Silicon Valley VCs rush into defence technology start-ups

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Investment in military tech start-ups is booming as the war in Ukraine and geopolitical tensions with China lead to growing confidence that the U.S. government will give lucrative contracts to Silicon Valley companies making cutting-edge defence systems.

U.S. venture capitalists (VCs) have agreed to more than 200 defence and aerospace deals in the first five months of this year worth almost US$17-billion – more than the sector raised during the entire of 2019, according to data from PitchBook.

This boom has mirrored the gold rush also experienced by the artificial intelligence (AI) sector, even as investment in start-ups in other parts of the tech industry has plummeted in recent months amid a broader downturn.

U.S. venture investment in defence start-ups surged from less than US$16-billion in 2019 to US$33-billion in 2022, PitchBook data show. Investors piled a record US$14.5-billion into such start-ups in the first quarter of this year.

Silicon Valley had shunned defence technology for years, spooked by association with controversial overseas conflicts and wary of the Pentagon’s notoriously slow and risk-averse procurement process, which has favoured established defence contractors.

According to interviews with more than 15 investors and founders, this wariness has given way to a belief that start-ups are finally in line to take a significant share of the U.S.’s mammoth defence budget, which has grown over two decades to reach a record US$886-billion for 2024.

Large VCs including Andreessen Horowitz and Sequoia Capital Operations LLC have begun to invest in companies that build defence products as well as, for the first time, “kinetic” weapons systems, a military reference to active warfare including lethal force.

“We’re seeing more VCs saying they’re comfortable investing in start-ups doing …tech that can have a kinetic effect used purely for the military,” says Mike Brown, a partner at San Francisco-based Shield Capital LLC and the former director of the defence innovation unit at the U.S. Department of Defence.

Sequoia Capital led a seed round of about US$6-million into Mach Industries earlier this year, according to two people with knowledge of the deal. Mach was started by 19-year-old MIT dropout Ethan Thornton last year and develops hydrogen-powered weapons and defence systems. Sequoia declined to comment.

Anduril Industries Inc., a defence tech company valued at US$9-billion whose largest backer is Andreessen Horowitz, recently revealed it was in talks to develop its first weapons by creating a “loitering munitions” version of its autonomous drones – aerial weapons systems that can wait passively for a target and then attack.

Last year, Los Angeles-based Anduril won a US$1-billion contract from U.S. Special Operations Command to lead the integration of systems that can identify, track and intercept hostile drones.

“We are at war, it is real,” says Teresa Carlson, who previously led Amazon.com Inc.’s efforts to sell its AWS cloud computing service to the U.S. government, and who recently joined Silicon Valley venture firm General Catalyst Partners as an advisor. “We now have to think about how we utilize tech in different ways.”

General Catalyst, which has US$33-billion in assets under management, launched a “global resilience” practice in April to back defence and intelligence companies.

The Russian invasion of Ukraine has been a “game changer” for U.S. military interest in commercial technology, according to former defence innovation director Mr. Brown.

The Ukraine war has been fought through a combination of traditional trench warfare and high-tech systems such as satellite communications, data intelligence and autonomous drones.

Private companies like Virginia-based defence group HawkEye 360 Inc. and Elon Musk’s Space Exploration Technologies Corp. (a.k.a. SpaceX) have provided Ukraine with satellite radar imaging to detect movement of Russian convoys and internet connectivity that’s resistant to Russian jamming efforts.

“The appetite has changed significantly since we started in 2015,” says Brandon Tseng, co-founder and president of Shield AI, a start-up worth US$2.7-billion that makes artificial intelligence-powered fighter pilots and drones. “That year, we pitched to 30 seed investors and got 30 ‘no’s’. Then Russia invades Ukraine and suddenly everyone is taking a look. The funds who thought it was taboo no longer do.”

As many as six defence tech unicorns – start-ups valued at more than US$1-billion – have emerged from the flood of funding: Shield AI, HawkEye 360, Anduril Industries Inc., Rebellion Defense Inc., Palantir Technologies Inc. and Epirus Inc.

But some defence tech founders cautioned that while the public procurement process had improved, it was still painfully slow.

Shield AI founder Mr. Tseng warns of the “valley of death,” a reference to the long gap between developing a prototype and being awarded a government defence contract, during which time young companies are likely to run out of cash and fail.

The large contracts awarded to companies like Anduril and ShieldAI are still an “outlier,” according to the founder of one defence unicorn who now works as an investor at a large San Francisco-based venture firm.

“It’s still incredibly hard to sell to the U.S. government; founders are up against a stack of unfair advantages and lobbyists [for the major defence contractors],” the person says. “There are a load of highly valued defence companies that still haven’t performed to the expectations of investors.”

“The key is to directly sell services to the people who are carrying out the mission,” says Vannevar Labs Inc. founder Brett Granberg. “If you crack that code you unlock eight or nine-figure contracts.”

Vannevar Labs’ revenue grew from US$3-million to around US$25-million last year on the back of a surge of government contracts, according to two people with knowledge of the matter. The company, which analyzes global communications to provide military intelligence, raised US$75-million in January from investors including Felicis Ventures Management Co. LLC.

In recent years, the U.S. has set up a series of government agencies to encourage more private sector development of tech with national security applications, including the Defence Innovation Unit in 2015 and Afwerx in 2017, which allows private companies to sell innovative tech into the U.S. air force.

In 2019, the U.S. created a new military branch called Space Force to conduct military operations in outer space, incentivizing a new round of private capital flows into defence tech focused on space warfare. Mr. Musk’s SpaceX has been one of the biggest private winners, receiving large contracts to help build communications and missile-tracking satellites.

Now, a significant number of investors believe that recent technological developments around artificial intelligence have provided a further onus on Silicon Valley groups to assist in U.S. defence efforts.

“The common wisdom for founders has historically been: don’t build a start-up reliant on selling into the government,” says Dan Gwak, managing partner at Point72 Private Investments.

“Now, there’s an existential technology advancement that I think can shift the global superpower balance,” he says, referring to the rapid development of AI. “The last time that happened was with the atomic bomb. Finally, we’re seeing the government taking steps to win the tech race.”

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