In a recent essay on startup funding, Paul Graham (of Y Combinator) provides some handy math to help entrepreneurs think through the value of an equity investment. The simple formula calculates whether the increased likelihood of success is greater than the dilution you’re suffering. For example, if you’re giving up 30% of your company you need the value of the company to increase 43% because then your remaining portion is worth more than the whole you started with. Of course the evaluation is totally subjective of whether a particular investment (or investor) is likely to increase your value, but at least it creates a framework for evaluation.

In the essay though Paul makes an interesting comment — it addresses Sequoia Capital.

“Greg Mcadoo from Sequoia recently said at a YC dinner that when Sequoia invests alone they like to take about 30% of a company. 1/.7 = 1.43, meaning that deal is worth taking if they can improve your outcome by more than 43%. For the average startup, that would be an extraordinary bargain. It would improve the average startup’s prospects by more than 43% just to be able to say they were funded by Sequoia, even if they never actually got the money.”

The assumption that taking money from Sequoia increases a company’s prospects almost 50% is an unsupported one. Are we to believe that Sequoia is really smart money? That their connections, advice and follow-on capital is by default that valuable? “Of course,” you might note, “look at their track record.” But that’s the wrong way of looking at it – rather we need to decide whether Sequoia is really good at picking winners or creating winners?

If it’s the latter, then yeah, Graham’s statement makes sense. But if it’s the former, that’s clearly a talent which makes Sequoia very wealthy but has little to do with their ability to impact a company’s success. Instead they’re just good at deal flow and winning the deal.

Later Paul comments on the chances of getting funded by Sequoia:

“The catch is that Sequoia gets about 6000 business plans a year and funds about 20 of them, so the odds of getting this great deal are 1 in 300. The companies that make it through are not average startups.”

Exactly – the companies which make it through are exemplary start-ups who likely have multiple funding choices. Which means very competitive deals which should lead to the entrepreneur actually having some leverage on terms.

Graham notes this but actually attributes these valuations to Sequoia’s beneficence and wisdom.

“The reason Sequoia is such a good deal is that the percentage of the company they take is artificially low. They don’t even try to get market price for their investment; they limit their holdings to leave the founders enough stock to feel the company is still theirs.”

So essentially Graham is saying: “Sequoia increases a company’s probability of success by taking below-market valuations, which lets the entrepreneur still feel incented, which, along with being able to say you’re funded by Sequoia, increases your odds by far more than 43%.”

I would posit that an equally supportable thesis is that Sequoia has access to great deal flow, does a superior job of vetting their pipeline and ends up with strong funding opportunities where the founders have enough leverage to derive healthy valuations and reasonable terms from their investors.