Optimus to Optimist: The Next Generation of Primes Pt. 1

This is the first in a two-part series on innovation in the defense industry. Stay tuned for part two.

Overview: How does the military innovate? 

Prevailing wisdom says the DoD suffers from a lack of innovation, that its vehicles for procurement are not set up for startup success, and that the organization is broadly incapable of flexibility and agility.

And while historically we see truth in these criticisms (some of the history we talk about in this piece), it is our firm and steadfast belief that this is rapidly changing.

Encouraged by an increasingly difficult threat environment and a peer rival in China, it is our belief that the right people, incentives, and systems are moving into place (both entrepreneurial builders and governmental buyers) for a true defense tech metamorphosis.

As the DoD seeks to upgrade its systems to meet the threats of today (and tomorrow) we are continually reminded that America’s most enduring competitive advantage is its people.

We believe that collaboration between the DoD and some of the brightest minds in the private sector is crucial to unlocking the full potential of emerging technologies, and we’re excited to partner with a select group of these entrepreneurs who are shaping the future of defense–and, in doing so–a safer, more resilient world.

In this two-part series, we explore: ‍

• The Dawn of a New Defense Era: We're witnessing a real-time, seismic shift in U.S. defense innovation, ignited by early leaders like SpaceX, Palantir, and Anduril.
• The Forces Driving Defense Reinvention: ‍Fueled by breakthroughs in technology, structural reforms, and shifting global dynamics (including  China as a true peer rival), and an unprecedented influx of outlier talent, this major push to rethink American defense production is the breeding ground for a new generation of primes to emerge. ‍
• The Future of Warfare is Autonomous and Intelligent: As the DoD transitions to smarter, unmanned, and attritable systems, the landscape is wide open for cutting-edge solutions across every domain of modern warfare.

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Yesterday's War

It has been 64 years since President Dwight D. Eisenhower’s farewell address, in which he famously warned the US people about the burgeoning power of the “military-industrial complex”.

Against the backdrop of the Cold War, Eisenhower, a former five-star General of the Army and decorated war hero himself, recognized the duality of a growing armaments industry - both the imperative need for a permanent defense establishment and the risks that profligate military spend and a consolidation of power posed to our democracy.

Fast forward to the early 21st century and Eisenhower’s warning has largely felt like a self-fulfilling prophecy.

While modern day defense spend (as a percentage of GDP) has steadily declined since the Korean War, national defense has remained a necessary and permanent business, with spend reaching a peacetime record of ~$817B during FY 2023.

But growth of the complex itself shouldn’t be surprising. Ike had known that a permanent defense establishment was always somewhat of an inevitability (catalyzed by a perpetual peacetime threat to our survival via nuclear warfare). 

What had been less clear, but was already taking form by the time of Eisenhower’s address, was the shape in which this system would take. How and to whom would the hundreds of billions of dollars be allocated to each year? How efficiently would we build and buy? How ready would we be to face the threats of tomorrow?

Herein lies the problem.

Despite the decades of development and trillions of dollars in spend, the Department of Defense has struggled to keep pace with the world around it.

Until only a few years ago, our nuclear weapons ran on 8-inch floppy disks (technology from the 1970s). Command and control systems were running on Windows 2008 servers and programmed in Java. Our military is so bogged down with process, that in the time it takes the Army to purchase a new pistol, China has built 60 ships.

The US spends more on defense than the next nine countries combined, yet historically, only ~4% of the budget has gone towards innovation, a share that has not increased over time.

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Soberingly, we are now five to six times slower at adopting new technology than our adversaries. And while technology has continued to advance at an unprecedented rate, we have largely been complacent in its adoption, continuing to operate under the same assumptions and spend on the same exquisite legacy systems that worked for yesterday’s war.

This is particularly concerning given we have a near peer adversary in China who has been systematically transforming their military for the future since 1993 and have the stated objective of being ready to invade Taiwan by 2027.

As former senior policy advisor to John McCain, Christian Brose, writes in his book, The Kill Chain: Defending America in the Future of High Tech Warfare, despite the seemingly unbreakable history of US defense supremacy: 

“Over the past decade, in U.S. war games against China, the United States has a nearly perfect record: We have lost almost every single time.”

The question then becomes, how did we find ourselves in this position, and why are we optimistic that despite 50 years of stasis, now is the time for change?

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The Rise of Oligopolistic Procurement

One reason for stagnation has been the continued and incredible consolidation of power for only a handful of American military prime contractors.

Following the end of the Cold War, then U.S. President George H.W. Bush and UK Prime Minister Margaret Thatcher proclaimed that the collapse of the Soviet Union would usher in a “peace dividend” (i.e. long term benefits due to a reallocation of heightened defense spend). This desired dividend meant a drastic reduction in defense spending which, under the Administration’s plan presented in 1991, would shrink to 28 percent below peak 1980s outlays by 1997.

As a consequence, this reallocation of spend also catalyzed a drastic shift in the way that the Department of Defense did business. 

In 1993, during what would later be dubbed ‘The Last Supper’, then Defense Deputy Secretary William Perry invited major defense company CEOs to the Pentagon for dinner and a surprise proclamation: “within five years, at least half of the companies represented at the dinner would not fulfill the nation’s defense needs.”

Part by necessity, part by design, following the meal, the government proceeded to allow, and encourage, merger after merger, leading to an incredible amalgamation of power for only a handful of American military prime contractors.

This government-encouraged consolidation, coupled with defense prime regulatory capture, made it nearly impossible for new companies to cross the procurement / contracting “valley of death” and effectively compete.

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Colloquially known as ‘primes’, today, the five largest of the American military contractors make up a staggering 30% of the military contracting dollars and one-sixth of the budget.

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‍The Most Complicated Business Enterprise in the World

“The DoD does not have an innovation problem; it has an innovation adoption problem,” ‍

- Eric Schmidt, former CEO of Google and first chairman of the Pentagon’s Defense Innovation Board (Source)

While some have placed sole responsibility on the primes, we believe the legacy acquisition and procurement preferences of the Defense Department have been just as—if not more—detrimental to getting the right tools into the hands of operators.

Written in 1983, the Federal Acquisition Regulation (FAR) lays out the set of rules for US government procurement. And while the expressed intention of FAR has been to increase competition, decrease expenditure, and diversify the federal governments’ contractor base, in reality, its mind-numbing and convoluted process design has done the exact opposite (see the graph below).

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One look at the graph and a logical conclusion can be drawn: that this process is still stuck back in the 80’s when it was written. As the world has continued to modernize - technological innovation cycles have drastically sped up. Where military technology once took decades to evolve, hardware cycles have shrunk to just a couple of years and software to months or weeks.

This inherent mismatch between FAR - built for decade-long procurement cycles of the 80’s - and the rapid and continuous ~12 - 24 month cycles of innovation today, poses one of the greatest risks to the US continuing to fall behind.

Beyond the onerous bureaucracy built into the DoD’s contracting process, the preference for cost-plus pricing, in which companies can bill for all allowed expenses plus additional payment for independent R&D, suffers from deep incentive misalignment. Because companies are covered for all incurred costs plus a fixed profit margin, contractors don’t bear project cost risk, incentivizing them to drive up costs to grow profits from their fixed margin. For the Pentagon this means paying more for less.

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Stay tuned for the second piece in this two-part series on innovation in the defense industry.

If you or someone you know is building this future, please shoot us a note.

Collin West (collin@ensemble.vc)

Conrad Shang (conrad@ensemble.vc)

Ian Heinrich (ian@ensemble.vc)