Foreign companies that outsource their product manufacturing to China often co-develop their products with Chinese manufacturers. In some cases, the foreign company has completed its product development and the Chinese manufacturer’s only involvement is in setting up to manufacture the product in high volumes. In other cases, the foreign company side has only a general product “idea” and the Chinese manufacturer is tasked with turning the foreign company’s napkin scribblings into a viable commercial product. Sometimes both the Chinese manufacturer and the foreign company contribute technology and know-how so the final product is a blending of both parties’ contributions.
The product development stage is the highest risk stage for foreign companies manufacturing in China, yet it is also the stage most neglected by foreign companies. Foreign companies will use NNN agreements in the factory search stage and they will use OEM agreements for the production stage, but they rarely use product development agreements.
This is a big mistake that often leads to one of two disasters for the foreign company.
The first disaster usually occurs when the Chinese manufacturer does not charge the foreign company anything for the product development work. In these situations, the Chinese manufacturer often will claim that any intellectual property in the developed product is its own and will generously offer to make the product on behalf of the foreign company at price, payment, quantity, quality and delivery terms chosen by the Chinese manufacturer. Our China lawyers see this all the time, especially with start-up companies involved in making products for the Internet of Things ecosystem. No matter how outrageous the pricing or other demands from the Chinese manufacturer, there is little the foreign company can do because it waited until development was finished before even considering who would end up with “its” IP.
The second disaster stems from foreign companies not considering the procedural issues necessary for successfully developing a product. Foreign companies far too often mistakenly assume that Chinese manufacturers can develop any product within the tight timeframes and close tolerances required by modern business. This often leads to the following:
- The product is never completed or never works properly.
- The product is not completed until after the market opportunity has passed.
- The product cost ends up being far higher than projected. And again, Internet of Things companies seem particularly prone to this.
The only good way to address the above product development risks is with a product development agreement enforceable in China. A good product development agreement covers the period between the NNN agreement stage when you are figuring out which Chinese manufacturer to use and the OEM agreement stage when you have already selected your Chinese manufacturer and know exactly what you will have manufactured.
A good product development agreement generally includes provisions addressing the following:
1. The product to be developed.
2. The technology the foreign company and the Chinese manufacturer will contribute.
3. Who will provide the product specifications and in what form.
4. Who will own the IP rights to the resulting product.
Our China attorneys often review product development projects in China where the Chinese manufacturer was asserting it owned all of the IP rights to the developed product. Typically, these Chinese manufacturers were agreeing to make “their” product available to the foreign companies, but they were demanding to be able to manufacture the product for their own sales under their own trademark and to make the product to sell to competitors of the foreign company. Foreign companies are usually stunned when we tell them that because they had no written agreement making clear that they (the foreign company) owned the resulting product, their Chinese manufacturers had legal justification in claiming ownership, since they both contributed technology and incurred all of the product development costs.
5. Who will pay for product development costs?
6. Who will pay for the molds and tooling?
This becomes a major issue when the foreign company seeks to use a different Chinese manufacturer after development of the product is complete. In this situation, the Chinese manufacturer that co-developed the product will likely do one of the following:
a. Refuse to release the molds, tooling, CAD drawings and other items required to manufacture the product.
b. Require the foreign company pay a substantial fee to secure a release of the molds, tooling, CAD drawings and other items related to the product.
c. Claim ownership in the IP related to the product and threaten to sue the foreign company in a Chinese court if anyone else manufactures the product.
The foreign company is particularly badly positioned if its Chinese manufacturer did the development work and produced the molds and tooling at its own cost though it is not at all uncommon for Chinese manufacturers to engage in the above tactics even when the foreign company paid for the molds and tooling. You are not going to be protected from this unless you have a written agreement (enforceable in China) making clear that you own the molds and tooling and penalizing the Chinese manufacturer for not immediately returning those to you. See Product Molds And Tooling In China: Three Things You Must Do to Hang on to Yours.
7. Setting of milestones. Chinese manufacturers often agree to do the development work, but fail to do so in a timely manner. Your product development agreement should provide incentives for your Chinese manufacturer to meet milestones and a penalty if it does not. The following is a typical arrangement:
a. The Chinese manufacturer does product development at its own cost, but the foreign company pays all hard costs for molds and similar items.
b. Milestones for development are set.
c. Clear specifications are set.
d. The parties agree on a target price and quantity for when the product is developed.
e. If the Chinese manufacturer meets the milestones and specs and agrees to sell at the target price and quantity, then the foreign company will enter into an OEM agreement with the Chinese manufacturer.
Chinese manufacturers usually prefer to cover all of the costs of product development because they want to own the resulting product and foreign companies far too often go along with this, without realizing this likely means the Chinese manufacturer will end up with the product and its related IP.