A Trep’s Guide to Sourcing in China
The following essay was written in January, 2014.
It is not uncommon for entrepreneurs to fear the idea of sourcing their products abroad, particularly to suppliers in a country like China, a place where the shanzhai culture of counterfeiting goods can be such a pervasive practice. Nevertheless, China still ranks among the world’s leading destinations for outsourcing. In spite of the risks, producers are still attracted to China because of its high technical prowess and relatively low costs. So are the fears warranted, or is what we are hearing simply overblown? Well, there is no discounting that the theft of intellectual property is a real risk in a country like China, but the fears of such risks may, in some cases, be misdirected.
While working with businesses to craft sourcing strategies, one thing that this consultancy has found is that many entrepreneurs are most afraid of the prospects that their own suppliers will be the culprits behind counterfeiting their goods. That is a real possibility, but we believe there are a few rules that entrepreneurs can follow to reduce the risk of this happening.
Select a reputable sourcing agent.
Many businesses, and particularly most small entrepreneurs, lack the knowledge to circumnavigate the business environments of foreign countries. Consequently, they may hire third-party sourcing agents to facilitate relationships with suppliers. This can be a useful entrée into those foreign countries, where differences in language, culture, and infrastructure may pose challenges. That said, though, entrepreneurs would be well-served to keep in mind some key points when selecting their sourcing agent:
· The sourcing agent must have real familiarity with the local business terrain, and he should also maintain an on-the-ground presence in that market.
· The sourcing agent should have a strong track record as a liaison, providing the entrepreneur with a fair number of references.
· The sourcing agent should report to the entrepreneur, in writing, on a regular basis, even if nothing new or unexpected is occurring.
· The sourcing agent is not a permanent fix. No business should foster an indefinite reliance on a third-party agency without cultivating its own direct channels for communications and accountability with its supplier.
· The sourcing agent needs to work for the entrepreneur, not the supplier. No exceptions.
Identify a reliable supplier.
Once the entrepreneur and the sourcing agent are ready to do so, the vetting and selection of a supplier really is no different from the way it is done domestically. The entrepreneur should verify that the supplier has the competency needed to build the products being sourced, the capacity to meet the requisite needs, and the ability to scale that capacity up when demand increases.
Accessibility should also be a concern for the entrepreneur; a lack of critical infrastructure near the supplier can hinder both communications and transportations, thereby adding to logistics costs. And, of course, the entrepreneur will need to confer with references provided by the supplier, to evaluate the supplier’s track record on, among other things, quality, timely deliveries, services, communications, and ethical business practices.
Lawyer up—and document everything!
“Shanzhai” is a Cantonese word used to refer to the inferior knock-offs of well-known products being churned out of some Chinese factories. As more and more outsourcing came to China at the end of the last century, the number of knock-offs exploded. Today, the shanzhai culture is so pervasive— and, unfortunately, so much more improved—that counterfeiting in China is estimated to cost businesses nearly $20 billion in potential revenue.
For small entrepreneurs new to the sourcing world, this can be disconcerting. And while there may never be a way to completely head off the risk of counterfeiting, having product designs properly patented and trademarked, alongside working with legal counsel to draft comprehensive manufacturing agreements that conform to both domestic and foreign rules of law, promises to be the best way to reduce such risks. A well-drafted series of contracts between the entrepreneur and the supplier (as well as any subcontractors, if necessary) should help to make clear the terms and expectations in this new relationship. In addition to a number of other components, a good manufacturing agreement should specify, in detail, the following:
· Product specifications
· Product standards
· Procedure for manufacturing
· Identification and descriptions of any subcontracted parties
· Payment schedules
· Deliveries
· Warranties
· Site inspections
· Framework for legal recourse
· Acknowledgement of intellectual property rights
· Confidentiality and non-use agreements
· Exclusions
· Shipping specifications (with details about performance, control of goods, insurability, etc.)
If the supplier has a reasonable reputation for being above-board, then there is probably little reason for immediate concern that this partner will be the culprit of any counterfeiting. In fact, the problem, more than likely, may originate with manufacturers with whom the entrepreneur has no contact and, consequently, no working agreements. These unconnected manufacturers are notorious for reverse- engineering products, sometimes at the behest of an entrepreneur’s competitor, and mass producing replicas of, or developing slightly different versions of, the entrepreneur’s product. To this end, the entrepreneur would be well-served to use resources in the foreign market, like those provided by some larger sourcing agencies, to monitor the foreign marketplace and identify incidents of counterfeiting.
Conduct on-site inspections and establish communications channels.
An entrepreneur cannot rely too heavily on the efforts of the sourcing agent. He must travel to the supplier to assess the operations. These site inspections not only bolster the entrepreneur’s familiarity of the manufacturing process, they provide him with a great way to build a direct rapport with the supplier. The goal is not to completely usurp the inroads forged by the sourcing agent, who should continue to work as a tactical representative of the entrepreneur, but the direct channels of communication can be useful when unforeseen issues arise.
Understand the role of the foreign government and the legal landscape.
To simply say that an entrepreneur should have ready and competent legal counsel at his disposal is a glaring understatement. Many foreign countries—and China, particularly—can be a litigation minefield for even the savviest businessperson, and for a small entrepreneur, legal challenges in these countries could overwhelmed both his personal savings and the finances of his new business. Therefore, it is quite imperative for an entrepreneur to retain legal counsel with a broad wingspan of resources in the market in question. He should also attempt to learn, in advance, as much as he can about the legal terrain of the foreign country, so as to fully understand where, if any, potential liability exposure may reside.
What’s more, it is important to have a clear picture of how intellectual-property rights are protected in the foreign country. China poses an interesting case, inasmuch as its overall handling of the shanzhai phenomenon has been spotty; yet, foreign firms have still elected to outsource to this country. The proper treatment of intellectual property had not always been a matter of serious interest in this country. In fact, it was not until 1992 that the Chinese entered into a Memorandum of Understanding with the United States, wherein China agreed to acknowledge the trademarks and patents of companies filed in the U.S., and in doing so, agreed to provide similar protections against the infringement of those works within its borders. That language was largely codified into law in 1996 with the signing of the Sino-U.S. Agreement on Intellectual Property Rights. Suffice it to say, though, the law did little to reduce infringements, and the intellectual-property arena remains as murky and troublesome as ever in China.
Part of the problem in China exists in its patent framework, while another part of the problem is owing to the manner in which cultural biases trump the rule of law. First, China splits its patents into three significant types: invention patents (which, until recently, were only available for product made and originally made in China); utility model patents (which protect the shape, structure, and composition of a good for a period of ten years); and design patents (which, of course, only protect designs). In order to enforce these patents, officials in China deploy a “double-track” system that allows an aggrieved party to challenge an infringement through administrative channels or a judicial course of action via the courts. While the administrative approach may seem less costly, it can be tremendously time-consuming with no assurance of resolution. Meanwhile, costs notwithstanding, the courts pose their own hurdles. In 2004, the number of patent lawsuits filed in Chinese courts stood at just over 2000, but by the end of 2008, that number jump with 8000 lawsuits filed, creating a backlog of cases threatening to overwhelm an already-burdened system. Complimenting this, though, is a problem deeply rooted in xenophobia. Judges have shown suspicious deference for local companies, and since many of these judges do not consistently write or publish their rulings, it is often impossible to determine the motivations behind their decisions.
For all of these reasons and others, an entrepreneur should follow the lead of larger businesses, who elect to fight infringement cases, when or if the opportunities ever present themselves, in the United States or other countries with more transparent courts and histories of upholding the rule-of- law, rather than places like China.
The outsourcing of goods can, of course, saves many businesses significantly on production costs, while increasing the margins on those businesses’ products. This fact has proven itself true for companies as large as General Motors in Detroit and as small as an industrial clamp maker in South Texas. But what is also true is that both businesses face the risk of losing their intellectual property to the shadowy side of manufacturing in a place like China, where counterfeiting has become a lucrative business. For this reason, like their larger counterpart, small entrepreneurs must do everything they can to protect their intellectual property. The high points shared in this missive are a good first step in that process.
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