China Manufacturing Contracts, Part 2: ODM Arrangements

As I mentioned in my first post of this series on China manufacturing contracts, Original Development Manufacturing (ODM) has become very common in China. Shenzhen in particular has become the “go to” location for start-up companies with an innovative product concept but no manufacturing facility. For low volume production of hardware and internet of things (IoT) products, China has become virtually the sole source for production.

The most common form of ODM for foreign start-ups in China is some form of co-development. This is a major change from the former standard practice in Asia. In the old days, U.S. entities went to Taiwan, Hong Kong, Japan or Korea for their development work. Under that model, the foreign entity paid for the development and the final product was delivered to the foreign entity as a deliverable with no strings attached. The ownership of IP was clear: the foreign entity paid the fee and the foreign entity had 100% ownership of the product.

With the co-development approach that is now almost universal in China, the approach is quite different.  There are two basic types of co-development in China. In the “new product” approach, a foreign entity approaches a Chinese factory with an idea for a new product. However, the foreign entity usually has just the bare outline for the new product: often no more than simple drawings and a specification sheet. The Chinese factory is then asked to develop that product with the often unstated assumption that the factory will manufacture the product when development is complete. In the “add-on approach”, the factory already has its own proprietary technology. The foreign entity then engages the Chinese factory to produce a new product based on the core technology owned by the factory.

The issue our international manufacturing lawyers keep encountering is that the legal consciousness of all the parties to these transactions is stuck in the old model of straight development for a fee. But the issues that arise under the new, co-development model are quite different from the former “straight” development model. The purpose of this post is to set out in a preliminary way the basics on what a foreign entity must consider when engaging in co-development in China.

None of the issues are easy to resolve, and the alternatives are very complex. Because of the difficulty, many foreign entities seek to hide their head in the sand and just ignore the issues. This is a mistake. It makes no sense to go to all the trouble of developing your product if, in the end, someone else (the Chinese factory) either owns the rights to “your” product or monopolizes the right to manufacture it.

The basic issues to consider in a Chinese co-development project are as follows:

1. Will the Chinese side do the development work at its own expense or will you pay for the development work? This is the critical first decision. Note that if the Chinese side does it at its own expense, you have very little ability to control the development process. There are several ways Chinese companies deal with this issue.

  • Some Chinese companies will do the development work at their own cost on the assumption that you are required to use them for manufacturing.
  • Some Chinese companies will pay the development costs up front, but then charge them back to you by applying some sort of fee to your initial purchases. Again, this assumes you are required to use them for manufacturing.
  • Some Chinese companies will charge a fee for the development work. Often this is a partial fee, and the Chinese company will charge the remainder to you by applying some sort of fee to your purchases. For example, if the total development cost is around $150,000, the Chinese factory will charge you a $50,000 upfront fee and then amortize the remaining $100,000 over a two year period. If you do not repay the entire amount during this period, the Chinese factory will then expect you to pay the remainder in a lump sum at the end of the two year period.

Note that all of these alternatives assume the foreign buyer is required to use the Chinese factory to manufacture the product.

2. What is the time schedule for the product development work? What happens if, as is normal, the Chinese side fails to meet the time schedule? This issue should not be underestimated. In our experience, the Chinese factory almost never completes production within the required time period. It also is not uncommon for the Chinese factory to never succeed in developing an acceptable product.

3. What is the final price goal for the product? If the Chinese side succeeds in making a workable product, but the price is triple what you need to viably sell it, that does not constitute success. Sometimes the higher price is because the Chinese factory was unrealistic in its initial estimate or it accepted an unrealistic price from the foreign buyer just to keep the work away from a competitor. In other cases, the Chinese factory will intentionally set the price absurdly high simply to drive away the foreign buyer so it can make the product for itself.

4. What exactly are the “deliverables” and what is the process for determining whether the deliverables meet your goals? Often the “deliverable” is no more than a working prototype. However, a single prototype cannot be considered the property of the foreign buyer. So when a prototype is the sole deliverable, the foreign buyer has in fact acquired nothing of value other than perhaps a commitment by the Chinese factory to manufacture consistent with that prototype.

5. Molds and tooling are usually of critical importance in developing a new product. With respect to your molds, you need to consider the following: Who will arrange to design and manufacture the molds and tooling? Who will pay for the molds and tooling and on what schedule? Who owns the molds and tooling? If you want to move the molds and tooling (not the intellectual property for the product, just the molds and tooling) to a new factory, do you have the right to do that? Often Chinese factories will say: yes, you can move the molds and tooling, but you have to pay a fee. In other cases, the Chinese will claim to own certain molds and tooling that are directly connected to what they believe is their proprietary IP. Deciding what fits into what category can be very complex. For how to keep your molds, check out China Mold Ownership/Mold Protection Agreements: More Important Than Ever.

Though these five issues are normally difficult to resolve, they actually are the easy part of the process. The more difficult issue is who owns what with respect to the intellectual property in the product. Determining that the factory owns 50% and you own 50% may be relevant for allocating income from commercialization of the IP, but it does not tell you anything useful on the practical level of manufacturing the product.

In tomorrow’s post, I will discuss the intellectual property issues related to determining who actually owns what in an ODM arrangement.