What Is an Exit Strategy?

What Is an Exit Strategy?

Let me explain what an exit strategy really is. It's a contingency plan that you, as an investor, venture capitalist, or business owner, put into action to liquidate your position in a financial asset or dispose of tangible business assets once you've met or exceeded certain predetermined criteria.

You might execute this strategy to get out of a nonperforming investment or to shut down an unprofitable business. In those situations, the goal is straightforward: limit your losses.

On the flip side, you could use an exit strategy when your investment or business venture has hit its profit targets. For example, if you're an angel investor in a startup, you might plan your exit through an initial public offering (IPO).

There are other reasons too, like major shifts in market conditions from a catastrophic event, legal issues such as estate planning, liability lawsuits, or divorce, or simply because you're retiring and want to cash out.

Understanding Exit Strategies

You need an effective exit strategy planned for every possible positive and negative outcome, no matter the type of investment or business venture. This planning is essential to assessing the risk involved.

As a business owner, your exit strategy is your strategic plan to sell ownership to investors or another company. It outlines how you'll reduce or liquidate your stake and, if things go well, walk away with a substantial profit.

If the business fails, that same strategy lets you cut your losses. Investors like venture capitalists use exit strategies to prepare for cashing out.

For you as an investor, these strategies and other money management techniques help strip away emotion and lower risk. Set your sell points for losses and gains before you even enter the investment.

Who Needs an Exit Plan?

If you're a business owner, whether of a small or large company, you need to create and maintain plans for what happens to your business when you decide to exit. As an entrepreneur starting up, you might exit via an IPO, strategic acquisition, or management buyout, while a CEO of a bigger firm could look to mergers and acquisitions.

Investors, including venture capitalists or angel investors, require an exit plan to cut exposure to underperforming investments and seize better opportunities. A solid plan also guides you on when to lock in profits from unrealized gains.

Why Is It Important to Have an Exit Plan?

You should have a clearly defined exit plan to minimize losses and maximize profits on your investments or business. Let me outline why this matters.

First, it removes emotions from the process. With a predetermined exit level, you avoid panic selling or rushed decisions when emotions run high, which could worsen losses or shortchange profits.

It also aids in goal setting. Your plan answers key questions and shapes future strategies, like setting a buyout price based on revenue to guide how big you grow the company.

Unexpected events happen, so plan for them. What if you face an illness, or lose a key supplier? An exit strategy minimizes losses and captures gains in those cases.

Finally, it's crucial for succession planning. Your plan details what happens when key people leave, like passing the business to family or selling stakes, to avoid conflicts.

Exit Strategies for Startups

If you're running a startup, plan a comprehensive exit strategy for when operations don't meet milestones. If cash flow dries up and no more capital is available, a planned shutdown and asset liquidation might be your best bet to limit further losses.

Venture capitalists demand this in your business plan before investing. You might also exit if another party makes a lucrative offer.

Develop your exit strategy in your initial business plan. It influences your development choices. Common options include IPOs, strategic acquisitions, and management buyouts (MBOs).

Your choice depends on factors like how much control you want to keep, whether the company should continue as is, and getting a fair price. A strategic acquisition means giving up control, while an IPO brings prestige and high rewards. Bankruptcy is the least desirable.

Valuation is key, so consult specialists to review financials for a fair value. Transition managers can help with the process.

Exit Strategies for Established Businesses

For an established business, you as a CEO should develop a comprehensive exit strategy as part of contingency planning.

Larger businesses often go for mergers or acquisitions, which can be lucrative for owners and shareholders. Rivals might pay a premium to gain market share, IP, or eliminate competition, potentially sparking bidding wars.

Factor in the time, costs, and regulations like antitrust laws for these deals.

If the business is failing, plan for liquidation or bankruptcy. Liquidation means closing and selling assets, with proceeds paying debts and going to shareholders.

Bankruptcy is a last resort, providing debt relief but possibly barring you from future credit or starting new ventures.

Exit Strategies for Investors

As an investor, you have several strategies to manage investments prudently.

You could sell your equity stake in a startup or small company to other investors or family, especially as part of a succession plan. Ensure they understand any conditions.

Apply the 1% rule: exit if the loss hits 1% of your liquid net worth to protect capital systematically.

Use a percentage exit: sell when the investment gains or loses a set percentage from purchase price, like 300% ROI or 20% drop.

Opt for a time-based exit: sell after a specific period if no positive return, freeing capital for better uses.

The Bottom Line

An exit strategy is how you as a business owner or investor liquidate an asset once conditions are met. It minimizes losses and maximizes profits by controlling emotions and setting goals.

Startups commonly use IPOs, acquisitions, and MBOs. Established companies prefer mergers or acquisitions, or liquidation and bankruptcy if insolvent. Investors rely on rules like 1%, percentage, time-based, or equity sales.