China Manufacturing Payment Terms

When I was in Shenzhen last month, co-blogger Steve Dickinson and I had a long lunch with China manufacturing guru, Renaud Anjoran of Sofeast. During our lunch, we talked extensively about what we were seeing in China manufacturing these days, particularly in the electronics and Internet of Things sectors. As we always do, we shared many of the horror stories we were seeing and hearing about as it is from those that lessons get learned.

Renaud told us of an American (or was it European?) company that had chosen to pay its Chinese manufacturer in advance, believing that by doing so, it would make for a “great relationship.” Instead, it led the Chinese manufacturer to keep the money and never make a thing. Renaud told he knew the manufacturer and he insisted the manufacturer was not a crook, but it simply could never prioritize making products for a company that had already paid it over those companies for whom it NEEDED to make product to get paid. The lesson learned from this story is how critical payment terms can be in influencing what gets made and how.

Renaud recently did a terrific post explaining this payment-results connection, T/T Payment Terms with China Factories: Set the Right Incentives. Renaud starts this post by noting that “at the end of the day, what the factory really looks at is, ‘how much of the order did we get paid, and how much room for maneuver do we we have right now?’” He goes on to talk about how Chinese factories very much tend to be “focused on the short term” and this means you as the buyer need “to think very carefully about payment terms.” In other words, “you need to make sure your Chinese supplier, who has over-promised to 10 customers and needs to disappoint 5 of them at some point, will think twice before deciding you will be among the unfortunate ones.” I 100% agree.

The article then sets out the following various payment options and the pros and cons of each:

100% T/T pre-payment. This is a beginner’s mistake. Renaud remarks on never having seen this sort of payment plan work out well in his 10+ years working in China and neither Steve nor I can recall such payment terms working out well either. Neither can I. I can though recall a number of such companies calling me because they have not received their products. I also recall getting a negative answer to the one question I always ask whenever a foreign company calls me with a China manufacturing problem: Do you have a written Manufacturing Agreement in Chinese that is crystal clear about what your Chinese manufacturer must provide you? I also recall being amazed at how many times the response was something like, “we don’t because we didn’t want to get off on the wrong foot with them” and then my telling them that our China lawyers would not be interested in taking on their case.

Renaud correctly notes this sort of payment plan gives your manufacturer “zero incentive to perform.”

30% T/T deposit, 70% T/T payment after passed QC inspection. Renaud describes this sort of payment plan as quite common and it is the one we typically see offered by Chinese manufacturers, especially in the electronics industry. Renaud describes these payment terms as being a “generally a balanced and fair deal,” but still with “a number of risks for the buyer” and he recommends negotiating a lower initial deposit, “especially if the products are very standard and could easily be sold to another customer” and payment of the remainder only after the product ships. .

20% T/T deposit, 50% T/T payment after production and after passed QC inspection, 30% after delivery in buyer’s country. These payment terms give you “some leverage until you receive the goods. If the manufacturer played games during the inspection, or ‘salted’ bad products into your order just before shipment, you can still catch it.”

Letter of credit (L/C) at sight. Renaud rightly notes that “only some suppliers accept a payment by L/C.” He then also notes that though these payment instruments favor the buyer, they are expensive. Our China attorneys are generally not big fans of letters of credit. First, it truly is the rare Chinese manufacturer that will accept them. Second, they are really expensive. Third, they have to be done right or they are essentially worthless, and they are rarely done right. Fourth, you need to use a trusted bank for one and Chinese banks do not generally fall into this category if you are a foreign company having your product manufactured in China.

100% T/T payment 2 months after shipment, with no deposit. This is sort of the gold standard for buyers, but even this payment arrangement is not without at least some risk:

However, if you have an ongoing business relationship with a supplier that you pay that way, you are still ‘hooked’ to a certain extent. Above all else, you probably need continuity of supply. If you find quality issues and you act in a way the supplier sees as unfair, they might stop shipping goods to you!

Renaud’s article then discusses how Chinese manufacturers take advantage of foreign buyers (especially in the Internet of Things sector) by not requiring “the foreign company to pay for the non-recurring engineering costs such as tooling, firmware code development, etc.” This is done as part of a strategy “to gain the upper hand in the business relationship in the long term” and “this is extremely dangerous for buyers of highly customized products.” If you want to know how dangerous this can be, check out China and The Internet of Things and How to Destroy Your Own Company, from which Renaud quotes extensively:

The foreign designer and the Chinese factory will work together for months or 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.

How does all this come about? The standard scenario goes something like the following. A foreign product designer comes to China and 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 can happen 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 that it is going to 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 that we will 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 our company has 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. Stated simply, absent a written contract to the contrary, it is generally true in this setting that the factory DOES own the intellectual property in the product.

Renaud then notes how Steve describes the legal consequences, but “from the perspective of the buyer, it is worse”:

In many cases they PHYSICALLY can’t do anything. The mold is in the Chinese factory; developing and fine-tuning a new one would take time and money. Maybe some code was developed for the firmware, but again the supplier (or, often, a sub-supplier) keeps the source code.

In such a case, having a contract that clearly spells out who can do what with the finished product, is extremely important. You will probably have to pay for some/all of the non-recurring engineering work for the supplier to agree to this.

Bottom Line: When outsourcing your product manufacturing to China, your payment terms matter. A lot.