Succeeding in Your Business: Learning the art (and science) of a prototyping business

“I invented a new product a couple of years ago and obtained a patent for my invention. A few months later, I set up a corporation with two other individuals to develop and market the product.

“The first individual is an ‘angel’ investor with deep pockets while the second individual runs a local manufacturing company with the ability to produce the invention in small quantities. The three of us are equal directors and shareholders in the corporation.

“At the recommendation of our corporation’s attorney, I assigned my patent to the corporation with the understanding I would get it back if the corporation was liquidated.

“From the beginning, we had problems developing a prototype for the product. The manufacturer said the design set out in my patent wasn’t workable, and we have made several modifications to the product in order for it to work the way we think our customers will want. Using our investor’s money, we have made two modifications to my patent reflecting these changes.

“After nearly two years of tinkering and delays, we still don’t have a working prototype of the product we can take to market. As the economy has improved, the manufacturer has obtained ‘paying jobs’ for his company, and our prototype has become a ‘back burner’ project for him.

“More worrisome, the manufacturer has hinted that when the prototype is ready, he wants to get a written opinion from a mechanical engineer saying the design is sound. We have an insurance company willing to write a products liability policy for this product, but there’s an exclusion in the policy for any design flaws, which I understand is standard for this type of insurance.

“We have approached a couple of mechanical engineers in our area and are being told the cost of obtaining such an opinion would be in the $15,000 to $20,000 range. Our investor is understandably nervous about putting that much money into the company without some assurance that the prototype will be finished and we will start seeing some sales. For his part, the manufacturer has told us he is not willing to assume responsibility for any liability that is not covered by insurance and that he needs the engineer’s opinion before he will release the prototype to the corporation.

“How do we break this logjam and move forward?”

The problem here is that your manufacturing partner is “wearing two hats.” On the one hand, he is an officer and director of your corporation and accordingly has a fiduciary duty to further the corporation’s business and affairs. On the other hand, he and his manufacturing company are working under contract to your corporation to develop the prototype. I am assuming that this contract is a “handshake” and has not been formalized in writing.

As the owner of the manufacturing company, your manufacturing partner has a fiduciary duty to that company as well. The two fiduciary duties are in conflict, which must be an uncomfortable position for him.

The first thing you should do is call a meeting with all the shareholders to discuss the situation and try to work things out. If the manufacturer can persuade the investor that the prototype is finished and ready for market, the investor may be willing to advance the funds necessary to obtain the engineer’s opinion your manufacturer needs to protect himself.

You may want to suggest that the investor should loan the corporation the money necessary to obtain the opinion. That way if the corporation folds, he gets his money back before anyone else does. You and the manufacturer could “sweeten the deal” by offering to personally reimburse the investor for two-thirds of the cost of obtaining the opinion (your pro rata share of the debt) if the corporation is unable to repay the loan within, say, one year.

If the manufacturer and the investor can’t see eye to eye, then you will have to consider hiring another contract manufacturer to develop the prototype — one who does not have conflicting duties and has mechanical engineers on staff who can provide the necessary comfort that the prototype’s design is sound. It will probably cost you more money, but you may be able to offer the manufacturer some nonvoting equity in your corporation in exchange for a discounted price.

If all else fails, you may need to dissolve your corporation, take back your patent (hopefully you kept it in your name with the corporation only as an “assignee”) and license it to a manufacturer with sufficiently deep pockets that they can assume all of the risks inherent in making, distributing, marketing and selling an industrial product. Dissolving a corporation usually requires a majority vote of the shareholders, so one of your two partners will have to agree to that.

One last thing: Since it appears your contract manufacturer partner has made changes to the original design, be sure he has assigned your company all of his intellectual property rights to those changes. If he hasn’t, you may be able to transfer only the original design to a new manufacturer, not the “new and improved” version.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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