In a recent conversation with Sequoia Capital’s Roelof Botha (he did the YouTube and Meebo deals among others), he dropped an interesting tidbit. The market in China for virtual goods – digital swords, armor, dresses, etc. used in online games and communities – is larger than the market for online advertising.  Let that soak in a bit.

Botha pegs the Chinese virtual goods market at about $1.2 billion annually and online advertising at $1 billion – estimates based on research from Sequoia, Morgan Stanley and IDC. Clearly, online advertising in China is an immature market and has a whole lot of headroom (multiple business opportunities there it would seem), but selling all those pixel-packed objects also has a bright future. “Virtual goods have an ability to tap into people’s pockets in a very different way,” Botha says.

Botha knows first hand. Not only has he reached into his own pockets to buy virtual goods, doing so has led him to his latest investment, a $4.5 million bet on Challenge Games, the Austin Texas-based online gaming shop that launched Duels last summer and is rolling out “Baseball Boss” now.

It was by playing Duels (it is what it sounds like – you challenge other people online to a duel) that Botha came to know Challenge Games founder Andrew Busey. Botha, a former rugby stud, is also a gamer – board games, video games, and online games – he plays them all. In an effort to “not get my butt kicked all the time” Botha attempted to buy some of the game’s currency to purchase higher-level weapons and get himself some wins.

His transaction, via PayPal, wouldn’t go through, so he emailed the company to see what could be done. In a bit of an ironic twist, turns out Botha, the former CFO of PayPal had screwed things up, not Challenge Games. But through the back and forth the two men began to talk about the broader potential that Duels represented, and the elements that could be replicated in a series of games. Here is some of what Botha has distilled it to.

• The game is browser based – A general Sequoia investing theme because it makes adoption virtually frictionless (think Google, YouTube, StarDoll, Meebo, JahJah and others).
• It’s free. Again no friction.
• Players can dip in an out at will, “or time slice” as Botha calls it. That makes it far mor casual than multiplayer games like World of Warcraft that require players to show up and play for hours.
• There is leveling. The better you get, the higher your level. Keeps people coming back.
• Lastly,  there is the idea of possessions. You can win things, buy things and trade things. The last element is how Challenge Games makes its money (and ultimately Sequoia too).

The second game to be released, Baseball Boss contains all these elements. It’s almost a re-skinning of Duels, but rather than fighting with a collection of characters and weapons, you assemble a baseball team by collecting virtual baseball cards of both present-day and historic players. With your team you then challenge other teams to a match. Tournaments, trading and buying players ensue. The virtual goods come into play, when you purchase “packs” of player cards, hoping for that rare player that will help your team win.

From a business perspective where it gets interesting is how the infrastructure Challenge Games built for Duels, a gaming platform really, is reused for Baseball Boss. Busey already built a payments system for Duels, he doesn’t need to repeat that (nor do players) for game No. 2 or those that follow. He has the architecture for hosting tournaments, trading and all the common elements figured out, so again he doesn’t need to reinvent those chunks of code.  In the future it is likely players will be able to take currency from one game, and spend it in another.

The games themselves don’t have the obsessive detail, 3D rendering and bells and whistle of say Grand Theft Auto IV, but they look good, and are much, much cheaper to produce. In the end, gaming like Hollywood is a hits business, and Botha is betting that Challenge Games will be able to produce enough hits to sell enough virtual goods that everyone can make some money.

But it is taking a more modest approach than its console game competitors.  “We are producing ‘Little Miss Sunshine,’ rather than the ‘Matrix,’ ” Botha says. “Or heaven forbid, ‘Waterworld.’ ”