Pentagon startup spending triples yet remains under 1% of budget

Venture capital flood into defense startups raises bubble concerns

Defense Secretary Pete Hegseth has rewritten rules and upended traditions that had for decades steered how the U.S. military buys weapons, according to a report by The Wall Street Journal. More than a year into his tenure, Hegseth has increased spending on high-tech defense startups while also pouring larger sums into traditional contractors he has publicly disparaged as slow and bloated.

Pentagon contract spending on the 15 highest-valued defense-tech startups in the last fiscal year tripled from 2022, according to an analysis from the Ronald Reagan Presidential Foundation & Institute’s National Security Innovation Base Report Card. Yet those startups accounted for less than 1% of total dollars for all defense contractors, a rate that has held consistent for years, the analysis showed.

Venture capitalists and startup founders have been anticipating a true defense reformation that hands power and billions of dollars to defense-tech startups long excluded from the inner circle of weapons procurement, the Journal reported. Investor exuberance has sent valuations soaring. Anduril Industries, one of the fastest-growing defense startups, doubled its valuation from $30.5 billion a year ago to $61 billion in May.

But many in the sector are anxious that Congress is preparing to slow the spending increase amid growing scrutiny of Hegseth’s spending and disapproval of the Iran war, a move that could puncture the bubble around defense tech, the Journal reported.

“We’ve got a shot to disrupt this thing,” said Philong Duong, chief executive officer of startup NODA AI, which has a military contract selling software for autonomous weapons.

Roughly 10,000 new defense companies have entered the market in the past two years, according to an analysis by the Center for Strategic and International Studies. So-called nontraditional companies, which include venture-backed startups, small businesses and commercial tech companies, received over $122 billion in the prior fiscal year, double the amount from a decade prior. During that same period, the Pentagon also doubled its spending on traditional primes, the top-tier mega defense contractors, to $372 billion, the CSIS analysis showed.

“Warfare is evolving faster than our acquisition system,” said Paige Craig, a defense-tech investor at Outlander VC. He called the dawning moment the “PC era of war,” meaning “it’s affordable and everyone is going to have fairly equal access to the fundamental means of warfare.”

Reforming the Pentagon’s acquisition bureaucracy is a herculean effort that has been tried repeatedly without much success since 1960, the Journal reported. The war with Iran showcases the persistent challenge. The U.S. has brought to bear few weapons systems that are less than 15 years old. The new systems include attack drones re-engineered from the Iranian Shahed drone and drone boats from startup Saronic. Most others are decades old and expensive, and Iran’s smaller and lower-cost arsenal has denied the U.S. military total victory, the Journal reported.

Among Hegseth’s biggest shake-ups: eliminating a requirements process for weapons purchases that was slow and cumbersome; suspending costly and rigorous cybersecurity requirements; and giving lower-ranked officers more power to buy the weapons they want. He also stood up programs catering to startups and sped up and added flexibility to contracting.

“We’ve been waging a war of attrition against the Pentagon bureaucracy to open up the aperture and make sure competition, speed, innovation and commercial options all have a seat at the table,” Hegseth said in a statement to The Wall Street Journal.

Michael Brown, a venture capitalist and an early leader of the Pentagon’s Defense Innovation Unit, gave the department an “incomplete” grade on its transformation efforts. He said the real test now lies with Congress to pass budgets that will benefit startups, such as the department’s $54.6 billion request for an autonomous warfare unit that would largely be allocated to companies building drones and AI weapons.

Venture-capital investment in defense and aerospace startups reached $16.8 billion for the first half of this year, exceeding any prior full-year investment, according to PitchBook. Some investors are calling a bubble, pointing to soaring valuations.

“I am very uncomfortable. I am not enjoying this moment at all,” Trae Stephens, co-founder of weapons maker Anduril Industries and a partner at Founders Fund, said recently on the podcast “Uncapped.” He added, “Prices are untethered from reality.”

The venture-capital flood has propped up more than 400 drone companies in the U.S. “In five years, you’re going to have 10 or 15, and that’s fine. That’s national consolidation,” said William Treseder, co-founder of startup Arkenstone, which helps defense companies sell to the government.

An analysis by Howe Wang at Frontier Optic, a market intelligence firm, tracked a cohort of 568 startups meant to reflect the universe of independent, commercial, venture-backed defense companies with contracts. The group received $4 billion in Pentagon contract spending last fiscal year, up from $1 billion in 2022, the analysis showed. That is out of around $506 billion for all defense contract spending.

“Spending on this group has grown very quickly, but the traditional primes are still capturing most of the additional dollars, and growth within the newer cohort is increasingly concentrated among a few large winners,” Wang said.

According to Wang’s analysis, Anduril and Saronic accounted for about a quarter of all Pentagon contract spending to the startup cohort last year. The phenomenon of a select few deep-pocketed defense-tech companies gaining bigger contracts has prompted lawsuits and protests by other startups accusing the military of playing favorites, according to documents viewed by the Journal.

But the Pentagon does not buy without budget approval from Congress, and elected officials have shown mounting resistance to Hegseth’s request for a $1.5 trillion budget. Officials from both political parties have also demanded scrutiny of the Pentagon’s spending on many loans and equity stakes in startups, many backed by venture capitalists including Donald Trump Jr.

A lot of startup technology is not ready for military sales, and even the most established defense-tech company, Anduril, has struggled with dangerous and costly weapons setbacks, the Journal reported.