Investors confront top of European defence start-up ‘hype cycle’
Concern mounts that not all newcomers to the sector since Russia’s full-scale invasion of Ukraine will survive
Nicholas Nelson has received about 1,200 pitches from European defence technology start-ups this year.
The general partner at Archangel, an early-stage venture fund focused on defence tech, said the pitches ranged from detailed presentations to a handful of slides, two-page memos and even a single drawing.
“The quality is getting better, but the quantity has gone up a lot faster,” he said.
Nelson’s experience is far from unique. The Ukraine war and the revolution in drone warfare have catalysed interest from entrepreneurs and investors in the sector.
More than 230 defence tech start-ups have been founded in Europe since Russia’s invasion in February 2022, including 52 this year, according to Dealroom. Venture capital investment in European defence tech has similarly jumped, reaching $1.5bn in the most active year yet.
While investors welcome the influx of what they say is much-needed capital to help Europe re-arm, there is concern that hype is outrunning reality.
“We are . . . approaching the top of the hype cycle,” said Nelson, who believes the sector has attracted a “lot of ‘defence-curious’ investors who were doing crypto, impact or climate two years ago”.
Investors said a shake-out was inevitable, especially in the crowded area of drones where some estimates put the number of start-ups at more than 500. Valuations, too, have been driven up as investors have piled into financing rounds, despite many companies still being years away from delivering battle-ready capabilities.
“You have a lot of people trying to do drone start-ups because they’ve heard that is important for Ukraine or to do AI for intelligence,” said Nelson. “If they understood the market or come from the services they would know that’s actually been a thing for quite a while,” he added.
Industry executives, meanwhile, are critical of what they see as the herd mentality of some European venture capitalists.
Torsten Reil, co-founder and co-chief executive of start-up Helsing, said when the company started, “there was a lot of ‘intellectual laziness’ among European VCs who had the attitude that we do not want to touch defence. Now everyone wants to get into defence and we have the same level of intellectual laziness.”
There is concern that the rush of money targeting one part of the sector could lead to other capability areas losing out on funding. One area that urgently requires more investment is air defence.
Russia’s recent drone incursions into Nato air space have underlined the vulnerability of Europe’s defences.
Despite some of the frothier valuations, most investors believe these are par for the course in a sector that is still evolving. There is also a long-term demand for its technologies.
Rana Yared, partner at Balderton Capital, believes the world is in a “secular trend of greater insecurity. If many people believe this then you should see a whole lot more money go into the sector writ large”.
She added: “There is little doubt that when you are in one of these big secular movements, you will end up with businesses that end up overpriced . . . and that is because the rising tide will lift all boats.” As a result, she said defence companies that had no operational experience were receiving close to the same credit as those with it.
Khaled Helioui, a partner at VC firm Plural and an early investor in Helsing, said “you will have people waking up to poor returns — but that is OK, venture has always worked this way”.
As long as “there are one, two, three, four or five [companies] that become category defining . . . this industry will not have any shortage of capital coming to it”, he added.
The level of management expertise within the start-ups is improving, with several funds drawing on people with military experience or a background in defence. The number of funds being launched that are dedicated to defence, such as Nelson’s Archangel, has also risen over the past two years.
Some sizeable contracts have also started to flow in what industry executives say is a sign of the market evolving.
Lorenz Meier, chief executive of software start-up Auterion, said scale had “ramped up hugely”. When Auterion started, an order of 100 drones was a big order. It now has a contract with the US Department of War to deliver 33,000 drone “strike kits” to Ukraine, Meier said.
However, he added that “investors have moved from admiring the increase in funding for defence, to focusing on margins and multiples, so we do expect some consolidation in the industry”.
Government contracts are critical if the industry is going to grow and become sustainable. “We’ve seen lots of capital that is going into start-ups,” said Dame Fiona Murray, chair of the Nato Innovation Fund, but now the “real question is, are you going to get capital accumulating into some of the winners?”
“For that to happen you have got to have big contracts. You’ve got to have governments and nations stepping up to drive big contracts and then investors have to invest at scale.”
One area in Europe where start-ups are still struggling to secure enough capital is in Ukraine. Ragnar Sass, an Estonian entrepreneur who founded venture firm Darkstar, said the best defence tech teams were in Ukraine where innovation cycles had become incredibly rapid.
In Ukraine, he said, there was “no bubble” and more funding was needed. The companies having the most impact in combat were in Ukraine and they “don’t talk, don’t have PR teams”, Sass said.
The challenge for anyone headquartered in Europe, he added, is the need to “build new versions of your product almost monthly now”, in effect requiring core product development teams to be in Ukraine. “All investors who are serious have to be in Ukraine.”