For all the talk of moving manufacturing out of China, most hardware companies that develop cutting edge hardware are pretty much stuck there, at least for a few more years. They have to go to China to have their product manufactured. There simply are not factories elsewhere willing and able to do small-scale manufacturing of these products. Not only that, but Chinese factories are pretty much the only manufacturers that will work with foreign start-up hardware developers to commercialize products that are often mere “concepts” when they arrive in China.
The problems arise when foreign hardware developers work with Chinese factories on projects that are more involved than the simple manufacture of a fully developed product design. In many situations, the foreign designer and the Chinese factory will work together over months and even years in order to develop a commercially viable product. When the prototype is finally complete, the question then becomes which entity actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns it. The Chinese factory says it owns it. The sad result is that way more often than not, the Chinese factory is correct. It owns the prototype and it will “allow” the foreign developer to market its product for them. If the foreign developer succeeds, that’s great. But if the foreign developer fails, the Chinese factory will have the product marketed by someone else, leaving the foreign developer who came up with the idea high and dry.
We have seen instances where the foreign designer and the Chinese factory worked together for years to develop a commercially viable product and then when the prototype is finally finished, the question then becomes who actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns the product while the Chinese factory says it owns it. Who does legally own it? Way more often than not, the Chinese factory does.
The standard scenario goes something like this. A foreign product designer works with a Chinese factory to commercialize an innovative hardware or IoT product design. In a cooperative co-development setting, the foreign party and the Chinese factory work together to create the prototype of the commercial version of the new product. All the work is done on a purchase order basis, with no written contract or other documentation.
At the end of the development cycle, the Chinese factory announces to the foreign developer that the prototypes are completed. The factory retains the prototypes in anticipation of moving to the manufacturing phase. However when the parties move to the manufacturing phase, it is normal for something to go wrong. This usually happens in two ways. First, the Chinese factory surprises the foreign designer by substantially increasing the projected unit price for the product or it announces that it cannot meet the quantity or delivery date requirements for the product. Second, the factory consistently manufactures product with substantial product defect/quality control issues.
Facing these problems, the foreign party confronts the Chinese factory and announces it will take the prototypes and have them manufactured by another factory. The Chinese manufacturer replies: “You cannot do that. We own all the IP contained in the product. We agree to manufacture the product for you exclusively for as long as you are willing to order on our terms. But you cannot take that prototype anywhere else. Only we have the right to manufacture that product. And, if you are not successful in making substantial sales, we will cut you off and market the product ourselves.”
The real problem with this scenario is that in most cases the factory is absolutely correct about the legal situation concerning the intellectual property in the new product because without a written contract to the contrary, the Chinese factory almost certainly does own the intellectual property in the product.
This situation where the foreign company loses all that it has been focused on for the last many months or years is due to the failure of the foreign designer to properly document the co-development process. If properly documented, this unfortunate result can be avoided.
How to Keep Your Product IP
The first step in dealing with China hardware co-development is to understand how the basic law of inventions works. Simply stated, a foreign developer that does not enter into a written agreement is relying on the default provisions of intellectual property law, particularly the law of patents. This reliance on the default provisions is a mistake because the default provisions greatly favor the Chinese factory.
It is a basic provision of the law of inventions in China that the party who came up with the “idea” does not own the invention; the party that takes the idea through to practical implementation does. This is generally true even when the party that achieves practical implementation has been paid to do so. What this means in real life is that even if you pay your Chinese factory for some or all of the costs of the development work done by the factory, if the factory in fact did the work, the Chinese factory owns the invention unless you have a valid contract to the contrary.
Since the default provisions of law do not protect the foreign designer, a contract that sets out the ownership rules is required. Though the factory may own the IP as a matter of law, the Chinese factory is also free to assign all or even a part of its ownership in the IP to the foreign designer via a written contract. However, this assignment is only effective if done with a clear written contract (in Chinese) subject to Chinese law and enforceable in China. This contract must state exactly what will be developed and which party will own the IP in the resulting product. Properly drafted, the foreign designer will own everything, as the foreign product designer intends. But, without such a contract — as in the case where there is nothing more than a purchase order — the result is the reverse. The entire result turns on the content of the contract.
How not to get Blindsided by Blended IP
In the above analysis, we assume a single product is developed and all IP in the product prototype was created during the development process. We refer to that setting as wholly owned IP. But increasingly, our China attorneys are seeing product prototypes that involve “blended IP.” For blended IP, the situation is more complex. In many projects, the co-developed product will make use of underlying IP independently developed and owned by the Chinese factory. In this setting, the new product prototype is like a surface shell layered over existing technology owned by the Chinese factory. The product prototype is a “blend” of entirely new technology and existing technology owned by the Chinese factory. The danger here is that many foreign parties think they are dealing with wholly owned technology when in fact they are dealing with blended technology.
Consider what will happen if the foreign party thinks its prototype is wholly owned technology when in fact the technology is blended. The standard problems arise and the foreign party threatens to take the prototype to a different factory. In this situation, the current Chinese manufacturer will often say something like the following: “We agree you [foreign developer] own the newly developed IP and you can do what you want with that IP. However, this is blended technology and we own the underlying technology in the prototype. For that reason, you cannot have your prototype made by another factory, so you are stuck with us. This result can be a disaster when the business and quality issues discussed above arise and cannot be resolved.
The Appropriate China-Specific Contract Can Save Your IP
The method for contracting to resolve the ownership issues of your product and its intellectual property depends on whether the technology is a wholly owned or blended technology. Many foreign parties at the outset will just assume they are working with wholly owned technology and they themselves own. It is essential right from the start to confirm whether your Chinese factory agrees with this assessment. In the written contract that governs ownership of technology in the prototypes, do not fall into the trap of working with formalistic legal definitions of who owns what IP in the product prototype.
Instead, use the following as your functional rules:
1. The Chinese factory will deliver production ready prototypes to the foreign party.
2. The foreign party has the right to do the following with the prototypes:
- Register applicable IP anywhere in the world.
- Manufacture the product in its own facility or contract to have the product manufactured in any factory anywhere in the world.
- Make use of the design (reverse engineer, clone, etc.) as the basis for the product and manufacture derivative products without restriction.
If the Chinese factory contractually agrees to the above, the IP in the new product will be wholly owned by the foreign party.
In most instances, the foreign companies that retain our China manufacturing attorneys believe from the outset (pretty much without question) that they wholly own the IP in the product prototype. They just assume this is the case and so it does not even occur to them to contractually document this before the development process begins. These foreign companies are then surprised when their Chinese factory refuses to agree to these conditions. But waiting until the process is complete means it is too late to resolve the issue.
Often the Chinese factory will take a compromise position and agree that the IP in the prototype is an example of blended technology. As with wholly owned technology, dealing with blended ownership should be resolved in a written contract at the outset of the development process. As with wholly owned technology, the goal is to avoid vague legal descriptions and to instead use a functional description of how the prototype will be used in practice.
Blended ownership is not co-ownership. By blended ownership, we mean the final prototype incorporates IP owned by different parties. The foreign designer owns some of the IP and the Chinese factory owns some of the IP. As a result, the production prototype is a blend of IP from different sources.
The functional definition starts with the delivery of production ready prototypes to the foreign designer. The issue that needs to be resolved is what can the foreign designer do with these prototypes. There are three basic options for resolving this issue:
Option One. The foreign designer owns all IP produced from the co-development process and can register and make use of that IP without restrictions. To the extent the prototype includes underlying technology of the Chinese factory or a third party, the foreign designer will be granted a perpetual, royalty free license to use that technology solely to manufacture the prototype and any products derived from that prototype. This license if far more restrictive than the situation that prevails in the case of wholly owned technology.
If the foreign party waits until after the development process is complete to raise the issue of securing a technology license from its Chinese factory, the Chinese factory will almost always refuse to grant such a license. Since all the power rests with the Chinese factory by this point, its position is perfectly natural. Nonetheless, foreign product designers are usually surprised to learn they are permanently stuck with the developing factory and cannot use any other manufacturer to make what they thought to be their own product.
Option Two: The Chinese manufacturer agrees to manufacture the prototype exclusively for the foreign designer. The parties agree in advance on price, quantity, time of delivery and quality terms for the product. So long as the Chinese factory can meet these conditions, the exclusive manufacturing agreement remains in effect. However, if the Chinese factory fails to meet any of these terms, the foreign designer has the right to have someone else manufacture the prototype under the license terms stated in Option One.
Option Three: Some Chinese factories will agree to “release” the prototype under the terms of Option One, but only after payment of a substantial fee to the factory. Oftentimes the Chinese factory will set this fee so high that this option is not practical.
These three options assume the Chinese factory is willing to resolve the technology ownership issue in a way that will allow the foreign party to move production to a different factory. In our experience, if the matter is discussed after development is completed, it is the rare Chinese factory that will agree to any of these options. Even if technology ownership is discussed in advance, the negotiation of acceptable terms can be difficult. However, it is critical that this difficult discussion take place before production starts. It is critical that the foreign party understand its exact situation on technology and prototype ownership before it wastes months or even years and incurs and spends substantial sums of money developing a product it will neither own nor control.
Consider the situation when your start-up approaches an experienced angel investor for series A financing. One of the first things any experienced investor will review is the ownership status of your core technology. Imagine what will happen when the investor realizes you do not own your core technology because your Chinese factory either owns or controls it. That is almost always the end of that discussion and it is often the end of the start-up as well.
To avoid “gifting” your technology to your Chinese factory, you must treat proper legal documentation as an essential and not a luxury reserved only to large companies. Proper documentation is even more important for hardware developers at the start-up stage because a loss of ownership at the start dooms the company down the road. A major multi-national has many products. If it loses one, it does not kill the company. But for a start-up, the loss of its key technology usually means death.