War Doesn’t Pay –

It sounded like a good idea: Help your country by making technology to combat terrorism and make a profit besides. But VCs didn’t bite and neither did the government. Here’s why.

Patriot Ventures opened its doors on July 4, 2001, hoping to raise a $100 million fund. Its founders had military backgrounds and they planned to use them to exploit an untapped market: anti-terrorism technologies. When the Sept. 11 attacks came, it appeared to be a chilling confirmation of Patriot’s strategy.

Fourteen months later, Patriot is still trying to raise its first fund-and its prospects don’t look good. For battered startups and bedraggled VCs, there was a hope in the months following Sept. 11 that the war on terrorism might be a business opportunity. It has not turned out that way. Neither the U.S. government nor commercial companies have gone on a spending spree to protect themselves from without and within. Hundreds of startups pitched anti-terrorism or other defense-related technologies in the hopes of getting venture or federal backing, but they have found little interest.

Most venture firms placed their security bets before Sept. 11 or pulled back from the space as part of an overall slowdown in deal activity. In the year preceding the attack, 209 companies with “security” somewhere in their description raised venture backing, but that figure fell 33% to 140 from Sept. 11 to Aug. 19 of this year, according to researcher Venture Economics (publisher of Venture Capital Journal). Startups that primarily focus on homeland security or the U.S. military saw even less interest. Just 27 such companies were funded after Sept. 11, based on VCJ’s analysis of data from Venture Economics.

There are companies that will get rich from the war on terrorism, but they’re going to be the same companies that get rich every time war is declared. Even with as much posturing as there hasbeen about replacing antiquated military and defense systems with the best technology in the world-built in places like Silicon Valley-no one in government is leading the way.

“If there’s one thing that’s changed since Sept. 11, it’s the absolute over-hype of homeland security investing,” says Mark Frantz, a vice president at the Carlyle Group, a private equity firm with deep government ties. “Some startups and venture firms that haven’t worked with the government think that it’s going to be the cure-all. In the words of the great 20th century hip-hop philosopher Chuck D.: Don’t believe the hype.'”

Most VCs and their investors are leery of working with startups dependent on the federal government. It’s too risky to rely on a single customer, no matter how deep its pockets, and it’s even riskier to be beholden to a customer that can set its own prices. “Silicon Valley VCs don’t invest in companies where the only customer is the government,” says David Chao, a general partner with Doll Capital Management. “We’ve seen a lot of forensic and biometric-type deals, but we haven’t invested in that stuff because the barriers to entry aren’t that high.”

Charlie van Horne, a private equity investor who spent five years in Russia in the early ’90s trying to turn guns into plowshares, says it is very frustrating to work with any government agency. “As you get into defense-related markets, you’re in a non-transparent world where your

ability to influence events is heavily impaired,” says van Horne, a managing partner at Abbott Capital Management Inc., a New York-based fund of funds with $5 billion under management. “The best venture firms want to see a path to a market that is going to be unencumbered except for those few things they can control.”

Startup Remedyne’s experience trying to raise money from venture firms or the government for a drug that kills anthrax has been “absolutely hell,” says Krisztina Zsebo, CEO of the Santa Barbara-based biotech company and an 18-year veteran of the biotech business. “When [Sept. 11] happened, we thought we could be an important player.” It’s a common refrain from little biotechs who thought they would see a windfall from VCs and the government following Sept. 11 but have been met only with skepticism.

Based on research done at the University of California at Santa Barbara, Remedyne has figured out how to tweak the genes in bacteria to create a pill to cure everything from ear infections to anthrax. After Sept. 11, Zsebo says, the company played up its connection to a cure for anthrax, but it quickly found that “companies with breakthrough technologies at the early stage of the game are basically being put at the bottom of everyone’s pile. Even with higher valuations, VCs are more willing to fund later-stage companies because they are a lower risk.” And if your principal customer is the government? Forget about venture funding.

Forget the Anthrax

Last fall Remedyne was looking for $25 million to develop its drug. It has since cut that figure in half. When talking with VCs now, Zsebo makes sure to tout her company’s ability to potentially cure diseases with huge commercial markets, like HIV, cancer, TB and hepatitis-not anthrax.

Sept. 11 has really only benefited a smattering of companies that happened to be in the right place at the right time, like Berna Biotech Ltd. The company, based in Bern, Switzerland, saw its 2001 annual revenue more than double based on $152 million worth of sales of smallpox vaccine. Its smallpox vaccine sales for the prior year: zero.

Even the pros who know how to navigate the Byzantine government maze can’t seem to find their way post Sept. 11.

John Prausa is a vice president of engineering and systems at SRI, the world’s largest non-profit R&D outfit. His group does 95% of its business developing technology for government clients. Of that, 80% is for military and intelligence units.

After Sept. 11, Prausa put together an inch-thick document highlighting SRI’s considerable capabilities in counter-terrorism. When the Defense Department put out the call last fall for new technology and ideas to combat mobile forces, locate and destroy underground targets, assist troops in remote and rugged terrain and defend against weapons of mass destruction, SRI responded with 50 proposals.

Of the more than 12,000 proposals put forth, the DoD funded 10 for $5 million. SRI got skunked on all of its proposals. Clearly, there is a lot of money being spent on the fight against terrorism. About $22 billion in extra funds in the current fiscal year is directly related to Sept. 11, and President Bush is asking for an increase to the $331 billion annual defense budget.

But where is it being spent? Planes and munitions are enormously expensive, as are the troops actually engaged in battle. At home, the money is being spent on visible signs of security-barriers, scanning devices and National Guard troops on bridges, things that make people feel safer.

“Does it do anything that makes us truly safer? No,” Prausa says. “I think we spent the last year preparing for the last terrorist attack, and we are not prepared for the next one.”

If It’s Broke …

The greatest frustration for tech entrepreneurs and scientists is that the U.S. government doesn’t seem to be investing in technology that will provide better security and perhaps forestall the next attack. After Sept. 11 and the anthrax attacks, there was a cry for detectors, so the government ponied up the dollars to buy anthrax detectors. But the ones they bought barely work, and in late June a cease and desist order on purchasing more anthrax detectors was issued by the DoD. Rather than spending money on fine-tuning better technology, money was spent on faulty, decades-old technology.

The phone didn’t ring over at SRI, which says it has developed a hand-held detector for bio-and chemical warfare agents that is 20, perhaps as much as 100, times more sensitive than detectors on the market. “Sure we need to get some stuff out there today but we need to also focus on the next generation of technology,” says Larry Dubois, a vice president at SRI and a former DARPA research development officer. “There are organizations that are charged to look a little farther out, and that just didn’t happen.”

Despite the government’s glacial pace, there are still VCs who want to do business with it. But even they admit that it’s with a great deal of caution. “It’s a very tough environment,” says Jack Biddle, a general partner with Bethesda, Md.-based Novak Biddle Venture Partners, probably the leader in bringing technology out of government labs. “The name of the game is to lose less than the competition.”

Proximity to D.C. gives his firm an advantage when picking over technology coming out of government labs, Biddle says. “There are areas where the government is a real leader in technology” he says. “People know that Tang came from NASA, but did you know QualComm came from the military, too? If you look at a technology like fiber optics, that was really led by the Navy. They needed secure communication that didn’t emit RF.”

The other advantage to focusing on the government is that it’s actually spending money. “The largest consumer of IT in the world is right here in Washington, and their credit’s good,” Biddle says. “It’s a lot better than WorldCom’s.”

The Carlyle Group’s Frantz warns startups and VCs to not get too excited about the government’s credit or the $38 billion budget proposed for homeland security. If any private equity firm knows its way around D.C. it’s Reston, Va.-based Carlyle, which has none other than former President George Bush Sr. as a senior advisor. Frantz himself served in the first Bush White House and later worked as a tech policy advisor to former Pennsylvania Gov. Tom Ridge, now the nation’s Homeland Security Advisor.

“It’s $38 billion, but that’s all in different agencies,” he says. “You know, $5.5 billion of that is for the Coast Guard. Only $1 billion of that $38 billion might be discretionary to Homeland Security.”

The Loneliest Number

He points out that the current administration, being Republican, is not likely to increase spending. The government also has a long history of working with very established contractors, like Lockheed Martin and Boeing, not startups. Short of that, startups and VCs must develop a two-pronged strategy for selling into the commercial sector as well as the government.

That’s the tack that Carlyle is taking. It has invested in ISR Solutions, a company focused on physical security at ports and utility plants. It also sees opportunities for startups in the physical security/access control space where larger security companies haven’t already staked a claim.

Venture firm In-Q-Tel has no choice but to work with government: It is part of the CIA and has to go to Congress every year for funding. The In-Q-Tel model is to fund private companies with commercial technology that can be transferred to those more discreet branches of government.

Gilman Louie, CEO of In-Q-Tel, says he’s actively looking at companies in video processing, energy sources, security and wireless applications. Like Frantz, he offers a caveat to those who would do business with the government: “It’s a good vertical, but the idea that your whole business can be built around the government is not necessarily sound.”

The question remains: Will the events of Sept. 11 open up new markets? Will the cost points be there? Eventually, says SRI’s Prausa, but they will be realized at great expense. Forensics, biometrics, advanced network security. They aren’t large markets now, but they will be. “I hate to say this,” he says, “but I think private industry needs to suffer the same kind of loss or perceive the same kind of threat to their business before they will respond. Until then, it will be business as usual with the government.”

Misguided Patriot?

The partners at Patriot Ventures believe there has been a shift in the way the United States needs to defend itself, so they’re forging ahead with plans to raise a fund to invest in anti-terrorism technologies. The aim is to find startups with compelling propositions, not try to commercialize government-developed technologies.

Patriot’s original plan was to raise $25 million from traditional limited partners and another $75 million from the Small Business Investment Corp. “It’s kind of fortuitous that we’re focusing on a space that now has become a very visible sector of the economy,” co-founder and general partner Ted Dumbauld told Red Herring in April.

Not as fortuitous as he figured. Patriot has reduced the goal for its first fund to a total of $50 million. “The target date we have now is October,” says Samuel Dinnar, a partner with the Waltham, Mass.-based firm. He remains convinced that Patriot is on target. “This is not the flavor of the month,” he says. “This is the flavor of the century.”

Old Enterprise Associates

Perhaps Dinnar and his colleagues should talk to New Enterprise Associates before they exert any more energy. It created an affiliate $23 million fund called Spectra Enterprise Associates in 1987. Its goal was to invest in and commercialize early-stage companies that grew out of the defense electronics industry. While its specific mission is different than Patriot’s, Spectra was on the front lines of working with defense agencies.

“In order for defense industry-related investing to make sense, the technology must have a dual purpose,” says Jim Cole, a former NEA partner who founded Spectra.

The fund invested in more than 20 companies, four of which are still part of the portfolio. It didn’t do deals that were pure defense plays because “it’s very difficult to exit pure defense deals,” he says. Spectra couldn’t find enough interest to raise a second fund and it hasn’t made a new investment in years.

It wasn’t a total flop. Several of its investments that serve multiple markets went public, including NetSolve, Rational Software, Spectrian and Vitesse Semiconductor. “It was a good idea at the time, but it turned out it was not a good enough idea to continue,” Cole says. What will continue, unfortunately, is terrorism. Whether the U.S. government can get past its inertia and start funding cutting-edge startups that promise to make a difference is the $38 billion question.