Scaling Defense Tech in 2026 and Beyond

The U.S. Department of Defense is taking steps to access more of the cutting-edge technology being developed outside the traditional defense industrial base. The 2026 National Defense Strategy promises more spending, fewer barriers, and explicit support for startups and nontraditional vendors.¹ That includes addressing what’s known as the “valley of death” — the stage between prototype and production in which many defense startups fail to secure follow-on funding or customers.

This shift could significantly accelerate development of technology, enabling many companies to deliver defense applications that might otherwise never see the light of day. But even in this new environment, some features of the business models that enable rapid development in commercial contexts — fast fundraising rounds, foreign co-investors, flexible governance, global supply chains — can raise eligibility issues or trigger serious legal liability for defense contractors, particularly if the issues surface after contracts are in place.

The risks are different at three critical stages in the life cycle of a defense supplier: securing early federal funding, pursuing classified work, and becoming a prime contractor. To navigate them, companies and their investors must work together on compliance from the outset. Those that are most successful understand that governance, ownership, and supply chain decisions have regulatory implications — and they plan for growth by addressing them early and throughout the life cycle of the company.

Securing Early Funding: SBIR Eligibility and Affiliation Risk

The Small Business Innovation Research (SBIR) program is often called the US’s largest seed fund. Through the SBIR, the federal government provides more than $4 billion annually to small US businesses that are developing cutting-edge technology and commercializing great ideas. For early-stage companies, SBIR contracts are often gateways to defense work.

To qualify for the SBIR, a company must meet specific eligibility requirements set by the U.S. Small Business Administration (SBA). The company must have fewer than 500 employees, including employees of its affiliates. And it must be organized and majority owned and controlled by US citizens or permanent residents.

The rules seem straightforward at a glance, but they can be tricky in practice. Take the rules on affiliates, for example. When a venture capital (VC) investor joins a board, the SBA may count employees across the VC investor’s entire portfolio as affiliates — meaning a company with 60 employees could find itself affiliated with thousands and, therefore, no longer eligible for SBIR funds. To be clear, board seats for investors aren’t inherently problematic, but companies need to understand the affiliation rules and address any complications with their investors before finalizing terms.

Closing a new venture round can also trigger new affiliates and lead to a company becoming ineligible for continued SBIR funding. Companies that draw down federal funds after becoming ineligible face False Claims Act (FCA) exposure, which can lead to damages of up to triple the amount improperly received, civil penalties, and whistleblower risk.

Ownership and control requirements have also become more complex — and more interconnected with affiliation risk. The SBIR and STTR Extension Act of 2022 requires national security screening for three categories: foreign ownership, participation in foreign government recruitment programs (such as China’s Thousand Talents Plan), and connections to foreign-backed investors.

Companies must disclose any foreign stake of 5% or more. Other triggers are less obvious: a US venture fund whose limited partners (LPs) include foreign entities, a syndicate with a foreign co-investor, management and board members who serve at the startup and at another company with foreign ownership or substantial foreign operations. Each requires disclosure and screening.

Companies that manage SBIR eligibility well treat it as a critical compliance issue from the outset, not as an afterthought. Working with counsel and their investors, they model affiliation scenarios before signing term sheets, structure board composition with SBA rules in view, and assess foreign ownership before each fundraising round.

Pursuing Classified Work: Facility Clearances and Foreign Influence

As defense tech companies grow, many pursue classified contracts that require access to classified information. That creates an additional regulatory hurdle: the facility security clearance. Foreign ownership that was manageable at the SBIR stage can become a more serious problem at this one.

Facility security clearance is an administrative determination that allows a company to receive, transmit, and safeguard classified information. The Defense Counterintelligence and Security Agency (DCSA) oversees the clearance process, which typically takes several months and often much longer.

The DCSA screens for foreign ownership, control, or influence (FOCI), the potential for foreign interests to affect how classified information is managed. Companies with foreign investors can qualify for the SBIR if the investors are passive and come from allied countries. FOCI assesses foreign influence — a test that can flag the same investors as problematic because of the information rights, advisory roles, or indirect pressure they might exert.

If the DCSA finds foreign influence, the company must implement mitigation measures to qualify for a clearance. These structures — special security agreements, security control agreements, proxy agreements — are not administrative checkboxes. They can require companies to appoint US-citizen board members with security clearances, establish government-appointed security committees with oversight authority, and segregate information flows. Implementation takes significant time and is expensive.

Companies that manage facility security clearance well do it early. They consider LP composition and co-investor nationality before those decisions become load-bearing. Experienced defense tech investors understand these requirements and structure their funds and governance terms accordingly. They negotiate governance rights with clearance requirements in view. Fundraising decisions made in year one can determine what programs a company can pursue in year five — and by then, it may be too late to restructure.

Becoming a Prime Contractor: Supply Chains and Liability

If a defense tech company becomes a prime contractor, its compliance obligations expand to cover its entire supply chain. In other words, the foreign ownership and influence scrutiny brought to bear under the SBIR and FOCI now extends to suppliers.

The 2026 National Defense Strategy makes this requirement explicit: Supply chains must be secure and US-based. Cross-border sourcing decisions are treated as national security decisions — and increasingly as legal ones.

Prime contractors must ensure their suppliers meet compliance obligations, such as export controls under the International Traffic in Arms Regulations (ITAR) and the Export Administration Regulations, cybersecurity standards, domestic sourcing requirements, and sanctions compliance. The prime contractor certifies compliance across the chain and carries the liability when something fails. A foreign-owned component supplier chosen for cost efficiency can become an export control violation. A software contractor with engineers overseas can create ITAR exposure.

And regulations on foreign involvement are tightening. In December 2025, the Federal Communications Commission banned all new foreign-manufactured drones and drone components from receiving federal authorization.² The ban was categorical — based on place of manufacture, not specific entities. Companies with foreign-sourced components in their supply chains suddenly faced exposure, including potential FCA liability if they’d certified compliance with requirements that no longer allowed those components.

Companies that manage foreign involvement well treat supply chain compliance as strategic, not operational. They map supplier nationality and component sourcing before relationships become embedded in programs. They build compliance into vendor onboarding. They apply the same rigor to suppliers that they applied to their own cap tables — because a supplier’s compliance failure becomes the prime contractor’s legal problem.

Structure Is Strategy

Defense tech companies that scale successfully treat regulatory compliance as a competitive advantage. The startup that structured its cap table with FOCI in view can bid on classified programs its competitors can’t touch. The company that audited its supply chain early can move faster when enforcement tightens. The regulatory complexity that looks like friction is actually a moat if companies know how to navigate it.