Leveraging Private Sector Investment for National Defense – Why Isn’t It Being Done?

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Undersecretary of Defense (A&S) Ellen Lord recently came out with a statement focusing on “trusted investments” in innovative companies that have the potential to contribute to critical missions of interest to the Federal Government. Innovative companies, many small or even startups, develop technologies that can provide critical advantages to the U.S. military and to other sectors of our government. If they receive investments (which may be necessary to their thriving or even surviving) from the wrong sources, it may compromise their ability to contribute to U.S. national security.

That this is an increasing problem is also recognized by the Committee on Foreign Investment in the United States (CFIUS). More stringent regulations have been issued on foreign ownership, control and investment (FOCI) of U.S. companies that have the potential to supply critical technologies important to national security.

First, I digress to say there are large companies that are highly innovative. Passing over those that typically come to mind I will remind readers of 3M Corp. which despite its name including mining and manufacturing, despite being a large multi-billion dollar company, invests billions in R&D and churns out new products so that much of its existing market at any given time did not exist several years earlier. Major defense contractors understand the limit of their own internal processes for innovation. Boeing has created HorizonX as a link to small innovative companies. Lockheed and others have similar initiatives. Innovation can occur internally in some big companies; other big companies seek it externally. Clearly, however, much innovation occurs in small, newly formed companies vulnerable to take over by whomever has dollars to invest. Some of those investments may be inimical to U.S. national interests.

Private Sector Financing and Other Transactions

All the above is prologue. If private investment in innovative companies is important to national defense; if innovative companies that can contribute to national defense need capital, why is there not a link between private investment and government funding for such companies? Mutual interests are involved. Why not promote them? The U.S. economy and national security will be enhanced.

What? Coordinating government and private investment? The first, basically mindless, objection will be – unlawful augmentation of appropriations. Mindless because even the Federal Acquisition Regulation (FAR) recognizes cost shared contracts (FAR 16.303). However, FAR would require any company engaging in a cost-shared contract to become a traditional defense contractor and give up its low overhead, agile nature as an innovative company (see FAR 16.301-3 requirements). FAR establishes the principle but also conditions that mean it won’t work.

Injecting private funding into other transactions (OTs) is not unlawful. The original dual-use OT authority (10 U.S. Code 2371) says “to the extent practicable…the funds provided by the government…do not exceed the total amount provided by other parties…” Coordination of government funding and private funding is encouraged to the extent practicable. The OT prototype authority (10 U.S. Code 2371b) is conducted under the authority of section 2371. Private sector funding is not mandated except in one case, section 2371b (d)(1)(C). There 1/3 cost-sharing is mandated. A recent amendment changed the source of the cost sharing from a “participant” in the agreement to “sources other than the Federal Government.” Third party financing as well as second party cost-sharing is encouraged. Note: OT cost-sharing, is not cost-sharing under Part 16 of FAR. FAR rules do not apply. The terminology cost-sharing does not literally appear in the OT statutes (resource sharing might be a better term).

With the basics out of the way let’s consider some history and then the future potential. Except for one provision of prototype authority cited above, resource sharing is not absolutely required. The very first OT agreement with Gazelle Microcircuits did not involve resource sharing. Gazelle was entirely dependent on VC investment and had no other revenue stream. Under the circumstances the government’s investment of $4million in addition to previous private investment of $12million did not require resource sharing. The Deputy Secretary of Defense supported this agreement before the Senate Armed Services Committee. Gazelle devices ended up in a wide variety of DOD systems. The basic technology underpins most cell phones and base station systems today.

Despite no requirement for competition and no absolute requirement for resource sharing OTs went big time with the Technology Reinvestment Project (TRP) which involved competition, resource sharing and multi-party agreements. In two years under DARPA leadership the TRP saw $762million of government funds leverage over $1billion in private funds supporting dual-use projects. A DOD funded review of the TRP conducted under the leadership of former Marine Commandant Al Grey concluded dual-use should be DOD’s default approach to advancing science and technology projects, and that innovative agreements (OTs) were essential to such an approach. TRP was transferred to OSD leadership as the Dual-use Applications Program and later ‘institutionalized’ by transfer to the Services where it faded away.

Going back to the Gazelle agreement, the government does not need to take an equity position in a company to gain a return on its investment (in addition to payoff in terms of military capability). A return based on royalties on product sales incorporating the sponsored technology can be negotiated. A return based on increase in company value prorated to the government’s investment upon Initial Public Offering (“as if an equity investment”) can be included in the agreement. For OTs the return can be credited to a special account and used for additional R&D. It need not be returned as miscellaneous receipts to the Treasury.

What Might the Future Hold?

Let’s face facts, the government does not communicate well with itself, much less with the private sector, especially the private sector outside of its kept cadre of traditional defense contractors. Valleys of Death exist because of the government’s budget process, but also because of stove piped organizations do not realize they are in the same game. How is such a dysfunctional system going to be able to communicate and engage private sector capital? Not well as we do things now.

Leadership needs to make sure we are all on the same team. Not just Team DOD, but Team USA. DOD should engage small innovative companies (without the burden of unnecessary overly complex DOD overhead), but also the financial community. This requires education, new thinking and language. DOD is not the only game in town or the most attractive, nor is it the technology or funding leader.

In addition to dual-use science and technology projects, resource sharing can take place in the context of major programs. NASA’s Commercial Orbital Transportation System (COTS) program resulted in the development of the Falcon9 space launch vehicle. NASA payments to SpaceX were based on a series of milestone accomplishments. Some milestones were technical or programmatic in nature. Others were financial in nature. NASA payments were conditioned on SpaceX injecting third party investment into the program. In DARPA’s Joint Unmanned Combat Air System (J-UCAS) program, both major defense contractors involved invested private capital into the program. The X-47A resulting from that program won the Collier Trophy in 2013. The past is prologue in this case. It can be done. It needs to be done. The future of private finance coordinated with government programs waits to be invented. The flexibility of OTs can be a major contributing factor as they were in the examples mentioned.

Other Transactions can play a significant role in bringing key players together: bringing them together on their own terms not requiring businesses startups to become “government contractors”; rather partners in a common endeavor. Reach out to the financial community and find common ground. There is no road map here but hopefully the beginning of a thinking process that gets us beyond business as usual, budget impasses, and organizational stovepipes.

written by Richard L. Dunn