China is the perfect location for start-up companies and SMEs from all over the world to bring innovative products to life, but without knowing how to create a manufacturing contract in China which will protect your IP and more, any dreams could soon turn into nightmares.
Manufacturing your new product in China is a great idea, but legal protection is required
There are numerous factories in China and beyond that can offer their support to help you design, develop and eventually manufacture the product you’ve got in mind (this is the New Product Introduction process basically).
Generally, you would think that if you pay for the above things, you will own 100% of the IP for your product such as design, molds, and tooling, but is this the case in reality?
Far from it, we’re afraid.
Here at Sofeast, we’ve had cases where the factory that produced a product for our client has secretly registered the client’s trademark in China and at the same time was producing a very similar product for our customer’s main competitor.
Our client only found about this by accident and when they did, it turned out that there was little they could do since there was no official NNN contract in place with their Chinese supplier.
Learn more in this blog post: Negotiating With Chinese Suppliers: The Terms you Need to Discuss
Listen to an in-depth discussion about manufacturing contracts!
We discussed the reasons to create an enforceable manufacturing contract with your suppliers and what types of information and agreements are included in this episode of our podcast.
A manufacturing contract in China will also guard against unauthorised subcontracting
Another common situation occurs when a customer selects their new supplier, audits the factory and feels happy to proceed with production.
At some later point, a manufacturing issue occurs and it’s essential to go onsite and check where the problem lies.
This is where it turns out that the supplier couldn’t or didn’t want to produce the entire product and decided to subcontract a part leaving our customer unaware about where a part of their product is produced.
Not only is unauthorised subcontracting like this one of the main drivers of production delays, but it also opens you up to quality problems, IP theft, or even PR issues (if it turns out that a sub-supplier is unethical for some reason)!
If your supplier is contractually bound not to subcontract unless it is to agreed sub-suppliers who you have full knowledge of, then this problem is greatly reduced.
Read more here: 8 Ways to Prevent Chinese Suppliers from Subcontracting
You’ll also be protected when opting to switch suppliers and move molds
We also commonly see issues that could be avoided by agreeing a manufacturing contract in advance when a client is unhappy with their current Chinese manufacturer and wants to move production to a new supplier’s factory.
Only then do they find out that the current supplier owns the tooling, not themselves, which makes this move from one side much more expensive and from another (as new tooling and molds may need to be created and set up).
There’s also subsequently no guarantee that your ex-factory won’t become your main competitor in future since they’ve got molds for your products, the production line, and experience of making your product in place.
Explore moving suppliers safely here: How to move Plastic Injection Molds between China Factories [10 Tips]
How to ensure that you set the rules and own 100% of your intellectual property (IP)?
The last point about validity in China is key because Western importers often create and use an English-language contract that is valid in their countries, not realising that they’re playing straight into Chinese suppliers‘ hands.
They know that, say, a Western contract won’t be upheld in a Chinese court of law, and so will usually not hesitate to sign such a document.
If they see a document in Chinese, referring to Chinese law, drafted by a Chinese lawyer or business, and with an official red seal, then that is a different story; they know that you take IP protection very seriously indeed.
What to include in your China manufacturing contract to protect IP?
- China NDA or more comprehensive China NNN agreement
- Product Development Agreement (PDA) – (if developing product/s with your supplier)
- Manufacturing Agreement (MA)
It is fine that the contract has an English translation, however, Chinese should be the main language of the contract, and it should be stamped with your official red seal (or that of the company or law firm preparing it).
Let’s look at each part in brief.
1. China NDA or NNN agreement
A China NDA (written in Chinese and by Chinese law) protects your IP or trade secrets. Sometimes this would be enough to help you outsource securely to China.
However, a more comprehensive NNN agreement is an upgraded version of an NDA as it offers three types of protection, namely:
- Non-use – the supplier cannot use your IP in any way
- Non-disclosure – the supplier cannot make public your IP or share with others (such as a friend’s factory, or via unauthorised subcontracting)
- Non-circumvention – the supplier cannot start making your products themselves and selling at a lower price to steal your customer base
Ideally, this would be agreed before you provide any of your product information to the supplier, especially if you have a very unique product on your hands.
2. Product Development Agreement (PDA)
The PDA* comes in handy when working with a Chinese supplier to develop your product in China. As mentioned earlier, many Chinese factories can help foreign startups and SMEs to design and develop their products.
However, if a PDA hasn’t been agreed, you may find that the Chinese ‘partner’ claims that your IP is their own now as they were instrumental in developing the product for you.
To avoid having the rug pulled from under your feet in a situation like this, it’s important to agree in advance before the supplier starts developing any prototypes:
1. The product to be developed.
2. The technology the foreign company and the Chinese manufacturer will contribute (also mentioning costs).
3. Who will provide the product specifications and in what form.
4. Who will own the IP rights to the resulting product.*
This is particularly relevant if it would take a long time to begin development with a new supplier and/or customized molds and tooling are expensive to replace.
If your product is fully developed and you are only using a Chinese factory to put your products into production, then adding this type of agreement may not be necessary.
*(Points from China Law Blog’s post about PDAs)
3. Manufacturing Agreement (MA)
Your manufacturing agreement defines, in strict detail, the finer points of your cooperation and relationship as client and supplier, leaving no room for interpretation (or funny business) on the supplier’s part.
These will be points like:
- Supplier exclusivity
- Manufacturing facility used
- Obligation to supply
- Product pricing and payment terms
- QC and inspection procedures and schedule
- Performance criteria and KPIs
- Allowed or unacceptable subcontracting
- Tooling and mold provisions
- Penalties for breaching contract
- …and more
As mentioned in this post, the MA is essential to have in place before authorizing production/wiring a deposit. Especially if you don’t pay by letter of credit.
What about PIs and POs? Are they still necessary?
Once this contract is signed you can issue POs, or you can have the supplier issue a pro forma invoice (PI) and confirm it.
Actually, it doesn’t really matter.
Your protection comes from the contract. Make sure no PO or PI mentions that some of its terms cancel/replace the terms of the contract. That’s the most important point to remember in future.
What’s the next step?
Now you can see the benefits of having a manufacturing contract in place. However, the buyer and the supplier should usually start to work on a term sheet, before putting it all in the format of an enforceable contract (with all the extra clauses that go with it).
Simpler than the contract, a term sheet helps you agree on key terms with a supplier to who you’re outsourcing manufacturing and puts you both on the right track. This will help the contract creation and signing process go more smoothly.
According to China Law Blog here, you should think about these questions when writing the term sheet to discuss with your supplier:
1. Identify the entity you will be paying; it may not be the factory itself but rather a holding company in Hong Kong/Singapore/Taiwan/etc. In general, unless this entity is acting as an import/export agent for the factory, the contract should be with the entity you are paying, and if things go South, your recourse will also be against that entity.
2. Think about more than just shipping terms. Think also about packaging terms (for each [widget], for each box, etc.)
3. You should have an inspection clause. Quality control is extremely important. In an ideal world, you would inspect after delivery and before you pay anything at. But few contracts are ideal. Think about when you want to inspect (probably both before and after delivery).
4. What will happen with defective product? The inspection process is closely linked to what you do with defective product. The worst outcome for you would be for the factory to sell your defective [widgets] on the grey market. Do you want to witness the destruction of defective product? Require a certification of destruction? Have the defective [widgets] shipped to you so you can destroy them? Something else? Also, think not just about when to inspect, but of what an inspection will consist. Will you inspect every [widget]? A statistically significant number?
5. What will constitute “epidemic failure”? Five percent of a shipment? Three percent?
6. Think about warranty provisions, and how they will be implemented. How long will the warranty last? Who will pay for you having to ship back the returns?
7. Think about timing — late shipments are obviously bad, but early shipments can be bad too, especially for seasonal items.
8. How and when will prices be determined? If the factory wants to change prices, how much notice must they give you? Are there built-in volume discounts?
9. What happens if you submit a purchase order and the factory doesn’t accept it? How long do they have to accept or reject a purchase order?
10. How much lead time must you give between a purchase order and the delivery date for that order?
11. Will you be selling the [widgets] all over the world? Will you be selling them in China?
12. Will the factory be using subcontractors? Do you care?
13. Do you want to restrict the factory from working with and/or contacting any of your competitors?
Not every question needs to be answered, but those that are most relevant are worth focusing on.
A typical term sheet may include the following points:
- Agreement term with supplier
- Exclusivity provision (IP ownership)
- Quantities to be purchased
- Order placement window (how many days before delivery?)
- Payment terms (schedule, deposit amount, etc)
- Delivery terms (Incoterm, etc)
- Shipping documents & customs clearance matters
- Agreed pricing (can it vary?)
- Reductions in cost over time (if applicable)
- Buyer’s specifications (any changes allowed?)
- Component & supplier validation (all to be validated by buyer?)
- Quality (quality standard to be reached)
- Compliance requirements
- Inventory (who is responsible for ordering and paying for inventory required for production)
- Safety stock (provides a buffer see above point)
- Product inspections (buyer’s inspection rights and plan)
- Non compete
- Warranty (how long?)
- Indemnification (what does seller indemnify buyer against, such as manufacturing defects?)
- Insurance (the seller needs to have what kind?)
- Limitation of liability
- Confidentiality (NNN agreement)
- IP usage (when and how it can and cannot be used, see above point)
- Obligation assignment (who can assign?)
- Labor requirements (no slave or child labor to be used, etc)
Unfortunately, unscrupulous suppliers do exist in China, and so having a contract in place which includes the above elements and is valid in China will go a long way to protecting your IP, avoiding losses, and making sure that your cooperation reaches your expectations.
Do you have any questions about this topic or experiences to share? Please leave us a comment.
Here at Sofeast, we are not lawyers. What we wrote above is based only on our understanding of the legal requirements. We do not present this information as a basis for you to make decisions, and we do not accept any liability if you do so. Consider consulting a lawyer before making legal decisions.
You may also be interested in these related blog posts from our CEO, Renaud’s, blog, QualityInspection.org:
- The 7 Most Common Product Launch Pitfalls in China
- How to Protect against Copies when you Manufacture in China
- How your Chinese suppliers might become your competitors
- What Needs to Be Done Before Production Starts (PPAP)
If you’re the kind of cautious importer who sees protecting IP and limiting the opportunity for problems to occur as a valuable activity, you’ll also love our guide to protecting your IP when manufacturing in China: