kaifulee1Kai-Fu Lee, who led Google’s China operations until last week, is launching a new early-stage investment fund and startup incubator based in Beijing called Innovation Works.

Lee says Innovation Works’ approach will be highly tailored for the Chinese market. It will have more hands-on mentoring, build projects in-house and then spin them out for larger rounds of funding later. The idea is to find young, hungry engineers in Beijing’s top universities, hire them, give them the room to experiment with ideas and then help them grow their projects later.

He says the Chinese market needs a more intensive approach in funding entrepreneurs because the education system is poor and company founders lack experience. There also isn’t as strong a financial ecosystem for supporting very young technology ideas.

He’s financing Innovation Works with $115 million from investors including Steve Chen, who co-founded YouTube, Foxconn Technology Group, Legend Group and New Oriental Education & Technology Group. WI Harper Group is the lead venture capital investor.

Lee built up Google’s China team, bringing the company’s market share in search to about 20 percent against Chinese competitor Baidu’s 76 percent, according to iResearch. He came to Google in 2005 after a highly publicized legal battle between the company and Microsoft, which sued Google and alleged that Lee had violated his employment contract when he switched jobs.

Here’s what he told VentureBeat in an interview:

VentureBeat: Why are you leaving Google?

Lee: I joined Google four years ago when it was a really exciting time to go to China. I got to learn about how this great company innovated and I started a business in China from almost nothing. I’ve accomplished all that, so now it’s time to do something new.

This is the perfect timing to start Innovation Works. First, it is a business opportunity. At this time, E-commerce, cloud computing and mobile computing are all at an inflection point of taking off in China. It’s really now or never to catch these three trains, which are moving very rapidly.

Another reason is that in the venture community, there is a huge amount of funding sitting on the sidelines for mid- to late-stage companies. But there’s almost no angel funding for Chinese startups unlike in the U.S. We want to fill that gap.

The third reason is due to the economic crisis. There is a huge amount of talent willing to look for alternatives now. I bring a strong personal brand. Now is the time to capture that talent and to fill a void.

VB: How will Innovation Works be structured? How will it work?

Lee: It’s really a combination of angel and seed funding, combined with a business-building platform. We’ll have two entities — one is the Innovation Works company, where we’ll hire 100 to 150 people and they’ll try a lot of ideas. The ones that work well will become entities within the company and they’ll be spun out later as independent companies.

Then there’s a fund and that’s on the side. It will basically provide the funding for the projects once they reach the seed stage. Each project will have a demo-building stage, which is done all inside Innovation Works. They’ll be able to flexibly try out a lot of things. Once they’re approved to be a real project, they will take seed money and execute.

The third stage will be Series A funding, where they will have to get external validation. However, we’ll continue to invest in these companies through the Series A and Series B rounds.

We’ll look at E-commerce, mobile computing and cloud computing projects. We will look at other projects in a larger range of areas as well.

VB: What about Google? What’s the best they can do to compete against Baidu?

Lee: I don’t want to say much about Google. We have successfully built a strong organization that has grown its market share and has four or five products now. I think the trajectory is positive.

VB: Ok, how will you help these young entrepreneurs steer their way through the Chinese market and cope with corruption and piracy issues?

Lee: That’s a very interesting question. Actually, those are the sorts of issues you’ll face if you’re a Chinese American moving back to China to start a new company. But I think most of the entrepreneurs we’ll work with will be home-grown. They’ll have never been outside the country. They’ll have a set of basic instincts in their arsenal on how to deal with these issues.

Instead, I think they will be stuck on a different set of problems. They have less training and they’re uni-dimensional. The Chinese education system is either very technical or non-technical. You have to choose distinct paths. You don’t have well-rounded entrepreneurs. They may have never touched or thought of business angles. They will need my coaching and they’ll need to have broader horizons.

The second thing is that they just have less experience. They are less able to evaluate business opportunities, to present ideas and get funding. They are also less able to recognize their own weaknesses and they might have unreasonable aspirations. All these factors hurt their ability to find funding. We’ll assist them to recover that.

As I mentioned before, there are problems with angel funding in China. We will provide that and help them find funding.

Another serious problem with early entrepreneurs is that there are sometimes problems with governance, with professional issues, and, like you mentioned earlier, corruption. Those things are of concern. We will address that not by fixing individuals, but picking ones with the right values from the start. We want to have a great base of high potential, trustworthy entrepreneurs and then help them build up the skills they don’t have.

Another really important function we’ll provide for the individual is team-building. We want to build up a complementary team with the skillsets needed for success. Very often, if you look at early-stage founders — whether it’s Jerry Yang or David Filo or Paul Allen, or Larry and Sergei — you find partners that are very much alike.

That can often work against them. Fortunately, these people found complementary partners. Imagine if Larry and Sergei never found Eric. Or if Bill Gates never found Steve Ballmer. A young entrepreneur may not recognize what they lack and what they need in a great partner. So what I’m going to do is try to play matchmaker and put together people from different talent bases.

One more issue is that some Chinese entrepreneurs expect that they’ll be CEO forever. This is common here, since many businesses are family run. They need to understand from day one that he or she will not have the guarantee of being CEO. We’ll set up structures and management teams around this idea.

VB: How will you choose ideas and entrepreneurs?

Lee: First, there has to be a selection process. Some people will be permanently affected by poor education. Others will have strong potential, and will overcome the education system on their own. I’ve seen this at both Microsoft and Google. I’ve built what’s considered to be Asia’s best research lab out of people who came out of the Chinese educational system.

You have to pick the right ones early who have the most potential and create a culture around that. I’ve done the same thing at Google China with a couple hundred engineers who are able to hold their own and innovate with product after product. We can create a nurturing environment. Innovation Works will find the people with the potential and empower them over time.

VB: Where will you be based? Will you look all over the country or mainly in Beijing and Shanghai? What cities in China do you think have the most potential to become a hub for entrepreneurship and technology like Silicon Valley?

Lee: We will be in Beijing. We already have a place and we’ll be hiring starting Monday. We will initially focus on Beijing. Beijing and Shanghai are the two obvious choices, which have already become like Silicon Valley. There are other areas which could become like the valley including Shenzhen, Guangzhou, Chengdu and Hangzhou.

The unique thing about China is that every city wants to be a Silicon Valley. They’ve set up the infrastructure. It’s very tempting to go to five cities, because I have the reputation and there are dramatic subsidies in all of these places. But to do so, first I need to build up the model.

VB: Who else is investing in Innovation Works?

Lee: At this point, the investors are basically the ones I listed plus a few other individual and company investors. We have the head of Foxconn, Steve Chen of YouTube, Yu Minhong, the WI Harper Group (they’re the lead investors).

VB: How does the structure of Innovation Works compare to that of a typical Silicon Valley venture capital firm?

Lee: The structure will be very different. There are parts that are the same — we have associates. We will also have analysts who will look at the industry, understand how it’s changing, compare it to Japanese and U.S. markets. They’ll seek out opportunities within different parts of China and look for ones in Taiwan as well.

The venture partner job category is also somewhat similar. But we don’t think we’re going to be attracting the seasoned, top executive, C-suite type of person. We’re really starting from an earlier stage. We would rather find young, excited people who will give their life and work like crazy to start a company. They’ll need more guidance, but that’s the typical profile of most founders of successful Chinese companies.

The partners will have experience and capabilities in company-building, and so it’s kind of like a VC without the financial aspect.

VB: Why is that?

Lee: I think angel and early-stage investing and company-building requires a different skill set. Our partner, WI Harper, will provide more of the financial advice.

VB: Will you develop relationships with universities and scout on campus the way U.S. VC firms have a symbiotic relationship with schools like Stanford and MIT?

Lee: We’ll actually be located inside Tsinghua University. The president is a personal friend of mine. We’ll first occupy the Tsinghua Science Park. If you look at top Chinese startups, a very large number of them are founded by Tsinghua or Beijing University graduates.

VB: So tell me about your areas of focus — how do you think mobile computing will evolve differently in China than it has in the U.S.?

Lee: Mobile computing will be about entertainment first and then serious applications later. It’s the reverse of the U.S. The Internet in the U.S. started in universities and it started with very simple applications that gradually became more sophisticated as bandwidth capabilities evolved.

In China, infrastructure is quite plentiful because when you have a strong central government, it can build out infrastructure. Bandwidth is not a problem. Users in China are also a lot younger. At the time the Internet was born, we were coming out of the Cultural Revolution. Many people didn’t have college educations. They had never touched serious electronics. Even today, 15 years after the Internet gained a widespread consumer audience, the average age of an Internet user here is 29 compared to 42 in the U.S.

The Chinese user base is very entertainment-focused. They’re interested in games. But now there’s critical mass — with about 200 million users — to start moving from fun into serious applications. On the mobile side, it’s just starting.

What’s very interesting is that there are two types of mobile users in China. On the one hand, we have young, urban professionals, who are about PC’s first and they are expert users. They’re thinking about how to type quickly and do the same types of tasks as on the PC. They want what knowledge workers in the U.S. would want.

But there’s an equal or even larger group of young people who are not knowledge workers. They’re teenagers or young adults who will want entertainment. A lot of the hot ideas in China for the mobile space are largely about building out the right games. Social networking will also be very, very important. That needs to develop first.

But gradually, there will be opportunities in serious applications. There are huge needs in the business space for maintaining contact lists from device to device. It’s 10 times worse here when someone loses their phone. The contact list is gone forever.

VB: And how will cloud computing evolve differently?

Lee: China today has no software industry. It’s been destroyed by piracy. The games industry in China grew as games went from standalone PC applications to networked gaming. I’m not going to build out games, but I want to point out that with a market that full of piracy, it’s been very difficult to build up a software business.

However, now cloud computing had made it possible for things to change. The Internet has created payment structures that work and there will be similar opportunities, whether it’s in Salesforce.com or in accounting-type models, to build subscription-based businesses. The Internet can be used as a mechanism to ensure limited piracy.

Another thing that will be huge will be how cloud computing can be used to rapidly develop new Web sites and E-commerce possibilities. Think of projects similar to Google’s App Engine. When those come to China, they will dramatically increase productivity and reduce time to market.

VB: And E-commerce?

Lee: E-commerce has been the one area the China has been lagging in. That’s partly caused by age and the entertainment-centricity of the market. But it’s also because of the lack of credit cards. Younger users don’t really have the disposable income, but all of that is changing and they’re getting wealthier. Payment mechanisms are being developed. This will really take off.

When I talk about E-commerce, I don’t just mean eBay or Amazon-types of commerce. A vibrant E-commerce structure will lift all boats, whether you develop a social networking site that can promote products or a real estate site that can make money through referrals or advertising, or a way to promote new electronic products and charge for downloads. Google will also benefit from E-commerce, allowing advertisers to track click-throughs or advertising inventory. We will be learning what has worked in Japan and the U.S. and we will pick whichever is more applicable to China.

The credit card will take off, but we’re not at that inflection point yet. There’s one credit card per 200 people, so the main payment method is cash-on-delivery. For example, a person on a bicycle will bring you books, then you examine them and pay for it. That’s probably what’s the most popular.

There’s also an escrow model, where you have a link to your bank account, but no credit card. A consumer keeps a direct link with a trusted party and that party doesn’t release funds until the consumer tell them to.

These are two mechanisms that people use to overcome the trust barrier. These are the two mechanisms that drove eBay out of China. The virtual reputation and rating system is just too much for people to have confidence in.

There’s also a third growing category using trusted payments that are directly linked to a bank account. But that only works with very, very large e-commerce sites that have developed a reputation and have a direct link to your bank account.

People are starting to develop consumer-to-consumer payment relationships, but that’s very young.

VB: So how many projects will you work with?

Lee: It’s limited by how many ideas we can generate and how many people we hire and mentor. We’re looking to hire 100 to 150 people and try 20 ideas over a year. Maybe 10 will be seed-funded out of that. Then maybe three to five will go on to a Series A.

The size and scope of what we’re doing is very unique. The approach we’re advocating is really designed for China. In the U.S., there’s a more developed ecosystem of ideas and entrepreneurs. The right combination will happen there organically. But here, people keep ideas to themselves. Until the culture of innovation in Beijing is like Silicon Valley, there is an opportunity and a need for a hands-on approach.

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