China (Shenzhen mostly) is the primary destination for manufacturing of small electronic consumer products. And since Internet of Things (IoT) products are red hot, this means our China lawyers get a steady stream of China IoT legal matters.
The big issue we most often see is this: the IoT product has now reached the mass production stage and is being produced in large quantities. Now that it has a commercial product, the U.S. or European (usually) buyer now seeks financing for its start-up company. The financier (be it angel, VC, private equity, or even someone’s father-in-law) then asks who owns the intellectual property in the product? With the rise of the Internet of Things (IoT), this question is often difficult to answer definitively.
How did we get to this point where the IP rights of a product are so often vague? The process has worked its way through three general stages:
Stage One. In the good old days (roughly 1981 to 1995), the situation was simple. There were two possibilities. In the first, the Chinese manufacturer made a standard consumer product. The foreign buyer purchased that existing product and perhaps required the Chinese manufacturer take the extra step of placing the buyer’s own trademark/logo on the product. In that setting, ownership of the intellectual property was clear: the Chinese manufacturer owned the product design and the foreign buyer owned its trademark/logo. In the second, the product was a long standing, well developed product of the foreign buyer. The foreign buyer brought the completed product to the Chinese manufacturer and contracted with the Chinese manufacturer to make a copy. In that setting, ownership of the intellectual property was clear: the foreign buyer owned all the intellectual property and the Chinese manufacturer owned nothing.
The simplicity of this sort of relationship encouraged the somewhat lazy practice of documenting the entire manufacturing relationship with purchase orders. NNN agreements, product development agreements and OEM agreements were seldom used, since IP ownership was clear and the price and delivery terms were resolved via the purchase orders. This approach would often lead to product defects, but that is for another post.
Stage Two. In stage two (roughly 1995 to 2015), a new form of manufacturer-buyer relationship developed. Foreign buyers began coming to China with no completed project in mind; they instead would come with a product idea or proposal. The foreign buyer would then work with the manufacturer to co-develop a product. In some cases the Chinese manufacturer would simply take a completed prototype and commercialize that prototype for mass production. In these cases, the foreign buyer arrived with little more than a basic idea and the two sides worked to co-develop the product. See China Product Development Agreements, for pretty much everything you need to know about China product development agreements.
The Chinese manufacturer usually would perform the product development work at its own expense, with the implied agreement being that it would be the exclusive manufacturer of the product. This co-development process typically used the same lazy “purchase order only” approach from stage one. This approach then led to the many issues we see today that make answering the “who owns what IP” question so difficult. To do the co-development process properly, the parties must define their relationship with three agreements: 1) an NNN Agreement, 2) a Product Development Agreement and 3) an OEM Agreement.
When these agreements do not exist, a standard set of issues arises: Who owns the product design? Who owns the molds and other tooling? Who owns the manufacturing know-how and similar trade secrets? If the buyer decides has the product made by a different Chinese factory, what compensation is owed to the Chinese manufacturer that co-developed the product? What are the Chinese manufacturer’s obligations to comply with the foreign buyer’s price and quantity requirements? If the Chinese manufacturer terminates its relationship with the foreign buyer and manufacturers the product under its own trademark/logo, is this a violation of any agreement between the parties? Absent clear written agreements, none of these questions have clear answers. In these unclear situations, the Chinese factory will nearly always be in a much stronger position than the foreign buyer and the Chinese factory will typically prevail in any IP dispute.
Stage Three. In stage three (2015 to today), we arrive at the IoT era. In designing, developing and manufacturing consumer products for the IoT market, the already unclear and problem-filled relationships of the stage two era are now magnified. In the IoT era a whole new set of issues has arisen. In the stage two era, there was at least the simplicity of two entities designing and/or manufacturing a single product. In the IoT era, the situation is considerably more complex. In most of the IoT projects we have done, the development process has expanded to include the following:
1. Product “concept” from the foreign (usually United States or European) buyer.
2. Product external design, from an international design firm.
3. Internal design and function, owned by:
a. The foreign buyer;
b. The Chinese manufacturer;
c. The provider of sensors and other components required to connect the IoT product to an outside network.
4. Design of the IoT product “app” (usually for smart phones). This involves two completely separate sets of software: the communication sending software residing on the IoT product and the communication receiving software residing in the application. In the same manner as the internal design, these software components may be written/designed by multiple parties: the foreign buyer, the Chinese manufacturer and (quite often) third party software design firms.
What happens then when the product is complete, and manufacturing is ready to start and the foreign buyer starts to seek funding: The funding source almost invariably will ask who owns the IoT product? Who owns its underlying IP? What our China lawyers have far too often found when we ask the foreign buyers these questions is that they usually don’t really know.
This “we don’t know” response does not sit well with potential sources of serious financing. Even worse, when the foreign buyer is pushed to answer the question, it becomes clear that it is not clear who owns the new product. Far too often the only ownership issue that is clear is that the one entity that the foreign buyer is the one entity that does NOT own the rights to the product. Even worse, it is usually not possible to fix the situation by this point.
Bottom Line: As manufacturing in China and the IP issues attendant with that become more complex, it becomes even more important that you have clear written agreements that answer the obvious IP questions in advance. It does not make sense for you to devote your time and your energy and your money developing an IoT product for someone else to own.
For more on the issues involving China and the Internet of Things, check out the following:
- China and The Internet of Things and How to Destroy Your Own Company
- China and the Internet of Things, Part 3 of 228
- China and the Internet of Things: A Love