PARIS/STOCKHOLM/PRAGUE (Reuters) -As venture capital investors look to profit from Europe's defence spending boom, speculators hunting for the next unicorn need to navigate hurdles such as EU sustainability guidelines and difficulties for start-ups in a market dominated by large prime contractors.

The European Union has earmarked up to 800 billion euros ($920 billion) for defence through 2030 with a bulk of that amount expected to go to prime contractors such as France's Airbus or Germany's Rheinmetall.

But with large defence contractors focused on meeting record demand due to the war in Ukraine, investors and start-up founders are betting that defence technology startups can fill an innovation gap in Europe, developing technology and driving growth and possibly attracting the attention of those big players later on.

"We think it's an important trend and we're investing behind it," said Sequoia investor Julien Bek. His firm invested $15.5 million in German autonomous drone company STARK in October 2024, according to PitchBook.

Russia's 2022 invasion of Ukraine and U.S. President Donald Trump's prodding of NATO countries to raise defence spending to 5% of gross domestic product from a current 2% have spurred the EU to ramp up its military spending plans.

It has also drawn venture capital funding into European defence tech, which hit $1 billion in 2024, up from a modest $373 million in 2022. That is up fivefold since 2020, yet Europe's defence tech sector has produced just three unicorns - startups with a valuation of $1 billion - and last year attracted just 1.7% of the venture capital money in Europe, according to startup data provider Dealroom. HURDLES Among the biggest barriers to entry for venture capital targeting defence tech in Europe are strict EU ESG rules, which forbid investment in lethal, single-use technology, according to more than a dozen investors, companies and government officials interviewed by Reuters. Many funds receive individual state government or EU backing, which in most cases precludes them from investing in defence. Despite the EU's support for Ukraine, only Estonia and Finland have established government-backed funds allowing for investments into lethal, single-use technology. Borys Musielak, managing partner at Smok Ventures, a U.S. VC firm based in Warsaw, said rules there had prompted funds like his to invest in cybersecurity. "In Poland nearly every fund has some part of it government or European funding, which makes it difficult to invest in defence," he said. Jan-Hendrik Boelens, CEO of Munich-based Alpine Eagle, which develops counter-drone systems, the topic of ESG represents a hurdle that remains for investors and startups.

"There are changes on the way, but I can't say that they've happened yet, at least not to the extent that they should," he said, referring to governments or investors changing policies to facilitate more defence investment. "If you are not a pure weapon of war, as it is called, then I think that is very fundable. If you cross this line into actually becoming a lethal weapon, that might still be very difficult to fund."   DUAL-USE TECHNOLOGIES Some VCs seek to avoid ESG restrictions by targeting so-called "dual-use" technologies that have civilian as well as military applications. Such technologies include computer vision where AI mimics human vision to interpret visual information, robots, cybersecurity software and autonomous drones. All three of Europe's defence tech unicorns - German battlefield software firm Helsing, German drone maker Quantum Systems and Portuguese drone company Tekever - market themselves as dual-use. Sten Tamkivi is a partner in Tallinn- and London-based investment platform Plural, which has invested in Helsing. "We and our limited partner base are aligned with the idea that defending the future of our democracies is a moral good, but some investor bases at other firms say lethal is not okay," Tamkivi told Reuters. London-based VC firm Balderton in 2025 led a 160 million euro funding round by Munich-based Quantum Systems. "Why this one? I think it's serendipity, right team, right company, right timing," said Rana Yared, a general partner at Balderton. "We passed on almost everything that we had looked at up until that point," she said. Founded in 2015, Quantum Systems' AI-operated reconnaissance drones provide real-time battlefield intelligence and are being used in Ukraine. "We have shown we can deliver due to three years at the battlefront, with more than 800 systems in Ukraine," Quantum Systems co-CEO Sven Kruck told Reuters. "The defence market is getting hotter," he said. "Every investor is now creating a defence fund." Last month the company raised 160 million euros to take its total funding to 310 million euros. It also reached unicorn status, as did Tekever. RULE CHANGES? With its increased defence spending plans, the European Commission is also looking to rewrite the rules to allow more investors to participate and individual governments are doing the same. The Commission has said next week it will propose giving governments more flexibility on defence procurement, which is another challenge startups face.

They also need to contend with figuring out how to connect to and sell to the big players and governments who represent the majority of the customer base, investors say. In Finland, the country's pension agency, the Finnish Industry Investment Ltd, has removed a clause that had prevented it from investing in defence. Prague-based Presto Ventures in partnership with Czech arms maker CSG launched a 150 million euro fund last year, which is able to invest in single-use technology. "With dual-use you don't have one market you are focusing on, but you have two, so you have to solve problems and needs of two markets," said Vojta Rocek, a partner at Presto Ventures.

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