Venture capital firms chase defense spending
By Jim Christie
SAN FRANCISCO, April 15 (Reuters) - Venture capitalists stung by the loss of millions from dot-coms and other companies making high-tech products for the consumer and business markets, are now turning their focus to the defense industry.
In the wake of the Sept. 11 terror attacks that prompted the U.S. to seek large increases in military spending, defense is seen as the latest growth industry by a group of investors always looking for the next big thing.
Although much of the military spending will go to traditional defense contractors like Boeing Co (NYSE:BA - news) and Raytheon Co (NYSE:RTN - news), some smaller players with innovative technologies are also seeing opportunities as the defense industry seeks to build more advanced and intelligent weapons.
``I'm having a lot of companies come to me and ask, 'Can you help us do business with the government?' explained Christopher Michel, chief executive of Military Advantage, a San Francisco venture-backed company that operates the Military.com Web site. ''They see defense as a growth sector.``
While many VCs and start-ups are eager to do business with the Pentagon, they face numerous hurdles. For starters, the defense establishment's plodding business culture differs starkly from the informal dealmaking that characterizes VCs and tech start-ups, especially those in Silicon Valley.
``In Silicon Valley, a handshake means a lot,'' Michel said. ``In the government, contracts mean a lot.''
TANKS VS. HIGH-TECH
Additionally, officials, who allocate and spend defense dollars, may not be excited by all the latest information technology, typically the main focus of venture investing.
To meet the Defense Department's traditional needs some venture firms have have put their money into the companies that make more old-fashioned war equipment, like tanks.
The Carlyle Group, which includes former Defense Secretary Frank Carlucci as an officer, took a big pre-IPO stake in United Defense Industries Inc. (NYSE:UDI - news), which makes armored vehicles, naval guns and missile launchers.
Arlington, Va.-based United Defense most recently received a $58.4 million contract for 27 M88A2 Hercules recovery vehicles for the U.S. military and in February it landed a $1.8 billion contract to further develop the next-generation self-propelled Crusader, a 155 mm artillery system that critics say is too heavy -- 42 tons -- to fit into a transformed, mobile Army. The Army, however, plans to spend $11.1 billion to develop, buy and support 480 Crusaders.
Some Silicon Valley venture capitalists, anticipating a bumpy road ahead for tech start-ups seeking Pentagon dollars, are urging the Defense Department to follow the lead of the Central Intelligence Agency, which has its own venture firm.
In-Q-Tel was started by the CIA in the late 1990s after the agency concluded it could not otherwise keep up with technology trends and needed private industry to track those trends, especially in information technology.
``It's basically about finding the needle in the haystack, and knowing what haystacks are out there,'' Gilman Louie, In-Q-Tel's chief executive, told Reuters. ``There has got to be a better way than government contracts.''
Since its launch, In-Q-Tel has invested in about 20 companies after screening 2,000 funding requests, Louie said, noting the CIA was ``smart enough to say they couldn't do it within their system.''
The CIA seems especially interested in companies that address its own shortcomings. For instance, In-Q-Tel helped fund Tacit Knowledge Systems, a Palo Alto, California-based company that makes software for organizations to link workers who share mutual interests, skills and knowledge.
A PENTAGON VENTURE FUND?
Tacit says its ``expertise automation'' software helps overcome compartmentalization within organizations. The goal is to offset the constant criticism of the CIA that critical information does not flow smoothly within the agency.
``They have the same problem as any big company of being self-aware at a granular level,'' said David Gilmour, Tacit's president. ``We're trying to discover needs for connections.''
Tacit also is trying to sell into the Pentagon and so far has had a warm welcome, said Elisa Cafferky, Tacit's manager for federal relations.
``An intelligence analyst gets it right away because they're in compartmented, secure environments, working in their little vaults and don't know who to call for help,'' Cafferky said.
Investments like Tacit are a positive sign to Jim Opfer, a former U.S. Air Force colonel and network architect for the National Reconnaissance Office who now heads the Silicon Valley venture firm LaunchPower.
But Opfer would prefer to see the Pentagon, like In-Q-Tel, tap tech start-ups rather than wait for them to come knocking. However, he would add a twist to the CIA's tie-up with In-Q-Tel.
While the CIA funds In-Q-Tel, a not-for-profit firm, Opfer wants the Pentagon to hire a for-profit VC firm to run its portfolio and assume risks and rewards as an investor.
Opfer also suggests that military officers serve tours of duty with such a firm to build tech industry contacts, especially in Silicon Valley.
``People in the Pentagon don't know what is going on in Silicon Valley,'' Opfer said, adding that tech start-ups also ``need to get inside the Pentagon's thought process.''
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