OpinionThe stage is set for a defense tech revolution
Opinion
The stage is set for a defense tech revolution
“The geopolitical climate, soaring military budgets, and the need for innovation in modern warfare are setting the stage for a defense tech revolution,” writes Amit Pilowsky, Co-Founder and Partner at Key1 Capital
Historically, defense tech and venture dollars have not been a harmonious mix. Lengthy business cycles, high capital intensity, and difficulty in achieving large-scale exits hampered startup innovation in the sector. For Israel, a country where technology and national security have been bound since its establishment, the potential of the defense tech sector is enormous and largely untapped.
But change is in the air.
The geopolitical climate, soaring military budgets, and the need for innovation in modern warfare are setting the stage for a defense tech revolution.
In this piece, we explore the multifaceted reasons behind the limited defense tech activity in the past and delve into the mega-trends reshaping the sector, uncovering why now is the perfect moment for entrepreneurs to seize the opportunity and drive the future of military technology.
Several factors have led to the limited defense tech activity both in Israel and worldwide. The first is the cripplingly long cycles in defense tech. From prototype -> POC -> purchase order -> delivery, it can take years to reap the rewards of even the most profitable defense tech solutions.
The second factor is that this sector is dominated by giants. Incumbents like Lockheed Martin, Northrop Grumman, Boeing, and establishments like governments and militaries, make pulling up a seat to the table a complicated and daunting endeavor.
The third factor lies in the significant capital required to bring a product to market. Achieving a military-grade standard demands a ton of cycles, testing, and proof of concept. Compounded with the necessity of incorporating hardware components into the solution, development inevitably becomes more costly.
The fourth factor is the need for companies to secure large contracts for profitability. Unlike SaaS businesses with high gross margins and recurring revenues, industries like defense tech operate with lower margins, (typically around 40%-50%), making them less attractive to investors.
Finally, exit values usually range from $300-500m, with $1 billion+ being clear outliers. This is due to the cash generation point above and the small pool of buyers, who are usually publicly traded and used to thinking in their own trading multiples of ‘low to mid-teens’ EBITDA, making valuation challenging.
What’s changed?
First and foremost, there’s the recognition that future warfare will be determined by superior technology rather than the number of tanks. The drone war in Ukraine and the missile attack by Iran against Israel demonstrate how technology dictates battlefield strategies. Today the “edge” lies not in hardware but in software prowess, enabling startups to become significant players.
Secondly, government entities and militaries have come to recognize that embracing rapid innovation and eliminating barriers to entry are essential to maintaining a technological edge. This includes the Pentagon’s Defense Innovation Unit (DIU.), and NATO’s Defence Innovation Accelerator for the North Atlantic (DIANA). This strategic shift creates opportunities for entrepreneurs with innovative ideas to prove themselves.
Third, amidst the escalating imperative to combat evolving threats, the rate at which military technologies are being adopted is unprecedented. A prime illustration is the Israeli army addressing the challenge of terrorists hiding inside tunnels. Previously deemed nearly impossible to manage, the army swiftly integrated a drone system capable of operating within tunnels without GPS signals. Remarkably, these drones were developed by a small start-up based in Tel Aviv.
Fourth, the geopolitical climate is driving many governments to allocate unprecedented budgets for military armaments. Japan announced a $302 billion military spend from 2023 to 2027, a 16.5% increase from FY 2023, and Sweden, Poland, and Finland have announced military budget increases of 28%, 69%, and 33%, respectively. These budgets will ideally be spent on the best technologies out there.
Finally, the defense tech sector has transitioned from the traditional 'System of Systems' approach to a more adaptable 'plug-and-play' framework. This change addresses the complexity of modern threats and the need for agile responses, allowing defense systems to quickly incorporate new technologies and accelerate innovation in military technology.
Israeli defense tech as a unique case in point
The lag of defense tech innovation in startups is particularly noticeable in Israel. Technology and national security have been bound together in Israel since its establishment, with Israel’s defense tech sector existing long before the development of its very own fighter jet, the Kfir, back in 1969.
Since then, Israel has seen a profound level of defense tech innovation primarily led by government and military-owned defense companies such as Rafael, IAI, and Maf'at, complemented by large defense companies such as Elbit Systems.
Considering the remarkable defense tech innovation coming from established entities in the country and the imperative need for defense technology, we believe Israel has yet to fully leverage its potential in this field.
Looking forward:
At Key1 we have witnessed the emergence of several promising defense tech start-ups over the past few years.
A common characteristic among these startups is that they were all relatively early-stage ventures, pre-revenue or earliest stages of revenue generation, but not yet at full ‘scaleup’ phase.
As we witness the development of this industry and the changes occurring to spur innovation, we are excited and energized about what lies ahead for defense tech and aim to take a more active role in supporting the most promising startups in the field.
Amit Pilowsky is Co-Founder and Partner at Key1 Capital
