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In 1997, Silicon Valley entrepreneur Jason Wu had an inspired idea -- to develop e-commerce encryption software in his native China for its nascent Web market. No competition. Cheap engineering talent. No cultural barriers. Just one problem: NetFront, his fledgling company, was U.S.-based, and foreign companies weren't allowed to sell encryption software in China.

Regardless, Wu claims, later that year NetFront obtained China's first license to sell commercial encryption software. Last October, NetFront launched a Web-based version for the Chinese market. The Sunnyvale (Calif.) company, which has more than 80 clients in China, projects $5 million in revenues this year and wants to go public.

Many foreign players -- small and large -- are struggling to tap China's Web mother lode. But NetFront's endeavors are eye-catching because encryption is such a sensitive issue for the government, which is in turmoil over how the Internet challenges its efforts to control information and suppress dissidence.

REGULATIONS.
China's encryption policies recently became an international issue. In October, 1999, the China State Council issued the lengthy Directive No. 273, which declared commercial encryption codes "part of national classified information," according to a translation on ChinaOnline, a Chicago-based Internet news service. Among 273's provisions: encryption-software producers needed licenses, their customers had to register with the government, and the sale of foreign encryption software was prohibited.

Foreign users were to register by Jan. 31, but their howls of protest embarrassed the Chinese government just as it was pitching for World Trade Organization membership. In March, the State Encryption Management Commission "clarified" Directive No. 273: It applied to "hardware and software for which encryption and decoding are core functions" -- not browser software, Microsoft Windows, or wireless phones. Also, users of foreign encryption products don't need to give a third party the "keys" to decode the encryption, and the government would revise relevant laws in accordance with WTO rules.

MOOT POINT?
With policy in flux, NetFront's early-bird status has become a bit awkward. Asked about the company, an official at the State Encryption Management Commission insists that NetFront has no license or permission to sell encryption software. But Robert Peizer, NetFront's manager for market communications, insists NetFront does have a license -- which he declined to show Business Week Online -- and says the March "clarification" makes the point moot. "Our position is we're browser-based software. We're covered either way," he says.

In a written statement, the company adds: "We believe we have the proper license(s) from the proper authorities to market browser-based Internet security products in China. However, the need for such a license is outdated.... There was a reversal of the government's previous position relative to Internet security software..."

NetFront contends it isn't fazed by the Commission official's statement. "Given the pace of recent changes, it isn't surprising if certain agencies are 'not with the program' yet, and give conflicting views," NetFront's statement adds. "Also, the rules had changed a few times even before the new regulation took effect, and various agencies fought for influence over the issue. We respectfully suggest that the viewpoint expressed by the individual contacted may not accurately or fully reflect the intent of the government's change in legislation specifically regarding Internet security software."

Perhaps. The recently formed commission -- members include officials from the State Security Ministry and the Information Industry Ministry -- is now the point agency on encryption regulation. Still, some government entities obviously thought it was O.K. to use NetFront products. China Information Highway, a government/private venture that includes the city of Beijing, confirms it uses NetFront's products for the online Beijing Bookstore.

So why would a foreign startup take on China's government over information control? Even before this year's brouhaha, encryption was a sensitive issue. "Jason knew it would be a tough battle," says Peizer, but he says Wu believed that China would inevitably realize that without secure communications and transactions, it would never reap the full potential of the Internet. China is also an alluring market. NetFront predicts that by 2003, China will be a $500 million market for online encryption and digital-signature services, with the worldwide market at $38 billion.

How has Wu gotten this far? Using a classic strategy for Asian-American high-tech entrepreneurs: making the most of his ties to the old country. (He says his father, a well-connected Chinese scientist, helped guide him through the licensing process.) And he plays the goodwill card heavily. Until last fall, the company gave away its services for free to most of its clients in China to establish relationships and win publicity. Wu and his father, who handles NetFront's government relations, cultivate officials and educate them about encryption technology, even though that information could foster the creation of state-affiliated competitors.

Wu, 35, grew up in Beijing. His father, a retired computer scientist, had worked for the Electronic Industry Ministry (now the Information Industry Ministry), which regulates communications businesses. His mother was a physics professor. Something of a wunderkind, Wu says he graduated from college at 17 with a physics degree, then worked as a researcher.

U.S. STUDIES.
In 1986, with a borrowed $100 in his pocket, he went to the University of Chicago to study experimental astrophysics. Tiring of theoretical studies, he switched to electrical engineering at Stanford University, where he earned a master's and doctorate in 1993. Wu then entered Xerox Palo Alto Research Center (PARC), the brain trust that invented the first commercial mouse and laser printing. Disappointed after Xerox declined to develop his research as fast as he wanted, he left in 1997 to found NetFront. His idea: an inexpensive piece of hardware for PCs so businesses in China, where Internet connections didn't yet exist, could communicate electronically. One big plus was that only the intended recipient could read transmissions.

Then, the Internet hit China, making his device all but obsolete. Wu's effort wasn't all for naught, though. Businesses, concerned about hackers and government surveillance and eager to reassure customers, still wanted privacy protection, so Wu shifted focus to software that encrypted e-mail.

His timing was much better. Armed with $150,000 in savings and $160,000 in angel money, Wu hired engineers to develop the product in Beijing while maintaining NetFront's headquarters in Sunnyvale. That decision was prescient. He says he spent around $5 million on work that would have cost up to $20 million in California. The arrangement would also -- he hoped -- get NetFront around the then-tacit ban on foreign encryption software. To get a license, Wu had to persuade authorities that NetFront had fully developed its product in China.

He turned to his connections -- his father, Siyi Wu, and Jeffrey Liu, a college classmate and NetFront's vice-president for sales and marketing in Asia. Liu, former head of the software division of the Information Industry Ministry, had handled high-tech policymaking and foreign software procurement. The elder Wu introduced his son to high-level officials in the Information Industry Ministry. "At least they weren't hostile to us," Jason Wu says.

Still, it took several months of tough negotiations to get the license. For all its connections, NetFront was a foreign company. Such a request was "not entirely within the letter of the law," says NetFront's Peizer. Wu convinced officials that his product would be less of a threat than those developed abroad. NetFront would even advise the Chinese on building a local encryption industry. The government granted the license but never formally waived the rules, which Peizer says is a common tactic. "They don't make it legal because they might want to hold [the law] over you at some time."

Launching the product wasn't much easier. In China, "customers have a long decision-making cycle, and it's even longer for the government," says Wu. "Sometimes customers are not clear about their requirements, not as sophisticated in the technology [as U.S. companies]. You have to educate them."

One big coup for NetFront was its collaboration with China Information Highway and Compaq Computer Corp. on the Beijing Bookstore, which claims to be Asia's largest online bookstore. NetFront provided full security for the Web site.

Still, sales lagged. Wu and his team realized that their encryption software -- like most -- was too complex. Clients needed dedicated staff to issue and manage passwords and digital signatures. The company shifted strategy again. Instead of installing its program on a client's system, NetFront would offer e-mail encryption and digital signatures as a service via the Web. Users would download a small piece of software at NetFront's Web site to exchange encrypted messages. NetFront would issue the "keys" with which senders encrypt messages and recipients open them, as well as digital signatures (lines of code certifying that the sender of a message wrote it and that it's authentic).

James Bidzos, an investor in NetFront and founder and chairman of Verisign, a Web security company, says that there are other Web-based encryption products, but NetFront's is the only one -- to his knowledge -- that allows users to verify that no one has tampered with a Web page.

HELPING OTHERS.
This will be a crucial year for NetFront. It's raising over $20 million from venture-capital firms and angel investors, including Bidzos. Since last fall, the company has been charging commercial customers in the U.S. and China for its online service. Monthly rates per user range from a few cents to a few dollars. So far, NetFront has two U.S. clients and says it is close to clinching deals with several more. Last month, the company signed a deal to provide encryption capabilities to Commtouch, a Web-based e-mail outsourcing company. NetFront's service is also compatible with several portals' free e-mail.

NetFront also wants to develop another line of business -- helping others market their products in China through partnerships and alliances, tapping its experience dealing with the bureaucracy. "You have to work closely with the government" to avoid getting snared in China's many restrictions, such as a vague prohibition against passing state secrets over the Internet, Wu says. "If you followed all the rules, you'd be dead." The challenge is figuring out which rules matter as China's government figures out how to live with the Net.