What Is an Exit Strategy?
An exit strategy is a contingency plan executed by an investor, venture capitalist, or business owner to liquidate a position in a financial asset or dispose of tangible business assets once predetermined criteria have been met or exceeded.
An exit strategy may be executed to exit a nonperforming investment or close an unprofitable business. In this case, the purpose of the exit strategy is to limit losses.
An exit strategy may also be executed when an investment or business venture has met its profit objective. For instance, an angel investor in a startup company may plan an exit strategy through an initial public offering (IPO).
Other reasons for executing an exit strategy may include a significant change in market conditions due to a catastrophic event; legal reasons, such as estate planning, liability lawsuits, or a divorce; or even because the business owner/investor is retiring and wants to cash out.
Key Takeaways
- An exit strategy is a conscious plan to dispose of an investment in a business venture or financial asset.
- An exit strategy helps to minimize losses and maximize profits on investments.
- Startup exit strategies include initial public offerings (IPOs), acquisitions, or buyouts but may also include liquidation or bankruptcy to exit a failing company.
- Established business exit plans include mergers and acquisitions as well as liquidation and bankruptcy for insolvent companies.
- Exit strategies for investors include the 1% rule, a percentage-based exit, a time-based exit, or selling a stake in a business.
Understanding Exit Strategies
An effective exit strategy should be planned for every positive and negative contingency regardless of the investment type or business venture. This planning should be integral to determining the risk associated with the investment or business venture.
An exit strategy is a business owner’s strategic plan to sell ownership in a company to investors or another company. It outlines a process to reduce or liquidate ownership in a business and, if the business is successful, make a substantial profit.
If the business is not successful, an exit strategy (or exit plan) enables the owner to limit losses. An exit strategy may also be used by an investor, such as a venture capitalist, to prepare for a cash-out of an investment.
For investors, exit strategies and other money management techniques can greatly help remove emotion and reduce risk. Before entering an investment, investors should set a point at which they will sell for a loss and a point at which they will sell for a gain.
Who Needs an Exit Plan?
Business owners of both small and large companies need to create and maintain plans to control what happens to their business when they want to exit. An entrepreneur of a startup may exit their business through an IPO, a strategic acquisition, or a management buyout, while the CEO of a larger company may turn to mergers and acquisitions as an exit strategy.
Investors, such as venture capitalists or angel investors, need an exit plan to reduce or eliminate exposure to underperforming investments so they can capitalize on other opportunities. A well-thought-out exit strategy also provides guidance on when to book profits on unrealized gains.
Why Is It Important to Have an Exit Plan?
Businesses and investors should have a clearly defined exit plan to minimize potential losses and maximize profits on their investments. Here are several specific reasons why it’s important to have an exit plan.
Removes emotions: An exit plan removes emotions from the decision-making process. Having a predetermined level at which to exit an investment or sell a business helps avoid panic selling or making rushed decisions when emotions are high, which could accentuate a loss or not fully realize a profit.
Goal setting: Having an exit plan with specific goals helps answer important questions and guides future strategic decision making. For example, a startup’s exit plan might include a future buyout price that it would accept based on revenue turnover. That figure would help make strategic decisions about how big to grow the company to reach predetermined sales targets.
Unexpected events: Unexpected events are a part of life. Therefore, it’s essential to have an exit strategy for what happens when things don’t go to plan. For instance, what happens to a business if the owner faces an unexpected illness? What happens if the company loses a key supplier or customer? These situations need planning in advance to minimize potential losses and capitalize on gains.
Succession planning: An exit plan specifies what happens to the business when key personnel leave. For example, an exit strategy might stipulate through a succession plan that the company passes to another family member or that the business sells a stake to other owners or founders. Carefully detailed succession planning of an exit strategy can help avoid potential conflict when a business owner wants to or has to depart.
Exit Strategies for Startups
In the case of a startup business, successful entrepreneurs plan for a comprehensive exit strategy to prepare for business operations not meeting predetermined milestones.
If cash flow draws down to a point where business operations are no longer sustainable, and an external capital infusion is no longer feasible to maintain operations, then a planned termination of operations and a liquidation of all assets are sometimes the best options to limit further losses.
Most venture capitalists insist that a carefully planned exit strategy be included in a business plan before committing any capital. Business owners or investors may also choose to exit if a lucrative offer for the business is tendered by another party.
Ideally, an entrepreneur will develop an exit strategy in their initial business plan before launching the business. The choice of exit plan will influence business development decisions. Common types of exit strategies include IPOs, strategic acquisitions, and management buyouts (MBOs).
The exit strategy that an entrepreneur chooses depends on many factors, such as how much control or involvement they want to retain in the business, whether they want the company to continue being operated in the same way, or if they are willing to see it change going forward. The entrepreneur will want to be paid a fair price for their ownership share.
A strategic acquisition, for example, will relieve the founder of their ownership responsibilities but will also mean giving up control. IPOs are often considered the ultimate exit strategy since they are associated with prestige and high payoffs. Contrastingly, bankruptcy is seen as the least desirable way to exit a startup.
A key aspect of an exit strategy is business valuation, and there are specialists who can help business owners (and buyers) examine a company’s financial statements to determine a fair value. There are also transition managers whose role is to assist sellers with their business exit strategies.
Exit Strategies for Established Businesses
In the case of an established business, successful CEOs develop a comprehensive exit strategy as part of their contingency planning for the company.
Larger businesses often favor a merger or acquisition as an exit strategy, as it can be a lucrative way to remunerate owners and/or shareholders. Rival companies often pay a premium to buy out a company that allows them to increase market share, acquire intellectual property, or eliminate competition. This raises the prospects of other rivals also placing a bid for the company, ultimately rewarding the sellers of the business.
However, a merger-and-acquisition-focused exit strategy should factor in the time and costs to organize large deals as well as regulatory considerations, such as antitrust laws.
Established companies also plan for how to exit a failing business, which usually involves liquidation or bankruptcy. Liquidation consists of closing down the business and selling off all its assets, with any leftover cash going toward paying off debts and distributing among shareholders.
As mentioned above, most businesses see bankruptcy as a last-resort exit; however, it sometimes becomes the only viable option. Under this scenario, a company’s assets are seized, and it receives relief from its debts. However, declaring bankruptcy could prevent business owners from borrowing credit or starting another company in the future.
Exit Strategies for Investors
Investors can use several different exit strategies to prudently manage their investments. Below, we look at several strategies that help minimize losses and maximize gains.
Selling equity stake: Investors with shares in a startup or small company could exit by selling their equity stake in the business to other investors or a family member. Selling an equity stake may form part of a succession plan agreed upon by founders when starting a business. If selling a startup stake to a family member, it’s important that they understand any conditions tied to the investment.
The 1% rule: Investors apply this rule by exiting an investment if the maximum loss equals 1% of their liquid net worth. For example, if Olivia has a liquid net worth of $2 million, she would cut an investment if it generates a loss of $20,000 ((1 ÷ 100) × 2,000,000). The 1% rule helps investors take a systematic approach to protect their capital.
Percentage exit: Using this strategy, investors exit an investment when it has gained or fallen by a certain percentage from its purchase price. For instance, Ethan, an angel investor, may decide to sell his share in a startup if it achieves a 300% return on investment (ROI). Conversely, Amelia, a venture capitalist, may decide to sell her share in a startup if it drops 20% in value.
Time-based exit: Investors apply this strategy by exiting their investment after a specific amount of time has passed. For example, Noah may decide to sell his stake in a business after 18 months if it has not generated a positive return. A time-based exit helps free up capital from underperforming investments that could be used for other opportunities.
Why is it important to have an exit plan?
Businesses should have a clearly defined exit plan to help manage risk and capitalize on opportunities. Specifically, an exit plan helps remove emotion from decision making, assists with strategic direction, helps to plan for unexpected events, and provides details about an actionable succession plan.
What are common exit strategies used by startups?
Exit strategies used by early-stage companies include initial public offerings (IPOs), strategic acquisitions, and management buyouts (MBOs). Entrepreneurs typically select an exit plan before launching a business that fits their longer-term business development decisions and goals. The exit strategy that an entrepreneur chooses depends on factors such as how much involvement they want to retain in the business and its future long-term potential.
What are common exit strategies used by established companies?
More established companies favor mergers and acquisitions as an exit strategy because it often leads to a favorable deal for shareholders, particularly if a rival company wants to increase its market share or acquire intellectual property. Larger companies may exit a loss-making business by liquidating their assets or declaring bankruptcy.
What exit strategies can investors use?
Investors can capitalize on gains and reduce risk by using exit strategies such as the 1% rule, a percentage-based exit, a time-based exit, or selling their equity stake in a business to other investors or family members. Investors typically set an exit strategy before entering into an investment, as it helps to manage emotions and determine if there is a favorable risk-return tradeoff.
The Bottom Line
Exit strategy refers to how a business owner or investor will liquidate an asset once predetermined conditions have been met. An exit plan helps to minimize potential losses and maximize profits by keeping emotions in check and setting quantifiable goals.
Common exit strategies for startups include IPOs, strategic acquisitions, and MBOs. More established companies often favor a merger or acquisition as an exit strategy but may also choose to go into liquidation or file for bankruptcy if becoming insolvent. Meanwhile, investors can exit investments using strategies such as the 1% rule, a percentage-based exit, a time-based exit, or selling their equity stake in a business.
