The Strategic and Financial Case for Investing in European Defense Startups and SMEs

The European defense landscape is undergoing a seismic shift, driven by geopolitical volatility, NATO’s renewed commitment to collective security, and the European Union’s ambitious rearmament agenda. For institutional investors, this transformation presents a compelling opportunity to allocate capital to defense startups and SMEs, which are at the forefront of technological innovation and strategic autonomy.

Strategic Imperatives: Geopolitical Tensions and Policy Momentum

The war in Ukraine has acted as a catalyst for European defense rearmament. NATO’s 2025 Summit in The Hague solidified a long-term commitment to increase member states’ defense spending to 5% of GDP by 2035, a stark departure from the previous 2% target [1]. This pledge is underpinned by the EU’s Readiness 2030 plan, which mobilizes over €800 billion in defense spending between 2025 and 2030. A cornerstone of this initiative is the Security Action for Europe (SAFE), a €150 billion loan instrument designed to fund critical capabilities like missile defense, drones, and cybersecurity [3].

The EU’s push for strategic autonomy is equally significant. The European Defence Industrial Strategy (EDIS) emphasizes collaborative projects to enhance economies of scale and interoperability, while the European Defence Fund (EDF) has allocated €1.065 billion in 2025 alone to support SMEs and mid-caps in R&D [5]. These policies create a fertile ground for startups to scale, as governments prioritize domestic innovation over reliance on U.S. platforms like the F-35, which critics argue offer limited economic returns for European nations [4].

Financial Case: Rising Investment and Exit Potential

The financial dynamics of the sector are equally compelling. European defense M&A activity surged by 35% year-on-year in 2025, reaching $2.3 billion, with AI, drones, and space technologies dominating the pipeline [1]. Startups like Helsing, a German AI firm developing attack drones, have raised €450 million in venture capital, while Quantum Systems, a drone startup, secured €63.6 million in 2023 [2]. These figures reflect a 500% increase in VC investment into European defense tech since 2018–2020 [1].

Despite challenges—such as 40% of defense SMEs struggling to access financing—the sector’s growth is accelerating. EU defense spending hit €343 billion in 2024 and is projected to reach €381 billion in 2025, with 80% of funds directed toward equipment procurement [5]. Startups are also benefiting from regulatory tailwinds: the EU’s Stability and Growth Pact now allows member states to use 1.5% GDP in fiscal space for defense, unlocking an additional €650 billion over four years [3].

Exit activity, though still nascent, is gaining momentum. Milrem Robotics, an Estonian robotics firm, was acquired by the UAE’s EDGE Group in 2023 after a decade of development, despite regulatory hurdles [1]. Similarly, ICEYE, a Finnish radar satellite company, has raised nearly $400 million, illustrating the sector’s potential for high-growth exits. With global defense tech M&A reaching $62 billion in 2024—a 82% increase—investors are beginning to see tangible returns [3].

Risk-Adjusted Returns and ESG Alignment

While defense startups typically require 10–15 years to mature, the Russia-Ukraine war has compressed procurement cycles, enabling earlier revenue generation. For example, Helsing’s partnership with Saab to upgrade the German Luftwaffe’s systems demonstrates how startups can integrate into traditional supply chains [2]. However, regulatory scrutiny—particularly in cross-border transactions—remains a barrier.

ESG alignment poses another challenge, as defense is often excluded from ESG indices. Yet the EU’s Sustainability Omnibus Package and proposed adjustments to the Corporate Sustainability Reporting Directive (CSRD) may ease compliance for SMEs [2]. By emphasizing dual-use technologies (e.g., AI for both civilian and military applications), startups can position themselves as contributors to broader economic and security goals.

Conclusion

For institutional investors, the confluence of geopolitical urgency, policy support, and technological innovation makes European defense startups and SMEs a high-conviction opportunity. While risks such as regulatory complexity and long gestation periods persist, the sector’s alignment with strategic autonomy and its potential for outsized returns justify capital allocation. As the EU and NATO continue to prioritize defense, the next decade will likely see a wave of consolidation and innovation that rewards early-stage investors.

Source:
[1] [Deterrence and defence], [https://www.nato.int/cps/en/natohq/topics_133127.htm]
[2] [25 European Startups to Watch in 2025 That Could ..., [https://www.bloomberg.com/features/2025-european-startups-to-watch/]]
[3] [Introducing the White Paper for European Defence and the ...], [https://defence-industry-space.ec.europa.eu/eu-defence-industry/introducing-white-paper-european-defence-and-rearm-europe-plan-readiness-2030_en]
[4] [The Curious Case FOR Spain's NATO Defense Budget ...], [https://www.linkedin.com/pulse/curious-case-spains-nato-defense-budget-startups-marc-c-lange-kcttf]
[5] [EU defence in numbers - Consilium.europa.eu], [https://www.consilium.europa.eu/en/policies/defence-numbers/]