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What Is a Decentralized Autonomous Organization (DAO)?

May 5, 2022
7
min

Decentralized autonomous organizations are one of the signature breakthroughs of the Ethereum system. DAOs are cooperatives that are collectively owned by their members.

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It’s not often that an experiment thrives after a prototype fails so spectacularly. Yet that’s what happened with decentralized autonomous organizations, digital cooperatives known as DAOs. The first notable one, known as The DAO, was launched in 2016 on Ethereum, the second biggest cryptocurrency network after Bitcoin. Just months after it raised $150 million worth of Ether, the currency used on Ethereum, it was hacked in June 2016 by a mysterious perpetrator who took $60 million of the tokens. Recriminations flew but eventually leaders in the Ethereum community isolated the tainted part of the network and started a new fork to compensate victims with newly minted Ether. 

Rather than becoming a footnote in crypto history, DAOs emerged as a new type of communal organization that exists primarily in the digital world of the internet. Today there are thousands of DAOs working on projects ranging from venture investing to fashion to nonprofits that help farmers. They are well funded—there is more than $8 billion in DAO treasuries based on the Ethereum network—and entrepreneurs are turning to them as innovative new corporate structures. Yet their membership-driven design poses thorny governance challenges.

What is a decentralized autonomous organization (DAO)? 

In a nutshell, DAOs are cooperatives that are collectively owned by their members. They are set up on blockchains, which are online networks that support cryptocurrencies. In keeping with the open source ethos of cryptocurrencies, DAOs are supposed to be transparent and fully public. As a membership organization, they are also designed to be egalitarian in nature. This has made them popular with crypto fans who believe in disconnecting from hierarchical bodies such as corporations, banks, and governments.

How do DAOs work?

Members form DAOs by establishing its mission and then raising funds through a token sale. They then design and program smart contracts to handle day-to-day activity such as paying bills. Smart contracts are decentralized software programs based primarily on Ethereum. Like the autopilot on an airplane, smart contracts automatically manage transactions between members and facilitate the organization’s operations. DAO members can vote on whether to make changes to smart contracts.

Many DAOs issue their own form of cryptocurrency, called a governance token, that enables members to vote on changes to the project’s direction or model. Members with more tokens have more voting power. DAOs also maintain treasuries to fund their activities. Members can direct smart contracts to manage the treasury and accept and make payments.

What are some examples of DAOs?

The spectrum of blockchain cooperatives and their objectives continues to expand. Here are some of the best known variants:

  • DeFi DAOs: Many of the leading DAOs operate in the marketplace called decentralized finance, or DeFi, which offers crypto trading, lending, and other fiscal services. Uniswap is a platform that lets users exchange tokens. It offers a governance token called UNI. MakerDAO is a group that provides crypto lending to users and facilitates the trading of a stablecoin called DAI, which is designed to be immune to the volatility that regularly roils the crypto markets. Aave, another lending platform, also uses a DAO to govern its activities. 
  • Investment DAOs: Some investors are using DAOs to compete with traditional venture capital firms in the hunt for crypto startups. MetaCartel Ventures has invested in about two dozen enterprises. BitDAO, an investment group backed by billionaire Peter Thiel, has amassed a treasury of $1.8 billion as it hunts for promising investments.
  • Special purpose DAOs: By using smart contracts, collectives can rapidly come together for a single mission. Investors formed ConstitutionDAO, for instance, last November to bid on an original copy of the U.S. Constitution. It raised more than $45 million but failed to win the document. UkraineDAO has received the help of Ethereum co-founder Vitalik Buterin and the Russian punk-political group Pussy Riot to raise aid for embattled Ukrainians.
  • Nonprofit DAOs: Philanthropists are tapping this structure to manage tax-exempt groups providing charitable services. Big Green DAO, founded by Elon Musk’s brother Kimbal, is devoted to teaching people, schools, and other groups how to grow food sustainably. Endaoment is designed to facilitate charitable donations of cryptocurrencies.
  • Art and fashion DAOs: Entrepreneurs in the luxury goods industry have embraced DAOs. Red DAO is a digital fashion venture that raised about $13 million worth of Ether. Flamingo brings together art collectors in a DAO that’s amassed $27 million in Ether. It focuses on non-fungible tokens, or NFTs, which are digitally unique files of images such as illustrations or paintings. PleasrDAO is devoted to the NFTs by the popular artist Pplpleasr.

How do DAOs compare to traditional organizations?

The first main difference between DAOs and traditional organizations is location. Conventional companies and nonprofits are registered and domiciled in legal jurisdictions such as municipalities and nations. This ensures they pay appropriate taxes and comply with laws and regulations. They can also be set up as limited liability companies, which protects officers and directors from being held personally accountable for the liabilities of the business. Even cooperatives typically have a physical headquarters. 

DAOs are different. Based on blockchains, they exist on the internet and do not domicile in a physical location. That’s the whole point of decentralization—there is no headquarters. Members communicate online, and the DAO’s website or social media channels serve as virtual meeting rooms where decisions are debated and made. As a result, DAOs do not have physical addresses.

The second difference is operational. Traditional enterprises are run by teams of managers reporting to a boss and a board. DAOs are managed by smart contracts programmed by members in consultation with one another. While cooperatives have been around for centuries, the use of blockchain technology has changed the way these entities raise capital and grow. 

What are the disadvantages of DAOs?

There are inefficiencies and vulnerabilities in this structure:

  • Security concerns: As the hack of The DAO in June 2016 demonstrates, these cooperatives are susceptible to cyberattacks. As open source entities, their smart contracts are visible on blockchains and hackers can exploit weaknesses. The prize: DAO treasuries, which can hold millions of dollars worth of Ether and other cryptocurrencies.
  • Legal limbo: DAO members may love being citizens of the internet but failing to register a cooperative can create legal and tax headaches. DAOs may be considered unincorporated partnerships, making their members subject to unlimited liability for anything that happens with their ventures, such as a hack. The U.S. government may not look kindly on DAOs’ failure to pay taxes. That’s why DAO advocates are urging members to swallow their countercultural pride and domicile in crypto-friendly states such as Wyoming and Colorado.
  • Inefficient decision making: Cooperatives may vest their members with democratic rights but management by the many is often an unwieldy and time consuming way to get things done. There is a movement afoot in DAOs to delegate decision making to representative committees, much like the way states use elected parliaments or assemblies.
  • Unproven model: DAOs have yet to demonstrate staying power as viable businesses or projects. Moreover, the U.S. Securities and Exchange Commission has stated that cryptocurrencies are subject to existing laws around registration and disclosure, which could complicate the governance of DAOs.

The future of DAOs

These organizations are poised to grow in number and popularity thanks to their clubby feel and acceptance within the crypto community. DeFi platforms are increasingly adopting the DAO model for governance because it’s so attractive to cryptocurrency enthusiasts and is consistent with the democratic ideal embedded in the culture of Ethereum. 

Yet regulators such as the SEC are also casting an eye on the proliferation of DAOs as part of their push to rein in the excesses of the cryptocurrency industry. There are some in the DAO community who want to embrace the inevitability of regulation, and the need to register and comply with corporate rules the same way conventional companies do. One outfit, Syndicate DAO, even helps its fellow DAOs take care of their legal documentation. 

As DAOs mature, chances are their members will increasingly seek to strike a balance between staying true to their decentralized ideals and complying with corporate rules.  

The bottom line

Decentralized autonomous organizations are one of the signature breakthroughs of the Ethereum system. The idea that a cooperative may come together online and manage itself through a software program has captured the imagination of entrepreneurs and investors. With their membership-driven governance model and use of cryptocurrencies, DAOs are a new type of corporate and nonprofit entity. Still, they may not operate smoothly in their pure state. It’s hard to manage organizations by crowdsourcing decisions, and DAO members may be setting themselves up for legal woes if they fail to properly register their groups or if officials impose highly restrictive new rules.

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