Investing in homeland security technologies: a venture capital perspective

Many venture investors are asking if start-up companies will be able to play a major role in the new homeland security technologies (HST) industry and whether HST start-ups will make good venture capital investments. For the investor, a convincing answer to these questions would have to take into account:

• The size and nature of the HST market
• Forecasted industry dynamics and market channels
• Possible challenges to companies already in the space

Homeland Security Technologies: a practical definition
In time, corporations and individuals may come to play a major role in safeguarding their security, but for the time being, the US government has appropriately led the way in defining, funding and providing homeland security. (This article will focus on the US market, which is currently the most relevant to the homeland security industry.) The mandate of the newly formed Department of Homeland Security, as outlined in the Homeland Security Act of 2002, states that: The primary mission of the United States Homeland Security Department is to:

• Prevent terrorist attacks within the US
• Reduce the vulnerability of the United States to terrorism
• Minimise the damage, and assist in the recovery, from terrorist attacks that occur within the US

For our purposes, HST will be defined as technologies that contribute directly to the fulfilment of this broad mission. Translating this definition into investment terms requires a breakdown of the field into relevant technology sectors. Giza Venture Capital, which has screened over 150 companies in the HST space, has provided the following sector breakdown:

1. Security and intelligence software
2. Explosives detection systems
3. Surveillance/border and perimeter security systems
4. Bio-terror: detection, diagnostics, treatment
5. Training and simulation systems
6. Access control/biometrics
7. Data security
8. Miscellaneous homeland security technologies

The Homeland Security Technologies Market: spending is slated to grow markedly
Spending on HST is already significant and is anticipated to grow further. The US Federal FY2003 homeland security budget of $38bn (without supplemental budget requests) can be seen as a general indication of the potential HST market. This figure does not include defence and intelligence budgets, which, in many areas, overlap with homeland security. Many point out, correctly, that much of this year's spending will end up going to services, and to the generic organisational needs of the emerging Homeland Security Department, but technology spending will still represent a major piece of this large pie. Additionally, the centre-of-gravity of homeland security spending should migrate toward technology over time. The evolutionary and reactive nature of the threat that the homeland security industry (like the defence industry) is intended to address will continuously demand new solutions, and new technologies will be required to enable these solutions.

Market research reports put corporate homeland security spending between $40bn and $80bn. (Homeland Security Market - Deloitte Consulting, 2002) While the government is currently leading the way, the corporate market is likely to follow soon. The notion that in the near-term purchasing and implementation of homeland security solutions can only hurt corporate bottom lines may slow adoption and pose challenges to growth, but key drivers are emerging that will eventually promote the spread of these solutions. These include:

1. Government regulation: As in the air transport industry, government regulators are bound to step in to address corporate vulnerabilities across sectors. The fact is often cited that 85 per cent of the ‘critical infrastructure' in the US is privately owned. To an extent, the regulatory process will be informed by intelligence assessments of specific industry vulnerabilities, as is happening in the shipping and port management industries. Additionally, the timing and nature of future terror attacks will play a role, as was the case with 9/11 and the massive tide of airport security spending that followed.
   
   
2. The insurance industry: We may see the insurance industry stepping in to influence the adoption of corporate homeland security solutions. Post-attack liability claims, particularly in the United States, could be significant across industries.
   
   
3. Conventional wisdom and customer demand. These may eventually drive corporate adoption of homeland security solutions, independent of government and insurance drivers, as has been the case in the data security space.
   

The above only addresses the US market. The US is not the only target of international terror, and it will not be the only market for HST. It is a fair assumption that considerable international markets will develop over time.

Young companies are important technology innovators
So far, large defence contractors have captured a major share of homeland security spending. It is important to note that the bulk of this work has been systems integration awards, such as the Boeing and Seimens contract to install explosives detection systems (EDS) in 429 US airports (worth over $1bn) and the Lockheed Martin contract to install explosive trace detection (ETD) systems (valued at approximately $500m). Note that the manufacturers of this equipment were, in all but one case, young technology companies. Invision (Nasdaq, INVS) manufactured most of the installed EDS machines while Barringer and Iontrack (acquired by Smiths Group and General Electric, respectively) manufactured virtually all ETD machines. Considering the current activity in airport security, the explosives detection sector is an interesting first test case for small technology companies within the larger industry dynamic.

For manufacturers that engage in R&D in the HST space, such as L-3 Communications (NYSE, LLL), large technology gaps and the rapid pace of technology development have forced partnership and acquisition trends. The EDS space alone has seen a number of acquisitions since 9/11. The objectively poor state of current EDS performance (the best machines offer less than 80 per cent probability of detection at greater than 30 per cent false alarm rates, and at low throughputs) strongly suggests significant room for technology innovation in the future. Indeed, in every HST sector, the adaptive nature of the terrorist threat all but guarantees the need for a steady flow of technology innovation. As in other technology sectors, the bulk of this innovation will take place in start-up companies.

Challenges

Government is a tough customer
Selling to government can pose serious obstacles to start-ups. Major challenges include surviving often protracted government sales cycles, negotiating government bureaucracy, and competing with entrenched players who frequently hold catch-all government contracts.

One response to the challenge of government sales cycles is a strategy of targeting government and corporate customers simultaneously. Actimize, (www.actimize.com) for example, sells two products based on its real-time pattern-recognition and analysis software. One product alerts financial institutions to fraud and money laundering as relevant transactions are taking place. A second product, sold to intelligence services, uses different data-streams to predict imminent terrorist activity. Though this ‘dual-sales' approach makes sense in many cases, it is important to recognise the challenge of marketing to these two very different types of organisations. Complex regulatory processes and often-arcane procurement bureaucracy make marketing to the government customer very different from marketing to corporate customers. Indeed, in many cases, this strategy will require maintenance of two completely separate marketing teams - a difficult proposition for start-up companies.

The systems integration giant
In the defence industry, large systems integrators play the role of gatekeeper for government sales. Weapons systems are generally so complex, that the Defence Department relies on civilian firms to integrate the numerous components and technologies involved, and to field and support operational systems. Contracts have become larger and fewer over the years, forcing consolidation in the defence industry. Today, a handful of contractors control the bulk of Defence Department spending. Although these contractors have tremendous technology subcontracting demands, the relative scarcity of prime contractor bidders makes it difficult for start-up technology companies to break into the defence market with attractive margins. A procurement model for the Department of Homeland Security has yet to emerge, but there is clearly an opportunity to correct some of the inefficiencies of defence procurement. Indeed, the relative simplicity and stand-alone nature of homeland security solutions, when compared with defence weapons systems, leaves room for a wider field of solutions providers. This should lead to increased competition for government homeland security contracts, giving start-up technology providers access to more sales channels, and offering greater opportunity to profit and grow from government spending.

Experienced management at a premium
Management excellence is a scarce resource across industries, but the homeland security space poses some unique challenges. Today, HST management teams tend to fall into three general categories:

1. Managers who, sensing opportunity, have recently migrated to the new HST space from other areas. It is difficult to predict the ingredients for success in such situations.
   
   
2. Managers who have led small-scale project based security companies for years, and who now are presented with the unique opportunity of scaling in the post-9/11 environment. Although these companies often enjoy a technology lead and might have significant experience working with government, their management teams generally lack experience in operating and growing in a competitive environment.
   
   
3. Managers of existing technology companies who have found compelling HST applications for their existing technologies. In some cases, this seems to be a winning formula, as evidenced by early sales. However, in order to move beyond initial sales, particularly with government customers, these companies have generally found it necessary to devote sizable management resources - often including hiring new team members - to the HST effort. This can be a difficult proposition for a start-up company, and often necessitates new funding.

The HST challenge for investors
Although the challenge to venture investors in the HST space generally mirrors that faced by the companies themselves, the issue of exit is one area where interests may diverge.

If homeland security spending does play out along the lines of defence spending, and the same limited field of potential acquirers continues to control government contracts, exit opportunities will be modest. Contractors competing for specific contracts of pre-defined scale have often offered royalty payments in exchange for the right to use a start-up company's technology. In some of the deals we have seen to date, these contractors demand exclusive rights to applications arising from a company's technology. Though this almost guaranteed revenue stream may make sense to the entrepreneur, who is free to enjoy his near risk-free income and move on to his next project, it is of little value to the exit-oriented venture investor.

As might be expected, recent experience has shown variability in strategic partners' demands on start-ups. Some partners have offered terms that will allow start-ups to continue to grow and seek new markets. Naturally, the best start-up companies, with the best technologies, will be drawn to the best partnership deals. The larger the field of companies that can act as sales channels, the better the exit prospects for HST ventures.

Venture Capital

Investment principles
Based on the nature of the market and of challenges to HST companies, the following principles should apply to operating and investing in the HST space.

1. Identify critical sub-sectors. As the dynamics of the HST industry unfold, certain sub-sectors will emerge as more attractive investment areas. This will be a result of markets, which will fluctuate as threat assessments and trends in terrorist activity change; and of channels to market, which will differ in quantity and quality across sub-sectors.
   
   
2. Minimise reliance on the government customer. Products that serve both civilian and government customers, and technologies that can support both civilian and government applications will, all other factors being equal, increase chances for success. That said, there will almost certainly be some exceptional opportunities for HST companies that target the government exclusively.
   
   
3. Smart Partnership. Companies looking to sell in the HST market will generally need to work through strategic partners. The key, here, will be to do so successfully without becoming entangled in the exclusivity web. One way of approaching this challenge is by trying to reach initial, small-scale sales, or beta-trials with government or corporate customers. Companies such as Quigo and Clearforest, which work in the unstructured data management area, have achieved trial sales with US Government agencies. Resulting demand for wider-scale deployment can be leveraged to attract bids from integrators to achieve favourable partnership terms. A wise strategy in any industry, which will almost be essential here, is the drafting of strong and experienced business development teams.
   
   
4. Team-building. As in any business undertaking, the number one factor in building success is management excellence. HST is a new industry, and the archetype of the ideal manager, with the appropriate experience and contacts, has yet to emerge. The industry is bound to develop a blend of attributes from the defence industry and from the traditional, venture-backed technology world. Successful HST managers will be open-minded enough to recognise the tremendous opportunities at the birth of a new industry, and willing to take the risks necessary to turn these opportunities into successes.

The Israeli opportunity
Israeli technology companies represent a special opportunity for the venture capital investor. Start-up activity in HST in Israel approaches the scale of such activity in the United States, and both Israel and the United States dwarf Europe in HST entrepreneurship and innovation. Israel's comparative advantage in HST stems from three factors:

1. Technology. A strong, multi-disciplinary technological foundation is already in place in Israel. Much of Israel's success in the internet and telecom fields can be attributed to technologies developed in the Israeli military and then adapted for civilian use. This process continues today, and is being applied to HST start-ups. In the homeland security field, the translation from military to commercial technology is more direct than in pure civilian areas, limiting development costs and risks.
   
   
2. Government. Israel's long history of government spending on the war on terror has produced a strong and established non-military security industry. Standards and testing regimes that are only now emerging around the world, or have yet to even surface, have been in place in Israel for years. The Israeli HST entrepreneur builds to an existing specification. Though specs are likely to vary from country to country and over time, in most cases the global nature of the threat and regard for best practices will ensure that they remain relatively similar. This has certainly been the case in the EDS space. Long experience and familiarity with operating procedures and specs present a distinct advantage in product development. The Israeli HST start-up has also benefited from generous government incentive programs. Many of the Israeli companies seeking venture funding today have funded themselves, to date, through Israeli and US government grants, usually giving up no equity or future rights in the process.
   
   
3. People. The Israeli technology phenomenon over the last decade has been well documented. In the late nineties, successes in the software, communications and life science fields propelled Israel to the number three spot (behind the United States and Canada) in the number of NASDAQ listings. In the course of the last year, experienced Israeli entrepreneurs have begun attacking the HST opportunity with all of their energy and resources. Israeli entrepreneurs share universal military backgrounds and security experience. Although it was not always called homeland security, Israelis have been engaged in homeland security activities for many years. This is not a new or foreign pursuit to the Israeli entrepreneur. Israel's experience in developing and employing technology in the fight against terror, in a manner compatible with the values of an open society, positions it uniquely as a major player in the HST space.

An answer for the venture investor
The pieces of the HST puzzle are falling into place. Market size, industry dynamics, and the success of early players all hint at great opportunity. Venture investment prospects, particularly in Israel, are attractive and available today.

Copyright © 2003 IVCJ

Tal Keinan is an investment manager at Giza Venture Capital.

Giza Venture Capital is an Israel-related technology fund renowned for its track record and has three funds totalling $316m. The fund has invested in 60, early to late-stage companies in the sectors of communications, IT and life sciences. For more information please visit www.giza.co.il

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Published in IVCJ, a quarterly magazine from IVC Research Center covering trends and developments in Israel's high-tech industry, including IVC's Quarterly High-Tech Survey, statistical analysis, high-tech company financing and venture capital funds.