Why is Defence so hard for SMEs?
The UK Parliament once again debated everyone's favourite type of business - the SME - and their involvement in defence programmes. MP's of all political persuasions lined up to sing the praises of innovative British SMEs and furiously agreed that the MOD should buy more from them. They also took the opportunity to plug defence companies located in their constituencies, even though many of them weren't actually SMEs, but we'll let that slide...
The latest published figures show that the MOD (just) meets it's target of spending 25% of it's procurement budget with SMEs. However the majority of this is indirect spend via Prime Contractors. Only 4% of the MOD's spend with UK industry was directly with SMEs
Having been a Director of a Small to Medium Sized Enterprise (SME) where defence grew to over half of our turnover, I welcome the interest but the debate didn't tackle what I consider to be the biggest challenges for small companies new to the defence world. The following are my highly subjective opinions on the matter.
The defence world is cliquey
I don't mean that there is some kind of conspiracy to exclude new suppliers, but if you are new to defence and turn up to any event, exhibition, supplier open day etc and one of the first things you will notice is that everyone already seems to know everyone else. And they're all talking in acronyms you don't understand. This happens naturally because over time people work together on multiple projects and get to know each other, and it's a small world where people move from the armed forces into industry, or between the established industrial players, and friendships form. There is nothing intrinsically wrong with this, but if you are new and have targeted people you want to meet and network with, it's hard to break through and get yourself noticed.
Defence revenue is hard to forecast
Every business is required to do forecasts and projections to justify investments and plan resources. But your forecast of revenue from new defence business will always be wrong - every single time. And if your company is new to the defence world, your Board will demand to know why, and you will struggle to explain it.
The reason you will be wrong is that every source of information you might use to forecast more than, say, 6 months ahead will be wrong. Particularly if your source is the MOD, because defence programmes are always late. Yes, (with the possible exception of some UOR/UCRs) - all of them. The MOD will try to point to how they are not really that bad, and that delivery performance is improving, but that is only after they have moved the goal-posts that they measure against. If you are doing 3 year forecast or longer, then whatever delivery dates were mooted when the programme gets initial or even main gate approval will be missed, as usually are those in the MOD's published Acquisition Pipeline.
The MOD exacerbates this problem by "over-programming" it's equipment plan - that is presenting a plan to spend more money on procurement than it knows it has available in any given year, deliberately baking-in inevitable delays as a matter of policy in order to later balance it's in-year budgets.
The revenue uncertainty is a big problem for small companies new to defence world, and even if you succeed in winning a contract, deliveries dates often slip from the contract dates through no fault of your own, and the contract will inevitably allow significant slippage without compensation or price renegotiation.
The paperwork
There's lots of it. Every significant UK defence contract will open with a long list of DEFCONS to comply with (other countries have their own equivalents). If you are new, you will groan and wonder where you can get them from, and then eventually you will discover there is a hitherto unknown MOD portal to register with that will allow you to download them all. After a couple of days going cross-eyed reading them you will then discover that most are actually boilerplate that the DE&S contract officer has copied-and-pasted from their last contract, and that many are inapplicable or irrelevant to you and/or the requirement. That's two to three days of your life you're never getting back.
Even if you are bidding to a Prime Contractor, they will just flow down all the DEFCONS from their prime contract to all subcontractors, regardless of whether they are appropriate or justified.
Contract liabilities
Speaking of Prime Contractor flow-downs, it is all to common for Prime's to flow down the full value of their own contractual liabilities and liquidated damages to smaller subcontractors (e.g. for late delivery or non-performance). This results in liabilities for SME subcontractors that are grossly out of proportion to the benefit of the contract. Not only is this patently unfair, it is also pointless since contractual liabilities that are so large that you bankrupt the subcontractor if you call on them are of no help to anyone. This is so obviously unreasonable that you can usually negotiate liabilities down to a more proportionate level, but it shouldn't be necessary.
Late payments aren't the biggest financial challenge
The Government has (quite rightly) introduced a requirement for Prime Contractors to promptly pay subcontractors within 30 days. A few Prime's find ways to cheat a little bit on this, for example by stating that payment will be 30 days following acceptance of goods or services, rather than after receipt as intended by the spirit of the of the rule, and then allowing themselves up to 30 days to get around to inspecting the goods you supplied. Despite this, the defence industry is far from being amongst the worst for late payments.
A bigger problem for SMEs is the issue of foreign currency exchange rates. If a significant percentage of the value of your work is parts or raw materials that are imported and paid for in a foreign currency, or the customer for your contract is going to pay you in a foreign currency, then managing exchange rate risk is a major issue.
The time lag between bidding on defence work and receiving payment can often be 2 years or more, allowing plenty of time for exchange rates to change dramatically from those assumed when pricing the work, potentially making the contract loss-making. And because of the inevitable delays and difficulty in accurately forecasting revenue as mentioned above, mitigating the risk using forward currency exchange contracts with a bank or other financial institution is almost impossible since you don't really know when you will receive or need to spend the foreign currency.
So what should the Government and MOD do?
There are a number of steps that could be taken to make the defence world less daunting for new entrants:
- There should be more events for suppliers that are only open to new SMEs with no previous experience of supplying into the defence world, where they can meet and network with DE&S, Prime Contractors and Subject Matter Experts e.g. from DSTL and the Trials Units.
- The MOD needs to get better at planning (and not just for the benefit of SMEs) and improve the accuracy of key sources of information like the Acquisition Pipeline that industry needs to plan resources and forecast revenue. And as I've said many times before, the Government needs to ban the MOD from 'over-programming' in it's equipment budget and thus presenting plans that everyone knows are impossible to achieve.
- The Acquisition Pipeline itself should carry more commentary about the status and progress of each programme, and in particular there should be an explanation when a programme is removed from the pipeline.
- There should be a statutory duty on DE&S to take more care in preparing bid and contract documents, and filter out requirements and DEFCONS that are inappropriate or irrelevant. This obligation should flow down to Prime Contractors too.
- There should be a further statutory duty on DE&S and Prime Contractors to ensure that all liabilities and liquidated damage clauses are reasonable and proportionate to the nature and value of the work to be performed.
- The Government should set up a scheme, perhaps administered by UK Export Finance, to offer guaranteed foreign currency exchange rates to UK SMEs bidding on Defence contracts involving importing or exporting, to provide a simple, low cost facility to reduce exchange rate risk.
Absolutely everyone is in agreement about the value and necessity of SME businesses in the defence world, and the conflict in Ukraine provides yet another timely reminder of the need for rapid innovation at times of war. British SMEs are bursting with ingenuity and dedication, but there is much more still to be done to make defence procurement accessible and welcoming to smaller businesses.
