Author: Lucy Cox, Graphics: Holly Ur
Since the end of the Cold War, the U.S. Defense Industry has been a desert of competition. New leaders, new companies, and new conflicts can bring that back.
It had been 46 years since the S&P 500 had last added a new defense company until September of 2024, when the U.S. defense industry faced its first major shakeup in years. Palantir, a company whose data mining technology helped find and kill Osama Bin Laden, was added as a defense company to the S&P 500. The Pentagon of the post-Cold War period has been dominated by five prime contractors, little competition, and defense specialists, rather than commercial companies.
However, with the rise of new conflicts and many experts warning we are on the precipice of global catastrophe if current conflicts continue to escalate, the American defense industry could face major shake-ups as calls to innovate grow.
With the U.S. facing an increasing amount of conflicts, the rise of cyber warfare, and the implementation of AI technologies into defense uses, the defense industry is on the precipice of a whole new order. The U.S. defense technology ecosystem must not remain divided and must continue to innovate in order to effectively lead the new world order. To do that, there must be competition in the defense industry.
Gone could be the days of five companies dominating the U.S. defense contracting market, but to do that, new and innovative defense companies must find a way out of the “valley of death” and into the pockets of the Pentagon. So how did we get here, and what can we do to bring back competition to the defense industry in America?
The Last Supper
In the Fall of 1993, a couple years after the end of the Cold War and the settling in of President Clinton’s first year in office, Secretary of Defense Les Aspin, then-chairman and CEO of Martin Marietta (now Lockheed Martin) Norman Augustine, and several other prominent defense industry leaders walked into the Pentagon…
In what is now known as the “Last Supper”, a quick briefing by Secretary Aspin resulted in slashed U.S. defense spending by 67%, and soon the 51 prime contractors with the Pentagon fell to only five. Large defense firms merged, while research and development funding dropped about 44% from 1985 to 1998. At the time, the relative peace and unipolar world order with America at the top sounded like a reasonable policy. Competition, and thus innovation in the defense industry was not as necessary, as we were not fighting a global power.
However, what resulted was not a massive decrease in relative defense spending. In 2023, the U.S. defense Budget was $877 billion, which is more than China, Russia, India, Saudi Arabia, the U.K., Germany, France, South Korea, Japan, and Ukraine combined. But are we getting more bang for our buck?
Higher Prices, Slower Delivery
With fewer companies and thus, less competition, Pentagon orders are taking longer and are more expensive for U.S. taxpayers. One major contributor to this innovation lag and the absence of expedited services is the Pentagon’s cost-plus contract system, which awards mostly defense primes with contracts that reimburse companies for production and R&D costs, plus an additional percentage for profit. Many leaders in tech startups argue that this system provides little incentive for reducing costs or expediting services, especially in times where urgency and cost efficiency are necessary.
The key to solving this issue could be providing more opportunities for commercial companies with more industry competition and more risk on the company’s shoulders (rather than the taxpayers’ shoulders). Commercial companies, like SpaceX, have been shown to make products for much cheaper than the government expects. For example, NASA estimated the cost of building a SpaceX rocket to be $4 billion — SpaceX was able to make it with $400 million. This is because of the absence of cost-plus contracting with SpaceX, and the prioritization of technology to speed up the process. Furthermore, Starship will reduce costs 1,000 times over the outcomes of traditional cost-plus approaches.
Additionally, there needs to be a total reevaluation of R&D funding from the Pentagon. Palantir makes note that Cost-Reimbursed Independent Research and Development (IRAD), is not real R&D in its true form. R&D should involve risk for the company, as a company putting its skin in the game, rather than the taxpayers, often leads to a greater incentive for innovation and excellence.
If Pentagon funding shifts to a system where there are capital risks for the individual company, rather than the taxpayer, it is rational to think that the U.S. could meaningfully cut costs on defense while getting better technology in return, and in turn, more competitive companies would be able to rise.
Small Businesses Need to Resources to Get Big
Last year, venture-backed companies took less than 1% of the $411 billion in defense contracts awarded. The Pentagon sends funding to founders through the Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs. SBIR and STTR are programs that give money to founders who apply to conduct R&D on various Pentagon needs through the Defense Advanced Research Projects Agency (DARPA). It is these companies that still have a very hard time getting past the “Valley of Death” in the defense contracting system.
DARPA assigns three stages to projects receiving funding: Phase I (concepts), Phase II (prototype), and Phase III (commercialization). The Valley of Death describes the peril startups face attempting to get from Phase II to Phase III, where only 16% of SBIR contracts make it to Phase III. From there, less than 1% of these companies make it to Program of Record status.
To solve this problem, the Pentagon has been attempting to redefine how it works with private companies. New projects, like the Defense Innovation Unit which collaborates with private companies, the Office of Strategic Capital which works to scale private capital to bolster national security, and NavalX which is the innovation arm of the Navy, are all currently working with new private companies to innovate in sectors that are fairly new and very important to modern warfare. Venture investment in defense tech has grown considerably since 2017, with the highest funding being in advanced computing and software; sensing, connectivity, and security technologies; biotechnology; autonomous systems; and AI.
Competition in these nascent sectors of defense is necessary for America to remain the world leader it has been since the end of the Cold War. Thus, the Pentagon must be a better investor and streamline processes toward external stakeholders by providing small businesses with more resources, more long-term investments, and incentives for working with startups.
This sort of outreach has so far been shown to work, as the Navy is seeing higher SBIR rates and higher rates of innovation because of projects like NavalX. As industrial base readiness and competition with Chinese capabilities on tech are ever more important, it is in the interest of the Pentagon to accelerate research labs in commercial tech.
Looking Forward: Policy and Current Progress
The Trump Administration, with its appointment of Pete Hegseth as Defense Secretary, is shaping up to be one of the disruptors in the defense sector. Elon Musk’s influence prior to his ousting also paved a way for a friendlier relationship with defense tech firms. His November 2024 tweet to Anduril founder Palmer Luckey calling for the Pentagon to open up to “entrepreneurial companies” like his and “pay for outcomes, not requirements documents” is encouraging for new companies looking to innovate in the defense industry.
Much of the Pentagon budget is still spent on conventional weapons systems and bureaucracy, which will need to change as priorities for warfighters change and as cyberwarfare becomes increasingly relevant. To do this though, the defense establishment needs to change. Already, key lawmakers and allies of the administration have hinted at being more open to reforms with Pentagon innovation spending.
For example, Alabama congressman and Chairman of the powerful House Armed Services Committee Mike Rogers recently endorsed a Palantir recommendation to shift a small percentage of the Pentagon’s budget to give funding directly to commanders for experimentation, rather than to the bureaucracy.
If the Trump Administration truly wants to shake up the rigid and typically traditional institution of the Pentagon, then it will embrace the ideas of the many defense tech startup founders that have already endorsed President Trump and worked with him. Companies like Anduril, have been seeing considerable advancements in their products receiving contracts.
For instance, Anduril received a considerable award with the Collaborative Combat Aircraft contract in April of 2024, where it will supply advanced drones to support fighter jets. This is a significant shift in bringing more competition to the defense sector which will, in turn, spur more innovation and a modernized American military.
While companies like Palantir and Anduril have been able to push past the Valley of Death and become unicorns in a defense industry dominated by five prime contractors, the health and progress of our military and leadership depends on more companies like them to innovate and compete in the defense industry.
While there is considerable optimism for a shake-up in the Pentagon to initiate this new era of competition in the defense industry, this optimism must be followed up with action by key actors in the government looking to bring true competition and R&D back to the world’s greatest military.
Take-Home Points
- The U.S. Defense industry is facing a lack of competition and needs innovation.
- The Pentagon’s method of awarding cost-plus contracts is hindering expeditiousness, innovation, and competition.
- New companies in defense have the power to bring lower cost and more innovative products to the U.S. military, but they need more resources.
- New leaders within and adjacent to the Pentagon have the power to begin a major shakeup in the industry and make the U.S. military even stronger and smarter.
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