The VCs Are Discovering Homeland Security

August / September 2004 By: Jay Ward Volume 2 Number 4

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For most venture capitalists, validating a target market is often achieved by reviewing analyst reports, trade association research, or customer surveys. A growing number of VCs, however, are finding that they need not search any further than the front pages of their daily newspaper.

There is an increasing interest in the venture community in homeland security technologies and the companies behind them. These technologies range from bio-technologies to combat anthrax and smallpox attacks to automated video-surveillance systems intended for intruder detection at the nation's ports. The common link among the technologies is the boom in interest in their application following the terrorist attacks of September 11, 2001.

While it is possible that much of the venture capitalist's attraction to homeland security technologies may be motivated by patriotism, most look at the 1,000 percent-plus appreciation in the stock price of explosives detection technology provider InVision Technologies, Inc. of Fremont, Calif., as sufficient justification for their interest in the subject. InVision's success, combined with a potential customer—€”the Department of Homeland Security—€”with a $110 billion budget, has motivated a significant number of venture firms to develop an investment focus in this area. In the relatively narrow area of knowledge-management software alone, industry research experts INPUT estimate that federal government spending on knowledge-management software and services will increase at a compound yearly growth rate of 9 percent to $1.3 billion in fiscal 2008 from $820 million this fiscal year.

Venture capital industry interest is strong. Venture capitalists from Osprey Ventures, California Technology Ventures, Sky Venture Capital, and Kline Hawkes & Co. participated in a conference call organized by the National Venture Capital Association (NVCA) on the topic of venture investing in companies focused on homeland security. Last month, in Washington, D.C., a workshop organized by the International Business Forum on "Venture Capital Investing in Homeland Security Technologies" packed a Capitol-area hotel ballroom with dozens of VCs from Silicon Valley to New York City.

The Washington conference was chaired by Jason Rottenberg, president of MILCOM Technologies. MILCOM is a venture-backed company that conceives, creates and launches technology companies in partnership with defense contractors, commercial companies, federal laboratories and other leading-edge research and development sources. In May 2003, MILCOM was chosen by the U.S. Army to manage OnPoint Technologies, a venture fund that invests in mobile power and energy ventures.

Another leading player in venture investing in homeland security appears to be Paladin Capital Management. The Washington, D.C.-based firm is currently making investments from its Paladin Homeland Security Fund, LP. The fund is expecting a July final close for its $250 million fund. It is focused on investing in "companies that have immediate solutions to reduce the vulnerabilities of —€¦ critical infrastructure, either by preventing a potential attack, defending against an attack in progress, or coping with and successfully recovering from the ramifications of an effective attack." The fund has a significant competitive advantage in execution: its team. One fund principal, James Woolsey, is a former Director of the Central Intelligence Agency; another, Lt. Gen, Kenneth Minihan, ran the National Security Agency.

Among the venture capitalists that are putting money into homeland security technologies, several consistent investment themes emerge:

Dual-use technologies are critical. Almost paradoxically, successful venture investing actually involves mitigating, not exploiting, risk. By ensuring a portfolio company has a quality team and proprietary technology, a venture capitalist works to reduce the "execution risk" that accompanies any investment.
Similarly, homeland security VCs try to reduce execution risk by investing in dual-use technologies: ones that will have a market in both the public and private sector. An example is Maitland, Fla.-based MeshNetworks, Inc. The company's MeshNetworks Enabled Architecture (MEA—„) technology leverages patented data routing techniques originally developed for battlefield communications. The company is working with the City of Medford, Oregon and the Orange County (Florida) Fire Rescue Department, but has also sold an OEM license to Capinfo Company Limited, the designated provider of telecommunications solutions for the Beijing Olympics in 2008. According to VentureSource, the company has raised almost $40 million from Apax Partner, Redwood Venture Partners, MILCOM Technologies and other investors.

Invest in 2-wqy management teams: Assembling the management team for a Homeland Security technology company is a more difficult challenge than in traditional venture investing. Given the dual-use imperative, it is critical to assemble a team that can perform in both the commercial and government arenas. The challenge is melding the skills and experience. As MILCOM's Rottenberg observed, "Federal agencies and commercial enterprises are clearly different customers. A successful company has to have experience selling to both. You have to be careful, however, in recruiting management. Most people with Defense Department procurement experience won't fit well in an entrepreneurial, start-up culture."

Get by with a little help from your friends. While strategic alliances are always important in evaluating technology startups, they play a critical role in the success of Homeland Security technology companies. The Nation's prime contractors such as Lockheed Martin, Northrup Grumman, Accenture, Bearing Point and EDS secure the majority of Federal contracts across a broad array of defense and information technology procurements. It is unlikely that a small, venture-backed, emerging technology company with a point solution will secure projects from the Department of Homeland Security or Defense Department on its own, without the help of a prime contractor partner. These agencies typically work with major prime contractors for complete systems and rely on the prime contractor to assemble the products and services that may incorporate a startup's technology. Venture capitalists will often look to the existence of a "teaming agreement" - that is, a formal partnership to pursue government business opportunities —€“ between a startup and a major prime contractor as evidence of the startup's ability to work with and secure business from prime contractors and the Federal government. Alternatively, a small business can demonstrate its viability by securing a Small Business Innovation Research (SBIR) grant. The Department of Homeland Security alone had $20 million approved for SBIR grants for fiscal 2004. Eleven other agencies also allocate grants under the $1.6 billion dollar program. (See "The Feds Have Funds for You", TechComm, April-May 2004)

In his report, "The National Strategy to Secure Cyber-Space," former White House terrorism adviser Richard Clarke made the following observations regarding the current conditions for a cyber-attack on the United States: "Potential adversaries have the intent; tools that support malicious activities are broadly available; and, [the] vulnerabilities of the Nation's systems are many and well known." These conditions appear to apply to the United States's physical, nuclear, and economic infrastructure as well. The venture capitalists exploring investments in Homeland Security technologies are seeking to secure superior financial returns —€“ and fulfill a national objective —€“ in a market that, unfortunately, shows little sign of cooling. "There will be a long term need for these technologies," observed Hal Brown, a Principal with the Paladin Capital Group. "We see this as an investment opportunity that will last a generation.
It has Cold War dimensions."

Jay Ward is an attorney in the venture capital and technology practice group, Reed Smith LLP, Oakland, Calif.