Continuity of Supply - Manufacturing Rights

The term “manufacturing rights” in most cases is really a misnomer as what you are really looking for is a license from the owner of those rights to make or have made the product. A license to manufacture may be sought in a variety of situations ranging from where the Supplier may not have the resources or capability to produce the product in the volumes required to having rights as a form of protection in the event the Supplier’s long term financial stability is of question. In the former situation you would frequently pay a royalty payment for the right to manufacture the product as the means by which the Supplier recovers payment for the partial transfer of their knowledge and rights.  In the latter situation whether you will agree to pay the Supplier a royalty or not would depend on the circumstances surrounding the license.

Manufacturing rights provisions traditionally consist of the following:

1. A description of the “package of information” the Supplier must provide the Buyer that would enable the Buyer to manufacture or have the product manufactured.
2. A description of Buyer’s rights to use the information to produce the product which would include any limitations on the production
3. A description of when the Buyer is able to exercise its rights and when those rights may be terminated.
4. Requirements for delivery of the Information package either directly to the Buyer for use or for placement into Escrow similar to a SW escrow situation.
5. The Compensation or royalties for the use of the Manufacturing package. These could be expressed as lump sum payment, or per unit royalty.
6. Any limitations or offsets against such royalty payments, For example one approach could be to use the Purchase Price as the Base, and then deduct all of buyer’s costs, investments and cost of management on a per unit basis and if there is anything left, that’s the royalty
7. An escrow agreement if the materials are to be placed into escrow.
8. Requirements on the part of the Supplier, if any, to keep the information provided or escrowed current.

The decision to seek manufacturing rights needs to be well thought through before pursuing these rights by asking the following questions:

a)    Are the Business prepared to manage the royalty payment process on their own (as hardware royalties cannot be managed under the SW warranty process)

b)    What can the Supplier license, and is it going to be enough to manufacture the product?  What will need to be licensed from a 3^rd party? At what cost?

c)    What skills and technology are required to build and test the product? Where will you get them if you plan to make it or have it made?

d)    What investments will be required to be able to manufacture the product in terms of things like capital equipment, testers etc.?

e)    If the product involves semiconductor chips, will you be able to purchase those chips and at what cost?

f)     If you need to have them made, what investment is involved in replicating all the Masks that are used and what FAB has the right technology level and equipment to be able to use copies of the existing masks and not need to convert them?  How much will it cost to convert them if they cannot be used as is?

g)    Where and how will all tests be performed and what is required to replicate the Supplier’s test capabilities?

h)    What subcontractors and material suppliers does the Supplier use and how will purchases from all those suppliers be managed? Are their any restrictions imposed by them that may restrict your ability to make or have them made or that would force you to use them?

Going through all the effort of negotiating Manufacturing rights will only be a significant waste of time unless you know that you can clearly make or have the product made at a cost that’s.  For some situations, such are where the Supplier is mostly outsourced and has most, if not all of the work performed by others, it may be easy as long as those subcontractors and material suppliers are allowed by the Supplier to sell to you directly and there is nothing that prevents them from making those sales.  They may have been willing to sell their product or license their technology to the Supplier but there could be situations were they may be reluctant or unwilling to sell it to Buyer. 

Let’s look at a sample and explain they type of rights sought and the terms:

Manufacturing Rights.

For the purpose of this Section the term Product shall mean the ________ and variations thereof and successors thereto sold to Buyer by Supplier under this SOW. For the purpose of this Section the term Semiconductor Vendor shall mean the supplier (or suppliers) with which Supplier has contracted for the management, production and creation of the complete, fully tested Product for Supplier. Any change to the Semiconductor Vendor or the ownership of anything necessary to produce the Product shall require notice to Buyer pursuant to Section ______hereof, and shall be subject to the provisions thereof. As of the date of execution of this SOW the Semiconductor Vendor is ______________________   “Manufacturing Package” shall mean all technology, documents, materials, authorizations, agreements, rights, licenses and information (including, but not limited to, the  Device Specification, Overview, Design Database, ASIC design specifications, RTL source files, structural netlist, simulation test-benches, simulation vectors, synthesis scripts, timing constraints and scripts, Microcode source files, and Microcode assembler any other documentation owned or controlled by Supplier, any test routines owned by Supplier, Semiconductor Vendor contacts, and contracts, authorizations, rights and/or licenses that may be needed to purchase the assembled and tested Product from the Semiconductor Vendor, as well as all information necessary to help Buyer have the Product manufactured by the Semiconductor Vendor) that are required to allow Buyer to develop, manufacture, produce, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product.

In this situation there was a Semiconductor Supplier that owned the primary technology required to produce the product and the Supplier’s Product was the equivalent of a derivative work building off that underlying technology. So one of the keys was if the Supplier was unable to perform, we would need to still have the chip made by the Semiconductor Supplier. To ensure that the Semiconductor Supplier and we had everything necessary to make the chip we identified what was required for the manufacturing package to both build and test the product.

(a)       Upon the occurrence of one of the trigger events (“Trigger Events”) listed below in section (c), Supplier shall provide Buyer with the Manufacturing Package as well as all information necessary to help Buyer have the Product manufactured by the Semiconductor Vendor. Upon execution of this SOW, Supplier shall obtain consent from the Semiconductor Vendor for Buyer to purchase the Product under such Semiconductor under and Adoption Agreement as set forth as Attachment A. Supplier shall further obtain consent from the Semiconductor Vendor allowing Buyer to assume and/or replace any open purchase orders placed on the Semiconductor Vendor on behalf of Buyer immediately upon a Trigger Event.

In this case the license and the delivery of the manufacturing package was tied to a triggering event which would allow Buyer to both receive the materials and commence production

(b)       Thirty (30) days after execution of this SOW, Supplier shall place the Manufacturing Package in Escrow under an escrow account (the “Manufacturing Escrow”) with XXXX Group, Inc. and Buyer shall become a third party beneficiary of such Manufacturing Escrow pursuant to the terms of the Escrow Agreement set forth as Attachment A to the Base Agreement.  (“Custodial Agreement”). 

As the rights were tied to a triggering event in the future, we required the materials be placed in Escrow so we could access them immediately on occurrence of the triggering event

(c)       Buyer shall have the right to demand from Supplier or the escrow agent, and Supplier agrees to immediately provide (either directly or through rights granted in the Escrow Agreement), the Manufacturing Package upon the occurrence of a Material Breach (as that term is defined in Section 15.4 of the Base Agreement).

In this relationship a number of items were defined as Material Breaches including the supplier’s failure to consistently delivery product.  The key is you want the right to manufacture to transfer before a Supplier enters into Bankruptcy as once they enter into Bankruptcy the trustee in Bankruptcy does not have to honor the agreement and would not be bound to provide Buyer with those rights.  

(d)       In the event of a material breach that is solely attributable to the breach of the Components SOW wherein Buyer elects to terminate for Cause only the Components SOW, Supplier grants to Buyer a limited,  non-transferable, non-exclusive, perpetual, royalty bearing (as set forth below) license under all intellectual property rights in the Manufacturing Package, to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product as part of Buyer’s product.

1. Buyer shall pay to Supplier a royalty for each Product sold by Buyer, after exercise by Buyer of the license set forth in this subsection (d).  The royalty will be calculated as 80% of the Price of the Product as last agreed at the time of such termination less Buyer’s cost of purchase of the Product from the Semiconductor Vendor.

2. Once per year the parties the parties will review the competitive position of Buyer’s product in the market place and negotiate in good faith reasonable adjustments to royalty to allow Buyer’s product incorporating the Product to remain competitive.  If there is a subsequent Material Breach by Supplier and Buyer elects to terminate any of the other Agreements, the license shall be royalty free. 

In that case if they breached the hardware SOW and we elected to terminate for cause we agree to pay them a royalty.  The royalty first backed out 20% off the price to account for costs and warranty risks being assumed. We then deducted our cost of purchasing the completed Product from the Semiconductor Vendor and if there was any amount remaining, that was their royalty payment.  We also allowed for the formula to be further adjusted downward based on the product’s competitive position in the market as pricing will normally erode over time and as such the royalty formula needed to take that into account

(e)       In the event of a material breach as provided for in section 15.2 of the Base Agreement, wherein Buyer elects to terminate the Base Agreement, Object Code Licensed Works SOW and the Components SOW, Supplier grants to Buyer a limited,, non-transferable, non-exclusive, perpetual, royalty free license under all intellectual property rights in the Manufacturing Package, to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product .

As the breach of other portions of the relationship would have cause the Buyer to assume substantial additional costs to do things like complete the SW, if the entire agreement was breached, the obligation was that it would be royalty free if we used it.

(f)        For paragraphs (d) and (e) above, If Supplier is not authorized to license or transfer rights granted to it by a third party that are necessary to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product, then Supplier will use its best efforts to acquire such rights from any such third party.]

We included a very high standard of performance for them to get any third party rights that were needed.

(g)       Buyer shall have all remedies available at law or in equity for enforcement of this section including the right to seek Specific Performance.

In this, because the supplier was financially questionable where money damages would not have provided and adequate remedy, we made it clear that for the Manufacturing Rights we had equitable rights including specific performance were we could go to court to order their compliance.