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Paul Graham has an interesting post that discusses his idea on how you can determine how much equity should be given to an investor or employee. This is often a tough thing to determine for entrepreneurs, but Paul tries to simplify it. His Equity Equation can be easily explained:

If an investor wants to buy half your company, how much does that investment have to improve your average outcome for you to break even? Obviously it has to double: if you trade half your company for something that more than doubles the company’s average outcome, you’re net ahead. You have half as big a share of something worth more than twice as much.

The equation is: 1/(1 - n)

In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 - n).

Venture Hacks followed this up with his thoughts on the post.

He makes a few good points, but these two are great to keep in mind and explain why you can’t just use the Equity Equation to determine how much equity you should give an investor or employee.

You have to pay market rates regardless of the equity equation.

This is true. If it is absolutely necessary to get something such as an employee or money, you will have to pay market value for them, even if it is not in line with what you can justify with the equity equation. If you can’t justify it, you shouldn’t do it, but sometimes you don’t have a choice. The other option is that you may be able to get money or employees for something well below the cost of what you could justify with the equation.

Consider the opportunity cost of spending shares on employees and investors.

Just because you can get an investment at terms that will make it beneficial for you, doesn’t mean it is the best use of those limited resources. For example, you give up 30% of the company for something that will double your company. What if you could double your business by only giving up 20%? Just because an option is good for you, it doesn’t mean it is the best.