Can Europe Sustain Its Defense Innovation Momentum?

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Newsletter (10) - Can Europe sustain its defense innovation

momentum?

(1) Introduction In today's newsletter, we examine the evolving landscape of Europe’s Defense, Security and Resilience (DSR) sector. Once overlooked by investors, defense innovation is now experiencing a surge in venture capital interest, driven by shifting geopolitical priorities and the need for strategic autonomy. We will explore the rise of VC investment in defense, the financial and structural barriers that still constrain the sector, and the path forward for scaling Europe’s defense startups.

(2) The Evolution of Europe’s defense Investment Dilemma For decades, Europe’s defense industry has been shaped by a paradoxical approach - prioritizing security while neglecting the financial foundations needed to sustain it. In the aftermath of the Cold War, defense spending across European nations declined significantly. Rather than expecting long-term stability, European governments relied on U.S. military power to uphold global security and support their geopolitical interests. This dependence allowed them to divert funds toward social programs, infrastructure, and other domestic priorities, ultimately weakening Europe's own defense industrial base. McKinsey estimates that from 1992-2022 European NATO member states underinvested defense spending by $8.6 trillion cumulatively, compared to 1960-1992. As a result, Europe’s defense industrial base faced a lack of institutional investments, with venture capital largely overlooking the sector. With no immediate war in sight, investors instead redirected capital toward sectors with higher short-term upside, such as the internet and software industries, which offered faster returns and fewer regulatory constraints.

Today, Europe’s defense industry is at a turning point, driven by geopolitical shifts that have acted as a wake-up call for the continent. In response, European NATO countries are set to increase defense spending by 53-65% through 2026, requiring an additional €453-488 billion. However, existing prime contractors cannot meet this surge in demand, having scaled down production and halted R&D after years of underinvestment. Many are now focused on clearing multiyear order backlogs rather than driving innovation. While state-led initiatives like the NATO Innovation Fund (NIF) and European Defense Fund (EDF) have attempted to boost investment, they remain insufficient to meet Europe’s defense innovation relative to global superpowers such as China and the United States. The result is a capital dilemma — where the demand for defense innovation is greater than ever, yet the financial mechanisms required to support it are still lagging behind.

(3) The rise of VC in European defense Specifically, the rise in demand for defense investment has attracted VC and other strategic investors, aiming to capitalize on the opportunity. The surge of VC in this sector can be broken down into three reasons:

Firstly, warfare is evolving, as seen in Ukraine. Traditional platforms like tanks and carriers are giving way to smaller, more modular systems such as drones and unmanned ground vehicles (UGVs), which offer greater adaptability. This transition not only accelerates the demand for

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software-driven defense solutions but likewise, supports the creation of an innovationfriendly environment for software-based and AI companies in the DSR Sector. At the same time, the urgency of these ongoing conflicts is forcing governments to increase investment in next-generation defense technologies that can be deployed rapidly. The key advantage of this shift is lower capital expenditures in this new generation of military supply which significantly reduces the barrier to entry for startups. Since high capex has traditionally been a major obstacle for emerging defense tech firms, this development makes startups in the DSR sector increasingly attractive to VC funds.

Secondly, increased government activity in defense spending is creating a trickle-down effect that is significantly reshaping Europe's VC market. Higher budgets in defense spending and increased institutional funds, such as Germany’s 100 Billion Euro special fund for military expenditures, increases market stability in the sector by making investments in the sector more predictable and creating an environment for defense tech startups to thrive. This influx of public capital first benefits large defense contractors such as Rheinmetall and Airbus, who then channel funding into the broader ecosystem by collaborating with tech startups. These partnerships offer mutual benefits - through long-term contracts startups gain predictable and sustainable cash flows which increase their ability to invest. Moreover, large defence corporations provide startups with access to advanced infrastructure and large-scale manufacturing facilities. On the other hand, through these partnerships, established defense firms leverage innovation without being slowed down by bureaucratic hurdles. A notable example is Rheinmetall’s cooperation with the German startup Helsing, which secured €450M in a Series C round in July 2024. Furthermore, the government expenditures in the defense sector signal long-term demand which attracts private capital seeking high-growth opportunities. This public-sector momentum is shifting defense from a traditionally slowmoving, government-dominated industry into a fast-growing, VC-friendly market driven environment.

Finally, there is an increase in government-backed VC activity and an increase in public-private partnerships. As interest in European national security grows, governments and institutional funds are increasingly acting as co-inventors in the DSR sector. For instance, Germany’s “Bundeswehr Cyber Innovation Hub” fund provides funding to startups to solve current military challenges. Additionally, the awareness of governments opens the door to new exit opportunities for VC firms. Traditionally, exits in the defense sector were limited to IPOs or M&A deals with defence primes. However, nowadays governments are directly acquiring VCbacked startups or facilitating strategic buyouts by defense primes. This dynamic makes the market more predictable and reduces investment risk, consequently, attracting more VC investments.

(4) Barriers to Scaling Defense Startups Despite rising investment in defense innovation, structural and financial barriers continue to hinder scalability. Institutional investors remain reluctant to back the sector, government procurement cycles are outdated, and Europe’s reliance on non-European suppliers creates supply chain vulnerabilities. These constraints limit the ability of venture-backed defense startups to scale effectively. Many European financial institutions classify defense alongside “sin stocks” such as tobacco and gambling, restricting capital flows. ESG concerns have led banks, pension funds, and sovereign wealth funds to exclude defense startups, despite rising

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geopolitical threats. In March 2024, 14 European Prime Ministers urged the European Investment Bank (EIB) to ease restrictions on defense investments. While the EIB has since removed certain funding limitations, many institutions remain hesitant to engage with the sector, fearing reputational risks. Following on from this, European defense ministries operate on slow, multi-year procurement cycles, making it difficult for startups to integrate new technologies. Unlike traditional defense contractors, VC-backed firms may struggle to secure long-term government contracts, creating an unstable revenue pipeline.

To counter this, European policymakers are pushing for greater domestic production capacity in key technologies. However, these efforts remain in their early stages, and until significant progress is made, Europe’s defense industry will continue to face supply chain risks that hinder its ability to scale. Ultimately, unlocking the full potential of defense startups requires more than just funding - it demands reforms in procurement, investment policies, and supply chain resilience. Without these changes, Europe risks falling behind in the race for defense innovation.

By contrast, Ukraine’s battlefield innovation has demonstrated the need for faster adoption cycles. Yet, European governments continue to rely on decade-long frameworks, delaying the deployment of AI, quantum computing, and autonomous systems. Shifting at least a portion of procurement budgets to 1-2 year cycles would allow for faster integration of emerging technologies, while also providing startups with a clearer path to scalability. Additionally, Europe remains heavily dependent on non-European suppliers for AI chips, semiconductors, and critical minerals, all of which are crucial for next-generation defense systems. With the majority of high-performance chips produced in the US and Taiwan, and China dominating rare earth supply chains, European defense startups face major supply constraints.

(5) Conclusion VC has emerged as a crucial force in reshaping Europe’s defence industry, unlocking new opportunities for startups and accelerating technological innovation. The rapid expansion of the DSR sector, driven by geopolitical urgency and evolving warfare dynamics, has positioned AI, autonomous systems, and deep-tech solutions at the forefront of modern defence strategies. However, structural and financial constraints remain, with institutional funding gaps, slow procurement cycles, and supply chain dependencies still limiting scalability. To regain this momentum, governments, investors, and industry leaders must align efforts to reform procurement processes, expand domestic production capacity, and establish responsible investment frameworks. If executed effectively, these changes will not only strengthen Europe’s strategic sovereignty but also ensure that defence innovation continues to attract capital, creating a more resilient, self-sufficient, and technologically advanced security ecosystem.