China Manufacturing Agreements and What Should Go in Your Term Sheet

Our international manufacturing lawyers believe the best way for us to draft China Manufacturing Agreements is for our clients to reach oral or “term sheet” agreement with their Chinese manufacturer and then come back to us with the terms. We then draft the manufacturing agreement based on those terms (and many more) and our client then presents that draft agreement to its Chinese product supplier. At that point, the Chinese product supplier either signs or additional negotiations ensue.

A few weeks ago, a regular client of ours was heading to China to negotiate a manufacturing agreement with a new supplier. This client sent us an email a few hours before it was to meet with its soon to be new manufacturer. The email listed out the following “deal points” and asked us what more they should get clear with their new factory:

  • payment 50% by LC, 50% net 45
  • tooling amortized over 30,000 [widgets], with remainder due after 3 years if 30,000 [widgets] is not met.
  • sales samples charged at 1.5x confirmed FOB pricing.

The client’s email noted the following still needed to be discussed:

  • agreement and process in case of defective pairs;
  • agreement in case of late shipment.

We responded by suggesting our client consider the following as well:

1. Identify the entity you will be paying; it may not be the factory itself but rather a holding company in Hong Kong/Singapore/Taiwan/etc. In general, unless this entity is acting as an import/export agent for the factory, the contract should be with the entity you are paying, and if things go South, your recourse will also be against that entity.

2. Think about more than just shipping terms. Think also about packaging terms (for each [widget], for each box, etc.)

3. You should have an inspection clause. Quality control is extremely important. In an ideal world, you would inspect after delivery and before you pay anything at. But few contracts are ideal. Think about when you want to inspect (probably both before and after delivery).

4. What will happen with defective product? The inspection process is closely linked to what you do with defective product. The worst outcome for you would be for the factory to sell your defective [widgets] on the grey market. Do you want to witness the destruction of defective product? Require a certification of destruction? Have the defective [widgets] shipped to you so you can destroy them? Something else? Also, think not just about when to inspect, but of what an inspection will consist. Will you inspect every [widget]? A statistically significant number?

5. What will constitute “epidemic failure”? Five percent of a shipment? Three percent?

6. Think about warranty provisions, and how they will be implemented. How long will the warranty last? Who will pay for you having to ship back the returns?

7. Think about timing — late shipments are obviously bad, but early shipments can be bad too, especially for seasonal items.

8. How and when will prices be determined? If the factory wants to change prices, how much notice must they give you? Are there built-in volume discounts?

9. What happens if you submit a purchase order and the factory doesn’t accept it? How long do they have to accept or reject a purchase order?

10. How much lead time must you give between a purchase order and the delivery date for that order?

11. Will you be selling the [widgets] all over the world? Will you be selling them in China?

12. Will the factory be using subcontractors? Do you care?

13. Do you want to restrict the factory from working with and/or contacting any of your competitors?

You do not need to answer all of these questions for a term sheet, but you should at least start thinking about them.
What do you think?

For more on China Manufacturing Agreements, check out China Manufacturing Agreement. Watching The Sausage Get Made.