Bloomberg Law
Jan. 12, 2023, 11:30 AM

Why DOD Should Get Out of the R&D Business: Mislav Tolusic

Mislav Tolusic
Mislav Tolusic

With interest rates increasing and persistent inflation, the federal government is going to have to do more with less. This is a huge opportunity for the Department of Defense to rethink how it finances innovation. The DOD should tap into the strong investor interest in dual-use technologies and the record amount of venture capital waiting to be deployed.

To do that, the DOD will need to radically adjust its funding priorities.

In 2001, for every procurement dollar, the DOD spent another 66 cents on its own Research, Development, Testing, and Evaluation (RDT&E). By 2023, the ratio increased to 84 cents. The amount of money DOD is spending on RDT&E is getting close to its spending on new equipment.

In theory, RDT&E investment should be pushing the scientific frontier and maintaining our technological edge. But should the DOD be a research organization?

Who Should Pay for R&D?

Two main assumptions are driving the DOD’s increase in RDT&E spending:

  • Basic scientific research leads to discoveries that are essential for new product development.
  • Weapon programs are specific to the DOD. No other market exists. Hence, the DOD’s research funding is the only way to develop weapons.

The first assumption doesn’t stand up to deeper scrutiny. For centuries, engineers have created products without understanding the science behind them. Romans built bridges long before Isaac Newton was born. Similarly, it was not until 1920, 17 years after the first flight, that scientists understood how wings create lift. History is full of examples where products are first built and then the scientific explanations follow to explain why those products work.

The limited market argument is correct but misses the point. Take stealth materials. They’re expensive and have no application outside of the military domain. While stealth airplanes provide an edge in conflict, I would argue that the main reason for having expensive stealth aircraft is lack of innovation. Stealth aircraft were a logical solution to countering radar systems, but they are also an incremental improvement, not a revolutionary change.

For example, Lockheed Martin’s F-117’s stealth fighter’s flyway costs were almost double the F-15’s. The F-117 is undetectable by radar but also a much less capable aircraft and was retired in 2008. It was slower. It didn’t have a radar and had no air-to-air fighting capability. It’s hard to argue that F-117 was a game changer. Only 64 were built. If F-117s were truly revolutionary, they would be in front-line service. Instead, F-117s are in museums and much older F-15s are flying.

If the DOD continues to direct significant funding to RDT&E, then we can expect more F-117s and incrementalism.

Lose the Checklist

Successful entrepreneurs know the secret to success—new products need to be 10 times better than current market alternatives. Successful investors will tell you when there’s demand, there’s funding. Combine the two and you have the ingredients for a radical improvement of the Defense Industrial Base.

The DOD should go back to its primary mission of running a military and have the private sector fund RDT&E. First, the DOD should aggressively start redirecting RDT&E funds towards procurement. In fiscal 2023, $140 billion was obligated to the agency’s RDT&E and $167 billion went to procurement. Going forward, DOD should keep the total RDT&E and procurement spending constant but reduce the RDT&E spending and transfer those dollars towards procurement. This would be an easy way to keep costs under control while at the same time resolving the inflationary problems affecting the industrial base.

Second, the DOD should simplify the acquisition process to tap into venture capital funding. The current procurement process is driven by a checklist of requirements. The Army’s list of requirements for gun replacement was 360 pages. Such level of detail doesn’t allow for innovation and differentiation, generally key advantages new market entrants have over established players.

The DOD should broadly specify the capability it needs, commit to buying the best products, and let private companies design them. As part of the process, the DOD should commit to holding a competition and award purchase contracts to the contest winners. This would be akin to how the private sector functions. Companies and their shareholders finance product development, not customers.

This approach would allow DOD to tap into the private sector funding. In the first three quarters of 2022 alone, VC funds raised $151 billion. Those VC funds will be investing in companies looking to create new industries and disrupt old ones. It would be logical to expect that as more RDT&E funding is allocated to procurement, more VC-backed companies would want to work with the DOD.

‘Shoot for the Moon’

VCs are in the business of investing in radically innovating companies. That’s risky and most companies fail. To reduce that risk, VCs diversify their portfolio and assume that a large percentage of their investments won’t work out. To cover investment losses, companies that do survive need to generate high returns. High returns can only happen if companies, figuratively and sometimes literally, shoot for the moon.

The DOD isn’t equipped to take such an approach. A 30% to 40% success rate would be viewed as wasteful spending. The DOD manages risks by funding incremental improvements and pushing that incrementalism to its logical end—fielding a product no matter what. In the long run, results are clear—slower technological advancement and more expensive weapons programs.

At the same time, American VCs are sitting on $290 billion in capital looking for investments. Rather than doing more of the same, Congress and the DOD should look to mobilize this capital by reallocating RDT&E funds to procurement and by streamlining and simplifying the acquisition process. The problem of innovation is not a problem of lack of capital. It’s a problem of how that capital is allocated.

Subscribers can find related content at Bloomberg Government.

Author Information

Mislav Tolusic is managing partner at Marlinspike Partners, a venture capital firm investing in companies focused on U.S. national security and commercial markets.

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