1. The Product Development Stage is the Riskiest Stage of Manufacturing
Companies doing overseas contract manufacturing often “co-develop” products with their overseas manufacturers. In some cases, the company seeking a manufacturer has completed product development and the only involvement from the manufacturer will be to figure out how to manufacture the product at high volumes. In other cases, the company seeking a manufacturer has nothing more than a product “idea” and the manufacturer will be responsible for taking the drawing on the napkin and turning it into a commercial item. In the middle, both the manufacturer and the company seeking a manufacturer contribute technology and know-how to the product and the final product is truly a blend of the two.
The product development stage is the highest risk stage for foreign companies engaged in contract manufacturing in a foreign country. This risk stems from the lack of clarity as to which entity will own the intellectual property in the resulting product and the need to ensure that the product will be developed in accordance with specifications, on time, and at a price that makes the whole venture commercially viable.
2. Product Development Agreements Reduce Risks
Though the product development phase is the riskiest stage in manufacturing, it is also the stage most often neglected. Our international manufacturing lawyers find companies typically use an NNN agreement in the factory search stage and they will use an OEM agreement for the production stage. But, during the all important product development stage, foreign companies typically do not enter into any agreement to protect themselves.
This failure to enter into a comprehensive product development agreement often leads to one of two disasters for the foreign company. The first is when the foreign manufacturer (often a Chinese or Vietnamese or Thai or Taiwanese company) does the product development work for free or builds the product with its own technology as a base. In these situations, the manufacturing company usually claims 100% of the IP in the product as its own once the development of it is complete. The manufacturing company will say: “we own the IP in the product, but we will agree to make the product on your behalf and we will agree not to sell to others. However, you must agree to use our company as the exclusive manufacturer of the product and you must accept our price, payment, quantity, quality and delivery terms.” We see this situation all the time, especially with new companies involved in making products for the Internet of Things ecosystem. Though these foreign companies are shocked when presented with these demands from their manufacturer, there is nothing they can do because they waited until development was finished before they even considered the IP ownership issue.
Second, foreign companies seldom consider the numerous procedural issues that must be addressed to successfully develop a product. Few manufacturers are professional product developers and it is a mistake to assume they have the skills to effectively 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.
- The product is not completed until after the market opportunity has passed.
- The product never works properly.
- The cost of the product as developed is far higher than was projected at the start of the project.
Though these disasters are common when doing development with factories in Asia, few companies even consider these risks. Since they do not consider these risks, they seldom enter into a well drafted product development agreement that addresses the necessary ownership and operational issues.
3. Key Terms for Product Development Agreements
Here are the key terms generally included in a product development agreement:
1. Exactly what product will be developed.
2. What the two sides (you the buyer and the Chinese manufacturer) will contribute in terms of technology. Who will provide the specifications and in what form?
3. Who will own the IP rights to the resulting product? In the last few months we have reviewed three product development projects in Asia (all involving the Internet of Things) where the manufacturer and the U.S. parties did not enter into a written product development agreement. In each case, the manufacturer agreed to make “their” product on behalf of the U.S. buyer, but they insisted they owned the IP to the product and they were free to manufacture the product for their own sales under their own trademark and to make the product for direct competitors of the U.S. buyer.
This position shocked all three of these U.S. companies and they were even more shocked when we told them that these manufacturers were taking a valid position because there was no written agreement to the contrary. For this reason, in any situation where development by the foreign manufacturer occurs, the parties must enter into a written agreement setting out the ownership rights on every product to be developed. This type of agreement must be executed even in cases where the manufacturer is doing nothing more than tooling up in anticipation of producing a product designed by the foreign buyer.
4. Who will pay for the costs of development? Who will pay for the molds and tooling? This can become a major issue if you as the foreign buyer decide to use a different factory to manufacture the product after development of the product is complete. If you seek out a new factory to manufacture your product you will likely get the following responses from the factory that did the product development work:
a. The factory refuses to release the molds, tooling, CAD drawings and related items related to your product.
b. The factory agrees to release the molds, tooling, CAD drawings and related items related to your product, but only after you pay it a substantial fee.
c. The factory claims the trade secrets related to the product developed belong to it and if you try to go elsewhere to have the product manufactured, it will sue you and your new factory.
You will be in a particularly bad position if your factory did the development work and has produced the molds and tooling at its own cost. If the factory did all of this at its own cost, you can be pretty certain it will request payment of a fee from you and can expect that fee to be high if you are taking the project to a competitor. However, even when you have already paid for the molds, factories will often refuse to release the molds to you without a substantial payment to cover the costs of their development work and factory set up. This will be the case unless you have a written agreement forbidding the factory from doing exactly that.
5. Setting of timelines and milestones. Manufacturers will often agree to do the development work, but will fail to do so in a timely manner. Milestones are therefore critical. However, there must be an incentive for your manufacturer to meet the milestones and a penalty if it does not. The following is a typical arrangement:
a. The manufacturer does the development at its own cost, but the product buying company pays all hard costs for molds and similar items.
b. Milestones for development are set.
c. Clear specifications are set.
d. The parties agree on a target price and quantity.
e. IF the factory meets the milestones and specs and agrees to sell at the target price and quantity, then the buying company will enter into an OEM agreement with the Chinese factory.
Often the manufacturer will require a minimum purchase level that will allow it to earn back its development fee. Some factories will agree to pay for the molds, but then require a minimum purchase at a price that allows them to earn back the mold fee. There are a lot of variations on these issues, but your objective should be the same: if you intend to hold your factory to milestones, you should set up a well-documented system of rewards and penalties by having a properly written and signed agreement.
Oftentimes, it is easiest to simply pay the manufacturer for development and set up an arrangement (again, with a proper written agreement) whereby the manufacturer will not get paid if it fails to satisfy the milestones. This approach simplifies the process, but it is unusual in Asia. Most manufacturers want to do the development at their own cost, because they want to own the resulting product. The problem is that unsuspecting American and European and Australian companies far too often just let them, without realizing that by doing so they have essentially just transferred their product and its related IP to their manufacturer.
4. The Product Development Questions We Ask
When tasked with drafting an international product development agreement, our international manufacturing lawyers virtually always start by trying to get a better sense of the project to know what to put in the agreement. The below is a fairly typical initial email we send clients that have retained us to draft them a product development agreement.
I will be the attorney drafting your product development agreement. Towards that end, please answer as best you can the following questions.
A. Basic information
Please provide the full legal name, address, and phone number of the manufacturing company with which you will be working, as well as the name, title, and email address of the representative who will be signing on behalf of that company. It is always best if you can get us this information in both English and in _____________ [the language of the country in which this manufacturer is based]
B. Scope of Work
- What products will this development agreement cover? I note that you mentioned a __________. Will there be any other products involved?
- Will a formal timeline be established with specific milestones? If so, please describe the timeline and milestones in as much detail as possible, including prototypes, the evaluation process and any required certifications.
C. Development Costs and Budgeting
- You mentioned that you will pay all product development and design expenses, including all costs related to molds, tooling, CAD drawings, etc. Will this include supplies and equipment as well?
- How will costing and approval of such expense items be handled? How will you pay?
- Will a formal development budget be drafted? If yes, how and on what schedule?
D. Development Proposal
- In what form will the development proposal be provided to your manufacturer? I note that you mentioned the Chinese company has created some CAD files. Did you provide them with a general concept and they created the drawing? Or did you provide other forms of development proposal?
- How will you determine the final product? Will a target of price, quantity, timing of delivery be set in advance, or will this be worked out during the development process?
E. IP Issues
- Will this manufacturer have any restrictions on its use of the IP created during the development process, manufacture of similar products?
- Do you expect this manufacturer to incorporate third-party IP into the final product? If yes, to what extent?
F. Relationship of the development agreement to the subsequent manufacturing agreement
- It seems that manufacturing is an assumed next step. If this manufacturer meets the targets/milestones, must you enter into an OEM agreement with them?
- If there is an OEM, is it exclusive? For example, can you go to another manufacturer, whether in _______ [the already chosen country] or in another country? Can you manufacture yourself in the United States?
- What happens if you decide not to pursue the project?
- What if you use another manufacturer?
- What if you abandon the project entirely? Must you pay a termination fee to this manufacturer?
- What if this manufacturer abandons the project? Must they pay you a fee?
I may have follow up questions depending on your answers to the above, but this will be a good start. I look forward to working with you on this matter.
To properly address the risks discussed above, a product development agreement enforceable in the country in which you will be doing the manufacturing is required. A product development agreement is intended to cover the very important period between the NNN agreement stage when you are testing the waters and the Contract Manufacturing Agreement stage when you have already selected the factory you will use and you have already determined exactly what you will have manufactured.