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Hardware Co-Development in China: Do it Right, Part 4

Monday, November 7, 2016 6:47
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(Before It's News)

China lawyers for the internet of thingsI am coming off two straight days of speeches before and meetings with start-up hardware technology companies here in Shenzhen. Early last week, in Hardware Co-Development in China I wrote about how our China lawyers often see situations where a foreign developer of a hardware or an Internet of things product loses that product to its Chinese manufacturer after having spent years in co-developing that product with the Chinese manufacturer. 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 whether the foreign developer that came up with the idea owns the product or the China factory that helped take it from concept to esign. 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.

When the Chinese factory completes the prototypes it will almost always retain them (rather than just hand them over to the foreign developer) 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 usually happens in two ways. The Chinese factory substantially increases the unit price to manufacture the product or it announces that it cannot meet the product’s quantity or delivery date requirements. Alternatively, the Chinese factory consistently manufactures defective products.

Facing these problems, the foreign party will tell its Chinese manufacturer that it will be taking the prototypes to have its product manufactured elsewhere. The Chinese manufacturer then announces that it owns all of the IP in the product (and oftentimes it will have registered some of this IP completely unbeknownst to the foreign developer) and only it has the right to manufacture that product.

In Hardware Co-Development in China: Do it Right, Part 2, I explained how Chinese factories far too often end up owning the hardware product prototype and its accompanying IP, much to the surprise and disappointment of the foreign developer. In Hardware Co-Development in China: Do it Right, Part 3, I explain how it is that the Chinese factory can end up owning the hardware product prototype and its accompanying intellectual property, and the basics of what you need to do to prevent that in a simple co-development situation. In this, the final part of this series, I explain how to protect your product and its IP in a situation involving blended technology.

The method for contracting to resolve the ownership issues of your product and its intellectual property depends on whether the technology is a wholly owned or blended technology. Many foreign parties at the outset will just assume they are working with wholly owned technology and that they are the owners. It is essential right from the start to confirm whether your Chinese factory agrees with this assessment. In the written contract that governs ownership of technology in the prototypes, do not fall into the trap of working with formalistic legal definitions of who owns what IP in the product prototype.

Instead, use the following as your functional rules:

  • The Chinese factory will deliver production ready prototypes to the foreign party.
  • The foreign party has the right to do the following with the prototypes:
    1. Register applicable IP anywhere in the world.
    2. Manufacture the product in its own facility or contract to have the product manufactured in any factory anywhere in the world
    3. Make use of the design (reverse engineer, clone, etc.) as the basis for the product and manufacture derivative products without restriction.

If the Chinese factory contractually agrees to the above, the IP in the new product will be wholly owned by the foreign party.

In most instances, the foreign companies that retain our China manufacturing attorneys believe from the outset (pretty much without question) that they wholly own the IP in the product prototype. They just assume this is the case and so it does not even occur to them to contractually document this before the inception of the development process. These foreign companies are then surprised when their Chinese factory refuses to agree to these conditions. But waiting until the process is complete means that it is too late to resolve the issue.

Often the Chinese factory will take a compromise position and will agree that the IP in the prototype is an example of blended technology. As with wholly owned technology, dealing with blended ownership should be resolved in a written contract at the outset of the development process. As with wholly owned technology, the goal is to avoid vague legal descriptions and to instead use a functional description of how the prototype will be used in practice.

Blended ownership is not co-ownership. By blended ownership we mean that the final prototype incorporates IP owned by different parties. The foreign designer owns some of the IP and the Chinese factory owns some of the IP. As a result, the production prototype is a blend of IP from different sources.

The functional definition starts with the delivery of production ready prototypes to the foreign designer. The issue that needs to be resolved is what can the foreign designer do with these prototypes. There are three basic options for resolving this issue:

Option One. The foreign designer owns all of the IP produced as a result of the co-development process and can register and make use of that IP without restrictions. To the extent the prototype includes underlying technology of the Chinese factory or of a third party, the foreign designer will be granted a perpetual, royalty free license to make use of that technology solely for the purpose of manufacturing the prototype and any products derived from that prototype. Note that this license if far more restrictive than the situation that prevails in the case of wholly owned technology.

If the foreign party waits until after the development process is complete to raise the issue of securing a technology license from its Chinese factory, the Chinese factory will almost always refuse to grant such a license. Since all the power rests with the Chinese factory by this point, its position is perfectly natural. Nonetheless, foreign product designers are usually surprised when they find out that they are permanently stuck with the developing factory and cannot use any other manufacturer to make what they thought to be their own product.

Option Two: The Chinese manufacturer agrees to manufacture the prototype exclusively for the foreign designer. The parties agree in advance on price, quantity, time of delivery and quality terms for the product. So long as the Chinese factory can meet these conditions, the exclusive manufacturing agreement remains in effect. However, if the Chinese factory fails to meet any of these terms, the foreign designer has the right to have someone else manufacture the prototype under the license terms stated in Option One.

Option Three: Some Chinese factories will agree to “release” the prototype under the terms of Option One, but only after payment of a substantial fee to the factory. Oftentimes the Chinese factory will set this fee so high that this option is not practical.

Note that these three options assume the Chinese factory is willing to resolve the technology ownership issue in a way that will allow the foreign party to move production to a different factory. In our experience, if the matter is discussed after development is completed, it is the rare Chinese factory that will agree to any of these options. Even if technology ownership is discussed in advance, the negotiation of acceptable terms can be very difficult. However, it is critical that this difficult discussion take place before production starts. It is critical that the foreign party must understand its exact situation on technology and prototype ownership before it wastes months or even years and incurs and spends substantial sums of money developing a product it will neither own nor control.

Consider the situation when your start-up approaches an experienced angel investor for series A financing. One of the first things any experienced investor will review is the ownership status of your core technology. Imagine what will happen when the investor realizes you do not own your core technology because your Chinese factory either owns or controls it. That is almost always the end of that discussion and it is often the end of the start-up as well.

To avoid “gifting” their technology to their Chinese factory, start-ups must treat proper legal documentation as an essential and this means they must set aside the funding necessary for doing the proper legal work from the start. Proper documentation is not a luxury to be used only by major corporations. In fact, proper documentation is even more important for hardware developers at the start-up stage, since a loss of ownership at the start dooms the company down the road. A major multi-national has many products. If it loses one, it does not kill the company. But for a start-up, the loss of its key technology usually means death.

Bottom Line: Do your hardware co-development right at the start and give yourself a chance for 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.

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