What Is an Exit Strategy?
An exit strategy is a contingency plan that is executed by an investor, trader, venture capitalist or business owner to liquidate a position in a financial asset or dispose of tangible business assets once certain predetermined criteria for either has been met or exceeded.
An exit strategy may be executed for the purpose of exiting a non-performing investment or closing a business that is not generating profits. 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 for the simple reason that a business owner/investor is retiring and wants to cash out.
- An exit strategy, broadly, is a conscious plan to dispose of an investment in a business venture or financial asset.
- Business exit strategies include IPO, acquisition, or buy-out, but may also include strategic default or bankruptcy in order to exit a failing company.
- Trading exit strategies focus on stop-loss efforts to prevent downside losses and take-profit orders to cash out of winning trades.
Understanding Exit Strategies
An effective exit strategy should be planned for every positive and negative contingency regardless of the type of investment, trade or business venture that is entered into. This planning should be an integral part of determining the risk associated with the investment, trade or business venture.
A business exit strategy is an entrepreneur's strategic plan to sell his or her ownership in a company to investors or another company. An exit strategy gives a business owner a way to reduce or liquidate his stake 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 entrepreneur to limit losses. An exit strategy may also be used by an investor such as a venture capitalist in order to plan for a cash-out of an investment.
For traders and investors, exit strategies and other money management techniques can greatly enhance your trading by eliminating emotion and reducing risk. Before you enter a trade, consider the three questions listed above, and set a point at which you will sell for a loss and a point at which you will sell for a gain.
Money management is one of the most important (and least understood) aspects of trading. Many traders, for instance, enter a trade without any kind of exit strategy and are often more likely to take premature profits or, worse, run losses. Traders should understand what exits are available to them and attempt to create an exit strategy that will help minimize losses and lock in profits.
Exit Strategy for a Business Venture
In the case of a startup business, good business people always plan for a comprehensive exit strategy in case business operations don’t meet 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 any further losses.
Most venture capitalists usually insist that a carefully planned exit strategy is included in a business plan before committing any capital. Business people may also choose to exit if a very lucrative offer is tendered by another party for the business.
Ideally, an entrepreneur will develop an exit strategy in her initial business plan before actually going into business. The choice of exit plan can influence business development decisions. Common types of exit strategies include initial public offerings (IPO), strategic acquisitions, and management buyouts (MBO).
The exit strategy that an entrepreneur chooses depends on many factors, such as how much control or involvement (if any) he wants to retain in the business and whether he wants the company to continue to run in the same way or is willing to see it change going forward as long as he is paid a fair price for his ownership share.
A strategic acquisition, for example, will relieve the founder of his or her ownership responsibilities, but will also mean giving up control. IPOs are often seen at the holy grail of exit strategies since they often bring with it the greatest prestige and highest payoff. On the other hand, a bankruptcy is seen as the least desirable way to exit a business.
A key aspect of an exit strategy is business valuation, and there are specialists that can help business owners (and buyers) examine a company's financials to determine a fair value. There are also transition managers whose role is to assist sellers with their business exit strategies.
Exit Strategy for a Trade
When trading securities, whether it’s for long-term investments or intraday trades, it is imperative that exit strategies for both the profit and loss sides of a trade be planned and diligently executed. All exit trades should be placed immediately after a position is taken. For a trade that meets its profit target, it could immediately be liquidated or a trailing stop could be employed in an attempt to extract more profit.
Under no circumstance should a winning trade be allowed to become a losing trade. For losing trades, an acceptable loss amount should be predetermined and a protective stop loss should be placed and strictly adhered to.
In the context of trading, exit strategies are extremely important in that they assist traders with overcoming emotion when trading. When a trade reaches its price target, many traders experience greed and hesitate to exit for the sake of gaining more profit. Ultimately, this leads to winning trades turning into losers. When losing trades reach their stop loss, fear creeps in and traders hesitate to exit losing trades, causing even greater losses.
There are two ways you can get out of a trade: by taking a loss or by making a gain. When talking about exit strategies, traders use the terms take-profit and stop-loss orders to refer to the kind of exit being made. Sometimes these terms are abbreviated as "T/P" and "S/L" by traders.
Stop-losses, or stops, are orders you can place with your broker to sell equities automatically at a certain point, or price. When this point is reached, the stop-loss will immediately be converted into a market order to sell. These can be helpful in minimizing losses if the market moves quickly against you.
Take-profit orders are similar to stop-losses in that they are converted into market orders to sell when the limit point is reached to the upside. Take-profit points adhere to the same rules as stop-loss points in terms of execution on the NYSE, Nasdaq and AMEX exchanges.