As web-based startups grow, they naturally begin to attract users across state lines and international borders. For founders who have worked hard to get this traction, this is rightfully considered cause for celebration, but it is important to consider that this expansion comes with a bit of additional risk. With larger and more widely distributed user bases, startups are exponentially more likely to see an increase in the frequency and complexity of disputes involving its users. While these disputes are to some degree inevitable, a startup can still safeguard its interests by crafting a clear dispute resolution policy in its terms of service.
There are a range of different ways that a dispute resolution policy can be crafted in a company’s Terms of Service, but the startup’s choice essentially boils down to two means of conclusively settling disputes- litigation and arbitration. As described below, the latter presents significant advantages to early-stage companies.
Litigation: If a startup chooses to use litigation as its preferred means for final dispute resolution, its Terms of Service will generally indicate that a particular state’s laws govern (i.e. Delaware or the state where the company is located). This does not, however, ensure that the dispute will be heard in a court in that particular state. Under certain circumstances, users-turned-litigants may be able to have their suits against the company heard in a federal court (referred to as “removal”) that will apply the designated state’s laws, even though the federal court may not be located within that state. Hence, while this method provides a startup with some certainty as to applicable law, there remain a number of drawbacks to a dispute resolution policy crafted in this fashion which include:
Forum: A litigation-based dispute resolution policy doesn’t necessarily provide for certainty as to forum given the possibility of removal to federal courts. Should removal occur, the startup will still have the “home field advantage” in terms of governing law, but, depending on the federal court selected by the user, it might lose the convenience of settling its dispute close to company headquarters. Instead, founders may be forced to travel to a federal court across the country to settle disputes with users. For founders short on time and money, this may pose a tremendous obstacle to mounting a defense.
Expense: It is also important to remember that this type of policy will require founders to incur great expense in the event of a dispute. Litigation involves significant costs in the form of court filing fees and attorneys’ fees, and even if the startup is successful in defending itself in court, it is highly unlikely that the company will be able to recover these expenses. In the event of removal to federal court, the startup may also face significant (and unrecoverable) travel costs. For early-stage companies trying to carefully manage limited funds, these enormous expenses may be prohibitive and the company may be forced to settle disputes on highly unfavorable terms.
Time: Another downside to litigation is that it can be an incredibly drawn-out process. Between initial motions, discovery, and the actual hearing (assuming no settlement is reached), the process can take years. When appeals are taken into account, disputes can continue on seemingly without end.
Public Relations: Beyond the substantive hurdles associated with litigating disputes, there is also the problem of public perception. Lawsuits, particularly suits where users are making incendiary allegations, can turn off users and destroy a company’s momentum. In a similar vein, pending litigation may also turn off investors who may not be willing to associate themselves with a company that has experienced a loss of reputation in the public eye. This sort of damage is incredibly difficult to recover from, even if the company ultimately prevails in handling its dispute.
Arbitration: While some of the issues associated with litigation are unavoidable (disputes with users will always entail a loss of time and money), arbitration presents an alternative that can in many ways mitigate these downsides.
Forum Certainty: An arbitration policy typically identifies not only the particular arbitration company that will be administering the arbitration, but also the location where disputes will be settled.
Reduced Cost: While there is no clear consensus as to whether or not arbitration is cheaper than litigation, there are reasons to think that arbitration can cut costs. While both litigation and arbitration require the use of an attorney, arbitration offers more flexible procedures than courts, so there may be reduced costs associated with motions and discovery. Additionally, where the parties have agreed to “final and binding” arbitration, the costs associated with the appeals process are eliminated.
Increased Efficiency: In addition to being cheaper, arbitration also generally provides for a quicker resolution of disputes than litigation. Additionally, arbitration policies can be crafted to eliminate appeals, further shortening the dispute resolution process.
Confidentiality: While filings and court orders in litigation automatically become part of the public record, arbitration allows for much of the dispute resolution process to occur outside of the public eye. One reason for this is that arbitration companies are private entities and are thus not subject to the same disclosure requirements as their government counterparts. Another is that arbitration provisions may explicitly require parties to agree that dispute resolution in arbitration will be confidential. The consequence of this heightened confidentiality is that the dispute resolution process has much less of a prejudicial effect on the company’s reputation and, by extension, its prospects of obtaining venture financing.
In light of these points, a dispute resolution policy centered around arbitration should be given strong consideration by most early-stage ventures. However, even if an arbitration provision proves to be the appropriate choice for a particular startup, its founders would be wise to consult an experienced startup attorney to handle its drafting, as they are complex provisions and, in light of the Supreme Court’s 2011 decision in AT&T Mobility v. Concepcion, they need to be drafted very carefully to ensure that they are fair and enforceable.