To maximize access to the latest technology to help fight and win wars, the U.S. Department of Defense should partner with venture-backed startups — not just small businesses more broadly.
But first, Congress must act.
Many of the recommendations in the February DoD Report, “State of Competition within the Defense Industrial Base,” are clear, thoughtful and urgently needed. However, there are two misguided ideas throughout the report that are worth interrogating — a focus on small businesses instead of startups and a lack of understanding of the role of institutional venture capital in America’s innovation ecosystem.
These two themes reflect commonly held misunderstandings in the defense innovation community.
The first misstep is that the Pentagon report repeatedly emphasizes working with “small businesses” when instead they should be focused on working with “startups.” Many people use these terms interchangeably, but they do not mean the same thing. American entrepreneur Steve Blank has a video on the pivotal differences between a small business and a startup.
In short, “small business” describes the universe of commercial entities that have fewer than 500 employees, including restaurants, barber shops, small consulting firms, auto repair workshops or any other type of business. “Startups” are the tiny subset of all small businesses that have the aspiration and have been recognized for their potential to take innovative groundbreaking ideas and become massive companies.
Professional venture capital investors evaluate, recruit and select promising startups, and then fund only the ones they believe have the greatest potential. Top firms often evaluate hundreds or even thousands of companies before selecting one to invest in. As a result, the statistics VC funding are remarkably similar to highly selective National Football League rosters — according to analysis by Stanford University, only two in every thousand new businesses end up securing VC funding.
In business, venture backing is a predictive signal of future potential. Over the past 50 years, only 0.19% of new businesses have been backed by VC firms. However, that tiny sliver have accounted for a whopping 28% of the total number of U.S. initial public offerings.
Said differently, a VC backed startup is roughly 200 times more likely to eventually become a public company than those that are not backed. Similar disparities are true for R&D spend, as that tiny percentage of new companies that are VC backed have gone on to account for an incredible 42% of the R&D spending by U.S. public companies. There are of course notable exceptions to these general trends, but the data demonstrate a stark truth: VC-backed companies are exponentially more likely to be drivers of economic growth and R&D innovation than their non-VC backed peers.
Given this data, you would expect the Pentagon to be rushing to recruit VC-backed startups to join the fight. Sadly, the Small Business Innovation Research program expressly prohibits the government from using VC investment as a criterion for contract awards. 15 U.S. Code § 638 - Research and Development, (7) Evaluation criteria states that “a Federal agency may not use investment of venture capital or investment from hedge funds or private equity firms as a criterion for the award of contracts under the SBIR [Small Business Innovation Research] program.” Despite calling itself “America’s Seed Fund”, the SBIR program expressly ignores the opinions of professional seed investors.
As we look to compile the best team we can to win the future fight, the Pentagon and Silicon Valley need to team up. Ignoring the role of institutional venture capital in identifying, supporting, and scaling the most promising commercial technology firms is at best inefficient and at worst it is grossly irresponsible.
Congress should remove this unhelpful provision of SBIR law and clear the way for the Pentagon to begin aggressively recruiting venture backed startups to join the national security fight.
Andrew Powell is the CEO and co-founder of Learn to Win, a software training company headquartered in Silicon Valley.
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