What are decentralized autonomous organizations? (DAO)

Background

In most large companies, there is a managerial hierarchy that governs how the company operates, making decisions about everything from how much employees are paid to the vision and goals of the enterprise. This often involves a CEO, other executives, and a board of directors.

Although policies that establish this hierarchy vary internationally, in the United States the boards of public corporations are generally elected by shareholders. However, shareholders don’t have the ability to make discrete, day-to-day operational decisions. While they might have the right to vote on major issues, this mechanism is underutilized by the average investor due to various barriers, such as registration requirements, timeliness of information and sometimes blurred cut-off dates for voting. Decision-making is therefore left to those at the top of the hierarchy.

The rationale for DAOs

Decentralization has been a core tenet of blockchain technology since its inception. It has long been hypothesized that Satoshi Nakamoto was inspired to create Bitcoin because of the failures that led to the 2008 financial crash, implicitly aiming to bypass the need for institutional trust and put financial power back in the hands of people.

Just as decentralized finance (DeFi) is the blockchain’s response to traditional finance, DAOs are the natural response to traditional corporate governance structures. DAOs are communities that have a common goal or stake in a common enterprise, like a DeFi protocol or a blockchain-based game. DAOs exist to govern their communities and make changes to their platform, all while automating the process through blockchain technology.

More broadly, DAOs seek to subvert the traditional hierarchical power dynamic, allowing individuals to vote more meaningfully on commonly held interests and, in doing so, attempt to automate democracy.

History: the first DAO

The first DAO was simply called “The DAO,” otherwise known as “Genesis DAO.” It was created in 2016 by members of the Ethereum community and was intended to operate like a decentralized venture capital fund, issuing its DAO tokens on the Ethereum blockchain.

However, within two months of its launch, the smart contracts were exploited for 3.6 million ETH. In this pivotal moment of early crypto history, Ethereum token holders voted to split the chain in a move called a hard fork. The new (and current) Ethereum blockchain reassigned the hackers’ funds to a smart contract where those who lost their ETH could reclaim them. The old chain became Ethereum Classic (ETC).

Ethereum has since moved on and grown its userbase, ecosystem of dApps, and token holders, whereas the Ethereum Classic community has waned over time.

How do DAOs work?

Structure

By definition, DAOs must be two things: decentralized and autonomous. In fact, these are the only qualifications of a DAO, and other aspects vary widely.

Being decentralized means that DAOs must allow equal participation across its members and not rely on a central governing body to make system-wide decisions. Generally, this is accomplished by considering any holders of the DAO’s dedicated token as members. Their voting power is proportional to the number of the DAO’s tokens they own.

Autonomy is accomplished through the application of smart contracts, which are hosted on the blockchain. Smart contracts promise transparent rules and execution of the proposals approved by Decentralized Autonomous Organization members.

DAOs have historically used a blockchain like Ethereum to record votes and keep them public. However, many now use an off-chain service called Snapshot that stores voting records on the decentralized storage solution IPFS as cryptographically signed messages. By taking the process of voting off-chain, DAO participants are spared from having to pay blockchain gas fees to participate in governance.

In 2021, a law passed in the US state of Wisconsin created a legal framework recognizing organizations who explicitly call themselves DAOs and follow this governance structure as limited liability corporations (LLCs), reinforcing and legitimizing the rights of these organizations and their members in the state.

Governance

Governance can be a complicated procedure, especially in large communities. Think about the voting system in place in your country and how many mechanisms there must be to account for every vote.

In the simplest form of governance, members of a DAO can submit proposals to the platform’s forum. These proposals have binary, or sometimes ranked, choices which the community can choose between—for instance, “for” or “against.” Proposals that meet the threshold (e.g. over 50% “for”) are then enacted by the DAO’s smart contracts and developers.

Different DAOs employ different voting mechanisms. Examples include:

• Token voting: This is the most common method, where members' voting power is proportional to the number of tokens they hold.
• Quadratic voting: This mechanism aims to give more voice to smaller stakeholders. Each member receives a limited number of votes, and the cost of each vote increases quadratically.
• Reputation-based voting: Some DAOs incorporate reputation systems, where members earn reputation points based on their contributions to the DAO.

Some DAOs divide their proposals into steps. In Uniswap, for example, the governance process involves a temperature check to gauge interest in a protocol change, followed by a consensus check that formalizes a discussion around a proposal, and then a final governance proposal which would enact the change if passed. Decentraland’s DAO similarly uses polls, draft proposals, and formal governance proposals to refine its process.

Legal and regulatory considerations

The legal status of DAOs is still evolving, creating potential uncertainties and challenges, including:

• Legal recognition: Some jurisdictions lack clear legal frameworks for DAOs, raising questions about their legal status and liability.
• Taxation: The tax implications of DAOs can be complex and vary depending on the jurisdiction.
• Securities regulations: Some DAOs may issue tokens that could be considered securities, triggering regulatory scrutiny.

These legal and regulatory uncertainties highlight the need for DAOs to carefully consider their structure and operations to ensure compliance and mitigate potential risks.

Benefits of DAOs

DAOs offer a compelling alternative to traditional organizational structures, such as:

• Decentralized governance: Decision-making power is distributed among members, rather than concentrated in a central authority.
• Increased transparency: All actions and transactions within a DAO are recorded on the blockchain, creating an immutable and auditable history.
• Community ownership: Members have a direct stake in the DAO's success and can participate in its governance.
• Automation and efficiency: Smart contracts automate many processes, reducing overhead and streamlining operations.
• Global collaboration: DAOs can bring together individuals from anywhere in the world, fostering borderless collaboration and innovation.
• Reduced bureaucracy: DAOs can operate with less hierarchy and bureaucracy compared to traditional organizations, enabling faster decision-making and greater agility.
• Trust and security: Blockchain technology ensures the security and integrity of the DAO's operations, reducing the risk of fraud or manipulation.

Types of DAOs

The different types of DAOs can be defined by the goals their communities have formed around. Some DAOs may fall into multiple categories because they have more than one purpose. As the concept of DAOs evolves and matures, it is inevitable that more types grow from new communities. Below are a few examples of the types of DAOs that exist.

• Protocol DAOs govern decentralized applications (dapps) for DeFi protocols, gaming, and metaverse projects, and other platforms that are built on smart contracts.
• NFT community DAOs customarily define membership in the organization based on owning NFTs in a collection.
• Investment DAOs act like venture capital firms that use collective funds from members to support shared interests.
• Collector DAOs are groups that collect assets with monetary value or particular meaning to their communities.
• Philanthropic DAOs are built by communities who want to collect donations for specific causes.

DAO Examples

Protocol DAOs:

• Uniswap DAO: holders of the UNI token have voted on changes to the platform such as fee structures, allocation of developer grants, and deployments on Ethereum layer 2 solutions and other blockchains.
• Decentraland DAO: Enacts governance proposals to create incentives for its MANA token and restructure fees to account for changes in token valuation.

NFT community DAOs:

• When the ApeCoin DAO was founded, its APE tokens were made available to anyone who owned one of the Bored Ape Yacht Club (BAYC) NFTs. This spread the APE governance token equitably across existing members of the community. The purpose of ApeCoin DAO is to allow BAYC owners and other stakeholders to vote on proposals that build out the BAYC-inspired ecosystem, such as the Otherside metaverse.

Investment DAOs:

• BitDAO: enables its token holders to vote on proposals that fund decentralized projects, communities, and companies. Two of its first investments were in the community gaming project Game7 and the Web3 development initiative EduDAO.

Collector DAOs:

• PleasrDAO: acquires important art and cultural pieces like the Wu-Tang Clan’s album “Once Upon a Time in Shaolin” – for which they paid $4 million. The members of PleasrDAO share ownership of the assets they collect, whether their intention is investment through art or simply amassing items with cultural significance.
• ConstitutionDAO: members pooled funds to attempt to buy—and collectively own—a rare version of the US Constitution at auction (although they were ultimately outbid).

Philanthropic DAOs:

• UkraineDAO: Had a goal is to raise funds to support the citizens of Ukraine during wartime.

DAO essentials

• DAOs are decentralized autonomous organizations that use blockchain technology to facilitate democratic governance and decision-making within a community.
• DAOs operate through smart contracts, which automate processes and ensure transparent execution of proposals approved by members. They often use tokens to represent voting rights and ownership within the organization.
• Various types of DAOs exist, including protocol DAOs, NFT community DAOs, investment DAOs, collector DAOs, and philanthropic DAOs, each with their own unique goals and governance mechanisms.