt, which is positioning, navigation and timing. So think gps. What do you do when GPS is being jammed or denied? You need a new technology that like helps you figure out where you are and what time it is. So there might be a government lab working on that that is funding 10 companies, R&D for 10 companies working in different modalities. And then you've got one program office on the acquisition side for the Air Force who is supposed to be acquiring new Alt, P and T technologies. That acquisition arm might not have been
- [37:13]
Host
talking to the lab.
- [37:14]
Defense Tech Investor
And so you might have companies that for five years are working with the lab and taking government money, perfecting a product. And then they go to the acquisition side and they say, hey, we're ready for you to acquire us at scale. And the acquisition side says, I don't have any idea who you are. I'm going to go buy this other product from Lockheed, who wasn't doing any work with the R and D side of the house. And that leaves a bad taste in everybody's mouth. It's wasted money. It makes the founders of those businesses feel like the government doesn't care. There's a lot of dysfunction that is starting to break down. So there's still two different organizations, but like the army, for instance, created this program called Fuse this year, which takes a lot of older sort of disparate army programs, and rather than having them run independently, has sort of like stacked them in serial. And so companies can enter at Gate one, there's one team that's then managing them from Gate one to Gate two to Gate three. And so you're not having that sort of disorganization happen in the army in quite the same way as it used to. And I think we're starting to see that across the other services. So I'm cautiously optimistic.
- [38:23]
Host
What's the best economic reason to invest into defense tech?
- [38:27]
Defense Tech Investor
I'll table your question for a second and say, I think as an American, it makes a lot of sense to be investing in defense and national security right now. As we talked about sort of the world order is changing dramatically, and if you want the outcome of that process to be positive for yourself and your kids as an American, I think it makes sense to be putting money to work in this space right now. It doesn't hurt that there's a lot of alpha to be had here. So talk about all the reasons why this market is broken. When you're investing in perfect markets, what you get is beta, right? If the market goes up, everybody does well, but no one's really generating any alpha. Defense is still broken. I mean, it's not as broken as it was five years ago, but that means if you understand how to navigate it, there's still real alpha to be found in this market. So that's one of the reasons to be investing in this space. If you understand it, there's real money to be made. The other reason is the market size, right? So $2 trillion, roughly, let's say, between US allies and partners, defense and intelligence, larger market than most and a lot more money flowing to it today. And then you look at the macro trends. So you say we've got potentially a conflict over Taiwan in the next few years with China. We have the war in Iran, you've got the war in Ukraine, which everyone thought I think would have wound down by now, but clearly hasn't all the terror organizations sort of reconstituting themselves in Northern Africa. There's a lot going on in the world, and that is going to drive a lot of demand in the future. Moreover, that demand isn't going to look like what it looked like 10 years ago. It's not aircraft carriers anymore. It's new technology.
- [40:01]
Host
Right.
- [40:01]
Defense Tech Investor
So there's a lot to be optimistic about from a financial perspective over the next 10, 20 years.
- [40:08]
Host
No one that I've talked to, whether in the space or outside of the space, believes that defense budgets are going down over the next decade. I've never heard anyone take thunder.
- [40:17]
Defense Tech Investor
It's crazy to say we might have a $1.5 trillion defense budget. But I think to put that in perspective, I want to say that'll be like three and a half, 4% of GDP. I mean, during the Cold War, I think we topped out at like 9% of GDP for defense spending. Towards the end of the Cold War, it was like 6 or 7%. So we're nowhere near historic highs. But the world is sort of in a historic bad spot right now, so there's still a lot of room to run, despite the sort of debt problems we have. And then if you are one of the defense bears and you think that the defense budgets aren't sustainable, what I would say to you is, even if that is true, even if it's true that we can't have $1.5 trillion defense budget every year for the next five years, we can't afford it. The world isn't going to get any safer, and America's security commitments aren't going away. And so the only way to address that if you're going to cut the budgets, is to cut the programs where you get less bang for your buck. And that is cutting from the programs that are things that we're not investing in. So that's cutting from aircraft carriers and traditional shipbuilding programs. It's cutting from the traditional cruise missile programs and moving more of that budget to things like Andrew's cruise missile replacement, the Barracuda. So I think budgets are going to go up. Even if they come down, more money is going to end up going into the sorts of things we're investing in.
- [41:41]
Host
Old warfare versus new warfare and new technologies. That's right. What's the strongest ethical argument for investing in defense tech?
- [41:49]
Defense Tech Investor
American ideals are some of the best ideals in the world. I think that we don't always live up to them, but I think that we try to, and that can't be said for everybody out there. And so a strong America is good for the world, and that's a reason to be investing in US Defense tech. I also think that investing in defense requires a much more nuanced view of ethics. I'll give you some concrete examples for this. Really, I think any investment is an ethical decision, and we should have more nuanced views of how we put our money to work. But I'll give you three companies so one company makes missiles. One company is an E commerce company and sells discount goods to folks online. And one company makes drones but won't put a bomb on their drones. Which of those companies is the most ethical company? Right. And I think that someone's inclination would be. Well, it's probably the E commerce company, but like, let's talk about these companies and these products more specifically. So the company that makes missiles is Raytheon. They're making SM6 missiles. Those missiles could be shot at ground targets and civilians and kill innocent people. But in fact they generally are used to shoot down missiles that have been fired at civilian populations. That's how we've used most of them in the last couple years.
- [43:12]
Host
Track record of them being used?
- [43:13]
Defense Tech Investor
That's the track record, Right. So their intent is to protect civilian populations. So is it ethical to buy those missiles or to invest in the companies building them? I would say yes, highly ethical. Those are defensive products. Even though they have an offensive use case that second company making drones, they decided they wouldn't put warheads on their drones. The engineers all got together, they voted. They said we're not going to weaponize our drones. But they did decide that they would put a laser designator on their. What's the laser designator you're used for? It's used to guide bombs to their target. So what's the ethical decision here? Like we won't kill people, but we'll help you kill people. All right, so maybe like the confused ethics, almost semantics.
- [43:53]
Host
Right.
- [43:54]
Defense Tech Investor
And then the third company is Temu, right. Came onto the stage. Chinese company selling really cheap products. I think they've captured something like 50% of the discount online e commerce market here in the US Put a lot of mom and pop businesses out of business. Has collected a lot of purchasing and personal information on U.S. persons and is funded partially by the Chinese Communist party. It is 100% economic warfare against mom and pop businesses here in the US and selling crap products, some of it made by, you know, Uyghur slave labor. What's the least ethical business of those three? And I would argue it's temu. Right? So I think if you are not even an investor in defense, if you are an investor, you have to think critically about what your money is being used for and what the intent is. And it rarely has to do with the product, it usually has to do with the founders and the company's intent of how their products will be used and how it will influence the world. So that's how we think about it, right? Like we would never invest in a company where their first market is to go sell missiles to African warlords of dubious intent. Right. And we've in fact kicked a bunch of companies out of our diligence funnel because of that sort of thinking. But it requires a much more nuanced
- [45:13]
Host
thought process to steel man. There's really two arguments or two considerations. One is I think a genuine consideration, the humanitarian case and thinking through the nuance of what is the incremental missile doing to society, doing to the world. I think that's a fair conversation to have. I think it shouldn't be had in a vacuum. We don't live in a world that only has one country with one military. The other one, unfortunately, I think is not necessarily a cynical but is more of an optical question. You could use the word virtue signaling, but an optics question, which is what happens if a student activist in freshman year talks about defense and this creates memeable idea that the university is investing into defense. That I think is more of an optics consideration which of course is important to manage, but it's less of an ethical thing. It's more of a self preservation for the investors and for the investment organizations. It's an economic case, not an ethical case.
- [46:15]
Defense Tech Investor
We definitely come across folks where the optics is their biggest concern. Right. They don't want to be seen as investing in a company that like maybe their product someday is misused by somebody or there's an accident or something and it finds its way back to them. I would say for those people, if you are interested in the sort of the patriotic case for investing in US national security, but you are worried about the optics, there are lots of ways to go about it. Certainly investing in manufacturing, investing in the sorts of like logistics and sustainment companies that make it possible to build sort of the national security base. On top of that, here in the States are all ways where you can put your money to work in a patriotic way that doesn't expose you to the same kinds of risks. But I would say if you were willing to take those risks, there's return to be had because lots of people aren't willing to take those risks. Right. So generally when you're investing, you want to be putting your money where other people are a little bit afraid to go.
- [47:17]
Host
Also on the relative aspect of it that ethics, when you think about American defense, unfortunately defense is more or less a zero sum industry. And who are the other players? Our main adversaries are China, Iran and Russia. If you look at the ethics of a Russia invading a neighboring country or Iran murdering tens of thousands of civilians, or China with a totally authoritarian and no freedom of speech and literally modern day slavery. On a relative basis, America's by no means a perfect country, but on a relative basis, there's no comparison to be had 100%.
- [47:57]
Defense Tech Investor
One of the most common fallacies that people fall into is they say, oh, I don't want that to exist, so I'm not going to invest in that. Or I'm going to advocate against it.
- [48:09]
Host
Right.
- [48:09]
Defense Tech Investor
I'm going to protest or whatever, which I get. But the option isn't that this thing that you don't like just goes away and then there's no consequences. Right. You have to live with the world that we live in and then do what you can to make it better. Right. And so in that world, like defense is an important aspect. Maybe someday humanity grows beyond needing to build defense products and all that capital sort of globally can go to climate projects and housing and those sorts of things. That's just not the world we live in.
- [48:43]
Host
Right.
- [48:43]
Defense Tech Investor
So we can choose to unilaterally disarm, but if we do that, I don't think the world ends up looking better than it does today. I think the world ends up in a pretty bad spot.
- [48:52]
Host
Speaking of underwriting, we've had this evolution where VCs have wanted to go nowhere near defense companies. In fact, most were prohibited by their LPA. So now a lot of VCs able to and actively building out teams to go after the space. What about on the LP side? Have you seen since 2019 LP sentiment towards defense tech and defense focused venture
- [49:18]
Defense Tech Investor
funds in 2019, 2020, most of the institutional LPs didn't want to touch it with a 10 foot pole. It was kind of funny because they might have had an investment in Anduril, but again, when Andrew first started, they weren't building sort of things on the kinetic end of the spectrum. They were working century towers and stuff like that. So I think some of the institutions were able to get stuff through their investment committee that they might not have been able to get through in 2020. 2021. Yeah, they didn't want to touch anything kinetic for sure. And defense as a category was pretty scary for most institutions. Family offices, it was definitely a mixed bag. You certainly had some patriotic families in there who were interested in the space, but no one really believed in the sector from a financial standpoint. So I think most of my early pitches when we were raising our first fund was pitching the sector as much as I was pitching our team and our expertise and why we thought that times were changing. Turns out we were right, but not everyone believed us, which is fine. Now I think the institutional LPs, some of them are actively investing in defense, which is great. If they're not actively investing in defense, they're at the stage of we are still thinking about how we're going to approach the market, but they've already decided they're going to approach it right. So they're trying to figure out how it fits into their portfolio. But very few people today are still dead set against it. I will say every once in a while we come across an institution, usually in a, in a blue state, we're a non political organization, but usually in a blue state that's a little bit more progressive where they're managing public funds and they still have requirements or restrictions on investing in certain kinds of defense products. But it's getting rarer and rarer. Even In Europe, their LPs are starting to change the way they approach the sector.
- [51:13]
Host
You've seen this evolution where first probably five years ago, LPs would sometimes have to divest from funds that ended up getting exposure to defense companies. Then if they just something like an anduril ended up in their founder fund portfolio, they were fine with that. It wasn't the intended consequences then it was about, well, it could be defensive warfare, not offensive warfare. And now we could do everything. So there's been kind of almost these four stages.
- [51:40]
Defense Tech Investor
It's moved through the spectrum for sure. I can remember this is only a few years ago. We invested in the seed round of Mock Industries. They disclosed their Series C or valued it I think around 2 billion now. But we were investing in their seed and I was talking with the founder Ethan at a coffee shop. We had already committed and he was telling us that he was evaluating a couple leads at the time, one of which was Sequoia. And I did a thing that I think maybe no VC has ever done until I did it. I tried to convince him not to take money from sequoia. And Sean McGuire over there who leads the defense investments is brilliant. He's a friend. I think he does great work. Definitely want him on cap tables. But at the time Sequoia hadn't divested from their China entity and Sequoia really even couldn't invest in defense. They still had restrictions, but it was for mock that Sequoia got rid of their own internal restrictions. They had to amend their documents to invest in defense and then they sort of finished their Chinese divestment. So I'm thrilled now that Sequoia ended up investing in the seed round. But yeah, the industry has just dramatically changed in terms of like how they are willing to approach defense. And then as I said, whether or not they're willing to take Chinese money or sort of adversarial capital onto cap tables, like all that stuff. A work in progress right now.
- [53:04]
Host
When a defense company gets hot, what are they looking for from their VCs that's unique to defense tech?
- [53:10]
Defense Tech Investor
That's a good question. I can only speak for, from our perspective, for us, because this is all we do is defense. Earlier in their life cycle. Most companies do not have a really strong ground game in D.C. so we help out a lot with that. So we spend a lot of time, like I said, there's four committees in Congress that work in defense. We spend a lot of time with those committees and their staff. And we help companies sort of build their early congressional engagement strategy and start building out those relationships. So we do a lot of that work. We connect a lot of founders with the right program offices. Program offices are the organizations inside the Department of Defense that make the purchasing decisions. Now they're called program acquisition executives. And so the department can be fairly opaque from the outside. So finding the right buyer can be challenging. We help founders with that. So it's a lot of blocking and tackling that we do for founders early on. And then I would say up through series A, once they've raised a substantial Series A, most of them start bringing all those functions in house and pay for it themselves. And the way we do that, which I think is relatively unique to us, and we kind of stumbled into it, it really wasn't an intentional strategy, is we run a fellowship program where we take active duty personnel and government civilians, usually like mid career to senior, so majors and colonels generally, or like junior political appointees, folks like that, staffers up from the Hill into mark. You take them into the venture firm for two months. We basically train them on how to be a mark associate, what we're looking for in companies, how we do diligence, how we evaluate founders, what technologies we think are compelling, teach them how venture works generally, and we send them back to their day job. We now have a hundred alumni out of that program. We do 10 people a quarter. We have, like I said, congressional staffers, folks who run program offices, colonels and generals who all come through this program. They live in our slack and our signal. So we actually get a lot of deal flow from these fellows and they help us evaluate companies but really like the true value is there is no office in the Department of War, Department of Defense or the intelligence community that is more than one hop from one of our fellows. And so we are able to leverage that network to help our companies find the right person to evaluate a company or a product or a technology all around. This like educational program we built, which really we did out of a sort of a patriotic sense that we wanted to give back to the community and also bring a little bit of education about how private markets work. But it's become this like secret weapon for us.
- [55:59]
Host
What about as companies get larger, how did the Top founders pick VCs as these defense companies start to scale?
- [56:07]
Defense Tech Investor
It's a great question. We don't generally do growth stage investing, although we do a little work with our LPs to help facilitate that for them when they're interested. Anduril is a great example. It's a team, like a founding team of iconoclasts. I think Trey Stevens is on record having said something along the lines of like, they've never had a VC or maybe with one exception, delivery, like the value that was promised at investment. And I think that the team there generally is aligned with that thinking. And so they're very skeptical on value add. And so then I'm thinking when you are picking which investors you want on your cap table, it's either those investors are bringing like value in hand. Like on day one, you're going to give me some equity in your company and I'm going to deliver some value to you today. So you have to prove it.
- [56:58]
Host
Almost a pay to play.
- [56:59]
Defense Tech Investor
Almost a pay to play.
- [57:00]
Sponsor/Advertisement Voice
Sure.
- [57:01]
Defense Tech Investor
You are just looking for people you want to be sitting around a table with or having a beer with on the weekends.
- [57:06]
Host
They're not going to provide any value. Who do I want to be around and who do I trust? If you could go back to 2019 and give yourself one timeless piece of advice about how you could be better as a defense tech investor, what would that one timeless piece of advice have been?
- [57:20]
Defense Tech Investor
Oh man. So many.
- [57:25]
Host
You have a couple?
- [57:27]
Defense Tech Investor
Yeah, I would have stocked up on whiskey for those like late nights where I'm just like sitting in a dark corner crying. The government does so many things that like, feel personal and just like screw with your life. And I've since like realized that it is not personal. It's just the machine grinding away. But there were a couple of years there where it felt very personal. And so I had some just bad days. Things were like, you get an email and you're asked to apply to a program, right? They've got an RFP out, they want some folks to do some things and then you do it and then you don't get selected for the program. And it's like, well, why did you email me and ask me to spend a week of my time and my team's time to do this? And then it's very personal, right? But it's not personal. It's just the machine grinding away. So understanding that I think would have like helped my mental health a little
- [58:16]
Host
bit earlier on, made you push through those times.
- [58:20]
Defense Tech Investor
Because when it's not a bad day, it's a great day. The team that we have, I just love working with them every day. I wouldn't tell my LPs this. I guess I will tell my LPs this. I would do what I do for free if I could afford to do it for free. For sure. I just love it. I get to play with cutting edge technology, work with mission driven founders who like really care about the problems they're trying to solve. I get to be part of a bigger mission and sort of like live my family heritage.
- [58:50]
Host
Your family has roots going back to the American Revolution.
- [58:54]
Defense Tech Investor
My grandma was an Adams, but goes back to John, Quincy and John. Every man in my family all the way back has fought in essentially every American war. As a kid growing up, like probably a lot of kids of my generation, I wanted to be a fighter pilot because I watch Top Gun and he doesn't want to fly F14 Tomcats. But I was fat and uncoordinated as a child and I was told by my family that I should go to law school.
- [59:19]
Host
One of the consistent patterns in all great entrepreneurs, especially these category creators like Palmer Lucky from Anduril or an elon Musk from SpaceX, is that they're almost by definition early. And it's understanding that when you're early, you're either super early, you might be five to seven years early, and then you're kind of out of luck, but you might be one to two years early. Suffering is the sign that you may be onto something extremely lucrative.
- [59:48]
Defense Tech Investor
It's true. I mean, you asked like, what lessons or what advice I'd give myself. And there's lots of advice, but I would never change anything, right? Like there's that sort of that dinner party question, like, what would you change if you could go back in time? I'd never change anything. Like, I love where I am in my life and what I do. And there were lots of painful moments, but I worry if I change those painful moments, I wouldn't be where I am today.
- [60:11]
Host
Right?
- [60:11]
Defense Tech Investor
So literally, I'd change nothing.
- [60:14]
Host
Alex Hermosi has been on podcast twice. One of my favorite guests, he has a saying that you don't work on the business, the business works on you. And sometimes it just takes that suffering, that pain is what actually forms you as an individual.
- [60:27]
Defense Tech Investor
100% agree.
- [60:31]
Host
5, 10 years from now. Is there an optimistic view of the future of defense tech?
- [60:36]
Defense Tech Investor
Definitely an optimistic view of the future of the industry. Like we talked about, the macro trends are sort of bad for global stability, which is good for this industry. Actually, one of the reasons I think makes sense to invest in defense is it's pretty countercyclical. So it's just a good piece to have in your portfolio. But the broader question, like, do I have an optimistic view of the world? And the answer to that is definitely yes. And actually, as I said earlier, I got into investing, doing deep tech investing, and then from there really got into national security. The reason I was doing deep tech investing is I was inspired by Gene Roddenberry and Star Trek. And I was like, why? Why invest in apps or consumer goods like when I can be investing in something? Like really trying to drive humanity forward towards that like post economic vision that Gene Roddenberry had. Right. Really, I think Star Trek is a whole separate topic and I think Star Trek is really an allegory for like self actualization. Right. Like basically technology has made it such that everyone in the Federation can be an explorer. And sometimes it's literally an explorer on the Starship Enterprise and sometimes it's an explorer more metaphorically in terms of doing research and writing and that kind of stuff. A beautiful vision for humanity. And I think it's one that's possible and enabled by technology. So like macro, I think I'm very optimistic over the next like five to ten years for the world. I think we still have a lot of disruption that needs to shake out.
- [62:05]
Host
On that note, thanks so much for jumping on. Absolute masterclass on defense. Looking forward to doing this again soon.
- [62:11]
Defense Tech Investor
Thanks for having me. This has been fun.
- [62:13]
Sponsor/Advertisement Voice
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