In Part 1 of this series, we talked about how the product development stage is the highest risk stage for foreign companies manufacturing overseas and yet also the most neglected stage. Foreign companies will use NNN agreements in the factory search stage and Manufacturing Agreements (ODM, CM and OEM) for the production stage, but they rarely use Product Development Agreements during the product development phase, oftentimes because they do not recognize they are in that stage or because they believe their NNN Agreement will protect them. This is a big mistake that often leads to one of two disasters for the foreign company.
The failure to use a product development agreement often leads to one of two disasters for the foreign company.
The first disaster usually occurs when the overseas manufacturer does the product development work at no charge. In these situations, the overseas manufacturer often will claim the intellectual property rights in the developed product are its own and will “generously” offer to manufacture the product for the foreign company at the price, payment, quantity, quality and delivery terms chosen by the overseas manufacturer. No matter how outrageous the pricing or other demands from your overseas manufacturer, there is little you can do because you waited until development was finished before even considering who would end up with “your” IP and now your overseas manufacturer owns it all. Our international manufacturing lawyers see this all the time, especially with start-up companies involved in making products for the Internet of Things ecosystem. See The Internet of Things: Do You Really Own “Your” IoT Product?
The second disaster stems from foreign companies not considering the procedural/operational issues inherent in successfully developing a product. Foreign companies far often mistakenly assume their overseas manufacturers can develop any product within the tight timeframes and close tolerances required by modern business. This often leads to the following problems:
- The product is never completed or never works properly.
- The product is not completed until after the market opportunity has passed.
- The product ends up costing far more than anticipated.
And again, Internet of Things companies seem particularly prone to this.
The best way to address the above product development risks is with a product specific product development agreement tailored to the country in which your manufacturer is located. A good product development agreement covers the period between the NNN agreement stage when you are figuring out which manufacturer to use and the Manufacturing Agreement stage when you have already selected your 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 specific technology the foreign company and the overseas manufacturer will contribute.
3. Who will provide product specifications and in what form.
4. Who will own the IP rights to the resulting product. Our international manufacturing attorneys often review overseas product development projects where the overseas manufacturer has asserted it owns all of IP rights in the developed product. These overseas manufacturers typically had agreed to make “their” product available to our clients while at the same time manufacturing the product for their own sales under their own trademark and for sales to competitors of our client. Our clients are usually stunned when we tell them that because they had no written agreement making clear they would own the resulting product and the resulting IP in that product, their overseas manufacturers are legally justified in claiming IP ownership because they contributed their technology to developing the product and because they incurred 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 manufacturer after product development is complete. In this situation, the overseas manufacturer that helped you to develop 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 you pay a substantial fee to give you 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 you in its own country if anyone else manufactures the product.
You will be particularly badly positioned if your overseas manufacturer did the development work and produced the molds and tooling at its own cost, though it is also very common for overseas manufacturers to engage in the above tactics even when you paid for the molds and tooling. You are not going to be protected from this unless you have a written agreement (enforceable in your manufacturer’s country) making clear you own the molds and tooling and penalizing the overseas manufacturer for not immediately returning those to you. See Product Molds And Tooling Three Things You Must Do to Hang on to Yours.
7. Setting milestones. Overseas manufacturers will often agree to do your development work but then fail to do so in a timely manner. Your product development agreement should provide incentives for your overseas manufacturer to meet the listed milestones and a penalty if it does not. The following is a typical arrangement:
a. The overseas manufacturer does product development at its own cost and you pay all hard costs for molds and similar items.
b. Milestones and clear specifications for product development are set.
d. You and your overseas manufacturer agree on a target price and quantity for when the product is developed.
e. If your overseas manufacturer meets the milestones and specs and agrees to sell at the target price and quantity, you will then enter into a Manufacturing Agreement with it.
Overseas manufacturers (especially in China and especially in Chinese-owned factories in Vietnam and Thailand) usually prefer to cover all product development costs because they want to own the resulting product and foreign companies far too often go along with this, without realizing this likely means your overseas manufacturer will end up with “your” product and its related IP.
In part 3 of this series we will discuss how to protect your molds and tooling when manufacturing overseas.