- February 22, 2022
- Posted by: Bogdan
- Category: Features
In 1602, the Dutch East India Company was formed in what many consider the world’s first initial public offering — allowing perfect strangers to share in stock ownership. Four centuries later, the joint-stock model — especially its incarnation as the modern business “corporation” — sets the pace for much of the economic world.
But, decentralized autonomous organizations, or DAOs, could soon disrupt the joint-stock capitalized business model, much as the Dutch East India supplanted the limited partnerships of its day — or so some may say.
“DAOs are the new limited liability companies (LLCs),” says DAO investor Cooper Turley of these leaderless internet-native entities where key decisions are typically made by consensus. “In five years, companies won’t have equity anymore. They’ll have tokens and they’ll be represented as DAOs,” while high-profile investor Mark Cuban adds, “The future of corporations could be very different as DAOs take on legacy businesses.” Others see DAOs challenging venture capital firms in the race to fund Web3 projects.
“I think DAOs are already replacing traditional corporations,” Sam Miorelli, an attorney who has been active in a number of DAOs including Curve Finance, tells Magazine. “The promise of DAOs is the chance to return closer to the historical norm of project-first where smart people with good ideas can get funding and build a community around a project without first finding a legal budget.” These decentralized autonomous organizations have some unique characteristics. According to law professor Aaron Wright:
“DAOs are not run by boards or managers, but rather aim to be governed by democratic or highly participatory processes or algorithms.”
Indeed, they have been described as operations that “resemble an online chat room with a bank account,” given that “virtually anyone from anywhere with Internet access can join a DAO, participate in its governance and share its profits,” Florence Guillaume, a professor at the University of Neuchatel’s Faculty of Law, tells Magazine.
The DAO of 2016
Things didn’t look so promising back in 2016 when one of the first decentralized autonomous organizations — unhelpfully named “The DAO” — was formed on the Ethereum blockchain network. Several months after its formation, “The DAO” was hacked to the tune of $60 million which led to a bitter split in the still-nascent Ethereum community, culminating in a “hard fork” to restore the stolen funds. “The DAO” cast a pall over decentralized autonomous organizations for some time.
Today, these transparent communitarian organizations still face critical regulatory and legal challenges. Will they need to pay taxes? Can they open bank accounts or sign legal agreements? Can they bring lawsuits against other DAOs?
“There is no ‘Model DAO Act’ the way there is a ‘Model Business Corporation Act,’” wrote attorneys Louis Lehot and Patrick D. Daugherty. They are “fundamentally unprecedented in law.” Key decisions, like deciding how funds will be spent, are often decided by a vote of members/owners who can number in the thousands. Needless to say, decision-making can be cumbersome.
A few things about DAOs: They are typically cooperatives hosted on blockchains like Ethereum (but not Bitcoin) that can handle chunks of software code called smart contracts that automatically execute when certain conditions are met. For example, if an airline flight is delayed by four hours (i.e., the condition), then a payment could be triggered via smart-contract code to the cell phones of passengers who had purchased flight insurance policies.
Most DAOs raise funds from the sale of tokens, which give investors/owners voting rights. Token owners make money if the DAO votes to pay dividends or through token price appreciation, similar to how investors earn profits in publicly listed joint-stock companies like Coca-Cola.
DAOs are just SPACs with extra steps
— Andre Cronje 👻 (@AndreCronjeTech) February 14, 2022
A better business model?
“There is a future for DAOs,” Erik Vermeulen, professor of business and financial law at Tilburg University, tells Magazine, given their transparency, security and open source governance protocols which mean that weaknesses are constantly probed and tested. Moreover, they discourage “rent-seeking,” i.e., manipulating public policy or the economy to increase profits. This is similar to when a company lobbies the government for subsidies. They aim to discourage natural and political monopolies because of their distributed nature, adds Vermeulen.
But, are they really superior to traditional organizational business models? Not all agree. “The current token system does not necessarily prevent monopolies because there are individuals that may own a large amount of the DAO tokens and thus may control voting results,” Sarah Hammer, managing director of The Wharton School’s Stevens Center for Innovation in Finance, tells Magazine, adding:
“All DAOs are different. Some DAOs are structured to facilitate inclusion and others limit their membership vis-a-vis something called token gating. Token gating requires the DAO member to authenticate that they hold the DAO’s NFT token in a crypto wallet before they enter the DAO’s Discord server or website.”
“The defining attribute that makes DAOs different from past organizations is the use of the blockchain as the root of trust,” Eric Lim, senior lecturer at the University of New South Wales, tells Magazine, “such that the inputs and outputs from decisions that matter are immutable and auditable.” This represents an advance over traditional centralized organizations, which Lim has called “a zero-sum game.”
DAOs have been attracting more attention in the mainstream press in the past year which has shed light on both their strengths and weaknesses. The ConstitutionDAO, for instance, formed on short notice in November, raised $47 million in a matter of days to bid on a rare first printing copy of the U.S. Constitution offered up for auction by Sotheby’s.
The DAO, described as a “financial flash mob”, gathered more than 17,000 “donors” — a signal achievement, in the view of many, and one, if it had succeeded, that would have put the historic document “in the hands of many” (e.g., in a museum), as opposed to a single individual who might never display it again.
Once the bidding began, however, it became apparent that the DAO’s transparent decentralized structure could be exploited. Everyone knew how much money had been raised by ConstitutionDAO and the amount that could/would be bid. “The problem with the ConstitutionDAO is that the maximum possible bid is completely transparent,” explained David Friedberg. “The seller will just bid against the DAO to get their max bid.” Ken Griffin, CEO of Citadel, walked home with the rare document.
Our final note is that we hope that, after we’re gone, the past few weeks serve as a reminder of what’s possible – that a group chat of internet friends with memes and dreams can strive towards ambitious goals 🙂
— ConstitutionDAO (📜, 📜) (@ConstitutionDAO) December 15, 2021
The unwinding didn’t go smoothly, either, as DAOs can be quickly formed for special events and disbanded afterward. “ConstitutionDAO’s core team struggled to come up with a plan to return investments as contributors bickered in online group chats,” the New York Times reported. “The average investment was about $200, but now the investors may have to pay that much in fees to get their crypto back.”
That experience hasn’t discouraged DAO proponents, however, who assert that, as with any innovation, growth challenges are to be expected. These entities are designed to flourish in the Web3 era. Moreover, DAOs’ decision-making processes can be streamlined by implementing digital-age variations like delegated voting, whereby owners (i.e., token holders) who are too busy to study the details or fine print of a proposal can assign their vote to a trusted third party.
As EY Global Blockchain Leader Paul Brody explains, shareholders in large corporations today can vote out management if it doesn’t perform effectively. In practice, this rarely happens but delegated voting changes everything. “Delegated voting rights are going to be a revolution and not just for DAOs,” Brody tells Magazine, adding:
“As people invest widely in both blockchain and traditional stock markets, it becomes impossible to keep track of all the key issues from executive pay to the carbon footprint. The ability to delegate your votes to industry or topic experts will allow owners to exercise a much stronger and clearer voice in the management of these companies.”
“Smart contract-based voting schemes make it possible to involve a larger number of individuals in decision-making, at least as compared to more cumbersome and expensive systems for collecting and verifying votes,” according to Wright. “The availability of smart contract voting protocols may make it possible for some enterprises to adopt their own individually tailored allocation of decision-making power between stakeholders.”
DAOs can also change who is hired for a project and how they are paid. “There is no question that DAOs are the future of work,” Anne Connelly, Faculty with the Questrom School of Business at Boston University, tells Magazine. “In an ever globalized society, the benefits of being able to hire internationally and pay across borders in crypto will provide an unprecedented competitive advantage.” These autonomous organizations provide participants with more power than they could possibly wield in traditional corporations, Connelly says. Workers “have more ownership in the outcome of the work, and those in developing countries will be less likely to fall prey to geographic class divides.”
Others are more measured, however. “We aren’t quite there yet,” says Vermeulen, adding that DAOs still have technical and operational shortcomings and may be prone to “Sybil attacks” and “51% attacks,” while Guillaume adds that “DAOs will probably not replace traditional corporations but offer new alternatives to existing corporate and social organizations. They will be the organization of choice for specific cases, but this will be greatly influenced by legislation and how DAOs will be treated legally,” further explaining:
“Entrepreneurs and other people looking for a legal structure to undertake a new venture might be more inclined to choose to create a DAO if this type of organization has legal personality and offers limited liability to its members.”
According to Miorelli, open-source legal work and open-source decentralized building blocks are two ways that DAO can bring on a lower-transaction-cost future for all. “This also goes for funding ongoing projects. The core innovation of DeFi projects — many of which are governed by DAOs — is that “the returns available when transaction costs decline to near-zero and when immutable contracts make enforcement of antiquated and classist rules like accredited investor regulations impossible.”
Governance challenges remain
DAOs will need to overcome some key obstacles — like sometimes diffuse governance structure that doesn’t handle conflict or competition well. “Coordinating and organizing activities in a decentralized community is definitely difficult, complex and unwieldy,” says Lim.” Meanwhile, Guillaume adds that “DAO governance structures need to reach a point where it is easier and more adapted to manage resources using smart contracts than using traditional organizational structures.”
However, DAOs cannot entirely eliminate the human factor and all the limitations implied therein. “DAOs don’t solve human organization issues but neither do corporations. No legal or organizational structure eliminates interpersonal conflicts,” says Miorelli, adding that any well-organized endeavor can try to manage those conflicts.
There are other reasons to hesitate before pronouncing DAOs as the future of organizational business models. There is a danger of convergence, for instance, DAOs evolving to resemble something like traditional top-down managed corporations. That is a question in Brody’s mind: “When does a DAO cease to be a truly participatory ecosystem and start to look like just another flavor of shareholder- — now stakeholder- — owned company, complete with full-time management team and a very corporation-like hierarchy?”
Will a DAO just be a corporation with tokens instead of shares? “Or, will it come to mean something more that implies a very high level of user and owner overlap, engagement and participation?” asks Brody. “I see DAOs as one of several business structures that people would consider alongside partnerships, sole proprietorships and corporations,” he continues, although he anticipates that most blockchain businesses will be managed by DAOs and many “protocol-driven technology businesses” as well.
More regulation coming?
Then, too, some DAOs seem almost too good to be true — like OlympusDAO which was, at one point, paying 2,681.5% APY for those willing to stake its OHM coin. Some dismissed the DAO as little more than a Ponzi scheme and some believe that it can be the future of DeFi. But, the brouhaha around it suggests that more regulation may be coming for these internet-native entities. Would that ensure DAOs’ future?
The answer isn’t clear. While some U.S. states such as Wyoming have handed down legislation around DAOs, Hammer notes, “many others have not done so. In addition, some DAOs may implicate federal regulations and securities laws in particular.”
But if you’re familiar with the Fourth Turning paradigm, you may understand that the organizational format that succeeded during the Industrial Age may not be the optimal format for the digital age.
There is a new kind of “firm.” The decentralized autonomous organization #DAO
— Erik Voorhees (@ErikVoorhees) July 14, 2021
“I do not think DAOs will replace the traditional corporate form any time soon,” Hammer tells Magazine. Traditional corporations like those formed under Delaware Corporate Law, for example, “contain structures that while imperfect — such as proxy voting — have stood the test of time.”
Moreover, supplanting traditional corporations as the dominant business organizational model “would require a radical transformation of the federal financial regulatory framework, which is unlikely to happen in the near future,” Hammer adds.
Collaborating across borders
Overall, there is much to get excited about regarding decentralized autonomous organizations. “DAOs are the first structure that enables large group coordination digitally with full trust and transparency,” Connelly tells Magazine. “Using blockchains, large groups of geographically dispersed people — many of whom can maintain anonymity — can now collaborate while having trust that any decisions made are the true will of the community.”
It’s also about “a dispassionate blockchain technology that treats everyone within the community equally” and allows for an “incentive structure that differs from that we are used to. It is about inclusive ownership and about doing what is right for the community,” adds Lim. Still, DAOs aren’t likely to fully sidestep the governance quandaries that challenge traditional business organizations, Miorelli warns:
“There are entire university departments devoted to optimizing organizations and I don’t think that discipline will be any less in-demand from DAOs than they are from traditional corporations. Regardless of the legal structure or name, it’s always the people that matter.”
DAOs also require a consensus mentality which may necessitate some getting used to. Lim has experimented with several DAOs, and he says it was a stark contrast to the way a university operates. “In a DAO, I have to convince almost anyone to get a project funded,” he says. “And, people are incentivized to talk to me. There is a single understanding that if the projects that provide value to the community get funded, the community will grow.”
So, do DAOs really represent an improvement over what exists already, then? “I am an optimist and I believe in the inherent value proposition of a DAO,” says Lim. The criticism that people throw at DAOs — that they are unwieldy, messy and ungovernable — “is the same critique that people have thrown at the philosophy of democracy. Both are, in my opinion, perpetual works in progress.”