China has over 125 million Internet users. The country’s GDP will exceed that of Germany by the end of 2006, according to industry estimates. U.S. private equity investments in 2006 are expected to surpass $6 billion, which may push China past Japan in terms of invested private equity capital.

Raj Kapoor, Managing Director of the Mayfield Fund, shares his views on the current climate for Internet start-ups.

That novelty and market size makes China one of the most interesting and exciting places to invest in the world. Still, the country has its own unique set of investment challenges, which sent Mayfield on a mission two years ago to find the perfect partner to help build its China portfolio. The firm found that in GSR Ventures. Staffed by veteran Beijing-based entrepreneurs who understand American and Chinese business rules, GSR helps Mayfield navigate China’s intricate regulatory waters and provides access to a new generation of Chinese entrepreneurs. On the ground in Beijing, GSR has co-invested in China with Mayfield since summer 2005.

Since making its debut investment in digital TV electronics maker SMIT, Mayfield has invested in startups that offer everything from online dating to cell phone chips to mobile phone messaging. While the venture landscape in China differs vastly from that of the U.S., Mayfield and GSR – run by Richard Lim, James Ding, Sonny Wu and Alex Pan -- share a common view of the market that guides all new investments.

1) Find big opportunities powered by the right connections. The first wave of Internet investment in China is over, creating giants like search giant Baidu, portal leader Sina and IM powerhouse Tencent QQ. Finding a Web 2.0 giant will take patience and, often, the right connections. GSR found an untapped opportunity in online sports lotteries. Sports lotteries were an underground market in China until the government, seeking revenue and control over the industry, decided to make it a legitimate business. The government granted one on-line and mobile sports lottery license: to startup SportsGG. Mayfield and GSR led a $30 million round in the business, which launched just before the 2006 World Cup. Another startup, SMIT, Mayfield’s first China investment, also holds one of few licenses to provide digital security chips for encryption in televisions.

2) Hire a stellar CEO and management team. “One of the biggest challenges for a company in China is the management team,” Kapoor says. “In the U.S. we almost take great management for granted because there’s so much experience here.” In China, he says, the Internet and even capitalism is relatively young so finding talented executives is more difficult.

For cultural reasons, replacing the CEO of a Chinese startup is often next to impossible, making that individual a critical hire and long-term partner. Investing in startups run by American-educated native Chinese, or “sea turtles,” helps the Mayfield/GSR team mitigate risk. These executives understand how business works in China, but also studied at top U.S. business schools and gained experience in U.S.-based or multi-national companies. Baihe’s co-founder Jason Tian, for one, worked for consulting giant Accenture, while PingCo co-founder Charles Wang was an executive at Yahoo! China before moving on to a startup. It helps when CEOs speak fluent English, too, Kapoor says, making it easier for U.S. investors to add value as board members and advisors.

3) Model businesses to reflect cultural differences. Baidu, for example, travels door to door to sell ads to local businesses not only because it’s cost effective, but because the personal relationship is valued in China. The country’s largest travel website, Ctrip, delivers tickets via bicycle courier to sidestep a dodgy postal service and because the labor pool is plentiful and affordable.

With millions of Chinese relocating from rural to urban environments, Baihe.com understood that the Internet would supply one of few ways for the masses to find marriage partners. The company avoided a casual dating website, instead launching a relationship-focused service that took off. “They not only had an innovative model but they launched it and saw significant uptake due to their focus on the needs of serious daters,” Kapoor says.

4) Understand and mitigate risk. General regulatory problems make the Chinese market unpredictable for investors, Kapoor says. For example, state-owned China Mobile, the world’s largest carrier, can decide to change revenue splits overnight, as it recently did, or bar a company from the industry for alleged infractions, creating havoc. “Rules can change overnight and you have to anticipate that risk going into the investment,” Kapoor says. “This doesn’t mean you don’t do the deal. You need a Plan B.” That plan requires working with people who have relationships with the right government and local officials to navigate the waters, he says.

As the Chinese market matures, Kapoor says, it’s taking larger investments than previously believed to fund growth -- although rounds remain smaller for mobile and Internet companies. SMS service provider PingCo, for one, received $1 million in a first round last December and will likely get more next year. “On average, including hardware sector investments, we think it will take $6-8 million to early-stage fund a company in China, whereas in the U.S. our target is $8-$10 million,” Kapoor says.

The good news, he notes, is that early-stage investment is less competitive in China, where most VCs are investing at the later stage. And early-stage opportunity in China still abounds. Digital TV, IPTV and the increasing use of broadband PC connections open up new forms of media and entertainment services. China also lacks a dominant social network like MySpace or an etailing industry that matches the maturity of the market in the US and Europe.

So what’s next for Mayfield in China? Entertainment and advertising services, along with selective e-commerce opportunities, are definitely areas for future exploration and investment. With a growing new market of consumers eager to explore online, the future, no doubt, will be exciting.