What Exactly is Venture Capital, and What Does It Have to Do with the Air Force? Published May 11, 2020 By Maj Abby Barger, USAF Wild Blue Yonder / Maxwell AFB, AL -- Photo Details / Download Hi-Res The initial cohort of AFVentures fellows recently finished their six-week immersion in Silicon Valley.1 The purpose of this immersion is to embed Air Force members with various technology start-up companies and venture capital firms to establish relationships and build bridges between Silicon Valley and the Air Force. The fellows are meant to provide Air Force insight and knowledge to the companies that will help the companies develop business opportunities in the defense sector. The hope is that these companies will provide innovative solutions to Air Force problems. The fellows learned how venture capital works and some of the difficulties that tech start-ups have in working with the Air Force as a source of capital. Photo Details / Download Hi-Res (Twitter photo by Mike Slagh, @MikeSlagh) Figure 1. AFVentures Fellows networking First, a basic primer on what venture capital is since so few Airmen are familiar with it. Businesses require money to operate; most businesses start small with an initial investment from their founder and then grow by taking out loans or reinvesting earnings back into operations. This method is called the organic growth model. But for some companies, especially in the technology sector, organic growth is not a viable way to grow a business, usually because they need to get to scale before they can become profitable or because they need lots of money up-front to develop a product. A company like Uber or Facebook needs to achieve large-scale operations before it can become profitable. A company like Warby Parker or Peloton might have high initial operating costs before they can create a profitable product. For these sorts of companies venture capital (VC) is a way to raise money.2 In the VC paradigm a start-up company pitches their idea and business plan to venture capital firms also called VCs. VCs are essentially match makers. They use their in-depth knowledge of technology and the business landscape of start-ups to choose which companies to give money to in exchange for an equity (ownership) stake. The money that VCs invest comes from limited partners which are typically wealthy individuals or institutions such as college endowments or pension funds. Venture-backed start-up companies then use the money to grow their business with the eventual goal of achieving an exit. There are several types of exit. Firstly, and commonly, the company may not succeed in which case they wind down their business, pay back as much money to their investors as they can, and close up shop. In VC-speak this is the downside risk. The types of companies that need venture capital are usually early stage tech start-ups with a high risk of failure. Because of this risk, many VC investments lose money. Of course, if all start-ups failed no one would invest in start-ups. Unsurprisingly, investors much prefer profitable exits. This happens when the company succeeds and is sold for more money than investors have put into it. This gives the initial VC investors a positive return on their money. There are several types of positive exits; the company might be acquired by another company, or it might be sold to the public at large through an IPO (initial public offering) on a public stock market. To offset the downside risk and maximize opportunities for upside gain, VCs build a portfolio of many companies. The theory is that although most companies will fail to return any money at all to investors, at least one company in any given portfolio will be wildly successful and return all the money invested in the entire portfolio several times over. In short, VC enables risky companies access to more money than they would be able to raise through other means by offering VCs the chance to make back a better rate of return than they could get by investing in more stable and mature companies. This is VC in a nutshell. For a more detailed look at it, Venture Deals by Feld and Mendelson is an excellent primer, or this even more condensed electronic primer. The San Francisco Bay area, known as Silicon Valley, is probably the most prolific VC hotspot in the world. Historically the US defense sector has been heavily involved in the region. In fact the San Francisco Bay area came to be known as Silicon Valley largely because of defense investment. The demand from the US military for technologies such as integrated circuits allowed companies to expand and improve these products into commercially viable mature technologies. The military necessity of the early Cold War drove a culture of entrepreneurial technological innovation in Silicon Valley that eventually outgrew its dependence on defense contracts.3 VC firms grew to take advantage of the high concentration of companies that needed lots of up-front capital. Today, military spending in Silicon Valley is dwarfed by private investment.4 Although no longer the primary nurturer of innovative technologies in Silicon Valley, the US military is still an important tech consumer. Plans for joint all domain operations and multidomain defense rely on developing new and innovative technology to enable future combat operations.5 The difficulty is that although the Air Force needs the innovative technology pioneered by small start-ups, the Air Force is also a difficult consumer for technology start-ups to partner with. Six weeks was not nearly enough time to learn how the Air Force acquisition system works. But it was long enough to begin to appreciate the challenge that companies face when working with the military. The first big challenge is that Silicon Valley businesses operate on different time horizons than the military, but not necessarily on faster ones for a given project. A typical venture capital fund lasts for 10 years. That means that the individuals and institutions that give money to VCs to invest have committed to not seeing any return on investment for at least 10 years. In cases where a company is not ready to exit in 10 years, funds often extend their life cycles. Also, in cases where the company is promising but needs more money, they raise additional rounds of funding, often starting by asking initial investors defend their equity by investing more capital.6 The VCs have committed to at least a decade and often multiple rounds of funding to helping a start-up grow and expand their business. This commitment is not so different from the long lead times or increasing costs common in defense projects. At the macro level, fielding new technology often takes more time and money than initially expected whether its defense-funded or venture-funded. The difference is not the length of time of the technology development or funding process, but the length of time specific entrepreneurs or VCs are involved with the project compared to the length of time individual members of the military are involved. Venture-backed business relationships are much more personal and hands-on than I realized because the parties involved plan to be working together for many years. Sometimes, a funding round will take a year or more to complete fundraising through check-writing. Through that timeframe, a VC would expect to work with the same person or small team from the start-up, and the founders of the start-up would expect to work with the same partner or small team at the VC firm. These relationships help them build trust that enables faster decisions and more willingness to take risk. Additionally, VC firms typically specialize in certain market segments, and so the person deciding whether to fund a company or not is often the same person who decides whether the product is going to be a good fit with the market it aims to sell to. If a company wants to work with the Air Force, it is not a straightforward matter of establishing a personal relationship. The military has many more layers of bureaucracy than a typical start-up or VC firm. Thus, the acquisitions process that matches companies with military funding involves different people than the ultimate end users of the product. This means that the people on the military side making funding decisions are not in the same position as a VC regarding technical ability to evaluate whether a product is likely to mature on timeline to fill the need it aims to sell to. Additionally, the typical tour length for an Airman is between two and four years, and often within a tour a member change jobs and positions multiple times. This changeover means that the people from the Air Force side of the deal are working on a much shorter timeline than their counterparts at the tech start-up. So, it is difficult to form lasting multiyear relationships that are the basis of many VC investing decisions, and that these companies typically leverage for funding. The additional layers in the Air Force system mean that funding decisions often take longer and involve more people than decisions coming from VCs. This timeline is probably the biggest single difference in approach to evaluating start-ups. VCs are able and willing to leverage personal relationship-based trust to move faster on funding decisions and to take a risk on nascent technology. Because the Air Force is structured differently, we have to rely on repeatable processes and the viability of the technology more than on the personal merits of the entrepreneurs building it. VCs assess entrepreneurs and founders themselves just as intensely as they assess the feasibility of their technology or the merits of their ideas. I am not sure this is a difference we can overcome. It is, however, important to understand it as a limitation when we seek to partner with tech start-ups in search of innovative technology. Often, VCs are not betting on the technology; they are betting on the entrepreneur. Another challenge is the difference tolerance for ambiguity and failure between VCs and the military. One entrepreneur in residence had built a company that achieved a neutral exit; that is, it did not lose money, but it also did not make money for his investors. Nevertheless, he is employed full-time at a VC firm to think about and start up a new company. When I asked him how long he had to do that before they stopped paying him, he indicated that while he did need to perform eventually, there was no great rush. In fact, the project I helped him with for six weeks is one he may never pursue. He simply thought it was an interesting business case and wanted to explore it even if he ultimately does not build it into a business. Other entrepreneurs I talked with were similarly ambiguous about the companies they were creating. Most saw these companies as steppingstones and learning opportunities. They fully expected to fail multiples times before finding a company or idea that would be successful. The managing partners at VC firms that I got to speak with had a similarly high tolerance for business failures. One of them told me that some of the best and most highly regarded entrepreneurs in the ecosystem have never founded a profitable business. He said he could not think of another area of business where you could be successful and well regarded without creating a successful business. I asked him how he evaluated entrepreneurs if business success was not important, and the answer was that he looks for creative ideas and determination and for someone that he would want to work with. Clearly, the tech start-up sector values creativity and trying new things very highly. But at the end of the day, VCs are placing bets on lots of these small companies in the belief that some of them will be successful. They are clear-eyed about the chances of any individual company or entrepreneur achieving success and have rationally adjusted their investing strategies to account for that. They evaluate entrepreneurs on how well they run the business, not necessarily how successful the business is. VCs recognize that many times success or failure depends on factors outside of an entrepreneur’s control. This fact is in direct contrast to the Air Force’s low tolerance for failure. Most senior leaders do not completely discount objective measures of past performance when evaluating their subordinates, and most military members are not nearly so sanguine about the possibility of failing at multiple multiyear projects before achieving success. This situation is a good thing as the country expects us to succeed at our mission of defending the nation. Still, there are ways we could learn from VC in prioritizing creativity and learning from failure. If the Air Force seeks to partner with tech start-ups to leverage innovative technology, we will need to learn to respect their value prioritization and to develop some mechanism for making multiple small bets on companies with the expectation that many will fail. When they do fail, we will need to learn from the failures and evaluate our business partners and ourselves on the metric of how well we performed, not just on the ultimate outcome. The Air Force will need to accept that not all companies it funds will succeed, and it is actually healthy for the innovation ecosystem to fail a few times to produce a better end-product. Maj Abby Barger, USAF Major Barger (BS, USAFA; MBA, Troy University; MBA, Troy University), chief, Joint Special Operations Doctrine at the LeMay Center for Doctrine Development and Education, Maxwell AFB, Alabama. Notes 1 “Air Force Ventures” website, accessed 5 May 2020, https://af-ventures.com. 2 Holloway, “Raising Venture Capital,” accessed 5 May 2020, https://www.holloway.com/g/venture-capital/sections/understanding-venture-capital. 3 Computer History Museum, “Secret History of Silicon Valley,” YouTube video, 20 November 2008, 1:02:46, 4 Statista, “Private Sector Outspends Defense Contractors in R&D,” 1 October 2019, https://www.statista.com/chart/19515/defense-spending-research-development/. 5 Curtis E. LeMay Center, “USAF Role in Joint All-Domain Operations,” 5 March 2020, https://www.doctrine.af.mil/Portals/61/documents/Notes/Joint All-Domain Operations Doctrine--CSAF signed.pdf; and Gen David L. Goldfein and Gen Jay Richmond, “America’s Future Battle Network is Key to Multidomain Defense,” DefenseNews, 27 February 2020, https://www.defensenews.com/opinion/commentary/2020/02/27/americas-future-battle-network-is-key-to-multidomain-defense/. 6 Nathan Reiff, “Series A, B, C Funding: How It Works,” Investopedia, 5 March 2020, https://www.investopedia.com/articles/personal-finance/102015/series-b-c-funding-what-it-all-means-and-how-it-works.asp.