The intelligence investor

The CIA’s venture capital operation has delivered more than 50 new technologies. Other defense agencies are starting similar programs to fight the war on terror.

During the war in Iraq last spring, millions of American TV watchers were mesmerized by computer-generated simulations of cruise missiles homing in on their targets as they flew over deserts, streets and devastated buildings. What civilians saw paled before the virtual images that military commanders got, enhanced by real-time data pouring in from reconnaissance satellites, unmanned aircraft and foot soldiers.

Without last-minute financing from one of the world’s most unusual private equity firms, U.S. military officials would have had to settle for a less accurate picture. In February, In-Q-Tel, the Central Intelligence Agency’s venture capital arm, invested about $2 million in Keyhole Corp., a Mountain View, California, start-up that developed the highly sophisticated three-dimensional imaging technology used by the National Imagery and Mapping Agency in Bethesda, Maryland. In exchange for In-Q-Tel’s investment, Keyhole licensed its software and helped complete installation of a secure server to process the data flowing into NIMA, which supplies geospatial mapping systems to the Department of Defense, the CIA and other security agencies.

As a technological advance the Keyhole investment was a thunderous winner, immediately aiding U.S. military and intelligence objectives. As a financial investment Keyhole is another story for In-Q-Tel: Although it seeks a financial return, the firm hasn’t received a payoff from Keyhole or dozens of its other portfolio companies as yet. Then again In-Q-Tel is not a typical venture capital firm.

The CIA formed In-Q-Tel in 1999 to modernize the government’s traditional approach to technology procurement, by which the military relied mainly on a few large, trusted defense contractors to produce weapons and other supplies. In contrast, In-Q-Tel, which is staffed by civilians and has a nonprofit charter, takes equity positions in promising start-ups that are too tiny to show up on the federal contracting radar screen. With funding from Congress, the venture capital outfit makes autonomous investment decisions, collaborates with co-investors and entrepreneurs to nurture portfolio companies and coordinates its activities with a secretive CIA body vaguely labeled the In-Q-Tel Interface Center, or QIC.

“The main purpose of In-Q-Tel was to address the difficulty that many people, especially technology people, have in dealing with the government,” explains CIA executive director A.B. (Buzzy) Krongard. A former Alex. Brown & Sons CEO and Bankers Trust Corp. vice chairman, Krongard joined the CIA in 1998 as counselor to the agency’s director, George Tenet, and became executive director, the CIA’s third-ranking officer, in 2001.

Successes like Keyhole -- its mapping system is one of more than 50 technologies delivered to the CIA from In-Q-Tel investments -- have made In-Q-Tel the envy of other government agencies. The U.S. Army and the Department of Homeland Security, among others, want to create their own early-stage venture initiatives modeled more or less on In-Q-Tel. The army, for one, wants to invest in start-ups, but without a QIC-like intermediary to make sure the technologies are used. Susan Bales, special assistant to the technical director of the Office of Naval Research, says her agency prefers “to use the tools we already have in our tool kit” -- scouting out promising technologies through regular contact with venture capitalists, for example, rather than going full bore into venture capital investing.

Skeptics, including many within In-Q-Tel, say straying too far from the In-Q-Tel model is not a good idea. In their view, In-Q-Tel wouldn’t have the success it does without its combination of independent management -- led by civilian CEO Gilman Louie -- and a dedicated group of well-connected go-betweens at the CIA. Paul Kaminski, a member of In-Q-Tel’s board of trustees who served as undersecretary of Defense for acquisition and technology from 1994 to 1997, says, “It’s a mistake the government often makes -- taking out the cookie cutter and stamping out six of these -- without the care it takes to get the right people and processes going.”

Even if these agencies did follow the textbook, people close to In-Q-Tel and academics who have studied it suggest that it would be counterproductive to have too many defense-oriented agencies chasing similar sorts of deals. They might end up competing with one another for the time and attention of other venture capital investors and portfolio companies.

And some caution that it’s too early to brand In-Q-Tel a success. Josh Lerner, a professor of investment banking at the Harvard Business School and an expert in venture investing, notes that start-ups typically take seven to ten years to mature, so a venture capital firm’s performance can’t be evaluated in just five years.

But in the wake of the country’s failure to thwart the September 11, 2001, terrorist attacks, hunt down Osama bin Laden or find weapons of mass destruction in Iraq, any promising new idea to improve intelligence gathering has natural appeal in Washington. Experts say that the CIA’s start-up financing effort has by far the best chance of achieving meaningful results. “I don’t think the others are going to be as successful,” says Howard Cox, an In-Q-Tel trustee and a partner at Boston-based venture capital firm Greylock.

In-Q-Tel is part of a historical shift in the way the military and national security sectors develop and procure technology. Through the 1970s the U.S. government dominated technology research and development through the National Aeronautics and Space Administration, the Department of Defense’s Defense Advanced Research Projects Agency, or Darpa, and other programs. Says Harvard’s Lerner, “The government funded all the technology from beginning to end.”

By the 1990s defense spending had subsided along with the prospect of a major U.S.-Soviet conflict. Silicon Valley came into its own as a private sector research and development center. “There was a concerted movement [by government] toward dual-use technologies that were developing in industry,” says Lerner. As a result, the historical pattern of technology transfer -- from federally financed laboratories to the military and eventually to civilian use -- reversed. By 2000, according to the National Science Foundation, the federal government was funding only 26 percent of all R&D, down from 67 percent in 1964.

In-Q-Tel takes the research trend a step further by identifying technologies before they come to market. Lerner likens the CIA’s gambit to corporate efforts to jettison some in-house R&D and collaborate more with universities or, in some cases, make strategic investments in other companies or partnerships.

“The government can do licensing and procurement and does a reasonable job of these,” says In-Q-Tel’s Louie. “You don’t need In-Q-Tel to do R&D when we have Darpa and the National Science Foundation. But how about engaging an entrepreneurial company? We’re interested in having a seat at the table and helping to set strategic decisions.”

A CIA FLAG ADORNS IN-Q-TEL’S CONFERENCE room. And the “Q” in the firm’s name is a joking reference to James Bond’s famed gadget man. But otherwise it’s hard to tell In-Q-Tel apart from its neighbors on Menlo Park, California’s Sand Hill Road, the venture capital industry’s main drag. The firm’s 55 employees work at that office and another in Arlington, Virginia. They are overseen by Louie, 43, a former video-game entrepreneur who headed Hasbro Interactive’s group before joining In-Q-Tel in 1999. In-Q-Tel has a Web site accessible to anyone -- friend or foe -- where it states its goals and invites entrepreneurs to submit business plans. Salaries are in line with those in the private sector, including bonuses and carried-interest incentives, and the firm coinvests alongside well-established venture investors like Kleiner, Perkins, Caufield & Byers.

What distinguishes In-Q-Tel from its peers, however, is the In-Q-Tel Interface Center. Operating within CIA headquarters in Langley, Virginia, and consisting of 12 senior-level government officials and three civilians (all have security clearances and only the name of the director, Thomas Benjamin, is publicized), QIC serves two purposes: to identify technologies that the CIA needs, and to push the agency to implement those that In-Q-Tel delivers.

“The ability [for information] to flow both ways is the key to the success of In-Q-Tel,” says Krongard, whom CIA Director Tenet personally recruited just before securing the first $30 million annual budget appropriation for In-Q-Tel in 1999. It takes a dedicated body like QIC, Krongard insists, “to turn [the agency] upside down and enable the technologies to reach us.”

Adds Kaminski, who heads Fairfax, Virginia, consulting firm Technovation and serves on the boards of several defense contractors, including General Dynamics Corp. and Rand Corp., “Not too many organizations are willing to put up with the pain and difficulty of setting up an organization like In-Q-Tel along with its QIC.”

Observers say that QIC has become increasingly effective. Of the 50-plus technologies that In-Q-Tel portfolio companies have delivered to the CIA, 30 are in pilot phases and seven have been deployed. The effort benefits from the personal support of CIA chief Tenet, who often pops in on In-Q-Tel board meetings.

Mainly focused on information technologies but expanding into areas such as biochemical sensors and nanotechnology, In-Q-Tel invests at a stage somewhere between the basic science performed in research laboratories and the product development that occurs at corporations. One case in point is Systems Research and Development Corp., a Las Vegasbased software house with an antifraud product called Nora (short for nonobvious relationship awareness) that has proved popular with casinos and retailers. “It looks for insider threats -- where an employee is a crook -- by connecting the dots between names, addresses and phone records that would require 100 humans 100 years to do,” says founder and chief scientist Jeff Jonas. In-Q-Tel, which invested in 2001, won’t discuss how Nora has been applied, but the software company has acknowledged that it worked on Darpa’s Terrorism Information Awareness project, a controversial information-gathering effort led by retired Admiral John Poindexter, which was defunded by Congress in September because of privacy concerns.

In addition to funding and government contacts, portfolio companies gain access to about 20 In-Q-Tel technologists, recruited from senior private sector jobs and led by president and chief operating officer Michael Griffin, a former chief engineer at NASA and deputy for technology of the Strategic Defense Initiative. These technology specialists monitor and counsel the portfolio companies’ engineers and scientists.

“There’s interaction across so many levels,” says Paul Shirley, who runs Qynergy, an Albuquerque, New Mexico, start-up developing a new battery technology. Griffin attends board meetings, though his advice, and that of other In-Q-Tel principals, isn’t restricted to technology. “It has been most useful to look at compensation, human resources in general, financing and other processes -- literally, In-Q-Tel’s entire policy and procedures manual,” says Shirley. “This helps us focus on building products.”

By all accounts, In-Q-Tel doesn’t attempt to take a dominating role at portfolio companies, in part because it’s usually a minority investor. Appropriated $150 million over five years, In-Q-Tel is the sole investor in only 16 percent of its more than 50 deals. It generally spends up to a few million dollars for a stake of between 3 percent and 20 percent, and it tends to take a portion of its interest in the form of warrants.

The firm does, however, use its stakes and board positions to influence, and at times save, products in development that it deems valuable. Early this year San Diegobased software company Graviton ran into financial trouble, and its investors, including Kleiner Perkins and Motorola, put it on the block. The company laid off its engineering team when its wireless sensor system for detecting chemical and radiological exposures was only two-thirds complete. In-Q-Tel helped arrange a transfer of Graviton’s technology to a new company, Soflinx Corp., which rehired the engineers and has begun to find a market for the product, says Neil Senturia, Soflinx’s CEO.

That ability to network and troubleshoot is what differentiates In-Q-Tel from clumsy government attempts to jump on whatever technology is hot, says Harvard’s Lerner. He adds that In-Q-Tel not only brings a different perspective from that of the independent venture capital sector, but also has the freedom to “go after funky, interesting companies.”

EVEN GIVEN IN-Q-TEL’S UNOBTRUSIVE SCALE -- ITS five-year budget of $150 million is dwarfed by the $5 billion portfolio of New Enterprise Associates, one of its occasional Silicon Valley co-investors -- critics question the wisdom of any government agency directly owning private equity. As Lerner notes, the National Institute of Standards and Technology’s Advanced Technology Program, which is designed to fund innovative early-stage research, provided $1.8 billion in grants between 1990 and 2001; of that, 43 percent went to already amply funded sectors such as information technology and biotechnology.

“They probably wouldn’t need to take equity stakes if they were willing to be straightforward in saying [to start-ups] that they’d use the technology if it’s successful,” asserts Lewis Branscomb, a professor emeritus at Harvard’s John F. Kennedy School of Government who served as science adviser to four presidents and as chief scientist at IBM Corp. in the 1970s and ‘80s. “They’d be better off giving [technology developers] the money and saying, ‘Sink or swim.’”

Privacy and security issues bother other skeptics who don’t like the idea of a CIA-backed company dabbling in technologies that might enable spying on the citizenry. “The stakes are quite high here when we’re talking about the civil liberties of Americans,” says Jonathan Koppell, an assistant professor of politics, policy and organization at the Yale School of Management.

In-Q-Tel chief Louie scoffs at the idea that the CIA might open “trapdoors” for snooping into commercial software programs. “If we were to do that, the whole benefit of our work would evaporate,” he says. “We don’t want to make our portfolio companies unsuccessful.”

THE NEW GOVERNMENT TECH INVESTORS ARE leaner and lower profile than In-Q-Tel. They may not invite the same criticisms, but outsiders don’t think they can achieve similar results. The CIA’s Krongard gives these more passive programs little chance. “It’s groupthink,” he grouses. “If the army has it, then the navy, air force, marines and coast guard must.”

The army is outsourcing its funding work to OnPoint Technologies, a joint venture it formed in May with Milcom Technologies, a Maitland, Florida, early-stage venture capital firm. Primarily interested in developing mobile energy technologies, the army capitalized OnPoint with $37.6 million. The group has made one investment -- as yet unannounced -- in a Boston company developing fuel cell technology.

The Department of Homeland Security, which includes the Secret Service, the coast guard and numerous other government bodies, has set up an analog to Darpa called Hsarpa, which will fund R&D projects but not take equity positions. And the Pentagon’s Special Operations Command decided in September to set up an outfit similar to In-Q-Tel called Arrowhead. Details are still to be announced, but the unit has, according to sources, hired a consulting firm to serve as a liaison between the venture investors and the army -- a role similar to that which QIC performs for In-Q-Tel.

“Our real focus,” says Jason Rottenberg, Milcom’s president and OnPoint’s managing director, “is making sure that we enable the army to transition leading-edge technologies as quickly and efficiently as possible, to get a foothold into what’s happening in innovation and to leverage the other capital that’s out there.”

Rottenberg says he doesn’t need a formal QIC-type apparatus because of his firm’s historically close ties to the army and because its fund is smaller and more focused than In-Q-Tel’s. “We don’t have a formal QIC, but we have regular communication with the army at all levels,” Rottenberg says. “We basically have the same thing.”

The Office of Naval Research, which spent $1.7 billion in 2000 on basic and applied R&D, isn’t embarking on real venture investing. “We talked about equity and board memberships and more traditional approaches to partnering with VCs,” explains special assistant Bales. “We decided that we should, in all fairness to our competencies and to the taxpayer, not seek additional funding or legislation.”

That means seeking out innovative technologies through networking in the venture capital community. Bales’s unit, which received $10 million from ONR’s science and technology division in October, has been holding a series of programs, called VC@Sea, on aircraft carriers off of Southern California, where ONR personnel mingle with entrepreneurs and venture capitalists, including representatives from the Carlyle Group, Draper Fisher Jurvetson and Venrock Associates. Two companies that came to the navy’s attention at these events are now doing development work for it -- Vocera Communications, a provider of wireless networks, and Ember Corp., which has a wireless sensor technology that can be used to monitor battlefield conditions.

“We’re working like In-Q-Tel does on building trust and deepening relationships with partners,” says Bales. “But we’re not seeking equity or board membership. We want to pay a fair price, and we’re willing to help test and be an early adopter and, if the technology is successful, let the company use the navy as a branding tool.”

Consultant and In-Q-Tel supporter Kaminski thinks that the army and navy may save some money by going their own ways, but will eventually be disappointed with the results. “They don’t see that it’s worth the overhead,” he says. “They feel more confident that their existing, established methods are a better way to buy what they need.”

Says a high-ranking CIA official who asks not to be identified, “The reason we have In-Q-Tel is to get away from the government model.” The others are simply “earmarking some money to be used by the same people, organized in the same way, to go out in the world and do something.”

The other security branches may be limiting their risk and getting some benefit from networking with the private sector, but, as any venture capitalist will tell them, they’re much less likely to see the huge rewards of a successful early-stage investment. As the CIA official puts it: “You ain’t going to reach the stars doing that. You might reach the next town.”