E67: Defense Tech’s Rise with 8VC’s Alex Kolicich

25:36When there's a new technological trigger, the general view of it is we will have huge gains from that technology. And it leads to what they say is the peak of inflated expectations, that optimism usually overshoots what's likely. And the technology inevitably disappoints because the human mind is extremely optimistic and we can imagine all sorts of possible futures. I think this is likely what we're doing with AI and AI safety and stuff like that, that we could foresee in 10, 20 years AGI where there's actual safety issues. But we are so far from that today. That's, I think, actually getting close to the peak of inflated expectations that people think of that as a front and center concern.

26:25You know, it's like I still talk to a person on the phone for customer support, but we're worried about AI is like hacking the nuclear weapons system. I'm like, let's take it one step at a time here. We're not really close to that. Once we have peak of inflated expectations, it usually leads to what you said is the trough of disillusionment, where actually you oversue it on the downside too, where all those positive expectations that we will have AGI often go to huge negativity that, oh, this whole technology wave is fake. And then after that, we have the slope of enlightenment and the plateau of productivity.

27:03And you saw this in the dot coms, actually, where you had the 2020 dot com run up. It burst and you had huge issues in Silicon Valley in general getting any funding because people who were very excited about Internet actually became very pessimistic about Internet. And then you saw a 20 year bull market where, you know, everything has become digital. You have the Internet on your phone now. You're connected constantly. Right. And so probably the world that exists today is at or maybe above the peak of inflated expectations people had in the 1990s. But it took, you know, 20, 30 years to get there.

27:40And so we're definitely not there with AI. You know, you have NVIDIA's at all time highs. You have OpenAI raised at 150 billion valuation. They're still growing extremely well. But if you look at aggregates in the space, you know, I think Sequoia had a good write-up on this where they took aggregate capex on AI hardware. It's like vastly exceeding revenue generated by AI companies in the actual deployment of AI. And that kind of starts to tell you that we make it close to the trough of disillusionment at some point where all this, you know, infrastructure that was built and the idea is build it and they will come.

28:20You know, the people actually don't come. The revenue doesn't manifest. And that's when people will be max pessimistic. And that's the time usually you go along. It will be fun. Certainly we're on a ride. So this would not be a VC conversation if we didn't talk about the exit environment. We are seeing more and more of what I call very large acqui-hires. And we can see this with the depth, with inflection. Is this a result of a diverse build innovation conundrum or incumbents just too large to build at this pace? Or is this a result of navigating anti-trust environment? You know, it's a great question.

29:00And I don't quite know the exact reason why we're seeing so few IPOs, as an example. I really thought that we would have more IPOs this year because the markets are actually quite good. There's a lot of liquidity. Anything AI adjacent is trading well. Multiples are not at a low. Even for software companies, they're at an average. And we just see, I think it's the lowest IPO count in over 10, 20 years. I think it's single digits, the number of companies that have IPO'd, especially in software. And it's the same in biotech, too. And I don't quite know why. There's maybe good capital availability for these businesses in the private markets.

29:46I know I'm on the board of a company that could go public. And the growth investors are saying, stay private, take my money. That's one driver it could be. On the M &A side, I do think it has a lot to do with regulation and Lina Khan, you know, threatening to block most mergers and acquisitions. And that's why you see these acqui-hire inflection character AI adept type acquisitions where it seems like they're doing a license agreement and then using that to dividend back to the investors. I'm only guessing at what they're doing because I don't have any inside information there. And then acqui-hiring the teams as a way around an outright purchase.

30:27So that does suggest that companies are afraid to do M &A. But it is actually, I also think that there's probably some part of the argument where companies are also at peak uncertainty, where you have this new trend. You're pretty sure foundation models will be important. And Microsoft doesn't care if the margins and foundation models are 80 % or 30%. They can't lose that layer, right? Even if it's a commodity, it needs to be a commodity on Azure. Same thing with Amazon. It needs to be a commodity on AWS. So those are like bread and butter acquisitions make a lot of sense. But if you start thinking about application software, is that going to get disrupted?

31:11Maybe you slow down your acquisitions there. So I think there's some probably cooling that's happening as a result of the new wave that companies don't want to make a bad acquisition. They don't know where value is going to accrue. And if you're going to make an acquisition, you care more that it's successful than that it is cheap. So you'd rather pay 2x three years from now and be sure that it's going to work than 1x now that you could lose all the money. That's my guess. What have you seen in terms of secondaries? You see more secondaries. I do think there's an opportunity out there for a sovereign wealth fund type entity to come and just do either fund-wide secondaries or fund position-wide secondaries.

31:50A lot of the secondary funds out there can't do very big size. But if you have funds that are 10 years old, like venture funds that have 10-year-old funds, there's no place really to exit a large position to get your investors liquidity. So there's some market for selling fund positions, but that's quite nascent, not that big. I think there's a big opportunity for someone to come in and say, hey, I'll take this position. I know it's good. I'll buy half a billion dollars worth of it at some slight discount. That's a gap that doesn't exist in the market today. but I think someone will do that. Hey, we'll continue our interview in a moment after a word from our sponsors.

32:29Shifting to the defense wave, you've mentioned that this is one of the most exciting and profitable areas of venture investment and now competing with primes on historic contracts. So I'd love for you to break this down. Why is this so exciting? Why is this most profitable and maybe overlooked? Yeah, we tend to think that the defense wave will be very important. And we're seeing, as we started the conversation, we said that there's a lot of change happening now, particularly due to AI, right? And driving a lot of change in industries and questions of where value capture is going to be. This is happening in defense, too.

33:08And if you look at, we track, obviously, the war in Ukraine quite closely. If you look at the war in Ukraine, warfare has completely changed. I mean, it's not even World War II type blitzkrieg tactics. You're back to like small group infantry assaults, extremely high battlefield awareness with drones everywhere, ability to have highly precision strikes, literal drones that can fly and track cars or people and explode into them. That's just completely changing the way warfare works. And that usually means that there's going to be a change in the way defense procurement works. We find generally the defense primes are quite good at some things.

33:51It's not that everything is bad. Defense primes are good at aeronautics. They're good at explosives. I always say they're good at boom. Don't compete on boom. What they're bad at generally is software, is AI, is autonomy. And that's usually where we see a lot of the gaps. So I think those technological changes and the changes in warfare are driving new openings or in capabilities that we need to procure as a country to defend ourselves in the next generation of warfare that I think uniquely startups today can address because that talent, that expertise doesn't necessarily live in the primes. And the country is now recognizing this too, and so are many of the leaders.

34:30So that's what's changing. If I can make just a side comment on how amazed I am that defense has become a hot space. There's people raising funds around it now. There's online communities celebrating startup defense. There's a whole area in LA, the Gundo, which is about defense type companies. I think back to when we invested in Endural. We were the first outside investor with Founders Fund in the Series A. And we literally had conversations internal at AVC with our partners where we were worried about our offices getting protested. And we gave a small chance that actually maybe our reputation is completely ruined because at that time everyone was against defense.

35:18Google famously pulled away from working, I think it was with the Army. You know, we're like, maybe nobody is going to want to work with us again because this is an unpopular thing to invest in. But we don't care. Like, we're going to do what we think is right. We think this is an important company. We think it's important to the future of our country. And so we're going to do it. And we did it. That was a conversation then. And now it's like the crown jewel of the portfolio where everybody loves it. Everybody thinks it's cool. And everybody wants to start a defense startup today. And I think that change in sort of the zeitgeist is so funny to me.

35:55And, I mean, it's a positive transition. We had the courage to stand up early and do it, and so did Founders Fund. A lot of these other funds did not. But I think it's a general positive, but it is very funny and a little peculiar. So that's good. But those are generally why I think it's important that tech has changed and there are new openings today. And we can go through it. There have also been changes on the government side that have made it easier, I'd say, in general to sell into the government, to be successful, to get early market signals. That's helped. But I'd say like the number one thing that has helped has been these companies that have been successful.

36:35You had SpaceX, which was really the vanguard early on. You had Palantir, which is the vanguard early on. And now you have Endural. These are all three companies that have gone into the space people thought was impossible and have succeeded. And so in somewhat mimetic fashion, it's shown people the way. And so now there's a well-worn path to do it. And the government has created more opportunity to make it easier to get in. But that's not like sufficient. It's like necessary, but it's not sufficient for success. Yeah, it's honestly quite interesting because I remember maybe like even like six years ago, like investors I invested in to defense or anything like this were kind of seen as evil.

37:20But now because of and like that's kind of a weird thing to be evil for, considering we have military and large government spending on all of the defense in the US. But I just think it's been hugely eye-opening now because we have the performance and all of the great outcomes from Palantir, Anderol, and SpaceX, like you mentioned, that have helped with the communications around that and the glow and the aura. And now it's just like, yeah, that's a reasonable place to invest. And you can invest into that because it's a big part of our economy, too. So I guess to go into that a little bit further on more specifically 8BC's investments in the space, in your piece, you've mentioned a couple of them.

38:03We just talked about Anduril. You've also invested into Saronic, Epirus, Chaos Industries, and most of which were founded actually within 8BC. So I'm just curious on that standpoint, given your early inclination to go into defense, how did you then double down and start incubating these companies? Yeah, it's a great question. And people always ask me, given that it is now a hype area, more people want to start companies in defense. So they'll always ask, what is the right way to do it? And it's not really, you know, there's questions of analogies. There's many ways to start companies. There's many strategies that work.

38:42They're not all the same. Software has gone down the ethos of like the lean startup. A bunch of really smart people get together, bootstrap or raise a small amount of money, create an MVP, go to market, start selling it, get market signals, have good unit economics, keep raising over and over again. That's one way to do it. There's also the biotech way of doing things where it's usually you start with IP or you start with a team and a thesis. The team is usually very credentialed. It's not two people out of school. They've done it before. And they have to raise large amounts of capital and large amounts of dilution because it might be 10 years before revenue.

39:23And the first market signals come at clinical trials. So it's not a revenue signal. It's an efficacy signal. You have to fund to that. And sometimes it takes$100 million to get there. And so it's very hard to do that as two people in your garage. It just is. And I think defense is a little more like the latter than it is the former. It takes, even still, there's great programs now in the Defense Department on getting companies revenue early. But even with that, it takes a very long time to get anything you create deployed in the field. Many procurement cycles, those can take years to happen. And oftentimes, they can scale up immediately when there's an immediate need.

40:04It's not necessarily prospectively. And so, generally, you need to know what to build, right? It's unlikely you're graduating Stanford and you know what the Army needs. Usually you are involved in the Army or you are involved in warfare. You're very in the know on the future of warfare. You have some view of what threats will look like in the future. So you know what's needed. You need to be able to build it. Oftentimes these are very technical, hard tech or, you know, AI autonomy startups, which are notoriously hard to build to be reliable enough. And then you need to know how to engage with government.

40:45And that's still a hard thing to do. Like we literally have people who work for us who help our companies engage with the government. And so we thought to ourselves, this is an area where we have unique expertise. We can have shared resources in engaging with government to understand what they need and help our companies get access to, you know, compete for contracts early on. And it requires huge amounts of capital up front where you need to really have conviction before to know this will work before you have any market signals at all. So we think that sets itself up really well for a build program, actually, where we can have these shared resources that all our companies use.

41:27We can partner with entrepreneurs who we do partner with, but we act like a co-founder. We're part of a builder because we bring a lot to the table and we support these companies with a lot of capital because it takes a lot of capital to get in. Right. And are there any other resources that you provide them, help with government contracts and that kind of thing? Yeah, exactly. It's a lot on the lobbying government contract side, engaging with government, understanding where the needs are, understanding what other primes or contractors are doing. We have like very good intelligence in general on like what the needs are in government.

42:03And I think this is a positive for the company because we're directly connecting innovators with the, you know, not necessarily policymakers, but people in the services via the correct channels, obviously, that can tell us where they think the puck is going and we can build for that. So you cited relevant changes and reforms to defense procurement for startups. What are each of these and what are their significance? I think there's a lot of things that have changed that have made it better. So I really want to highlight how important like SpaceX was in particular and getting these early contracts.

42:43And what they did initially actually was they got these firm fixed price contracts, FFPs, where the way defense used to mostly work, and I'll make this abridged if you're interested. You should just read my update. I go into more detail there. But you used to do cost plus contracting where the government would say, we will pay you X amount to do the work, to do the research, to build the hardware, plus a margin on top. And in that way, all the risk actually of development goes on the government, not on the company itself. And so that's why you have programs that go massively over budget and you have, you know, a lot of, they're not scandals, but you look at it, you're like, okay, there's a lot of waste going on there.

43:28Because the contractor in that case, they don't have any skin in the game. Actually, the more they spend to, you know, succeed in that contract, the more margin they make. You see this in healthcare too. The more the spend is, the more dollars in profit they make. So the incentives there are all for high cost. SpaceX at that time got firm fixed price contract. They said we will, where firm fixed price contract is like the way everybody else in the economy generally buys things, where it's, I will buy this at X price. It's firm fixed price. And there you push the risk of development to the company itself.

44:09And so the company has to have confidence that they can do what they say they do at the right price without overruns. And the defense primes generally don't like these contracts. and startups generally do like these contracts. Enduro, for example, would create and take the risk on products themselves. And when they sell to the government, the product is already done. They've taken the risk themselves on developing it and thinking the government wants such a product, and they'll sell it at a certain price, whereas the prime generally won't do that. So that's one. And then two is there's been an increase in this type of contracting called OTA, other transaction authority contracting rather than FAR contracting.

44:48FAR contracting is like a very bureaucratic way of contracting where you generally can't do one bidder or anything like that. The contracts are 900 pages long. The procurement cycles are incredibly long. They're actually generally biased towards the primes winning. And there's more use now of this new authority called other contracting transaction authority, OTA, where the branch in question can actually have a lot more autonomy on the decision gets made. how the decision gets made. The contracts are one page, like we'll buy X of this for Y price. It's a lot faster. It's much more the way I see the rest of the economy does business, where there is some procurement still, but there's a lot more flexibility to say like, we ran tests, this is the best provider, we're going to buy quickly, it's going to get delivered.

45:37Because time is the enemy of every startup. Time for defense crimes doesn't matter, but time Wasted is the enemy of every startup. And so that's just led to faster contracting with governments, with the DOD in particular, which means startups can grow faster, which means they get more funding. And there have been other programs like, I didn't talk about DIU, which is the Defense Innovation Unit that works with areas of government, of the branches of the military, tries to find areas of need, and then engages with investors and companies to try and fund at the earliest possible prototype stages solutions to those needs.

46:15And so when I talk about we engage a lot with government, it's like a lot is through DIU. They give real size contracts. You can get 10, 20,$30 million contracts from the DIU, very early stages to create prototypes to compete for some program, which is helpful funding. And then there's more programs, I won't mention all the acronyms because it's all acronyms, that come after that, where they'll try and match funding you got from the private sector in one way or another to help you build manufacturing capacity before you've gone through full procurement at the congressional level. Because you want to buy something, oftentimes it has to get into a budget.

46:52And if anybody's familiar with the way the U.S. government works, there's a lot of continuing resolutions. They don't want to deal with it until the very end. So it can take years to actually get to procurement, even when somebody wants to buy something. And so they have now funding that can help get you through what that used to be called the valley of death, but they help you fund the company, fund manufacturing until those big purchase orders come in. And so there's been a great infrastructure created to get ideas to the private sector in a more democratic way, where now everybody can talk to EIU and understand what the needs are.

47:26Get funding for prototyping to compete, right? There's no cronyism here. It's like the government will have a wreck. They'll have a bunch of companies compete. The best product is the one that gets bought. And then there is funding if that happens to be a startup. And that funding does exist in partnership, usually with the private sector, to bridge that value of death to when the real orders come in. And so that has really changed, I think, all of those things put together has changed the conversation where it's now an appealing investment. So this has really changed the playing field for defense startups.

48:02How would you advise startups to take advantage of this? I think it's still very important to realize, well, first you have a great team that can build complex hardware, software, or technology in need. And so you should really understand why what you're building is different, why Raytheon can't just do it, because Raytheon is good at a lot of things. We shouldn't be too pessimistic in general on the defense complex because American military equipment is better than any else, right? And so you should be technically excellent and know that you can out-execute these great firms. Two, you should have a great partner or great people on the team that can engage with government.

48:42I think the one thing we learned early on at Palantir was you needed to be engaging with government much earlier than we thought. Eventually, the best product will usually win, but not always. And eventually it can be very long. And so it's really important to have either lobbyists or government relations people that can have your voice heard, give you a seat at the table when these decisions are made, because it's not just like starting a normal startup, I would say. I won't go much more into depth of that. But there's a lot that goes into the early phases to reduce your time to market if you know what you're doing.

49:22and three is you better be very good at fundraising because you're going to be raising money with very little commercial progress or traction and that is a hard thing to do and so it's not an area I think most people should go into to be to be frank most of these companies I mentioned that we invested in are started by people who were actually at one of these successful companies Endural, Palantir, or SpaceX before, or who were in military service themselves, and they know sort of the landscape. It's very rare that someone's a complete outsider and comes in and succeeds here. And I'd also say that if there's one thing we're pessimistic on is that I think we probably think it's a little overhyped in general, where we think it's real, for sure, but it's not going to be an opportunity the size of software or AI or something like that.

50:14The defense budget is naturally limited as a percentage of the economy. And so we think there'll be many new primes created, but it's going to be on the order of tens, not hundreds or thousands. And so in terms of opportunity, unless you have some real competitive advantages, like, and you can articulate, this is why I'm the person to do this for this gap that exists in the defense space, it's probably not the right opportunity. Super insightful. So as we wrap up, one last question. But as you reflect on this moment in time versus even our conversation in Q1, there has been a lot of change and a lot of exciting moments, a lot of surprising moments.

50:54uh the devin devin launched ilia left open ai there's very large aqua hires there's shutdowns what has most surprised you over the course of h1 2024 and maybe even was there anything you got wrong my views on ai keep changing so um because everything's so turbulent you know i initially thought that application layer companies wouldn't do well i think incumbents actually well i initially thought incumbents would capture all the value. And then when I saw Devin, actually, my mind changed where I thought there is room. Like if you take the thought experiment of saying, now we have this super intelligent layer that we can enter into any software system that exists in the world.

51:41If that existed 20 years ago, would software look different than it does today? Like the answer is probably yes. So it's very possible then that we will create new application layer software companies today that could disrupt the incumbents. And I think Devin really opened my eyes to that, where I said, okay, this could be actually just what software looks like going forward. This sort of like supervisor worker type paradigm, where it's not workflow software, it's supervisor software, where you supervise the agents. So that was probably the biggest mindset shift that I've had. I still don't think it's going to be completely monolithic where all application software would die because I spent the first 10 minutes of this call saying I was bullish on application software.

52:27I think in most cases incumbents will stay, but there will be areas like software development, maybe law, things like that, where you can have a new workflow system or system of record. But perhaps the most surprising, and I keep tweeting about this and it's so perplexing to me, is I tend to really admire open AI AI as a company because they do the best work. They were the vanguard in the space. Sam took a bet very early that we would hit that inflection point in AI, and it was not obvious when he did it. And it took courage and it took a lot of foresight. I always think that should be rewarded when people make contrarian predictions and they're right, it should be rewarded.

53:09So I admire that company a lot, but it's very surprising to me how many people leave and some of their best people leave. It makes it a little worrying. And every time I see it, you know, we've three new leaders left last week and that goes to a litany of others who left beforehand. That's really surprising and shocking to me. And it makes me question, like, will they be the leaders going forward? I think, I don't know, like your guess is as good as mine, but I don't think we've ever seen pre-IPO so many leaders leave the best like crown jewel company in Silicon Valley. It's common like you IPO, everyone gets rich and they leave.

53:51Okay, that's normal. But before IPO, right in its like heyday, you don't see the best people leaving the best company. So it's just highly irregular. That's a really good point. It's a very good point. Well, Alex, back by popular demand. Thank you so much. This was so fun. And again, appreciate your insights and all your quarterly reports. Cool. Thanks so much for taking the time. Turpentine VC is a podcast from Turpentine, the network behind Moment of Zen and Econ 102. If you liked the episode, please leave a review in the Apple Store or rate us on Spotify.