Venture Math In Defense - Part II: Exits
While Venture Math in Defense: Part I covered the basics of investibility and briefly touched on factors that have traditionally made investing in defense challenging, in Part II, we cover exits in the defense tech market and some of the recent trends.
At the end of the day venture capitalists (VCs) are just investors. We need to be able to buy shares in a company at a low price and then sell those shares at a higher price. Most content around VC focuses on the first half of the equation, how VCs invest, but the second half is equally important.
In venture capital we invest in private, unregistered securities. This means that, unlike stocks, which many of us can trade instantaneously via an app on our phones, the shares VCs buy in companies is illiquid. It can’t easily be sold to anyone else, in fact, in many cases, it would be illegal for VCs to sell their shares to someone.
So how do VCs sell their shares (exit) after they have invested in a company? It happens in one of 3 ways:
Secondaries: In a secondary transaction one investor sells their shares to another investor. While it may sound simple, there are many challenges to executing a successful secondary transaction. (1) Finding a buyer can be quite difficult since there is no major stock exchange set up and you can’t broadly advertise the stock you want to sell. (2) Negotiating price can be extremely challenging since there is no free market helping to establish fair value. Given this and other factors, sellers often need to offer a discount. (3) Providing confidential information on private companies to buyers can be hard if not impossible but without that confidential information it is hard for buyers to do the diligence that they need to purchase the shares. (4) Selling shares on the secondary market can negatively impact the company by creating a perception that its most knowledgeable investors are leaving or by flooding the market with shares making it harder for the company itself to raise capital. (5) The shares likely can only be sold to accredited investors or qualified purchasers (legal terms) which dramatically shrinks the pool of viable buyers. For these reasons, while secondary sales are a tool in the VC toolkit, the vast majority of exits in VC happen through either an IPO or a merger/acquisition (M&A) event.
IPO: The company “goes public” and registers its securities on an exchange like the NYSE. This is almost always the most profitable way for an investor to exit but it is also the rarest. How rare is an IPO? Only about 1% of venture backed startups ever go public despite this being the goal of most venture backed founders. That might seem like a low hit rate, but to put it into perspective, in 2022 there were more than 5 million new businesses formed and only 181 IPOs for an (extremely rough) hit rate of .0036%. IPOs are rare because to be publicly traded, companies traditionally need material revenue in the hundreds of millions annually, very sophisticated accounting, legal and back-office operations, and a plausible continuing growth story. Very few companies ever reach IPO scale.
Given that secondary sales are challenging and that IPOs are extremely rare, most of a VCs exits and a material portion of their returns will need to come through the third option, M&A.
M&A: The company (and all its shares) are acquired by another (larger) company. As in IPOs and secondary sales, M&A has its challenges. It can be time consuming and immensely distracting for a startup to engage in the extremely invasive marketing and due diligence processes which are required to consummate an M&A transaction. Even when companies can manage these processes while concurrently building their business, the business often suffers an operational setback as few startups are equipped to run their business in parallel with an M&A process. Thus, when M&A fails it isn’t rare for it to contribute to the death of the startup. These are high stakes transactions. Finally, even when the transaction itself is successful, integrating the two businesses can be challenging and costly. Many M&A transactions that make sense from a theory perspective end up being a disaster in the real world. All that said M&A is the most common positive outcome for a venture backed startup and while all acquisitions are unique, a high potential technology company might expect to be bought for somewhere between 5x and 20x their top-line revenue. i.e. a company with $50M in average annual sales that is growing quickly and has solid margins, depending on the market, might very well sell for $500M or more, which while not what their investors might have dreamed of initially, is probably an entry in the “win” column.
5x-20x revenue is great, right? You can definitely build a successful VC firm with a handful of material exits in that bucket. In fact, M&A should be a great exit strategy in an industry like defense where we know that the largest buyers, the major prime contractors, are rarely able to innovate internally and so must rely on partnerships and acquisitions in order to grow and maintain relevancy.
The problem is that M&A has traditionally sucked in the defense sector and the 5x-20x multiple on revenue that forms the price range in other industries is closer to 1x-2x in defense.
Why the huge difference between defense and other technology industries?
The answer is surprisingly straightforward… the largest acquirers in defense are the major primes (Lockheed, General Dynamics, Raytheon, L3 Harris, Boeing, and Northrop Grumman) and these primes themselves are only valued by the public markets at between 1x and 2x revenue. They’re valued at these low multiples because cost plus contracting means that their margins are slim and while their revenue is consistent, it grows slowly.
Here is a quick and dirty example of what this means when it comes to M&A. Let’s say there is a private defense company called Casper making cloaking devices and it generates $50M in current year revenue. It might be valued in the private markets at $1B, a whopping 20X top-line revenue. If a major prime worth $20B, we’ll call them JetCo that is valued at 2X topline revenue acquires Casper for $1B what happens on day one of the acquisition is that JetCo destroys $900M in enterprise value. They spend $1B in cash to acquire Casper, which the public markets now value at $100M (2X $50M in revenue). It might be smart for JetCo to acquire Casper even if it incinerates nearly $1B in market cap given the strategic value Casper provides but major corporations like the defense primes are governed and incentivized by quarterly share price.
Under the best of circumstances acquisitions take years to fully integrate and JetCo is unlikely to reap the strategic benefits of the acquisition for several years. This can be particularly true in defense where the Department of Defense is notoriously slow at acquiring (read paying $$$ for) and fielding innovative technologies at scale. Meanwhile JetCo’s share price is punished in the short-term. This dynamic dramatically shrinks the venn diagram overlap between the companies that the prime contractors should be acquiring from a long-term strategic value perspective and the companies that would be willing to sell to the primes. The companies in the overlap tend to be building discrete components that might be valuable but lack any real shot at hitting an IPO or becoming a vertically integrated prime themselves.
What this means is that in the defense market many of a VC’s successful investments turn out to be financial losers. This suppresses returns in the aggregate (obviously) but perhaps just as bad it increases the variance in a portfolio of defense investment because now the portfolio’s returns need to rely almost entirely on much rarer IPOs. For limited partners and financial engineers, variance = risk. The net effect is that a defense-focused VC strategy used to require limited partners to be willing to take greater risk on average for lower returns on average. Not exactly a compelling value proposition.
BUT we have hope because times are changing. In the last several years we have seen a new crop of venture capital backed defense tech startups begin to reach scale. This includes companies like Anduril, Shield AI, Epirus, Skydio, and Rebellion Defense. As these companies, built on silicon valley DNA, hit scale they are becoming acquisitive and true to their roots they are beginning to acquire other defense tech companies at traditional tech company multiples more in line with the 5x to 20x discussed above.
These tech startups can afford to pay tech company multiples because they have begun to pioneer new business models which afford for higher margins and potentially higher growth rates than the traditional prime contractors. Anduril alone has acquired 5 defense companies in the last 2 years. One of these acquisitions, Dive Technologies, was followed by an announcement only a few months later that Anduril/Dive had secured a ~$100M contract based on the combination of the Dive hardware with Anduril’s platform. Anduril’s latest acquisition, Blue Force Technologies, seems to be aligned with an interest in competition for contracts aligned with the collaborative combat aircraft (CCA) program, a contract, which if landed, can be significantly larger than the first Dive contract. To the extent Anduril and its contemporaries can continue to see outsized success as a result of smart M&A decisions, we will continue to see them engage in a robust M&A strategy that drives VC returns.
Finally, my hope, though we haven’t seen any evidence of it yet, is that as the scaled defense tech startups begin to capture market share from the traditional primes, the primes will recognize the importance of an aggressive M&A strategy, even if it means sacrificing short term share price for long term growth. In fact, I think eventually the traditional primes will have no choice but to (1) begin competing in the M&A market and (2) launch VC partnerships, if they want to stay relevant. Once that flywheel begins spinning the defense innovation ecosystem will finally have reached full maturity in this cycle and we’ll see phenomenal venture returns. Unfortunately, we’re probably still at least 5 years out from this part of the ecosystem functioning properly.
In summary, VCs ultimately need to sell the companies they buy and one of the most important avenues to do so is through an M&A transaction. Over the past couple decades those transactions have been uniquely unrewarding in the defense industry but the emergence of new defense primes like Anduril and Shield AI has fundamentally altered the equation. Things aren’t perfect yet but they’ve changed dramatically for the better and the future is bright.
At Marque Ventures, we’ve seen a sliver of the future and we’re pursuing it aggressively.