How Our Broken Financial System Undermines Defense Innovation
Financial reform should be recognized as a national security priority
Image Credit: US Navy
As investors in both private ventures and small cap companies, we have witnessed many small, yet highly innovative start-up technology companies struggle to sustain funding year after year. The performance of the technology is rarely the issue. The real challenge is in waiting for large, lethargic bureaucratic organizations to take the risk of working with a small company. While investors wait for this long process to play out, they are forced to repeatedly raise additional rounds of funding just to keep the company afloat. Thirty years ago, many of these companies might have already gone public, giving investors a viable exit and granting the company access to substantial public capital. Today, an Initial Public Offering (IPO) isn’t realistic until far more revenue is generated. To receive returns on early investments, the best many investors can hope is often an acquisition of the company by one of the larger firms in the industry.
Small companies operating in the defense industry are running into similar problems. They are struggling to sustain funding long enough to win the government contracts necessary to generate success and returns for investors. The result is only a few extremely large companies dominate the industry, and innovation is impeded. Unfortunately, most people analyzing the problems of the defense industrial base view this as a unique problem to the defense industry and offer solutions that typically feature calls for more government subsidies and defense policy changes.
Yet, the problems that these small defense companies experience are practically the same as those that the rest of the small cap companies in the market face, and they stem from the same sources. The factors that are making it more difficult for defense tech companies to compete with larger-cap firms and raise necessary capital are not unique to the defense marketplace. There is a deeper illness plaguing the entire U.S. economy, and the cause is a broken financial system that is struggling to support the kind of dynamic, entrepreneurial growth that built American economic strength. It is vital that U.S. policymakers work to remedy the causes of the brokenness if we are to succeed in promoting innovation in the Defense Industrial Base (DIB) and the broader economy.
Lack of Competition in the Defense Industrial Base
The number of prime aerospace and defense contractors has plummeted from roughly 50 in the early 1990s to just five today. This dramatic consolidation has raised serious concerns about the health and competitiveness of the defense sector. In 2022, the Office of the Secretary of Defense for Acquisition and Sustainment published a report titled the “State of Competition within the Defense Industrial Base,” which found that there was a severe lack of competition in the DIB and argued that increasing new entrants is a critical DoD priority.
Recommended solutions to this problem in the DIB tend to narrowly focus on DoD actions. They typically involve some sort of DoD program to increase outreach to small businesses, strengthen M&A oversight, or create “bridge funds” to help companies sustain funding in the “Valley of Death”—the time between a company develops a product and wins a contract with the DoD.
There are certainly merits to many of the recommendations, but there are also many problems. These kinds of solutions, even if implemented successfully, will likely fail to obtain the desired outcome for the defense marketplace because the core issues plaguing the defense industry ecosystem do not originate in the defense industry and are not unique to it. Consolidation, struggling for capital, and barriers to entry are issues that are impeding innovation and growth across the U.S. economy.
Burdensome Regulations for Public Companies
Since 2000, the number of publicly-listed companies has declined by 36%, with only around 4,500 publicly traded companies today. The number of IPOs per year has also plummeted. Consolidation and the lack of new entrants has been a feature of the public markets as much as it has been for the defense industry over the past three decades.
Why is it that companies are no longer going (and staying) public? Why are many companies choosing to get acquired rather than list on an exchange? The answer lies in the increasingly burdensome regulatory environment that disincentivizes public participation and skews capital toward large incumbents. There has been a gradual buildup of well-intentioned but ultimately damaging regulations over the last three decades. These laws have raised the cost of going and staying public, especially for small- and mid-sized firms. There are many such regulations, but here are some of the main culprits:
1. Regulation Fair Disclosure (FD) of 2000
Regulation FD was a rule set by the Securities and Exchange Commission (SEC) to prohibit the selective disclosure of material nonpublic information to the market in the hopes it would “level the playing field” for investors. The regulation made company executives personally liable for everything they said to potential investors, deterring them from speaking freely with investors about their business. It also discouraged sell-side analysts from covering smaller companies, which is a critical support for such companies to attract investor attention. A 2005 study by the National Bureau of Economic Research (NBER) found that this chilling effect on communication had a disproportionate impact on small- and mid-cap companies. Forecast errors rose, earnings announcements triggered more volatile stock reactions, and companies faced higher costs in disseminating information. The consequence was a steep decline in market visibility for new and emerging companies.
2. Sarbanes-Oxley Act of 2002
Passed in the wake of the Enron and WorldCom scandals, Sarbanes-Oxley sought to prevent corporate fraud by imposing strict auditing and reporting requirements. It required company executives to personally attest to the accuracy of the company’s financial statements, mandated that they pay for external auditors of their financial reporting, and subjected companies to significant compliance burdens. A 2008 survey by the SEC itself found that Sarbanes-Oxley cost the average company $2.3 million annually in direct compliance costs, compared to the initial estimate that it would cost $91,000. A 2022 survey by business consulting firm Protiviti confirmed that these costs remain substantial. For many firms, the expense is so high that going public simply isn’t viable until they reach a much larger scale.
3. Dodd-Frank Act of 2010
Enacted in response to the 2008 financial crisis, Dodd-Frank increased oversight of financial institutions and added new compliance layers for public firms. It also led banks to scale back small business lending, according to another NBER study. Reuters reported that the law made IPO underwriting more expensive and complex, further deterring firms from seeking IPOs.
These regulations were all put in place with the best of intentions—primarily to reduce fraudulent activity in the financial markets and protect smaller investors. However, the unintended effects are that fewer companies are able and willing to afford the costs of accessing public capital markets, thus limiting the ability of innovative companies to raise capital.
The Stifling of Innovation
The cumulative effect of these regulations has been to concentrate capital in the hands of the largest firms. With fewer public companies and limited information on smaller companies, investors funnel capital toward well-known large cap firms. As these giants grow, they often acquire smaller competitors before those firms can fully develop.
This undermines innovation in two ways. First, larger firms, once dominant, tend to slow down their R&D efforts—less competition means less urgency to innovate. Second, small firms with transformative ideas may never see the light of day. The cost of scaling up is too high, and private funding is too uncertain. Instead of going public, many are acquired—and their innovations are absorbed into bureaucratic machines.
Start-up and smaller private companies face an uphill battle in sustaining funding because of the difficulty in obtaining capital through going public. These companies are forced to repeatedly turn to venture capital or private equity investors for more and more rounds of funding. After decades of watching startups struggle to reach the public markets, venture capital investors are now less incentivized to support early-stage firms.
Financial Regulatory Reform—A National Security Imperative
Due to the nature of the long delays in winning government contracts, defense firms are particularly vulnerable. American start-up defense firms may have a winning technology, but they are significantly disadvantaged if they must continue turning to private investors to sustain operations until the government awards them a contract or to obtain the necessary capital to rapidly scale production.
Additional DoD acquisition initiatives and government subsidies have little potential to solve the problem of the lack of competition and innovation in the DIB. Instead, there needs to be a significant legislative effort to roll back the legislation and regulations that are discouraging U.S. companies from gaining access to the full investing power of the American public. The longer we wait to solve these core issues, the more likely it is that our surviving defense tech firms fail and our nation’s technological superiority erodes. Success in this effort would not only empower smaller defense companies, but it would also unleash innovation across the U.S. economy, further strengthening our national security.
The United States has long drawn its military strength from the dynamism of its private sector. If we want to maintain that edge, we must stop treating financial system reform as a niche financial issue and start recognizing it as a national security priority.
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