Anduril May Have a Point

Replacing Cost-Plus Contracting Would be a Good Thing

Anduril is one of the most controversial startups in the tech world, and it’s not hard to see why. Its signature product, a virtual border wall, comprised of drones and surveillance towers instead of concrete, stands in direct opposition to Silicon Valley’s pro-immigration ethos, which doesn’t spend too much time differentiating between border crossings and H1B visas. It is the second startup of Palmer Luckey, the founder of Oculus who was ousted from Facebook amid controversy over his 2016 donations to pro-Trump groups that made internet memes and billboards about jailing Hillary Clinton.

That hasn’t stopped the company from growing quickly: it reached Unicorn status with its Series B round in September 2019, only two years after its founding. The round was led by well-known VC firm Andreessen Horowitz, who wrote a blog post explaining their investment. Blog posts of this genre are usually perfunctory announcements about how XYZ startup is going to make the world a better place, but this one had to try a bit harder than usual given the subject matter. It did bring up one interesting point: Anduril will not sell its technology via cost-plus contracts.

In a tech industry currently facing a reckoning over the economics of unprofitable startups, cost-plus contracts sound like a VC’s dream: the customer (the government) agrees to pay all the R&D costs of a new technology, plus a fee (profit) upon delivery. The cost-plus model is the standard for military contracts, including big-name programs such as the F-35 and Gerald R. Ford-class aircraft carriers. Note that both programs were marked by extensive delays and cost overruns. But in a cost-plus contract, that’s not a problem for the contractors, only the taxpayers.

The Department of Defense has pushed back against cost-plus contracting in the past, with mixed results. The most famous example was the Bell-Boeing V-22 Osprey, which was changed to a fixed-price contract partway through development in an effort to contain costs as the Cold War was winding down. Anyone remotely familiar with the history of the Osprey knows that the exact opposite happened: the aircraft suffered through years of delays, and was almost killed by then-Secretary of Defense Dick Cheney on numerous occasions. It was only saved thanks to an extensive lobbying effort by Bell, Boeing, and the Marine Corps. (For those interested, The Dream Machine is an excellent history of the Osprey program.)

The main criticism of moving to fixed-price contracting was that it led to too much unpredictability for the military industrial complex, more affectionately known as “the industrial base” that should always exist as a foundation of American military capacity. Removing guaranteed payments to established defense contractors would lead to its dangerous deterioration. It’s easy to see how a Huntington Ingalls bankruptcy or the collapse of the F-35 program would endanger national security.

On the other hand, the death of a startup with a few dozen employees is relatively low risk (good, because that’s what happens to most startups). It’s easy to imagine an alternative market of smaller startups offering fixed price contracts, with most upfront R&D funded by venture capital. This approach has limits: it would be hard to convince anyone in the government to trust a 2-year-old company with a critical, expensive program. However, Anduril’s largest confirmed contract to date is $13.5 million, a small sum of money in the defense contracting world. But a larger number of upstarts could provide a credible alternative to existing contractors for military programs focusing on computer vision, deep learning, and other new technologies for which incumbents have no clear edge (as opposed to, say, fighter jets).

Ultimately, if Anduril or any other newcomers end up achieving significant success, the allure of cost-plus contracts may become difficult to resist. They may be deemed Too Big To Fail, and successfully lobby their way to lucrative, bloated contracts that double as job creation programs in key congressional districts. From a financial perspective, this would be a tremendous success for the startups and their investors. “You either die a hero, or you live long enough to see yourself become the villain.”

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