How Software Companies Can Enter the U.S. Defense Market

When U.S. software firms consider their primary markets, many largely avoid the defense sector. That’s true whether they are established tech companies or early-stage startups. The reasons are clear: Pentagon procurement has historically, and largely, focused only on the acquisition of physical supplies and equipment, yielding processes unsuited to software licensing. Bureaucratic challenges also frustrate companies because they lead to long sales cycles. And many tech employees have refused to work on defense projects, citing cultural and ethical concerns. With these challenges, funding through venture capital and other sources has been hard to come by for firms operating in or looking to expand into the defense market.

However, there have always been exceptions, like Amazon, Microsoft, and Google cloud services — or early-stage emerging technology startups, like the 50-person startup Pendulum — that expanded to the defense market soon after finding commercial product-market fit. These exceptions prove that U.S. software companies can succeed in the defense market. In addition, multiple factors are making the Defense Department’s $800 billion budget more accessible to these firms. (We focus on the U.S. in this article because it’s hard to draw parallels to other countries’ very different startup cultures and defense markets.)

Our experience working with both startups and the defense industry leads us to believe that now is the time for founders of expanding software firms to consider the defense market. In this article we’ll explain why and lay out a plan for selling to the government while attracting funding along the way.

Why now?

Three factors make the defense market a much more appealing vertical for U.S. software startups today.

First, the Pentagon is a motivated customer and has already made some moves to court software vendors. Determined to keep pace with China, it has increased the speed at which it procures and integrates emerging technologies by revising a number of its existing acquisition processes. The Defense Department has also established commercial-friendly organizations (such as the Defense Innovation Unit and AFWERX) and software-specific procurement processes (such as the Authority to Operate and Platform One). It has created cloud software certifications such as FedRAMP and partnered with AWS to offer GovCloud to make it easier for software vendors to satisfy the security requirements to get their product in front of government employees. These changes have made it possible to spread commercial software to the government.

Second, the defense market is stable amidst many commercial market headwinds. Widespread layoffs and the collapse of Silicon Valley Bank have roiled commercial markets. For software companies, the market downturn has caused return on sales spending to drop, customers to slash IT budgets, and large enterprise sales to take longer to close. In contrast, the Defense Department is a stable customer. The Pentagon maintains a consistent and large budget, with high switching costs for their software solutions. Once a company lands a recurring revenue contract, annual revenue allocations are significant and low risk. This gives the Pentagon qualities similar to the largest, most attractive enterprise-sized commercial customers while also making it a more stable customer.

Third, private capital investors are increasingly supporting companies in the defense market. The value of venture capital deals into aerospace and defense tech was greater in each of 2021 and 2022 than in all of 2010 through 2019 combined. We believe that the upward trend is caused by investor desire to engage a critical, yet digitally undisrupted industry. And it seems to be working: Defense contracts in areas like cybersecurity and AI are enabling investors to capture returns on investment. Landing recurring revenue from federal government contracts shows enterprise company maturity and the ability to address complex needs. For AI data labeling startup Scale AI, for example, expanding into defense meant a trajectory-defining $250 million contract a year after their Series E. Top-tier firms like Andreessen Horowitz, Founders Fund, and Lux Capital and defense-focused firms like America’s Frontier Fund and Shield Capital are among those investing in the space.

How to tackle the defense marketplace

Despite the attraction, thousands of startups leave the defense market. Companies fail in the defense market because they mistake non-recurring revenue from the Pentagon as success and then get trapped in the “valley of death,” crumbling before they build a scalable product worthy of recurring software subscriptions. (While most software companies aim for a recurring revenue model to gain stability and scale, this is even more critical for companies in the defense market, in which new contracts present even higher up-front R&D and customer acquisition costs.) On the other hand, companies also fail by focusing exclusively on generating annual recurring revenue through big-ticket sales like programs of record, running out of money chasing long federal sales cycles.

Or they redesign their commercial products to meet the specific needs of individual defense customers. Such bespoke specifications limit the utility of the product to other defense customers, preventing scale.

In contrast, we’ve observed that companies which have successfully scaled within the defense market have taken these three tactics:

Use Commercial Traction to Secure Early Defense Revenue

A commercial company should enter the defense market only after it has achieved commercial product-market fit, where growth efforts are clearly resulting in customer traction. This allows the company to focus on defense customers that align most closely with its commercial customers while preventing  it from over-specializing specific defense products that are incapable of wider scale. In addition, commercial sales help these companies stay afloat during long federal sales cycles.

For such an early-stage company, the first step into the defense market must be to secure non-recurring revenue, i.e., one-time grants, such as Small Business Innovation Research (SBIR) awards and/or Accelerate the Procurement and Fielding of Innovative Technologies (APFIT). These opportunities provide the funding necessary for companies to avoid what is called the “valley of death” — in which a company perpetually achieves one-time revenue contracts that are unable to deliver sufficient returns on investment to justify costs — by identifying defense revenue potential and possible defense product-market fit while mitigating the costs startups face in the defense market.

The key, however, is to not mistake non-recurring revenue for success, or even meaningful business. Rather, non-recurring revenue comprises the training wheels for the earliest-stage companies to first find defense product-market fit and build relationships before taking the next steps to secure recurring revenue.

Use Existing Channels to Get to Recurring Revenue Faster

A company can cut down the time required to move from non-recurring revenue to recurring revenue by leveraging existing sales channels — big players already in the business of selling to the defense market. The most common channel partners are prime defense contractors like Lockheed Martin, Boeing, and Northrop Grumman. “Primes” are intimately familiar with procurement processes and control multiple channels for delivering solutions through the Pentagon’s 2.2-million-person bureaucracy. Partnering with these primes enables companies to quickly deliver product to government employees so they can validate product-market fit as soon as possible.

The primes’ sales channels offer several opportunities to validate product-market fit. For example, Applied Intuition, an autonomy software company, started in the automotive sector but identified a defense market need for its offerings. As a first foray into defense, they subcontracted with prime contractor and vehicle manufacturer General Dynamics to bid on an autonomous vehicle design in 2021. Since then, they’ve been able to win meaningful direct defense business. Primes also offer an opportunity for software companies to integrate their product within a prime’s hardware platforms so companies don’t have to build their own hardware or convince government buyers to sign up for annual software subscriptions. Overwatch Imaging, for example, puts their imaging software on cameras that prime contractor L3Harris sells directly to the government, bypassing the need to have government buyers subscribe to Overwatch Imaging’s software directly.

There are some downsides to working with primes. As hardware or services businesses, their meager software-reselling efforts may generate revenue at levels that are uninteresting to startups; they also often squeeze their suppliers on payment terms. Companies may also get stuck as subcontractors only to be acquired for a middling price. For companies that decide that partnering with a prime is too risky, there are other existing channels to explore, such as big tech platforms like AWS and Snowflake. Their marketplaces tend to work better with software partners — though big tech platforms offer less value to startups in the defense marketplace than primes..

Regardless, the value companies find in working with any of these existing sales channels is saving time and money in learning whether selling to the Defense Department is a compelling business strategy.

Build a Dedicated Team to Scale Defense Sales

Successful commercial-first companies with validated defense product-market fit can scale their product and achieve sustainable recurring revenue by establishing a dedicated federal sales team. Properly setting up a federal team allows companies to chase recurring revenue opportunities and create a steadfast defense software business.

Commercial deals close in a matter of months and larger deals take closer to a year, while federal deals typically take well over a year. Thus successful commercial companies entering the defense market compensate their federal sales teams through multi-year quotas and pay commissions on renewals to ensure deep, long-term product deployment. These companies measure federal sales success by focusing on upcoming pipeline and customer touchpoints.

Federal sales require salespeople who possess the rare combination of having federal customer knowledge and relationships (usually through public sector experience), as well as a personality suited for the team-based environment necessary to close complex federal deals, relative to commercial salespeople, who tend to be territorial and competitive.

The objective of the sales team is to achieve the annual recurring revenue necessary to grow a strong defense business. The most popular goal is for the company to be included in Programs of Record, meaning that they are working on a project tied into a line item written in the Defense Department’s annual budget. However, there are other options to capture recurring revenue. One popular pathway is through the decentralized Operations & Maintenance (O&M) contracts widely available across the Department. Accessing these types of funds requires consistent coordination with operational military personnel, but obtaining the contracts can be incredibly simple (for example, the GSA schedule). This is analogous to bottoms-up, product-led growth rather than a centralized approach.

Finding the right investor backing

While companies can seek investor support at any of these steps, companies have the greatest likelihood of raising funding after finding product-market fit in the defense market. Three categories of venture capital (VC) firms operate in the defense market: Large firms, defense-oriented firms, and strategic investors.

Large VC firms are generalist firms possessing billion-dollar-funds, such as Andreessen Horowitz, General Catalyst, and Founders Fund. They fund companies that can become category-defining unicorns. The reason for this is that VC returns are driven by a few successful outliers (often called the Power Law): The larger the fund size, the bigger individual companies need to become to return the fund’s capital. Therefore, headline-grabbing VC defense investments often highlight companies like Anduril that only pursue defense sales because they are capable of challenging existing prime contractors. But commercial companies entering the defense market can also secure checks from large VC firms after demonstrating the potential for massive scale across the Pentagon. For example, while Scale AI only had a $750,000 non-recurring SBIR before raising their $325 million Series E, the additional funding helped them get a $250 million defense contract a year later.

Many defense investments also come from specialist mid-sized VC firms that explicitly help companies scale in defense. For example, America’s Frontier Fund and Shield Capital have traditional venture capital fund structures but dedicate their resources and networks to support companies selling to defense. Specialist VCs do not need category-defining success to make the same return allowing them to support a wider range of companies selling to defense.

Strategic corporate investors such as Lockheed Martin Ventures and Boeing’s HorizonX-AE Industrial study emerging technologies and offer strategic partnerships on top of earning returns. For example, Lockheed Martin Ventures’ efforts to scout AI/ML tech led to its investment in Fiddler. Strategic investors look after their parent corporation’s strategic interests and can even help startups become a vendor to their parent corporation (L3Harris invested in Overwatch Imaging while adopting their technology). Strategic government investors such as In-Q-Tel, the U.S. intelligence community’s venture capital outfit, prioritize technology relevance. Strategic investors can often help with getting non-recurring funding, being a channel partner at the earliest stages, and providing credibility for the next round.

The defense market is primed to be transformed by cutting-edge software. This sea change need not be limited to a select few defense-only tech startups or contractors. Defense can be a lucrative additional vertical, for today’s U.S. commercial software companies—one that looks particularly attractive today.