Let’s Go Aero is a small manufacturer in Colorado Springs, Colorado that makes compact trailers, camper trailers, bike racks, and hitch pins. Marty Williams is the President and founder of LGA. In 2003, Marty designed a new bike rack that could hold two bikes on the rear of a car and in 2007 he filed an application for a patent.

In 2007 he also took his new invention to the SEMA show (Specialty Equipment Manufacturers Show). His new product was a big hit and he was pursued by four of the largest bike rack manufacturers for a licensing agreement. Marty was interested in signing a licensing agreement with a company who had the manufacturing capabilities, distribution channels, and resources to bring his product to market quickly in North America. Because like most small companies, LGA simply did not have the resources or cash flow to bring a new product into the market quickly.

Marty signed a licensing agreement with a large corporation, the Cequent Group, in January of 2008. The Cequent Group was the word’s largest manufacturer of towing equipment. The agreement called for an upfront payment of $400,000 and a 7% royalty fee on every product sold. Things were going very well for Marty and LGA, and in 2009 at the SEMA show his product was selected the “Best New Engineered Product” by the auto industry judges.

But by 2010, everything began to change. By that time Cequent had successfully integrated the products into their manufacturing system and was selling the product through their distribution channels under their own brand. They now had complete control of the product, and in January 2010, Cequent decided to cut off royalty payments to LGA

By late 2010, this dispute resulted in a Federal Lawsuit and the resulting litigation would embroil Marty’s company for several years. Even though the original license was terminated under Federal Court supervision in early 2012, Cequent continued to sell the formerly licensed products under the assumption that LGA probably could not afford the attorney fees to stop them.

The way Cequent handled this licensing agreement is a business strategy used by many large corporations to access good new product ideas and reduce their upfront developmental costs by as much as 40%. More specifically, the strategy is to find small manufacturers with new products at trade shows or in the marketplace, and then force them to sue for their royalty payments and fees, with the assumption that the smaller company will not have the financial resources to litigate the problem in court over a long period of time. The loss of the product sales, future sales, and royalties along with the cost of litigation could bankrupt the small company.

You may think that these kinds of cases are rare, but attorneys say they are becoming common in the U.S. Large corporations must have continuous product development and innovation to compete in today’s global market, and they would like to find ways to reduce their development costs and lower the risks of new product development. By developing a strategy to control a new product, lower the costs and risks, and reduce their time to market – essentially having their cake and eating it too.

Small and midsize manufacturers who are innovative and good at new product development (but not so good at marketing, distribution channels, and financial agreements) should be wary of signing agreements with large corporations, particularly if their balance sheets are not very strong.

It is the dream of most small manufacturers to invent a new product and sell it to a larger company to handle all of the manufacturing and marketing. The dream includes getting a big upfront payment and then relaxing as the royalty or other payments come in. Very seldom will the inventor company get all of his money up front, which means they have to negotiate some kind of agreement. These agreements are very problematic, so it is a good idea to understand the various strategies used to steal your invention, or not pay you in full.

Here are five of the most common strategies used:

  1. Reverse Engineering – This is a strategy of finding new products by purchasing the product with the idea of copying the product idea and then incorporating it into their own product line without the permission or knowledge of the original manufacturer.

If the original manufacturer doesn’t have a patent it is a simple straightforward process, and you can copy it right down to the bolt sizes and pin stripes. If the product has a patent, the reverse engineering is more difficult because it must be engineered without patent infringement. Reverse engineering is very common in the machinery industry, but it is usually involves copying specific features of the competitor’s product.

The Chinese have taken reverse engineering to new heights in their ongoing efforts to steal products by counterfeiting. Regardless of whether the product is a small electrical component or a large production machine, they will copy the product whether it is patented or not because their legal system protects them.

  1. Knockoffs – This strategy is similar to reverse engineering, but instead of trying to make the product like the original product, the knockoff company simply tries to make it cheaper. The big objective of knockoffs is to lower cost, so a lot of corners are cut and the product is usually not as good as the original. Quality is not the objective, it is all about price.

The large retailers are very good at sending American products over to China to be knocked off. The idea is to bring in a cheaper product and then push it into the marketplace as a substitute. They count on the consumer not being able to tell the difference between the knockoff and the original product.

In a previous article, I wrote how Sears knocked off Dan Brown’s Bionic Wrench by using a third party to send it over to China and then re-sell it in the U.S. for 50% of the original retail price. American big box retailers have created a huge industry in China doing knockoffs of American products, particularly the products without patents.

  1. Rollups – In this strategy, the target manufacturer with a new product is purchased, and the selected new products are integrated into the purchaser’s product lines. Depending on the purchase agreement, the acquisition might turn out to be a good thing for the purchased company. But it is more likely that once the purchase is finalized, the purchaser will get rid of the employees, strip the company of the best products, and not live up to the details of the agreement. The buyer is in a strong position to avoid paying fees, progress payments, royalties, or providing jobs,  because the original company has been stripped of resources and is no longer in a position to fight the buyer in court. In the last 25 years investment bankers have developed sophisticated strategies in buying troubled companies and then stripping them of anything saleable.
  1. Workarounds and Patent Trolling – One way for companies to find new product ideas is to be a “patent troller.” These companies simply troll patent ideas that have weaknesses and then they design a similar product without infringing on the patent. Marty Williams says, a “work around” is synonymous with “design around,” whereby another party tries to skate around the protected technology by changing the design enough to invoke ambiguity. They already have the language of the original patent and their description of their “design around” is different enough to claim non-infringement of an issued patent, part, or technology.

From the larger company’s point of view this is a viable strategy. It solves several big problems of new product development. They don’t have to be innovative and go through the creative process of coming up with new product ideas. They simply look for good ideas and products that smaller innovative companies have already developed. This enables them to shorten the whole process and bring new products to market quickly.

  1. Licensing – This is explained in the LGA story, but there are many variations of how the buyer (licensee) will pay for the licensed product. The general idea is to develop some type of agreement to get a new product with strong market value and IP protection (like a patent). The essence of licensing is how the company pays for the new product in terms of a down payment, fees, progress payments, percentage of sales, or royalties.

The strategy for the idea of designing a license agreement that will steal the product at the lowest cost is based on three ideas:

  • First, the purchaser acquires an exclusive license that gives them total control off the product line.
  • Second, they move all of the customers and sales over to their systems as quickly as possible.
  • Lastly, once they control the sales and products they control the owner of the company that developed the products. Once owner loses all control he will be at the mercy of the licensee company who now owns the new license. It is at this point that the licensee can ignore the license agreement and stop all payments.

The decision to stop payments is simply a calculated risk and a cost/benefit decision. The larger company knows that nobody will go to jail and so the problem is simply reduced to civil trials and court costs. As long as the sales of the new product exceed court costs these corporations will use these strategies. Some would make the case that these strategies are the essence of good free market capitalism because managers are doing everything they can to increase sales, reduce costs, and bring higher returns to the investors.

But Marty Williams did not give in to these threats. He went ahead with the lawsuit, which has spanned three years. Part two of this article will explain what is required in time, cost, and legal processes to fight the license cheaters in court.