It’s a time to buy: M&A for the national interest

Large pile of one hundred dollar bills. (Jackal Pan/Getty Images)

From business schools to boardrooms, Venture Capital has been on a tear over the last decade. Buoyed by near-zero interest rates, the asset class grew in the United States from $33.1 billion in 2013 to its peak of $329.9 billion by 2021, a roughly 896 percent growth rate that fueled the creation of around 1,000 unicorn companies, driven by promise and potential rather than profitability.

Some of these truly generational companies, such as AirBnB, Palantir and Uber, touch the way many of us live, work and play. But for every successful VC-backed startup, there are legions of technically talented builders who paddle hard to catch the perfect wave, but rarely make it work: According to HBS’s Shikhar Ghosh, 75 percent of all venture-backed startups that raise more than $1 million ultimately fail.

Patriotic defense and national security entrepreneurs are not immune. Defense-focused venture capital has grown substantially since 2019. In 2022, $35.8 billion was deployed across 800 deals, and despite a minor decline in 2023 ($34.9 billion across 627 deals), at the midway point of 2024, $9.1 billion had been invested across 228 deals in the face of a broader market slowdown.

In sum, over the last 5 years, over 2,000 companies have raised almost $100B in venture capital across 14 Defense Department Critical Technology Areas.

Yet since 2019, just 20 companies have received more than $25 million in government funding last fiscal year — highlighted in the Wall Street Journal in July.

This is all occurring in the highest interest rate environment seen in a generation, which has already hit the venture sector hard, with venture funding contracting and companies shutting down at record rates. In addition, slower-sale-cycle public sector-focused tech companies now have to compete with capital-hungry AI companies that can show viability at much quicker rates.

Thankfully, during the interest rate spikes of the 1970s, playbooks emerged on how we can turn high-interest rate challenges into impactful opportunities.

Post-WWII, America was booming, driving new public policies that created massive influxes of capital into Wall Street. However, these large pools of capital remained risk-averse and mainly invested in highly stable investment-grade bonds.

Then came the Iranian hostage crisis and the corresponding oil shock. Energy prices spiked, inflation skyrocketed, and interest rates followed. Otherwise, strong companies found themselves downgraded, by no fault of their own but simply due to the macroeconomic conditions. These once-strong companies became known as “fallen angels.” Due to their downgrading, these companies found it more difficult to raise capital, and in some cases, they were shunned out of the capital markets.

Where many saw distress, few saw an opportunity.

Some players in the financial markets realized these companies were being penalized due to factors that had little to do with the quality of their products and the prudence of their management. Once these external factors subsided, the companies would be fine.

Non-investment-grade debt was discovered to have very good risk-adjusted returns, and profit-driven bankers and investors jumped on board to facilitate and issue high-yield debt packages to these fallen angels. Non-investment-grade debt was used to help finance these fallen angels and also to support other financial activities such as leveraged buyouts.

The parallels to today’s defense tech companies are startling. Many were born of the zero-interest-rate policy (ZIRP) era of deep tech resurgence, which provided investors with abundant capital, resulting in inflated valuations attempting to emulate Palantir and SpaceX.

Inflation in the wake of COVID (another global black swan event) and the resultant interest rate increases isolated even very good product companies, creating an opportunity not too dissimilar from the fallen angels of the 1970s and 1980s.

Saddled with ZIRP-era valuations, very good companies, perhaps even those nearing the elusive “product-market fit,” are currently at the whims of market forces that have left them unable to get off the cheap-cash treadmill and adjust to a new cost of capital environment.

These critical companies and their deep R&D investments, paired with expensive operational requirements ranging from security clearance to compliance standards, cannot adapt as quickly as commercial sales and marketing-heavy enterprise software companies.

The result is an enticing pool of “venture fallen angels” — companies with some evidence of product-market fit and near-term commercialization potential, but not quite enough potential for venture capitalists to put more money in.

Who are these venture fallen angels? Well, we put our theory to the test, and here is what we found.

Our principles are to consider companies that 1) have raised venture capital, 2) have not finalized product-market fit, and 3) have seen financial headwinds that might make them viable targets.

We used Pitchbook data to select a list of companies with an enterprise value of less than $50 million that had raised funding before 2022 (so not companies with fresh runway) in aerospace, defense, and/or deep tech. We manually confirmed that their product(s) fit the defense thesis and vetted them to ensure they are properly American entities. That yielded 385 companies.

Next, we enriched this database with government revenue data from the most comprehensive publicly available set of resources, including USAspending.gov, FPDS.gov, SAM.gov, and SBIR.gov.

We found that 119 of the 385 had received some form of federal obligation.

Next, we looked at whether a company was healthy and growing. This includes looking at overall headcount (year-over-year, and six-month growth) — both in aggregate, and just the product team.

We found that the average company in the cohort was 8.5 years old with 100 employees. On average 29 percent of their staff was engineering or technical, and their rate of headcount growth was slowing. In fact, over the past six months, headcount at these companies was flat: It averaged about 1 percent growth. Some saw declines of up to 85 percent and growth reaching a high of 80 percent. On a 12-month basis, the average growth rate stands at just 4 percent.

Unsurprisingly, revenue is also disproportionately concentrated among a few high performing companies. The top five companies account for nearly 40 percent of the total obligations, while the top 10 represent over 50 percent of the total.

What surprised us most is that some of these companies were high fliers. They are not limited to any single product or segment, instead cutting across cybersecurity, AI, additive manufacturing, UAS, and more. Additionally, while federal revenue is stagnant or shrinking, they may have pivoted to commercial use cases. As such, the acquirers may need to be creative in how they structure the deal, and be open to carveouts and atypical capital structures.

Beyond this, any successful “venture fallen angels” deal will have — at a minimum — three key hurdles to overcome:

1. Startup / Prime Relationship: Cultural differences and relative disparities in perceived value will likely prove difficult — especially for companies that have not achieved significant revenue milestones.
2. Venture Investor Approval: Perhaps one of the biggest challenges is getting venture investors to sign off on the deal. Given the power-law nature of the business, once they determine that an investment is unlikely to be a big winner (“fund returner”), investors tend to spend less time on it, and may be less likely to give it the time, focus, and approval needed to close a deal.
3. Integration: For strategic buyers, deals cannot be managed at arm’s length by a corporate development function. The business unit that will ultimately use, integrate, or sell the product needs to play a leading role in the transaction. Without this buy-in, the deal is likely to fall short, and the technology is unlikely to have more success inside its new home.

Strategic M&A in the defense industry is notoriously difficult, with most participants holding a lower risk appetite than their purely commercial cousins. That said, the upside — for country, and profit — is immense.

In the government-driven market, we must beware the “false fail” — where the inability to gain traction in the time allotted (before the money runs out) is conflated with building “bad tech” or a product no one wants.

Historically, distribution in the national security sector has been the greatest moat; the mammoth legacy providers, borne out of World War II consolidation, have massive capture teams who spend every waking moment shaping future acquisitions and ensuring they are well-positioned to win. But like any industry, the convergence of the innovation-forward Trump administration, competition with China, and the most significant technology paradigm shift in the 21st century have created an unprecedented opportunity for disruption.

So it is the time to buy and build, consolidate and create for the national interest.

A different approach is sorely needed, lest these companies begin to fail, entrepreneurs chase other dreams, and investors pack away their checkbooks to chase AI, crypto, or whatever new wave emerges.

Tanveer I. Kathawalla (LinkedIn) is the Founder of Pioneer1890, a Venture and SMB special situations firm focused on critical industries.

Kris Reddy (LinkedIn) is a Marine veteran, Investment fellow at Pioneer1890, and Co-Founder and CFO of Tuple Technologies, a technology company with operations related to semiconductors and cloud engineering services.

Dhaler Battle (LinkedIn) is an accomplished founder and venture capitalist with extensive experience identifying, investing in, and supporting data-centric companies worldwide. 

Analytics and Data Support: Frontier Optics is a business information platform offering analytics and research services, focusing on federal investments in government contracts targeting early-stage emerging technologies.