THE PORTFOLIO OPTIMIZATION MODEL
The purpose of the portfolio optimization model is to maximize innovation ROI in a large company. I created this model for a few reasons:
There are great resources for managing a product but very few for managing a portfolio of products
Innovation only works if companies exit invalidated investments - in new ventures and in mature businesses. This model is designed to illuminate exits.
This model is designed to help businesses collaborate across silos. It identifies where legacy businesses are in need of a turnaround and where new ventures can be scaled.
This model is designed to enable CFOs and CEOs to easily communicate the ROI of innovation to innovation-agnostic investors on Wall Street.
The underlying premise of the model is what I call a company’s innovation fertility rate. A company’s fertility rate is growth generated from new ventures plus growth generated from turnarounds as a percentage of total earnings. All companies should seek to have the best fertility rate in their industry,
How to use the portfolio optimization model
The portfolio optimization model should be used to monitor and reallocate investments every 2 months. Here’s how it works:
Create a growth advisory board - This investment review committee should include the CEO, CFO, and a team of external experts.
Set clear hurdle rates and expiration dates. Identify clear performance milestones that need to be surpassed for a business to advance to the next funding round. How will validation be measured both quantitatively and qualitatively? Additionally, it is important to establish expiration dates. What's the maximum amount of time a team can work toward validation before time runs out and they must return capital to the firm?
Celebrate invalidation - Any team which proactively says, “We hoped to surpass our milestones, and did what we thought would achieve that goal, but we weren’t successful, we’d now like to return our funding and try something else.” This team should be celebrated as loudly as the team that objectively crushes it.
To exit or pivot? - It’s much easier to shut down an invalidated early venture than a huge, core business. The appropriate way to sunset or pivot a business needs to be carefully calibrated across all levels of maturity.
Measure total portfolio performance - This will take a while to get right. But at a certain stage you will be able to wrap up each portfolio deep dive with an aggregated portfolio valuation, and a clear calculation of your company’s fertility rate.
Don’t do this without your CFO
It is mission critical to estimate the enterprise value and growth rate of every business in your organization, at every level of maturity. It cannot be left to the business owners to conduct these valuations on their own. It is essential to involve the CFO early in the implementation of the portfolio optimization model so that the metrics that you track are credible and defensible in quarterly earnings calls. There are some other important things to note:
WARNING 1: The enterprise value of a pre-revenue venture is calculated in a way that is fundamentally different from a mature business. I recommend using the innovation options model developed by David Binetti to value a pre-revenue venture.
WARNING 2: Your CFO will need to determine whether revenue, profit or EBITDA is the most important metric, and at which levels of maturity they apply.
WARNING 3: Over-correct for data automation. The portfolio optimization framework will fail fast if it requires business leaders to spend days manually collecting data. Be prepared to make an early investment in data automation and business intelligence. Product and project leaders should be accountable for performance but not responsible for data collection.
There are actually three layers to the model
The maturity layer evaluates a portfolio across multiple stages of product maturity: launch, growth, maturity and decline. It identifies opportunities to leverage the established system for scaling businesses to accelerate a venture into growth. it also identifies venture capabilities that can be used to prolong growth ina business that would otherwise decline.
That’s the highest level. The two next layers of the model are the UUUSE layer, and the Power Transition Layer. I speak about them in separate blog posts.
