Historically, defense technology and venture funding have not been a harmonious mix. Long business cycles, high capital intensity, and the difficulty of achieving a large-scale exit have hindered innovation for startups in the sector. For Israel, a country where technology and national security have been intertwined since its founding, the potential of the defense technology sector is enormous and largely untapped.
However, there are signs of change.
Geopolitical developments, rising military budgets, and the need for innovation in modern warfare are setting the stage for a defense technology revolution.
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Amit Pilowsky of Key1 Capital.
(Sam Itsakov)
This article explores the multiple reasons why defense technology activity has been limited in the past, delves into the megatrends that are reshaping the sector, and reveals why now is the perfect time for entrepreneurs to seize the opportunity and drive the future of military technology.
There are several reasons why defense technology activity is limited both in Israel and globally. First, defense technology cycles are unusually long: from prototype -> POC -> order -> delivery, even the most profitable defense technology solutions can take years to reap the rewards.
The second factor is that the sector is dominated by giant corporations: incumbents like Lockheed Martin, Northrop Grumman, and Boeing, as well as institutions like governments and the military, making getting to the negotiating table a complex and difficult task.
The third factor is the significant capital required to bring a product to market. Achieving military-grade standards requires numerous cycles, testing, and proofs of concept. The solution must incorporate hardware components, which inevitably increases development costs.
The fourth factor is the need for companies to secure large contracts to ensure profitability. Unlike SaaS businesses with high gross margins and recurring revenue, industries such as defense technology operate with low profit margins (typically around 40%-50%), making them less attractive to investors.
Finally, exit values are typically in the $300-500 million range, with $1 billion+ being a clear outlier. This is due to the cash generation points mentioned above, as well as the small number of buyers. Buyers are typically public companies and are accustomed to thinking of their own EBITDA deal multiples in the “low to mid teens,” making valuation difficult.
First, there is a recognition that future wars will be decided by superior technology, not by the number of tanks. The Ukrainian drone war and Iran’s missile attacks on Israel show that technology will dictate battlefield strategy. Today, the “advantage” is in software capabilities, not hardware, which allows startups to become significant players.
Second, government agencies and militaries have come to recognize that embracing rapid innovation and removing barriers to entry is essential to maintaining technological advantage. These include the Department of Defense's Defense Innovation Unit (DIU) and NATO's North Atlantic Defense Innovation Accelerator (DIANA). This strategic shift creates opportunities for entrepreneurs with innovative ideas to come to fruition.
Third, the pace of military technology adoption is unprecedented, given the growing urgency of countering evolving threats. A good example is the Israeli army, grappling with the challenge of terrorists hiding in tunnels. Though previously thought to be nearly impossible to manage, the army quickly deployed drone systems capable of operating in tunnels without a GPS signal. Amazingly, these drones were developed by a small Tel Aviv-based startup.
Fourth, geopolitical developments are causing many governments to allocate unprecedented budgets to military equipment. Japan has announced a military budget of $302 billion from 2023 to 2027, a 16.5% increase over FY2023, while Sweden, Poland, and Finland have announced military budget increases of 28%, 69%, and 33%, respectively. These budgets would ideally be spent on the best technology.
Finally, the defense technology sector has moved away from a traditional “system of systems” approach to a more adaptable “plug and play” framework. This change addresses the complexity of modern threats and the need for agile responses, enabling defense systems to rapidly adopt new technologies and accelerate innovation in military technology.
Israeli defense technology is a unique case
The slow pace of defense innovation among startups is particularly notable in Israel, where technology and national security have been intertwined since the state's founding, and the country's defense tech sector existed long before it developed its own Kfir fighter jet in 1969.
Since then, Israel has seen significant innovation in defense technology, led primarily by government and military-owned defense companies such as Rafael, IAI, and Muffat, complemented by larger defense companies such as Elbit Systems.
Given the impressive defense innovations by domestic incumbents and the urgent need for defense technologies, we believe Israel has yet to fully tap into its potential in this field.
At Key1, we have seen the emergence of several promising defense technology start-ups over the past few years.
A common characteristic of these startups is that they are all relatively early stage ventures, either pre-revenue or in the earliest stages of revenue generation, and have not yet reached the full “scale-up” stage.
We are excited and energized about the future of defense technology as we witness the changes that are driving development and innovation in this industry, and we aim to play a more active role in supporting the most promising start-ups in this space.
Amit Pirowski is a co-founder and partner at Key1 Capital.
