In China Product Development: Focus on Manufacturing Rights, I set out the ideal resolution of product manufacturing rights issues that arise in co-development projects in China. As I noted in that post, in our experience it is often difficult to convince the Chinese side to agree to that ideal option. So what do you do when the Chinese side refuses to agree? You have a number of options, including the following:
Option 1: License the underlying technology from the Chinese side. When the Chinese side takes the position that it will retain the rights to the underlying technology in your product, your next step is to try to negotiate a license to that technology. This kind of license is common around the world, and it can take many forms, including the following:
a. Negotiate a standard license for the underlying technology for which you will pay a license fee. You can pay this fee as a lump sum or as a per unit royalty for each item manufactured in a separate facility. In some settings the license payment is based on purchasing a certain number of units at a premium price. After that amount has been paid, the foreign party then has a license to manufacture elsewhere. This standard license approach is a very common procedure around the world, but it is seldom used in China. As Chinese manufacturers become more sophisticated about monetizing their technology, this type of agreement will become more common, and our China lawyers are already starting to see that happen.
b. Negotiate an agreement with your Chinese manufacturer side that allows you the freedom to manufacture the product in a different facility, but only if your Chinese manufacturer is unable to meet predetermined quantity, delivery date or price terms. Often this license will allow manufacturing in a different facility only for amounts in excess of a predetermined minimum. For example, the Chinese factory may produce 100,000 units per year at a set price and the foreign party is permitted to use a different facility only to manufacture anything in excess of 100,000. The flaw in this approach is that it assumes the Chinese side will be capable of manufacturing the first 100,000 units, both in terms of quantity and quality. Where this is not true, this leaves you as the foreign product developer hostage to the Chinese factory, which can be financially devastating.
Option 2: Walk away. It is surprising to me how many times foreign hardware entrepreneurs fail even to consider the basic option of refusing to work with a Chinese company that will not cooperate on key manufacturing rights issues.
It is critical to understand what the Chinese side means when it states it will under no circumstances release the manufacturing/IP rights in a co-developed product. What the Chinese side means is: We own the product. We will manufacture the product and we will allow you to sell the product on our behalf in a foreign market. If you succeed, great. If you do not succeed, we will simply refuse to accept your future purchase orders. We will then either market the product ourselves or we will engage some other company to market the product. That “other company” will normally be an established player in the market, and not a mere start-up like you. In other words, you will be reduced to becoming essentially the Chinese company’s sales agent and you will be subject to being terminated even for that at any time.
Most start ups are looking for new money. Consider how hard it is to raise new money when you are in the situation where you have no control over “your” product. Since the result will be an economic disaster, it is often best to simply walk away when it is clear that the Chinese side is trying to put you in an untenable situation.
Option 3: Turn the tables. Some foreign developers do not walk away because they feel they have no other option; they think they are forced to work with the Chinese manufacturer. Though this situation is dangerous, it can work so long as the foreign entrepreneur is willing to turn the tables and operate how a Chinese company would operate in the same situation.
In the turn the tables approach, the foreign developer basically “writes off” the co-developed product. The product is not treated as the foundation for the start up company. Instead, the co-developed product is treated as a research project that will provide the foundation for an entirely new product. For this new product, the foreign product developer will work to achieve control over the technology and the manufacturing rights. It may take several rounds of development, but the goal of the foreign developer is always to achieve complete product control, using the Chinese manufacturer as a test bed for developing a new technology.
Many foreign product developers are confident that they can pull off this reversal of roles. They tell me that they will not walk away because they have this plan. In my experience, it is quite difficult to turn the tables on Chinese manufacturers. Chinese manufacturers have been using this strategy themselves for many years and they usually can see what is happening in time to take early action to protect themselves. However, if well planned, this strategy can be successful. The key is in the planning. If the plan is not laid out clearly from the very start, there is very little chance of success.
We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.