You have a great product that you want to be made in a foreign country about which you know little. What do you do? Do you use a sourcing agent and if you do, how should you pay that agent and what should you have it do? Perhaps most importantly, how should your various contacts with your agents and your manufacturers be structured? The below seeks to provide answers all these questions.
1. Should You Use a Sourcing Agent for Your Overseas Manufacturing?
You essentially have two choices. You bring in and pay a person or a company to help you find the right foreign manufacturer or you do it yourself. Both have their pros and cons.
We have seen competent and incompetent and legitimate and illegitimate intermediaries use all four methods. Is going it alone better? Much of the time it is, but certainly not always.
I cannot tell you how many times a client has retained one of our international manufacturing lawyers to assist in making the switch from using a sourcing agent to going direct with a brand new and far cheaper factory only to have the old factory tell our client it can now reduce its prices by 20-50 percent because it will no longer need to kickback 20 to 50 percent to the sourcing agent.
I also cannot tell you how many times a client or a potential client has given us some completely invalid reason as to why their sourcing agent is “different from the rest.” We commonly hear that such and such sourcing agent must be good and honest because it is being used by some competitor or because it has an office in the United States or in their home country. If only it were that clear-cut. As near as I can tell, there is little to no correlation between a sourcing agent having an office outside China and its quality.
One of the things you need to beware of with sourcing agents is that many want you to believe they are not sourcing agents, but that they themselves own the factory. This is a common lie, and it is common because so many companies fall for it, usually to their detriment. The sourcing agent will talk about “our factories in China or in Vietnam” as though they own them even though they merely work with them. As we discuss in the sections below on NNN Agreements and Manufacturing Agreements, this difference really matters.
The following are just some of the real-world examples of companies that got in trouble by using third-party sourcing agents without contracts to protect them.
1. American company pays Vietnamese company a couple million dollars to make a toy for it. Vietnamese company never makes a single toy. American company hires my law firm to explore options for pursuing the Vietnamese toy manufacturer. Our international dispute resolution attorneys look at the manufacturing contract and notice that the signing party is a completely different entity than the Vietnamese toy manufacturer with which our client thought it had the contract. It turns out our client’s contract was with a “sourcing consultant” who operated out of a $600 a month single office in Hong Kong. Skeptical of ever being able to collect from this company, our client (wisely) chooses not to pursue litigation.
2. Many years ago, an American company called us after just having learned that its two-million-dollar order of Christmas tree lights would not be delivered to the United States until December. We called the Chinese factory, and they told us they had no idea who our client even was. It turned out that our client had unknowingly been using a sourcing agent (we figured it out by looking at some Chinese language documents) and it had no contractual relationship with the actual factory. To make matters worse, the Chinese factory was intentionally not producing our client’s order because our client’s sourcing agent owed money to the Chinese factory. Our client ended up having to pay millions more to the Chinese factory to get it to deliver the lights on time.
3. European company gets bad product from its Chinese shoe manufacturer and so refuses to pay the remaining $800,000 or so for the shipment. European company then gets sued in China and retains my law firm to assist. Turns out that the lawsuit in China has been brought by a Chinese sourcing agent whose contract with our client makes clear that it gets paid for brokering each transaction, whether the transaction goes well or not. In other words, there would have been a very good chance this sourcing agent would have prevailed in its lawsuit against our client because it had fulfilled all requirements of its deal with our client, and the manufacturer providing bad product was irrelevant. These sorts of contracts are disturbingly common. Our client ended up settling.
4. American company hires out the alleged best United States manufacturer for a particular type of sporting goods product. This U.S. manufacturer told American company that it would make the sporting goods product for the American company in China. American company agreed and within about a year it learned that the American company did not have any factories in China; it was outsourcing the manufacturing to an unrelated Chinese company. American company learned this after the Chinese manufacturer started selling the American company’s sporting goods product as its own. American company also learned that the Chinese manufacturer had secured a patent on the sporting good. This eventually led to incredibly expensive litigation involving six lawsuits, one in China, and four in three different states in the United States.
But enough about how bad product sourcing agents can be. What does a good sourcing agent bring to the table, how do you find such a sourcing agent, and what do you do once you have one?
A good sourcing agent will accomplish some combination of the following for you, depending on your own priorities:
- Find you a manufacturer that can make your product or tell you that is not possible.
- Find you a manufacturer that can make your product at the quality standard you need or tell you that is not possible.
- Find you a manufacture that can make your product at the price point you need or tell you that is not possible.
- Not cause you to lose your vulnerable IP at any stage of the process. This means your sourcing agent should either not reveal your IP or turn you over to legal counsel to protect it.
- Continue working with your manufacturer after it has been chosen to ensure high quality or even to ensure that your products are evolving to meet changing technologies or demand or whatever.
There are a lot more things that good sourcing agents do beyond just the above, but this list should be a start.
I wish I could give some sort of definitive answer regarding whether to use a sourcing agent or not, but I can’t. This decision truly must be made based on your own circumstances.
2. How to Choose Your Sourcing Agent
As anyone who has ever worked with me knows (and as is true of many lawyers) I am a perfectionist. If a client comes to me for legal help for their China manufacturing, I almost always question them about their potential or actual product supplier(s) and how they found them. I ask these questions because I know from experience how important it is to choose the right manufacturer and I am borderline obsessed with making sure our clients have the right manufacturer for what they will be doing.
My favorite speech is on how to protect your intellectual property from China, and I start that speech by talking about how the following three things matter most in this:
- Good partner (the Chinese company you choose).
- Good contracts with the Chinese company you choose.
- Good registrations (register your trademarks and your copyrights and your patents in China, when applicable).
If choosing a good Chinese partner is important for protecting your IP, that choice is even more important for ensuring quality product on time.
So, we now get to the proverbial question: how do you choose the right Chinese manufacturer? The baseline question then becomes whether you should find that manufacturer yourself or use a third-party sourcing agent to do so. Unfortunately, there is no one answer to this question. About all I can tell you here is that there are many bad sourcing agents and a few great ones and choosing a bad one is virtually always going to be worse than doing it all on your own. If you do decide you need a sourcing agent, choose a good one.
Today though I am going to pull from an excellent post from the always superb Quality Inspection Blog. The post is aptly named, Sourcing from China 101, Part 1: Do You Need a Sourcing Agent? and if this issue is relevant to your China business, I urge you to go there and read the whole thing.
The post nicely lays out the following four options for companies looking to have their products made in China by a third-party manufacturer:
According to the post, 80% of importers go direct and thereby “control the whole process and avoid paying commissions to any middleman or agent.” It states and I agree that “if you are organized enough to manage suppliers . . . .and if you can satisfy the minimum order quantities (MOQs) of suppliers, this is probably the best option for you.” I would, however, add “knowledgeable enough” to this sentence.
The post then discusses how over 90% of sourcing agents get a hidden commission from the factory and it calls this “normal business” in China and how when things go wrong, sourcing agents “often tend to defend the factory!” I agree with this though the 90 percent figure may be a bit too high. But you get the point. In fact, this post quotes me using that same figure, though I used it more for rhetorical effect than as a hard and fast number:
Dan Harris has a similar view of most agents:
I often describe China sourcing agents with the following: “Ninety percent are crooks or incompetents, and most are both. But ten percent are worth more than their weight in gold.”
Perhaps most importantly, the post lays out key questions you should ask potential sourcing agents before you engage one:
- How will they get paid, and by whom?
- Will you be able to visit the factories before/during production?
- Can they provide referrals or testimonials from satisfied customers who buy the same type of product as you? Make sure to contact two of them and get confirmations.
- Do they do quality inspections by themselves? Or do they resort to a specialized third-party? Will you get a report every time?
- Will you get an update every week on the production status?
- Can they share their management system with you? You need to make sure they have processes in place. Most agents don’t follow any established procedures.
- What guarantee do they offer in case a supplier scams you? If shipments are behind schedule? If you receive junk product in your warehouse?
- Are they located in the area where your products will be sourced? (Do a quick search on globalsources.com and you will have an idea about the main area for your product category.)
- If you keep re-ordering the same products from the same sources, will you pay less for the sourcing agent’s services after the first order?
These are all great questions. When our clients ask one of our international manufacturing lawyers to refer them to “good sourcing agents,” we typically ask them the following three questions:
- What is the product for which you will be needing a sourcing agent?
- How do you want to pay the sourcing agent?
- Have you decided on a country you think will be best for your product(s)
We ask the first question because a sourcing agent that is great for sourcing clothes in Mexico is not usually the right sourcing agent for sourcing electronic devises in Thailand. The good news on this score is that good sourcing agents don’t source products with which they are unfamiliar. So if we have a client that wants help sourcing an unusual product and we do not know sourcing agents involved with that product, we will go to the good sourcing agents we do know and ask them for referrals.
We ask the second question because sourcing agents can charge differently, and some are less flexible than others. Some sourcing agents require a large upfront payment to get started and others are willing to work on a percentage basis. Generally, the more you pay up front, the less you will pay in total over time. Our start-up clients tend to prefer paying a percentage per widget manufactured and our bigger clients tend to prefer paying upfront.
We ask the third question because most sourcing agents are good with only a few countries.
How then do you find a sourcing agent “worth their weight in gold?” The best way I know, unfortunately, is word of mouth. I say “unfortunately” because this means you already need to know someone who works with international manufacturing enough to be able to give you a good recommendation. My law firm’s international manufacturing lawyers have a long list of good sourcing agents, divided up by the type of product to be sourced (we don’t recommend someone on the medical devices list to someone making socks and we don’t recommend someone on the clothing list to someone making an Internet of Things product), by country (we don’t recommend our favorite Latin American sourcing agents to someone whose product should clearly be made in Thailand), and by how they charge. I assume other attorneys that do a steady stream of international manufacturing work have similar lists. Logistics companies can be another good source, as can market entry consultants and those with a long history of having their own products made overseas.
3. How Sourcing Agents Charge for Their Services
In working with an intermediary/sourcing agent/broker to get your products manufactured overseas, you should understand both how you are paying them and how much. There are multiple ways to pay these intermediaries, including the following:
1. You pay the intermediary an upfront flat fee for the sourcing agent to, among other things, find you a manufacturer and negotiate with the manufacturer on your behalf. In this sort of arrangement, the intermediary usually drops out after you place your first order, and that order is completed. The biggest benefit with this method is that you pay once, and the intermediary has less incentive to permit the foreign manufacturer to overcharge you. The biggest disadvantage to this method is that you must come up with a large chunk of money right away and it is still possible (and not uncommon) for your intermediary to strike a side deal with your manufacturer to get a 5-55% secret commission on every sale. If your intermediary has a side deal with your manufacturer, it also has an incentive to use a too-cheap manufacturer to be better able to hide its secret commission from you. Too-cheap manufacturers are more likely to have quality control and delivery problems.
2. You pay the intermediary by the hour to, among other things, find you an overseas manufacturer and negotiate with the manufacturer on your behalf. In this sort of arrangement, the intermediary often will remain on board indefinitely to help you with quality control issues. The pros and cons of this payment method are similar (though a bit reduced in terms of the upfront payment) to the pros and cons of method one.
3. You pay the intermediary some percentage on top of what the manufacturer charges. In this sort of arrangement, it is typical for the intermediary to find you a manufacturer, negotiate on your behalf with the manufacturer, and remain on board indefinitely to help with quality control and to keep collecting its percentage payment. The biggest benefit of this method is that you do not pay anything up front. The biggest negative of this method is that when our international manufacturing lawyers have been called in when a problem has arisen, more than half the time we discover that the intermediary’s alleged 5% commission was actually anywhere from 20% to 300% — yes 300%, with 30-50% commissions being the norm. Again, to the extent your intermediary is hiding the amount of its commission from you, it has incentive to use a too-cheap manufacturer, which heightens your risk of quality control and delivery problems.
4. You pay the intermediary some predetermined fixed amount for your product and the intermediary steps in and essentially becomes the seller. This means that the intermediary is responsible for quality control issues and — if you have an appropriate contract with this intermediary, this also means it is legally liable for bad quality and late deliveries The biggest benefit of this sort of arrangement is that it is usually the most honest. You know what you are paying for your product and the intermediary does not lie to you about what it is paying for your product because that amount is irrelevant. When I buy cheese at my grocery store for eight dollars, I hardly care what my grocer paid for the cheese and no representations about what it did pay are being made. If the cheese is bad, the grocer is on the hook, plain and simple. But I am no doubt paying more than if I were getting my cheese straight from the dairy farmer.
4. NNN Agreements When Using a Sourcing Agent
The multitude of potential arrangements when using a sourcing agent for your overseas manufacturing creates uncertainty about the appropriate contractual protections. That is: should you have an agreement with the sourcing agent, the factory, or both? And what type of agreement?
We are big fans of using NNN agreements with potential business partners (especially overseas factories). Knowing this, our clients will sometimes come to us and say that they are having goods manufactured in China, India, Vietnam, Thailand, Mexico (or wherever) and they need an NNN agreement “for everyone”. The problem is that NNN Agreements are overused and nearly half that we see were either unnecessary or — worse — the wrong agreement to use. Using a sourcing agent makes using an NNN Agreement even more complicated.
If you don’t know the identity of the factory manufacturing your goods, an NNN agreement with them is out of the question because you can’t enter a contract with an unknown company. And if you have an arrangement with a sourcing agent or a factory, there is a good chance that an NNN agreement won’t go nearly far enough. In short, the arrangement you have with your sourcing agent will determine the agreements you need, and with whom. It will probably not surprise you to hear that the answer is: it depends.
In an ideal world, if you are dealing with overseas factories directly, you would want NNN agreements with the factories with which you have initial talks, product development agreements with the factories that develop products for you, and Manufacturing Contracts with the factories that actually manufacture products for you. In this situation, the agreement with the sourcing agent should be simple because it is not doing much – it will basically be an NNN agreement with some additional verbiage to cover the finder’s fee. You don’t want the sourcing agreement to be the only agreement in place because it offers so little protection.
If you are dealing exclusively with your sourcing agent, then you won’t – in fact you can’t – have any agreements with the factories. You will need to look to the sourcing agent exclusively for everything: non-competition, non-circumvention, non-disclosure, quality control, ordering, warranty, etc., because you have no contractual privity with the factories and no way to hold them responsible for anything. This can be useful if your sourcing agent is based in your home country because it will likely be easier for you to sue that company if something goes wrong. But, and as I noted above, this presupposes that your sourcing agent has assets, and that your agreement allows you to hold it responsible for the actions of the foreign factories.
Some clients ask our international manufacturing lawyers if they can just have NNN agreements “with everyone” and leave it at that? Certainly, it does not hurt to have NNN agreements with every party on the sourcing agent/manufacturer side. But it won’t cover all potential forms of liability – not even close. It will only hold counter-parties liable for misuse of your IP. For some clients, this is enough, particularly during initial phases when they are unsure whether their IP can really be commercialized.
And no matter what agreements you sign with your sourcing agent and factories, you still need to register all your IP (patents, trademarks, copyrights) in the country in which you are having your products made. You could have an ironclad agreement with a great sourcing agent who only uses wonderfully compliant factories, and it won’t mean a thing if some third party registers your trademark or copies your patented goods. You should be clear with your sourcing agent as to whether you or it will be securing your IP overseas. And whatever choice you make here should be reflected in your sourcing agent contract.
5. Manufacturing Contracts When Using a Sourcing Agent
One of the legal issues we often must resolve is whether our client who is using a sourcing agent would be better off contracting with that sourcing agent for the manufacturing of its product, or contracting directly with the factory, while still paying the sourcing agent for its services. One of our manufacturing lawyers recently explained to a client some of the things the client should consider in determining whether to contract with its sourcing agent or to contract directly with its overseas manufacturer:
You raise the usual and standard issues related to this kind of contract. To start, it makes no sense to have essentially the same contract with two parties. You must choose with whom you are going to contract. Will it be your sourcing agent, or will it be the factory? You should contract with the entity that will issue the invoice for the product and in this case (unless we change things) that is your sourcing agent. But if you contract with your sourcing agent, you can and you should also have a contract with the factory that deals with issues like ownership of intellectual property, ownership and control of the materials, non-circumvention and non-compete and similar. However, many factories are not willing to sing that kind of contract if they are not the direct seller of the product.
The old way was to enter a contract with the sourcing agent, loading all liability on them. Since Sourcing Company X is a U.S. company, operating in this way is pretty much like making a purchase from any U.S. company that outsources its manufacturing around the world. The question is: can Sourcing Company X perform? Does it have the resources to do the work and the asset base to deal with any problems?
As you have figured out, there can be many problems with the “old way.” If you are purchasing from a huge company like Apple, you don’t really care about who their ultimate suppliers are because you know Apple will do the work and you know Apple will stand behind the products and you know it has the resources to handle pretty much anything that can go wrong. For a small company like Sourcing Company X, the analysis is more difficult.
If there is a defect, can you rely on Sourcing Company X to fix things? If there is a late delivery or a short delivery, can you rely on Sourcing Company X to address this in a way that does not require your staff go to your overseas factory? Can Sourcing Company X ensure the materials are properly processed and securely stored and maintained in a situation where you have no direct contract with the overseas factory? What if the factory goes bankrupt: what happens to the materials then? Will Sourcing Company X remain liable in that situation? Can Sourcing Company X ensure all payments will be made to the factory and to the suppliers of the factory? Can Sourcing Company X ensure the factory and its suppliers and the suppliers to its suppliers will not steal your IP or circumvent you by going directly to your customers? If circumvention happens, will Sourcing Company X aggressively take care of the issue, and does it have the financial resources to cover for liability?
If the answer is yes in each case, then you should contract with Sourcing Company X. The more difficult situation is if you conclude Sourcing Company X may not be fully able to deal with these issues. In that situation, we consider whether you are better off with a contract with the factory overseas or better off with a contract with Sourcing Company X here in the U.S. and insured here as well. Can Sourcing Company X really perform and if you contract with a single overseas factory, does that put you into a better position if something goes wrong You will need to make this decision based on your own business judgment, since you are the one with direct contact with the players. We can help you with this by conducting due diligence checks on the two companies.
6. Additional Reading on Overseas Product Sourcing
In China Sourcing 101: the 15-Part Guide for New Buyers, The Quality Sourcing Blog compiled a 15-part series for those looking to buy products from Chinese suppliers. This blog series consists of the following 15 articles, all of which apply with near equal force to sourcing from anywhere in the world:
- Do You Need a Sourcing Agent?
- How to Identify Potential Suppliers
- How to Verify a Manufacturer
- Second Choices vs. “Never Again”
- Negotiation: The Terms you Need to Discuss
- Keep Some Leverage with Suppliers
- Pre-Production: Describing What You Want
- Project Management of Your Orders
- Check Quality Early in the Manufacturing Cycle
- Always Verify Quality Before Shipment
- Build Good rapport with Suppliers
- How Closely Do You Follow Your Productions?
- The 5 Steps to Developing a Good Supplier
- How a Factory Can Improve Quality
- How a Factory Can Improve Productivity
If you want help on how to better source your products internationally, I suggest you work your way through the above blog series. And if you want help on the legal side, I suggest you read Manufacturing in China: Minimizing Your Risks by Doing Things Right.
Now you know. . . .