Defense Electronics: The Secrets To Success In Building DE Startups –

The second year of the war on terrorism and possible confrontation with Iraq have focused investors’ attention on defense and homeland defense. The events of Sept. 11 have drawn many new investors into the sector, spawned a host of new companies and redefined some old companies. Not all of the companies now billed as being in the “security” space will succeed. Defense and homeland defense will generate a growing appetite for new technology. Startups can benefit from the increasing demand if they can navigate the challenging process of government procurement, and strong management teams and experienced partners and investors will be imperative to secure these objectives.

Three forces shape the environment for investment in defense: First, the long-term security needs of the United States have increased. The worldwide proliferation of technology and increasing globalization bring new challenges, from weapons of mass destruction to terrorists at home. The deployment of security equipment and networks to address this proliferation has lagged the development of technology.

Second, conventional war is changing. Unmanned Predator drones fire Hellfire missiles in Afghanistan on command from U.S. Central Command headquarters in Tampa, Fla. Commanders some 7,000 miles from the battlefield receive real-time images of firefights from satellites and wirelessly-networked soldiers. The government requires an increasing amount of technology to reduce risks to U.S. soldiers, address new threats and coordinate increasingly complex weapons systems. Emerging forms of warfare demand that America retain its technological lead in secure, high-speed communications.

Third, unconventional threats have emerged. America faces adversaries who are dispersed, hidden, sophisticated and determined. In addition to U.S. assets abroad, there are innumerable targets at home, from civilians to commercial buildings to the national infrastructure. New threats from biological, chemical, radiological and Internet-based attacks dictate a response from new groups-“first responders,” health care workers, postal workers, government employees, network administrators and others.

These forces generate demand for new products and services. The government has dedicated an impressive sum to this effort: Pres. Bush has requested a Department of Defense budget of up to $380 billion for fiscal 2003, $40 billion more than last year. Another $60 billion-plus will be spent on defense electronics and IT and $20 billion for civilian agencies’ IT. The administration’s plan for homeland defense includes a $3.5 billion budget for first responders, $11 billion for border security, $6 billion for defense against bio-terrorism and $700 million for intelligence gathering and information sharing.

Battling Incumbents

Unfortunately, startups are likely to find selling to the government challening. Government procurement has long been concentrated among a few contractors. The largest five receive 65% to 70% of direct Defense Department spending. Whether the newly formed Department of Homeland Defense will follow this pattern remains to be seen, but the initial IT outsourcing contracts for the Transportation Security Administration have been won almost exclusively by large entrenched integrators.

Young companies, then, would be well served by foring partnerships with the key contractors and integrators in the effort to sell to government entities. Government sales cycles are frustratingly long, and the reasons for this are unsurprising: In defense, the government procures integrated systems assembled by large contractors rather than buying individual products from startups, because subsystems must be reliable, compatible and supported over the long term. Plus, government regulations are complex, providing experienced players with an advantage.

Several factors will determine the success of young companies: understanding the technology landscape, identifying specific customers within the government and securing the right partners. Startups should research long-term initiatives, like the Army’s Future Combat System, an envisioned system of networked manned and unmanned subsystems that may substantially shape future procurement. New technology providers must identify agencies and procurement officers that have budget authority within government programs. Startups with point products should forge alliances with the contractors the government will likely choose to build complete systems.

The emphasis on defense and homeland defense will benefit startups and investors in specific technology areas that are likely to include the following:

    * Physical security. Specialized integrators will knit together, install and manage a range of products to securing vulnerable facilities (like airports) through access control, surveillance and identity management.* Sensor technology. The battlefield and homeland need new technologies to detect and protect. Specifically, low cost infrared cameras, new imaging technologies and chemical or biological sensors are needed for integration into larger systems.* Secure/reliable communications. New technology on the battlefield and in the homeland require secure, reliable communications, from short-range wireless to wide area networks.

In addition, spending on database integration, the analysis of unstructured data, and middleware tools will increase. Finally, the government’s increased use of technology will drive indirect demand for supporting infrastructure, including scalable storage for the data generated by new sensor and analysis networks, network security products to protect coordinating systems and IT services.

For its part, the government needs to do a better job of understanding how to support and benefit from the plethora of eager technology startups and streamline its Byzantine procurement process. The Feds are eager to do just this. Senior Defense Department officials frequently visit Silicon Valley and other technology hotbeds, and various security-related agencies, including the CIA, have launched venture capital liaison and investment operations.

Bob Grady and Jay Koh are members of Carlyle Venture Partners, the North American venture capital fund of The Carlyle Group. The Carlyle Group has been an active investor in the defense and security sector for 15 years. The Carlyle Group has $14 billion in private equity under management, including $1.6 billion in venture capital.