By Rob Margetta, CQ Staff

The roiling economy might leave few immediate scars on the larger homeland security market, but experts say the situation could have serious consequences for the small and midsized businesses that drive much of the innovation in the field. Homeland security firms developing new technology and other innovations do not rely on credit, so the recent freeze of business loans is not the problem, according to Scott L. Greiper, managing director at the investment firm Legend Merchant Group. Rather, the issue is that the investment capital those companies rely on is also disappearing. “It’s the most difficult financing environment I’ve ever seen,” said Greiper, who heads The Convergent Security Group, a division of LMG that provides financial and strategic assistance to homeland security-related business. “These companies in large part don’t have the stable revenue bases to drive cash from revenue into research and development.”

Whereas large homeland security players have both intellectual property and established revenue streams to help them weather the storm, many of their smaller counterparts were in the low- or even pre-revenue stages, angling for contracts while operating on investment cash from sources that include the commercial banking sector and regional banks. Strategic investors - those who specifically target security companies — could provide a safe source of funding, but firms that aren’t already working with them might not be able to survive, Greiper said. Already, he said, some companies that watched their valuations drop have had to close up shop. “They’re in very difficult straits,” he said.

Thomas McMillen, CEO of Homeland Security Capital Corp., said those small companies furthest on the edges of product development are likely the ones that will be hurt. “The problem with this kind of economic downturn is that you lose innovation,” he said. With the financial sector buckling down, there will be fewer “angel investors” and others willing to nurture a start-up, McMillen said. Additionally, falling stock prices give those who are looking to invest much safer options, he said. “You can buy GE at an unbelievable discount,” he said. “You’re not going to go for some of these smaller deals.”

Market conditions have created what Greiper called “a distressed seller’s market” for small companies hurting in terms of financing. In fact, he said, the current environment provides another kind of buying opportunity: for those running large homeland security companies and have the cash to acquire small business assets.

Uncle Sugar Still in Business

A few bright spots unique to the homeland business environment still exist. For one, McMillen said, the largest single homeland customer — the federal government — is going to keep spending. Marc Pearl, president of the Homeland Security and Defense Business Council, agreed that there is still considerable pressure in Congress to fund homeland efforts. “An economic downturn or an economic bump or whatever this is does not mean that the federal government can stop protecting and defending the homeland,” he said. But he predicted that cuts are likely in selected areas, and Congress and the Department of Homeland Security are going to have to look at better ways to leverage federal money with the states, localities and private sector. “It’s going to be absolutely necessary that programs and resources are spent and defined more strategically,” he said.

But Greiper said homeland firms, especially the smaller ones, can’t depend on government contracts for their survival. Companies need to diversify their revenues, selling to the private market as well as DHS and related agencies. Greiper said the problem facing small and mid-sized businesses is not new. Years ago, he began to see firms without diversified revenue streams “bleed out a slow death” waiting for contracts from DHS, the TSA and other federal sources. “I thought this was a problem years ago,” he said. He added, though, that the homeland market has another factor in its favor: demand, from both the private and public sectors, is still high. Greiper described the current homeland challenge as the opening stages of moving from an analog environment to a digital one, requiring networking and intelligence systems. “We still have a long way to go,” he said.