EUVC #277: On The Rise of Defence Tech with Nicholas Nelson, GP of MD One Ventures

0:00In a world where podcasts outnumber humans, we try at EUVC to be mildly more interesting. Tune in at eu.vc to watch this episode instead of just listening. eu.vc, where the extraordinary is just another Monday. Welcome everyone to another hopefully great episode of the European VC podcast. Today I'm here with Nicholas. Nicholas, or Nick as you'll also hear me referring to him, is from MD1 Ventures. He's a very good friend of mine and a great emerging manager. And we have a bit of a special episode for you because we are going to be talking about the rise of defense tech. And we're not going to do that just through a normal journey style conversation as we always do.

0:53Instead, I've asked Nick to prepare a somewhat thought provocative or thought provoking speech or talk on the topic. And I did that to begin with because we were going to have Nick up for the Go West conference the Investor Day there in Gothenburg happening just today. So 5th, 6th and 7th of February. And then I said, fuck, Nick, we should definitely bring this on for the pod as well. So here we are. But Nick, before we get into the talk on the rise of defense tech and exactly why this is such a big space that have been overlooked for so long time, I would just love for the audience to get to know you a little bit.

1:42So tell us about your journey into venture. No, thank you very much again, Andreas, for having me on. Been a long time coming, so thrilled to be here and looking forward to the rest of Go West. I guess so my story to venture is similar to many of the specialist VCs you'll speak with. Venture capital wasn't really on my radar for the first half of my career. Having spent, I'd say, about half of my formative years living in Europe, when I went to university, I was going in a completely different direction. And I decided to focus on international relations because it seemed like a natural fit for both my personal background and what I was really interested in, what caught me up in the mornings in terms of society.

2:20So after graduating with that degree, I didn't know precisely what function I wanted to have, but I did know I wanted to work in aerospace, defense, and government services. I felt like that was a really interesting connection between where I professionally wanted to go and my own personal experiences. So based on that and to gain wider exposure, I worked in management consulting for a few years in London, as well as in North America, before taking a kind of a unique opportunity due to one of my clients there to move over to government with the U.S. Department of Defense, or also called DOD. At the DOD, I had a chance to work on a number of critical issues, including emerging tech.

2:58It was really the latter that kind of sent me down a bit of a rabbit hole as what I was really seeing at that time, it was kind of a unique inflection point for government and the military, which was capabilities that traditionally been the purview of major governments, such as, I don't know, drones, satellite imagery, and the like, were being democratized, really. And that was completely across the spectrum. So not just to other countries, but also, and at the time, much more dangerously, non-state actors or what some would refer to as terrorist groups. At the same time, there was also brewing internal discussions within DOD and wider US, UK, and other governments about kind of new internal capabilities around software and tech companies who are starting to sell more and more into DoD.

3:45However, those companies were facing a lot of antibodies, if you will, or significant pushback, both from the military services and government, but also the primes or the big aerospace and defense companies, which I'll touch on a bit more in my talk later on. Most notably, though, for those listening and those familiar with the industry a bit, was a company called Palantir Technologies. And while Palantir has gone on to being one of, I guess I would say, one of the biggest defense tech success stories out there along with maybe SpaceX. They literally had to fight truth and nail for every single thing they got within the department and to really gain purchase.

4:21And they did that through a lot of bottom-up user stories, basically working with the end users rather than trying to go at the very senior levels. And that was a lesson that resonated with me and really stuck with me. having actually been an early user of Palantir and just seeing how functionally much more capable it was and how it enabled myself and my colleagues to do our job better. For lack of a better term, I guess I caught the tech bug. This led me to leave government and to go earn my MBA, where I focused on engaging, advising early stage startups in tech, and which directly led to my first real role working with and advising an early stage national security startup.

4:57And this would really set the stage for my eventual move into the defense tech ecosystem. Following my MBA, I was lucky to find a unique opportunity to work with Mod or Deloitte, the leading consulting firm. And I say unique because I was brought to do something fairly non-standard. A senior partner brought myself and two other consultants in, and we launched, pardon the pun of it, the first space sector practice of any global professional services firm. And for the firm at the time, what was really differentiated was we worked cross-functionally. So it wasn't just with big companies or big government agencies.

5:32We also worked with startups and accelerators across the spectrum, all within the aerospace, space, and government adjacencies. And we kind of were a startup within a startup, within a big company, if you will. And by the time I left a few years later, we had scaled that practice from just the four of us with spit and duct tape to over 60 people. and from there, I wanted to get a little more hands-on. So I joined a mid-sized aerospace and defense company, which is now about$10 billion globally, where I led a strategy and M &A efforts and gained my kind of first real exposure to corporate venture capital, which also included a quick shout out to VC University, which was offered via the University of California Berkeley School of Law.

6:15And this in turn led to my very first angel investment. And as they say, the rest is history. So after the last few years being back in Europe and leading European initiatives and programs for a major R &D portfolio, I left Germany and returned to the United Kingdom, where I'm currently based, and joined MD1 Ventures as a partner. For those who haven't heard of MD1 yet, and I hope you soon will, we are the first national security and dual-use tech VC in Europe. I've been around for coming up on two years now, and we invest in companies at the pre-seed and seed stage across Europe and are normally the first check-in.

6:51So that's kind of it in a nutshell of how I got here and where I'm doing MD1 now. And hopefully that is a good lead into the story today or my talk today. But thanks, Andres. I actually think instead of diving into your story, because I think this is the fable story of almost any VC, right? So there's always nuances in it and we could pick it apart. But I would much rather that we get into the topic of today. And of course, to set the stage, at least my curiosity for this is, of course, seeing everything that's happening with the geopolitical space completely changing these years and anyone thinking about where the world might be in 10, 20 years because of their tech investing role, as an example.

7:36We'll also see that we're definitely looking at a different situation when it comes to the powers that rule the world, most likely. We're seeing now the rise of cyber warfare that's changing everything. We're seeing very capable drones that cost a fraction of what it costs to shoot them down. So we're just seeing a widespread bending of the old world order. That's at least how I think about it. I've always said that at some point there'll be a wall and I want to make sure that I'm on the right side of it. Here you have the reasoning why I am doing what I'm doing with the UBC. So, Nick, this is at least how I come into this talk.

8:22And I think many will as well. Seeing Ukraine, seeing Israel, Palestine, seeing everything that's happened the last period, seeing the rise of China and just thinking, what's the role of tech in this? So, Nick, I'll queue you up like this and then I'll let you take it from there. Perfect. I think that's an ideal lead in, if you will, Andres. And at the end of the day, I think there has been a tendency to think that because, especially pre the second invasion of Ukraine in 2022, there was an idea that maybe this just didn't affect people or wasn't going to affect those in tech or venture. and there's a great line I'll borrow, a lip relief from The Economist, which was, you may not care about geopolitics, but geopolitics definitely cares about you.

9:07And I think that's kind of a good way to start getting into my talk because I think for most of your audience and you referenced Ukraine again, as did I, they're probably going to assume that in talking about defense tech, the majority is going to be about Ukraine. After all, that's kind of what's driving all this renewed interest in defense tech in Europe, really, isn't it? However, the reality is that European defense investment into tech was already increasing prior to Russia's second invasion of Ukraine in February 2022. For numerous reasons, however, VC funds and tech companies, especially in Europe, have largely been missing out on this investment surge that actually has been occurring since really around the time of the first invasion of Ukraine, which was in 2014.

9:50That oversight really has left a significant gap, which if not properly addressed, will not only provide a strategic advantage for Europe, but most importantly, it can do a lot of other things for the folks in the audience today who care, which really is the fact that adding defense and dual-use companies to your portfolio can make a difference, but more importantly, will offer or likely offer attractive returns. But first, kind of taking this to first principles, how can we quantify this investment opportunity? I think that's really critical for those who are on the fence here within this particular issue area.

10:25And at the end of the day, this is critical because the purpose of venture capital, even in this case for us, mission-driven venture capital, is about generating returns as well as impact. And there's an increasing body of evidence that suggests that the overall tech valuation delta between Europe and the U.S. is declining across a lot of different sectors. So in my generalized research and reporting on defense and dual use, they're often excluded or indeed combined with other sectors. And as someone with the background in the space, I decided to take a step back as I saw the landscape shifting early on.

11:02And I was interested in figuring out whether or not this delta still held true for a defense and dual use if you consider it its own sector. So in doing so, I evaluated an array of U.S. and European defense and dual use tech companies across both the United States as well as five European countries. As part of this, I used five key criteria for that comparison. And that was ARR, CAGR, headcount, margin, and then I know somewhat subjectively, product market fit. The results were staggering. For similar startups across those categories, and again, depending on the subsector and the European nation the startup was based in, the average valuation difference between the US and Europe was 42 % less in Europe than the US on average.

11:47And that's without leers removed from the equation. Now, given this, for me at least, it is evident that there's a clear opportunity. But I want to shift focus before I delve too much into that and look at why this sector is so important. So as we already covered fairly well, first, European defense spending was already trending up prior to the second Russian invasion of Ukraine. This is particularly actually the case, despite common wisdom, in comparison to the United States, which is often compared to not only when it comes to defense, but also broader technology. The spending gap between Europe and the United States actually closed between 2016 and 2020 with what we call dual members, those who are members of both the European Union and NATO, narrowing the gap by nearly 20 % between them and the US.

12:34EU nations that are also NATO members increased their defense expenditures during this time by over 48%. And that was in 2021, This was, again, the year before the invasion of Ukraine or a second invasion. EU nations accounted for 21.3 % of total NATO defense, which was up from 18.3 % in 2016, which is fairly sizable given the short time frame. So I guess the question really becomes, if not the eventual second invasion, what was driving this increase? In short, while Europe may not have anticipated the scale of the invasion of Ukraine the second time around, they were seeing the future that they may not be able to rely on the U.S.

13:15At the same time, the geopolitical environment was changing, and there was really this growing desire to see Europe as a capable actor of its own, all of which I'll talk about more in a bit. So going back to 2020, I published a piece for a leading think tank identifying these upward trends, but also laying out why we had not seen the emergence of defense unicorns in Europe as there had been in the United States. And really chief among these reasons has been a lack of private capital engagement, which is really why I want to explore it with you here today. So overall, why is private capital, specifically venture capital funding in Europe late to the game for defense?

13:55VC funds are supposed to be an ideal world identifying investing in tech and trends before they become the status quo. And like I mentioned earlier, the opportunity space had been growing for several years. So Andreas, if you could actually go ahead and pull up the first slide. Yes, and to upper one, I am now pulling up the slides. And if you are on EU.VC watching this, you know, we just look at it. But of course, we will also have Nicholas try and be, you know, talk us through it so clearly that you don't have to tune in to EU.VC. But as always, that's where we have these recordings with videos so that you can actually get to know the VCs that you're listening to.

14:42And in this case, also look at the slides. We only have four slides. They're not super text heavy. So don't tune in just because we have them. No, thank you, Andreas. And this is getting to what you kind of alluded to in your introduction, which was the idea of great power competition, this rise of a more multipolar world where a lot of different countries have a say in achieving their agenda. And really what this slide shows is that traditional lines between what was defense technology and commercial are starting to, well, have started to blur and in fact are fairly blurred or broken down entirely.

15:15And I won't go read through all the different points of the slide, but first and foremost, there are some fundamental misconceptions about what defense technology is that this slide is trying to get after. And for those listening, defense technology is not just about bullets and bombs, but instead is really focused on what I would call key enablers. For instance, there are no startups building chemical weapons. That's not really what defense tech is. If you look at the seven technology areas prioritized by NATO, each one has a civilian use case. So if you're a deep tech investor, if you invest in, I don't know, quantum technology, biotech, manufacturing, even communications, you are already investing or looking at sectors or technologies that could be leveraged for a defense.

15:58And these are, as most listeners know, referred to as dual-use technologies. Over the last years, despite the invasion of Ukraine, the top defense and dual-use tech segments were actually not in munitions or these big traditional companies or use cases, but instead included things like energy, command and control, or biotech. So if we just take Europe, for example, you can see these include companies like the Munich headquartered Helsing, which became the first actually European Union-based defense tech unicorn back in 2022, or London-based labors technologies, which last year raised the largest defense tech seed round in UK history.

16:39So with the former, really is more Helsing is more focused on artificial intelligence and electronic warfare, and the latter is revolutionizing command control reach. You'll note that neither of these involved in the production of so-called bolts and bombs. So really, it's about shifting what the concept is or what the understanding of what is defense fundamentally gets after. And so what else was really kind of delaying this within Europe? And second, that was really the belief that defense was kind of overdone or not really a concern anymore. However, countries have been developing cutting-edge technology for defense purposes throughout history, and despite desires otherwise, they'll continue to do so for the foreseeable future.

17:23Over the last 30 years in particular, the West, and when I say the West, I mean the United States, North America, and obviously NATO and its European partners, have been involved in global conflicts, but far out of sight, which has led to an overwhelming, what I would call, false sense of long-term security at home. If you go back to 1986, the historian political scientist John Gaddis coined the term the long peace, which was describing the post-World War II lack of great power wars. Three years after that, Francis Fukuyama, who's a famed scholar, declared the spread of liberal democracy was inevitable and we were witnessing the end of history.

18:01Fast forward to 2012, a couple of years before the first invasion by Russia of Ukraine, the Nobel Peace Prize was actually awarded the European Union with the Nobel Committee lauding the Union and its forerunners for over six decades, contributing to the advancement of peace, reconciliation, democracy, and human rights in Europe. At the same time, NATO's annual summit communicated that year focused on cooperation and partnership. That's all to say that people thought we could kind of move on from defense, and this was not something that was going to be impactious anymore. In 2015, moving a few years ahead, this idea that we were enjoying an unprecedented time of peace and that conflict would be relatively small and far away, was finally more closely looked at by a scholar of data science, as well as Nassim Nicholas Taleb, who wrote the book The Black Swan, or The Impact of Highly Improbable.

18:51They wanted a more definitive answer to the question, are we truly trending towards peace? So what they did was they looked at armed conflicts with more than 3 ,000 casualties from 1500 to 2015 AD. The result was they were unable to identify a significant downward direction and suggested that wars were randomly distributed actions over time, not following any particular trend, so that the idea of this new era of prolonged peace was never really going to last by historical trends. So, Andres, if you can move forward one slide, please, slide two. So back to 2012, while Europe was celebrating its Nobel Prize and its ability to promote peace, Vladimir Putin was starting his third presidential term, and Russia military spending, in real terms, was the highest it had been since the Russian Federation's reemergence as an independent nation after the fall of the USSR.

19:44Similarly, China increased its military expenditure by over 11 % in 2012, which followed a nearly two-decade-long trend of double-digit increases of defense spending. and was then mirrored by subsequent increases in the years that followed 2012. Conversely, in 2012, NATO was still embroiled in Afghanistan, where I was actually deployed as a civilian that year supporting ISAF. So just two years later, European minds and budgets finally started to come around to the idea that great war power or conflict between major powers may not be anarchism after all, forever. And many Western institutions, their push for cooperation and peace and that they could exist outside these alliances and unions and partnerships was kind of misplaced.

20:30This was driven in part by the first Russian invasion of Ukraine. So military expenditures within Europe in the years leading up to 2022, as we covered the start, began rising. This was also buoyed by a growing mainstream awareness of the need for defense technology after 2022 and not being an outlier, but a recognition instead of the enduring need for Europeans to stay at the cutting edge of defense. Finally, at the same time, as all this is going on, European private as well as public capital markets have been an impediment to technology development and defense within the sector really writ large.

21:11European governments, activists, and the European Union itself have long pushed for aerospace and defense companies to being included on investment exclusion lists for an array of rationales from them producing firearms, the manufacturing of certain explosives, and even low fuel economy. Yes, really low fuel economy, or even the involvement in nuclear supply chain. What this meant for the sector was that sovereign wealth funds and investment firms excluded aerospace and defense or A &D companies from the small Amin says enterprises or SMEs all the way through to the prime contractors, such as Airbus, BAE Systems, and Ryan Mattel from their portfolios.

21:53In public markets, this increases volatility, resulting in lower valuations, and raises the cost of capital for these companies. Thankfully, however, this is slowly starting to change. An example of this was Sweden's own SEP group dropping their restrictions around defense and aerospace in the last year. So shifting gears a bit, now that I've covered why venture capital is lagging European defense and dual-use investment, let's look at the opportunities for investors moving forward. Private capital is the critical driver of the defense economy. Rapid development and deployment of defense capabilities requires really an understanding of how defense investment has fundamentally changed in the last decade.

22:39Technological investment trends have accelerated, which in turn, as from the first slide, started shifting the balance of power in foundational research and development, or R &D, away from governments and militaries to emerging tech companies and venture capital. Now, outside of Europe, the US and China have been adapting to this new reality, with both embracing fast-growing venture-backed startups focused on dual-use and defense tech, as well as creating thereby an array of new defense unicorns. This has not yet been matched in Europe. And without the private capital ecosystem to support these companies, the continent is at risk of being left behind.

23:16Now, many investors and government officials, at least those outside of their respective ministries or departments of defense, are unfamiliar in a lot of cases with modern defense markets and the associated defense and dual-use technologies. As already mentioned, defense requirements have expanded, really going beyond kinetic equipment that most people may really think of, so firearms, bombs, and fighter jets. Increasingly, defense relies on key enablers such as space capabilities, unmanned systems, which colloquially known as drones, artificial intelligence, and other analytics. While the US and China have recognized this shift and increased both government and private sector investment in these areas, this has not yet been matched in Europe.

23:57So looking at the slide that Andreas has just pulled up here, slide number three, let's take a generalist look at that. Now, Now, you can look across the numbers here about the number of startups that have entered the U.S. ecosystem. But from a generalist perspective, you'll all be familiar with Founders Fund if you look over to the bottom left-hand corner of the slide, one of the leading U.S. venture capital funds. Founders Fund is well known for being an early investor in Facebook, Airbnb, and Stripe. But what you may not know is that they are the second most prolific investor in the world in dual use and defense technologies, having led rounds for Palantir, SpaceX, and Andrel, the major defense tech core in the US, as well as more recently, companies like RaceWatch and Kevalna.

24:38So Andres, can you shift one more slide to the final slide, slide number four? Finally, startups are driving defense innovation and looking at the defense sector landscape is important to understand the existing legacy European aerospace defense companies by referring to at the very start of the podcast as primes and why they are critical for the sector. They are not, and while critical for the sector, they're not really the key drivers of this new defense economy. Primes are large companies with multi-billion euros in annual revenue, which due to their scale, as well as all the previous contracts they've completed, are viewed by governments and militaries as capable of leading major multi-year development efforts traditionally focused on building bespoke, multi-mission, hardware-based assets.

25:23In Europe, somewhat differentiately, these primes have the characteristic of being what I call national champions. That means most have their respective governments as major shareholders or even outright owners. Unsurprisingly, these companies are mostly structured in their home countries, and their largest customers are their respective governments. As to be further expected, these companies are deferred to for most, if not all, of the major government contracts and really continue to mirror their governments and their operations and makeup. But European primes significantly, unfortunately, underperform with revenue per full-time employee only one-eighth of their U.S.

26:03counterparts. At the same time, they've demonstrated recent inability to drive forward major cross-border development programs, such as the multi-billion euro FCAS or Future Combat Air System. A lot of this caused by contract disputes and kind of the strife between primes in different countries. In short, collaboration between these primes is limited and is restricted, and their actual operations are restricted due to an individual or handful of European countries, rather than being pan-European. Now, slowly but surely, European governments are recognizing that they need a different approach and are dedicating budget towards startups and fund investments, including the European Investment Fund, which just launched its$175 million defense and security vehicle, alongside the 1 billion euro NATO Innovation Fund.

26:51They need to educate dedicated private capital to grow this market, particularly at an early stage. Now, thankfully, surely some European VCs and U.S. VCs investing into Europe in search of alpha have started addressing and investing in the sector. But these have largely been few and far between. In my analysis, there remains significant opportunity to generate returns and impact On average, as mentioned at the start of this podcast, when comparing these very same US and European defense tech and defense first startups with similar headcount, margin, revenue and product market fit, the European startups are still valued at 42 % less than their US counterparts, meaning there could be significant opportunity to join ELF as a result of these opportunities.

27:39In sum, investing in defense presents significant opportunities no matter who you are. For value investors in general, there is clear valuation dealt to be taken advantage of. Similarly, for impact-focused investors, such as ESG, particularly the S or social, then defense is a must for your portfolio. Without the ability to protect a country's own citizens from misinformation or even from, yes, actual invasion, the rest doesn't really have much of an impact. The cultural stigma, institutional barriers against defense and dual-use technology investments are finally rapidly collapsing, and the sector is proving to be a vital and robust opportunity for the investment community.