When you look at the financial sections of newspapers and magazines over the past few months, you get the sense that capital, entrepreneurs and technology innovators are flowing toward a new homeland security space - a market in which the buyer is essentially one customer: the federal government.
There's no question that our security-conscious government has money to spend in these areas, during a time when a lot of traditional buyers aren't spending anything. So a military or homeland security play has understandable appeal now, and some defense contractors with low margins have been given high valuations. But if hordes of investors and startups expect to make a meal out of the federal market, many of them are going to learn a hard lesson.
Through the Gatekeepers
Our fund is based in Washington, the heart of federal contracting, so you might think our portfolio is brimming with government-oriented vendors. It isn't. We know that while many professional services businesses have prospered as contractors, it's a problematic space for early-stage technology companies. Government sales are often channeled through large "gatekeeper" contractors that comfortably navigate the GSA schedules, arcane omnibus contracts and other procurement red tape this market requires. You can't just pitch a great new technology to the Department of Homeland Security, you need a contracting vehicle, and access to these large contracts and customers is often controlled by entrenched acronyms like SAIC, AMS, GTSI and EDS or large integrators like Booz Allen Hamilton and Lockheed Martin.
Despite our government's best intentions, the reality is that the technology provider that wins a given military or homeland security contract is the one that best fits through the system. The same way a "best-of-breed" software product can lose out to a product that's part of popular software suite, the government takes a total-systems approach to procurement, usually favoring integrators that serve up "components" that are interoperable with its existing data capabilities. This is complicated by a Byzantine thicket of buying agreements, teaming arrangements and subcontracts. So if an established contractor hired by the Department of Homeland Security is looking for a technology product they can pass through directly on their umbrella contract, your radical, system-changing technology is probably not going to see the light of day.
Even if you can solve the contracting game, the government still isn't a great place to be for an investor, if that is your portfolio company's only customer. We venture capitalists like to see our companies position themselves with several strong customers and a high growth ceiling in the commercial markets. At Core we sometimes see spinoff technology companies from established contractors who pitch us on their experience with government agency procurements. Our concern, though, is that someone who dwells entirely in the federal space is naturally going to be more oriented to procurement accounting than determined to get a fair market price for their product. We think in terms of possible exits, and a one-way exit strategy is not appealing.
First Task is Integration
Still, let's assume that the Department of Homeland Security would, at some point, be able to make use of new technologies - either from new, smaller contractors or from established giants that have plucked out some innovators. Given the challenges that face a department stitched together from smaller agencies, and the tasks of unifying a front-line defense against domestic threats, this department must complete a monumental system integration project before it can worry about looking for exciting new intrusion-detection systems or smallpox vaccines.
Thus the immediate opportunity, as the department brings together several assets, is for readily deployed systems integration products - though even the best integration efforts may be stymied by the deep bureaucratic divisions that exist between the FBI, the CIA and other security fiefdoms.
After integration, a principal homeland security task will be coordinating first-responder programs on the local level, and most technologies will be required to deliver information quickly to these officials. A host of medical technologies and IT solutions will likely be necessary over the next decade as the Centers for Disease Control and other agencies develop new systems for feeding information to first responders. If 40 people show up with similar symptoms at a center in Denver, for example, software that can aid in diagnosis and quickly discern patterns will be indispensable.
New Applications for Shelved Ideas
Other technologies that are adopted might not necessarily be new. They may be innovations that were developed by defense contractors years ago, but had no immediate application and have sat on the shelf. The Pentagon has a deep inventory of these dormant projects. Fifteen years ago, when I worked at a contractor that supported federal labs, we developed systems for tracking explosives with special chips that respond to radio-frequency (RF) signals. That idea drifted away, but in the past year I've seen waves of RF-based security proposals. My sense is that right now a number of defense innovators are dusting off their shelved inventions, but these were usually funded by long-view military labs - not by VCs who must make smart decisions about what will be commercially usable within the next few years.
My final word of caution about homeland security technologies relates to how the government tends to transform its vendors, a trap I have seen played out a few times. Most VCs aren't terribly interested in services companies; we prefer a new idea that carves out a unique, high-growth market niche and can be productized. But the government does not look or specific products as much as it looks for the best answer to a very specific problem that few other customers may have - say, data mining software that can scour millions of records to match names and faces with airplane ticket buyers. If you have something like that, you'll likely have to shape it into a custom-built "solution" for the agency. Then you must do the work of integrating the technology within the agency, and supporting it when the government calls with additional needs. Then, perhaps related agencies begin to use your solution as well, each with its own support needs.
Before long, your company structure and culture have adapted to serve the government, and you have morphed from a product company into a services company. And if you're operating only in the government sector, where talented personnel tend to migrate constantly from supplier to supplier, you may lose top staff to other contractors more often than you would in the private sector. Having said that, I'll note that becoming a federal contractor can be a good thing too - hundreds of very successful businesses count the federal government as their best, or only, customer. Startup companies just need to be sure that's what they want to be.
Federal procurement is certainly going to sustain a great many technology providers in the years ahead. But for these reasons, as a venture capitalist I'm not quite ready to throw my suitcase on the homeland security wagon just yet.
Mark Levine is a managing director at Core Capital Partners (www.core-capital.com) in Washington, D.C.