You might get your Chinese suppliers to sign contracts, you might come and check quality, you might decide on re-orders based on their performance… But, at the end of the day, what the factory really looks at is, ‘how much of the order did we get paid, and how much room for manoeuvre do we we have right now?’
You may plan things for the next few years. But many business people I have met in China seem to plan for the rest of the day! There may or may not be deep-rooted cultural reasons for that. But the fact is, people here are much more focused on the short term.
As the buyer, you need to think very carefully about payment terms. You need to make sure your Chinese supplier, who has over-promised to 10 customers and needs to disappoint 5 of them at some point, will think twice before deciding you will be among the unfortunate ones.
Another warning is, suppliers will tell you there is one standard, the ‘30% deposit before production, 70% before shipment’ setup. Do not accept it at face value.
I have seen a variety of payment terms along a continuum that would look like this.
Let’s walk through some relatively common options.
100% T/T pre-payment
This is typically a beginner’s mistake on the buyer’s side. They are impressed after visiting a nice-looking factory, and they want to show some goodwill — ‘look, we are easy to work with, please take our orders and do a good job’.
I don’t remember seeing this situation EVER ending well in my 10+ years working with importers in China.
Why is that? Well, the manufacturer has zero incentive to perform. Remember, they might be thinking ‘what will I have on my table tonight?’, not ‘how can I best grow my business over the next 10 years?’
Does another customer want a production to be shipped fast? (And who doesn’t?) You order will be bumped a few days/week late. And so on.
Do you find some quality issues, and request them to re-work or re-produce the goods? They will adopt a ‘take it or leave it’ attitude.
30% T/T deposit, 70% T/T payment after passed QC inspection
This one is quite common. It is generally a balanced and fair deal. There are still a number of risks for the buyer, though.
Note that you can probably negotiate 2 changes:
- A slightly lower deposit (which should be called “initial and nonrefundable payment” for clarity), especially if the products are very standard and could easily be sold to another customer;
- Payment of the remainder after shipment — in practice the supplier faxes the bill of lading to you, you check with your freight forwarder (assuming you buy FOB), you send the payment, and the supplier sends you the original documents.
If the factory has completed most of the production and you haven’t paid in full, they are ‘hooked’ too and you have a bit of leverage. As soon as you have paid in full, you have zero leverage and you need to count on a contract (if you have one) and on the hope of future business (for what it’s worth in the supplier’s eyes).
20% T/T deposit, 50% T/T payment after production and after passed QC inspection, 30% after delivery in buyer’s country
This is an improvement. You keep some leverage until you receive the goods. If the manufacturer played games during the inspection, or ‘salted’ bad products into your order just before shipment, you can still catch it.
This is especially valuable if you do some assembly, some custom printing, etc. on the products once you receive them. The workers might notice some defects. There is no need to spend time solely for inspection.
Letter of credit (L/C) at sight
Certain companies always use letter of credit for orders above a certain amount (say, 30,000 USD) or for first-time suppliers. Only some suppliers accept a payment by L/C.
The big advantage is, there is no need to wire a deposit to the supplier. So, if something goes wrong, you as the buyer are not ‘hooked’. This payment instrument is clearly favorable to the buyer, but it is expensive (high bank fees).
There are a few risks to watch out for, too.
100% T/T payment 2 months after shipment, with no deposit
Some purchasers manage to extract these terms from a small proportion of Chinese suppliers. This is extremely favorable to the buyer.
It will be easier if you buy high volumes of low-complexity products, and if many suppliers are competing for your business.
However, if you have an ongoing business relationship with a supplier that you pay that way, you are still ‘hooked’ to a certain extent. Above all else, you probably need continuity of supply. If you find quality issues and you act in a way the supplier sees as unfair, they might stop shipping goods to you!
Not paying for the non-recurring engineering costs such as tooling, firmware code development, etc.
This is actually tacitly encouraged by most Chinese manufacturers. It is their strategy to gain the upper hand in the business relationship in the long term. This is extremely dangerous for buyers of highly customized products.
Steve Dickinson describes this on the China Law Blog, in an article entitled Hardware Co-Development in China: Do it Right, Part 2:
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 who actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns the product while the Chinese factory says it owns it. Who does legally own it? Way more often than not, the Chinese factory does.
How does all this come about? The standard scenario goes something like the following. A foreign product designer comes to China and works with a Chinese factory to commercialize an innovative hardware or IoT product design. 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.
At the end of the development cycle, the Chinese factory announces to the foreign developer that the prototypes are completed. The factory retains the prototypes 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 can happen in two ways. First, the Chinese factory surprises the foreign designer by substantially increasing the projected unit price for the product or it announces that it cannot meet the quantity or delivery date requirements for the product. Second, the factory consistently manufactures product with substantial product defect/quality control issues.
Facing these problems, the foreign party confronts the Chinese factory and announces that it is going to take the prototypes and have them manufactured by another factory. The Chinese manufacturer replies: “you cannot do that. We own all the IP contained in the product. We agree that we will manufacture the product for you exclusively for as long as you are willing to order on our terms. But you cannot take that prototype anywhere else. Only our company has the right to manufacture that product. And, if you are not successful in making substantial sales, we will cut you off and market the product ourselves.”
The real problem with this scenario is that in most cases the factory is absolutely correct about the legal situation concerning the intellectual property in the new product. Stated simply, absent a written contract to the contrary, it is generally true in this setting that the factory DOES own the intellectual property in the product.
Steve describes the legal consequences. But let’s look at the situation from the perspective of the buyer. It is worse. In many cases they PHYSICALLY can’t do anything. The mold is in the Chinese factory; developing and fine-tuning a new one would take time and money. Maybe some code was developed for the firmware, but again the supplier (or, often, a sub-supplier) keeps the source code.
In such a case, having a contract that clearly spells out who can do what with the finished product, if extremely important. You will probably have to pay for some/all of the non-recurring engineering work for the supplier to agree to this.
In short, there is no shortage of payment options. Some are much more favorable to the buyer. And yet, even the most favorable to the buying side include serious risks! You need to evaluate not only what suppliers will or will not accept, but also what behaviors you will encourage…