by Michael Masterson

When I began my career in the information publishing industry, I had enormous enthusiasm for every new idea I ran into. Whenever someone would suggest a new book, audiocassette series, or periodical, I was all ears. If it had -- or seemed to have -- a big potential and a great story, I'd usually fall in love with it. Over the course of the next few days, weeks, or months, I'd do everything I could to give birth to this next great brainchild.

I was fortunate to have, at that time, the counsel of a partner/boss who understood reality a bit better than I did. He was able to douse many of my hottest ideas by asking me simply, "Do you believe in it enough to put in half of the capital?"

"Well," I thought, "you own the business. That should be your job." But I was wrong. And I learned how wrong I was the hard way. Because every three or four times I was crazed on some great new idea, he let me test it in the marketplace. And three out of four times (my actual track record may have been worse . . . it's too painful to remember), the idea bombed and our business -- the business he owned and was funding -- lost money. Because of me.

I am prone to guilt, so this laissez-faire approach to teaching me about start-ups had a much greater effect on me than his challenges or his counseling. ("Michael," I remember him saying 100 times, "you have to decide if you are fish or fowl. You can't be in every business that looks interesting. Choose one area and focus on it.") To make a long, embarrassing personal history short, in the period of time that I worked under his mentorship, I changed from being a very quick and enthusiastic backer of new money-making ideas to being a very skeptical and conservative investor.

Most of my investments in business these days are in small, start-up ventures. And as an investor in these types of businesses, I'd much rather put my money into something with reasonable but probable prospects, as opposed to something that has fantastic but only possible prospects. Twenty-five years of investing experience has taught me that I'm not that good at spotting winners. So when I invest in start-up companies now, I focus on three factors that are, in my experience, the best predictors of a new business's future growth:

1. Efficiency of Customer Acquisition

The first and most important job of a businessperson is to make a sale. Without that first sale, nothing else can happen. Natural entrepreneurs understand this. In starting a new business, they devote 80% or more of their time and money to that objective: selling the product. When investing in start-up businesses or evaluating someone else's idea for a new business, my first two questions are:

Unless I get good answers to those two questions, I take no further interest in the project, because I know its chances of success are very slim. Compared to making the first sale, every other aspect of the business -- from creating a good product to providing good customer service to taking a share of the industry -- is insignificant.

2. Gross Profit Margin

I prefer businesses that have substantial markups. Being in the information publishing business, I've been spoiled in this regard. Since we sell analysis, interpretation, and advice (as opposed to raw information), we can charge significant markups -- sometimes 500% to 1,000% -- depending on how valuable we believe that advice is.

Higher margins give the beginning business builder more money to spend on marketing. Having more money to spend on marketing gives him a better chance of finding an efficient way of acquiring new customers. Although I acknowledge that there are plenty of interesting and profitable businesses in the world that operate on small margins, I prefer not to invest in them. Especially as start-ups.

Success in business is all about learning from mistakes. Growing a successful business is about making all the mistakes you need to make without going broke in the process. Companies that operate on big margins allow for a lot of mistakes. I like that kind of allowance.

3. Back-End Potential

A large margin allows a new business to discover a formula for acquiring new customers. But unless the business can find a way to convert those initial transactions into substantial, longer-term business relationships, the business model is faulty. A business that depends entirely on new sales for growth and profit is like a vehicle driving uphill on a road coated with oil. It may have enough traction to travel for a while, but eventually the work involved in moving exhausts the engine and wrecks the car.

I like businesses that can expand geometrically. Businesses that can acquire an increasing number of customers from an expanding market and then improve the value of those customer relationships by selling them more, better, and more-expensive products. If acquiring new customers is the front end of the business, making those customers more valuable is the back end.

So when I look to invest in a new business, I want to see all three components in place: an efficient customer acquisition protocol, a high profit margin, and the potential for big, back-end profits.

And forget about the latest hot story.

Reprinted with permission of Early to Rise (www.earlytorise.com, Tel: 1-866-565-1117), Copyright ETR, LLC, 2004.