Australia needs to do better to mobilise private capital to support defence and national security

The 2023 reorganisation of the Australian Defence Force innovation effort into the Advanced Strategic Capabilities Accelerator has been hailed as a panacea to help unblock the path forward for new age defence tech to eventually find its way to uniformed defence force.

It is hard to see how this path is nothing more than a repeat of past efforts.

But what do we want from defence innovation and industry?

Do we want it produce the latest and greatest in modern defence tech ready for the uniformed service? Well … yes … but what actually is that now and what is that tomorrow? If you know the future of combat innovation, then I have a battleship to sell you!

Innovation isn’t about something we know that we need, at best, it is to answer a gap we know we have. If you are asking for square holes to be filled, you will get square pegs, too often, billions of dollars overrun and years late.

What we need from investment in defence innovation is to build a good private capital base that is used to risking in a known environment and capable of producing returns.

If this is done right, it can also build local industry capability to a point that can react faster and even get in front of defence innovations. A local defence technology industry will need to first sell to the world, our market here is too small with too narrow requirements and even if we had a super-engaged main local customer (ADF), they are still too small to allow for scale for globally relevant companies.

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A robust local defence technology industry can:

• Allow more supply chain elements and native capability on shore.
• Acts as a draw card to our young engineers and scientists – talent is where the game is, technology is created by people, smart people; we need them in the defence work force.
• Allow us to rapidly meet changes in combat innovation in a few short quarters rather than half a decade, with a robust deep defence tech sector we can meet these challenges faster.

Incentive model

We need a better way and we have a working example that act as a pathfinder for us. Over the last 20 years, private investors have injected not just capital but also eyeballs into the world of (mostly) software-based technology companies that many would know as tech start-ups. This has led to a deep strata of not just capital but also support ranging from:

Accelerators – structured, guided investment and business formation that enables faster learning with capital and expertise (Startmate, Tech Stars, River City Labs Accelerator, and many more).

• Co-working spaces allowing the gathering of businesses on a similar journey help create the creative collisions between increasing deep industry networks.
  Events – start-up weekends, tech festivals, pitch fests and more.
• Angel investors – early-stage investors ready with capital and advice to assist start-up teams.
• Professional equity and debt funds – pooled capital (or dedicated corporate balance sheet capital) that can write bigger cheques and increasingly with deeper non-capital offerings in terms of networking, executive placement and more (in recent years, this is not just local capital but also global firms have made substantial investments in Australian businesses).

Aside from the capital, which is important especially to individual businesses receiving it, this also brings a wide variety eyeballs and opinions. It brings a wider set of investors with different life and commerce experience to opine and make an at-risk investment.

These investors are not spending taxpayer funds. They are investing either their own funds or funds they are stewarding on behalf of others, where if a return is not made, they lose, as their compensation is made up materially of success fess (not success on investing but success on returning profits to investors). In many cases, the people operating the investing businesses have their own funds in the pool of invested capital.

They have alignment with an outcome, they care viscerally if it doesn’t work. How much of the stake of ASCA or the previous DIH was contributed directly from the employees or senior leaders’ bank accounts?

The presence of incentivised investors is more important than the capital. Friedrich Hayek, Austrian economist and political commentator, argued that information is decentralised – that knowledge is unevenly dispersed among different members of society – and that as a result, decisions are best made by those with local knowledge rather than by a single central authority who are at best, inefficient and, at worst, impossible.

We need more opinions; gatewaying decisions with a few academics and senior ranked military commanders does not work. If senior academics and flag officers can pick the next combat innovation then I still have that battleship they can buy!

No one person nor group of people in a government-related hierarchy can be plugged into a vibrant and (seemingly from the outside) chaotic innovation ecosystem. Real innovation is messy, it cannot be engineered but must rise from the bottom up and not be dictated from the top down. It is a game of networks and connections that, at times, defies mapping and if the mapping is possible, it is only temporary given the fluid nature of what happens.

The way we get these opinions is to bring private capital into defence. This is easier said than done because there are lots of things wrong with defence as an area that investors would willingly risk capital, a selection of these things are:

• Defence forces by and large have a large requirement for hardware; hardware is well named as it is hard. Hard to get outsized investment success in a hardware business rather than a software one, in essence, there are easier places to invest capital. A lot of capital has gone into low-cost scalable businesses with fast iteration between product releases. This does not favour the low-risk approach for defence focusing on day one reliability. There are pure software businesses in defence but they are fewer and many are dual use enough that they are already attracting funds from investors that can see past any ESG issues.
• ESG – this is a fine modern principle, typically held by the well-off in robust Western democracies protected by a strong government and military but over the years, defence-centric investments (and especially anything of any utility to a war fighter) have fallen out of favour due to views and perceptions on ESG. There has been a partial turn around thanks to the Russian actions in Europe but the inertia in the funds already raised and the world view of the people controlling them and any new funds is not helpful.
• Customers – in Australia the ADF is a fickle customer inflicted, historically, with a lack of urgency to get capability into the field and beset with sovereign risk that very often sees foreign capability brought in when it all seems too hard. The ADF is also a small market at (only) US$32 billion when compared to the allied market (countries we could reasonably be expected to be able to legally supply) of US$1.2 trillion (AU$1.83 trillion).

Positively attract investors

How can investors be attracted? Tax incentives. And the incentives already exist, over the last 20 years and seven years, respectively, Australian investors have been able to benefit from the ESVCLP and ESIC tax incentives.

ESVCLP is the Early Stage Venture Capital Limited Partnership scheme which, to massively paraphrase, gives investors a 10 per cent tax credit and then relief on capital gains tax on any profits. ESIC is the Early Stage Innovation Company scheme, the smaller investor version of ESVCLP which gives certain investors in certain early-stage companies a 20 per cent tax incentive and also capital gains tax relief.

Both of these schemes exist and both are seen as a material tool as to why the Australian tech start-up scene has so much success. Please note, I say material tools, as there are lots of other things including access to technology, modern business philosophies, and the enabling of smart young people with a visceral zeitgeist of change that have contributed as well.

We need to repurpose these schemes for defence, let’s give them a khaki wash!

How? By changing the definition of companies to be included in each scheme’s relevant eligible investment definition to specifically carve in defence tech companies and then we supersize the incentives to bring private capital to the table.

First, we need to include into both of those schemes positive language that unambiguously includes defence technology companies producing any defence technology that our allies could buy from us. This has to be export oriented so we can build a robust and deep defence technology sector and because our home market:

• Is too small.
• Has a main customer not accustomed to engaging small local firms over international primes.
• Will only have a limited subset of requirements compared to the allied market; there are more problems to solve in the wider allied market.

By supersizing I mean we could do some or all of the following:

• Increase the tax credit on the ESVCLP and ESIC from 10 per cent to 100 per cent for defence technology enterprises.
• Make capital losses claimable (currently not under both schemes).
• Increase the maximum investment amounts from eligible investors in ESIC which is currently $1 million pa (example: from $1 million pa to $20 million pa).

The benefit in using these schemes instead of introducing new ones are:

• Time – the Defence Strategic Review got one thing right, we have blown the warning time.
• They are known and known to work.
• Investors are familiar with them.

If investor incentives are to be used to bring private capital to defence then let’s use what works. If we are to increase the incentives to bring investors to this sector then we also need to increase the deal flow, this can be done by thing similar to:

• Increase the eligible company requirements so more companies are included in the test (ESIC eligible companies are currently limited by a revenue and expense test, move to the ESVCLP asset test for defence tech companies).
• Make a broad definition of “material military use” instead of dual use – something the firm being invested in needs to have a material military use. Many firms in Australia, thanks to the past opaque grant-based funding mechanisms, have taken on a myriad of work to keep the lights on while building military capability, this should not prejudice their viability for this scheme if they now have more civil products than potential military ones.
• Carve in any firms that are the recipients of any DIH/ASCA, Warfare Innovation Navy, Plan Jericho or other defence tech innovation granting schemes to make it easier for firms to attract external capital.

Pipelines are important

Local indigenous business sector does not just happen at scale. A business ecosystem from an investment standpoint is a pipeline, you start with:

1. Wild ideas and skilled people deploying their own labour and capital - personal savings, credit cards, residential equity or family working capital.
2. Then early-stage funding by family and friends.
3. Then angel investors – typically experienced business people with some capital to risk and happy to contribute cash and advice.
4. After that comes more structured funds and pooled capital.
5. Then debt, venture debt and/or growth funding.
6. Mergers and acquisition (exit).

This ecosystem cannot be stood up at once. Trying to bring in growth stage funders (step five above) when there may be few opportunities will not create a market for capital. What is required is hundreds of engineers and scientists in stage one building their businesses each year. Progressing through to the tens or scores of companies that will make it to stage four.

As companies grow and win, their number decreases as the ones that did not find success or failed to attract subsequent capital. And that is what we need, these are the “failures” of the start-up mythos.

But they do not fail, they just proved what doesn’t work (or work yet, timing is cruel and sometimes the biggest determining factor in success) and need to be considered as such.

Many times, in a mature innovation funding environment, the founders of failed businesses are seen as worthy of a second go – if they played the game with a straight bat, kept their investors in the loop, and did the right thing – this is often seen as a desirable quality worthy of backing again. Failing to maturity is a sign to burgeoning success.

In summary

We need private capital in the defence innovation sector. It is about building a native defence tech sector that primarily sells to the world but gives Australia options as we bring more and more onshore for our own needs.

Let’s start at early stage to build the pipeline for the future; the programs already exist; they work and investors like them – no need for ground-up redesign.

We have lost out strategic warning time. Private investors are here, they are used to and comfortable with a well-known incentive framework – let’s get them deployed.

Steve Baxter is the lead invester, founder and managing partner at Beaten Zone VC.