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What Is an Exit Strategy?

An exit strategy is vital to the effective management of profits or losses for investors and businesses. Startups commonly use exit strategies like initial public offering (IPOs), strategic acquisitions, and management buyouts. Established businesses often choose mergers and acquisitions or, if needed, liquidation or bankruptcy.

Investors use strategies like the 1% rule, percentage-based exits, and time-based exits to manage risk and maximize returns, keeping decisions objective and free from emotional bias. Implementing a well-defined exit plan helps in succession planning, goal setting, estate planning, and preparation for unexpected events. Exit strategies created before they’re needed are an important aspect of safeguarding business and personal interests, and assets.

The Mechanics of 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 outlines how a business owner will sell their company ownership 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.

The Importance of Exit Strategies in Business and Investing

Business owners, whether of small or large companies, need plans to manage their business 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 like venture capitalists or angel investors need an exit plan to reduce risk from poor investments and explore other opportunities. A well-thought-out exit strategy also provides guidance on when to book profits on unrealized gains.

Crucial Benefits of Exit Strategies

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. Setting a clear exit point helps avoid panic selling and rushed decisions, preventing losses or missed profits.

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.

Top Exit Strategies for Startup Success

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.

Venture capitalists usually require a solid exit strategy in the business plan before investing. 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 an 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 frees the founder from ownership duties but also means losing 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.

Successful Exit Options for Mature Businesses

In the case of an established business, successful CEOs develop a comprehensive exit strategy as part of their contingency planning for the company.

Large businesses often prefer mergers or acquisitions as exit strategies since they can be lucrative for owners and 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 or acquisition strategy must consider the time, costs, and regulatory issues like antitrust laws.

Established companies plan exits from failing businesses, typically through liquidation or bankruptcy. Liquidation involves shutting down the business, selling assets, and using leftover cash to pay debts and distribute to shareholders.

Bankruptcy is often a last-resort exit, but it can sometimes be the only 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.

Strategic Exit Approaches for Savvy 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 when a 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.

The Bottom Line

An exit strategy is a plan to liquidate or dispose of an investment or asset when specific conditions are met. The dual purpose of exit strategies is to minimize losses and maximize profits by removing emotional decision-making and establishing clear financial goals. To manage risk and ensure favorable outcomes, investors employ exit plans such as the 1% rule, percentage- or time-based exits, or by selling equity stakes.

From a business standpoint, it’s important to have an exit strategy in place for various scenarios, ranging from startups to established businesses. For startups, common exit strategies include IPOs, strategic acquisitions, and management buyouts. For established businesses, there is a preference for mergers and acquisitions, but when faced with insolvency, liquidation or bankruptcy are unfortunate final options.