16 July 2024
By Arthur Karell and Renny McPherson
Systems thinking is a central element of military leadership. The challenges our operational forces face downrange belie simple categorization and linear approaches. Warfighters must make sense of complex problems by looking at them in terms of wholes and relationships in order to cut through gordian-knot problems. To us, two Marine Corps combat veterans who went on to build and grow security technology businesses, it’s a lesson we now apply to investing in security- and defense-related technologies.
We are investors in systemic security. Systemic security is composed of the holistic elements of security that today most people consider to be in disparate stovepipes. While it is important for investors to make sure they understand the realities of possible venture scale outcomes in defense tech and cybersecurity broadly, it is essential for all participants in the security ecosystem to understand the range of emerging threats to individuals, commercial and government enterprises, and the United States.
Practically, the systemic security approach guides our investment philosophy and provides a framework to analyze investment opportunities. Our framework for systemic security starts with technology, featuring active races between great powers for AI leadership and quantum supremacy, for example. Security as an investment category includes military-specific security technology applications, cyber warfare and cybersecurity, as well as influence and cognitive operations, strategic supply chains, and economic and financial measures. To invest across the full spectrum of security, one needs to have expertise that encompasses commercial enterprise go to market, government contracting, and how particular companies should stage pursuit of commercial and government use cases and customers.
Most traditional investors do not think holistically about security; there is no “security” category or sub-category in traditional investment analysis. What we at First In view as a common set of threats, solutions, customers, go-to-market strategies, and product technologies, is often split between stovepiped sectors such as Aerospace & Defense (A&D), Cybersecurity, Manufacturing, and Technology. Our national adversaries certainly don’t see it that way. Competition with the Chinese Communist Party (CCP), for example, is taking place across all instruments of power – diplomatic, informational, military, economic, financial, intelligence and law enforcement (DIMEFIL) and in multiple domains simultaneously: cyber, space, air, land, sea, information, and electromagnetic. Viewing the market through the traditional sector lens will miss relevant products and technologies and will not anticipate investable opportunities at various levels across a product value chain.
The “defense tech” theme is a case in point. “Defense tech” is enjoying a moment of late among investors, due in part to the geopolitical headlines. We are highly aligned with the view that increasing global uncertainty and a corresponding focus on security is spurring investable opportunities. We have been professing that thesis for over a decade, since first working on security technologies in the private sector. Defining what “defense tech” means and finding an edge given its popularity, however, takes systems thinking. Newer investors to the theme may be less familiar with the manufacturing automation opportunities in the A&D sectors, or in the necessity of enterprise cybersecurity for any defense-specific hardware or software product. Similarly, they may not feel comfortable investing in emerging strategic-level weapon systems, despite the fact that these technologies are central to global deterrence, and the actual prevention of war.
First In operates in the gaps between industry classifications and investment styles. Our organizing principle is to be systemic security investors first. We have a differentiated view on venture scalability in the security market, given its idiosyncrasies, than most investors and certainly than most venture capital firms that invest in security tech. Some venture investors in the space seem to assume that defense technologies will generate similar SaaS return profiles that result from high-margin, software-like economics. The reality is often different for defense and dual-use companies. That does not preclude venture-type returns in the security market, but it does bifurcate the market even more so into those product companies that will have truly strategic impact and are venture investable at multiple stages, and those that are likely to exit into the mid-market, yet can still produce a 10x return for the earliest investors.
An example of the former is Castelion, which is tripling revenue year over year due to the national command-level demand for its end-to-end hypersonic weapon system development. An example of the latter is a hardware component startup that could build and bolt on sufficient scale to become a billion-dollar systems integrator, but can also support an exit base case of mid-8 digit revenue with OEMs, a year over year growth rate several times that of industry average, 20% operating margin (in-line with the rest of the A&D sector), and a 12-14x earnings valuation (A&D public comps are 18-22x). Early investors in that company at a post-money $12M entry point can produce a >8x gross return even after several rounds of dilution in the latter case.
In addition to bottoms-up analysis, we also have a top-down systemic view that security technologies are both an input for and an outcome of the convergence of connectivity, software, and hardware automation known colloquially as the 4th Industrial Revolution (“4IR”). Not only are technologies like cybersecurity and A.I. critical for the development of 4IR, but its impact has the potential to rebalance manufacturing power and supply chains to the benefit of the U.S. and its allies. Building products that secure our societies is, as an industry, a comparative U.S. economic advantage: because those products require greater skill and are higher-value, they reduce the advantage of low offshore labor costs. For this reason, investing in the U.S. security “industry” is not simply a protectionist concept. We see it as a growth area for export as well. One of our most recent investments, for example, is in a company (still in stealth mode) that serves as a platform to integrate best-in-class cybersecurity solutions for critical U.S. partners abroad.
We encourage founders who are building systems that impact security in novel ways to reach out to us. We work to give technology product companies the best chance of success in markets that often do not conform to traditional sectors. We know that many of these emerging security products have more than one path to venture scale outcomes. We are inspired by the entrepreneurs taking on the challenges in this space each day, the entrepreneurs who are driven to ensure that America and its allies have access to the best security technologies in a complex and dangerous world.