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 predetermined criteria for either has been met or exceeded.
An exit strategy may be executed to exit a non-performing 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 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 IPOs, acquisitions, or buy-outs but may also include strategic default or bankruptcy 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. 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 their ownership in a company to investors or another company. An exit strategy gives a business owner a way to reduce or liquidate their 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 to prepare for a cash-out of an investment.
For traders and investors, exit strategies and other money management techniques can greatly enhance their trading by eliminating emotion and reducing risk. Before entering a trade, an investor is advised to set a point at which they will sell for a loss and a point at which they 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 an exit strategy and are often more likely to take premature profits or, worse, run losses. Traders should understand the exits that are available to them and create an exit strategy that will minimize losses and lock in profits.
Exit Strategies for a Business Venture
In the case of a startup business, successful entrepreneurs plan for a comprehensive exit strategy in case business operations do not 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, a planned termination of operations and a liquidation of all assets are sometimes the best options to limit any 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 initial public offerings (IPO), strategic acquisitions, and management buy-outs (MBO).
The exit strategy that an entrepreneur chooses depends on many factors such as how much control or involvement the entrepreneur wants to retain in the business, whether they want the company to continue to be 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 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 Strategies for a Trade
When trading securities, whether 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 circumstances should a winning trade be allowed to become a losing trade. For losing trades, an investor should predetermine an acceptable loss amount and adhere to a protective stop-loss.
In the context of trading, exit strategies are extremely important because they assist traders in overcoming emotion when trading. When a trade reaches its target price, many traders become greedy and hesitate to exit for the sake of gaining more profit, which ultimately turns winning trades into losing trades. 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 to exit a trade: by taking a loss or by making a gain. Traders use the terms take-profit and stop-loss orders to refer to the type of exit being made. Sometimes these terms are abbreviated as "T/P" and "S/L" by traders.
Stop-losses, or stops, are orders placed with a 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 help minimize losses if the market moves quickly against an investor.
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.