Let’s imagine that instead of ‘working to earn’ you earn by other means: by playing a game, curating content, or learning a new skill. Or maybe even by jogging. What does that look like? And what sort of structures will be in place to support this sort of work?
Some think that the answer is the ‘decentralised autonomous organisation’ or DAO (pronounced ‘dow’). Fans of DAOs think that a shift away from the traditional corporate structure, supported by blockchain technology, is inevitable and a welcome shakeup. Sceptics question the popularity of the DAO, and the extent to which an uptake of DAOs across the corporate world is realistic.
In this article, we summarise the basics of DAOs, explore how DAOs compare to a typical company, and outline some key benefits and challenges for DAOs.
There is no universal definition of a DAO, but put simply, a DAO is a system of governance, supported by blockchain technology, which aims to ‘decentralise’ decision making. To break it own, at least in theory, a DAO is:
DAOs are supported by blockchain technology, in most cases, the ‘Ethereum’ network: a blockchain capable of storing transactions. A ‘blockchain’ is a ledger organised into linked ‘blocks’ of data (think of an enormous Excel spreadsheet). Community validation is used to keep the ledger synchronised and accurate, as between different users (or ‘nodes’) on the network. This means that no third party is needed to validate a transaction and – at least in theory – transactions are immutable, which means they are unable to be amended.
When we say ‘smart contract’ we mean a computerised transaction, used to execute contracts, which typically follows an ‘if this happens, then that happens’ structure. You can think about it like a vending machine – you put coins into the machine, key in some code, and the machine is programmed to release a specific product. In the case of a smart contract, users’ accounts can only trigger the performance of a specific function (say, the issue of a token) by submitting transaction requests which meet the ‘rules’ programmed into that contract. Advocates for smart contracts say that it removes the need to trust your counterparty to follow through with the intended outcome of the contract (and in some ways might remove the need for middlemen such as banks, and god forbid, lawyers!).
A DAO is usually established by smart contracts which define and codify a governance framework. In theory, a DAO could be used for any objective, and so DAOs necessarily operate on a ‘spectrum’ – from being established to achieve simple, automated tasks, through to a mixture of ‘on chain’ and ‘off chain’ decision making processes.
‘On-chain’ governance refers to the governance processes that happen on the blockchain platform, based on rules specified in that platform’s programming code. One such example is the formal voting of token-holding members on a particular issue relating to the governance of the DAO. In contrast, ‘off-chain’ governance happens outside the blockchain platform, and can be both formal and informal such as discussions on social media or online forums.
At its most basic level, members hold ‘tokens’ which (like shares in a company) serve to measure each member’s stake in the DAO and give members the right to participate in the DAO’s objectives and governance. While some use the terms ‘token’ and ‘coin’ interchangeably, there is a difference between the two. A coin in the crypto-world refers to an asset that has its own blockchain, such as the well-known ‘Bitcoin’. By contrast, a token is another form of crypto-asset, but one which runs on top of another’s blockchain and has various uses other than being a store of wealth or form of payment. For instance, tokens can be used to access a product or service, or can confer certain rights upon token-holders. Tokens are programmable and kept secure by a holder’s ‘wallet’ and private key. Forms of tokens include cryptocurrencies and NFTs, the latter of which we have explored further here.
That being the case, a common use-case for DAOs is to organise individuals who are interested in a single and common goal, say, making a bid for a copy of the US constitution, purchasing a copy of Jodorowsky’s Dune storyboards, or raising funds to help Ukrainian civilians.
Let’s say that our DAO is aimed at creating a platform (like a piece of software or an online game). Users interested in contributing to the development of the platform could purchase ‘tokens’ linked to the DAO. Those tokens might give voting rights to members and the right to propose resolutions to be voted on by other members. Sounds familiar, right? But they might also allow members to interact with the platform as users. Members vote on all sorts of decisions – from how the platform will be developed to how funds will be spent. As the running joke goes, a DAO is a group chat with a bank account.
Proponents of DAOs see the structure as providing a means to distribute power and allocate resources to those representative actors with a vested interest in a project. And to get it all done efficiently, without the drawbacks seen by DAO enthusiasts as inherent in the traditional corporate form, including the need to trust one another.
From an NZ corporate law perspective, the typical governance of a company involves the vesting of decision-making powers in a board, subject to constraints expressed in the constitution of the company and, in the case of some decisions, approval by special resolution of shareholders. The board can delegate decision making further to agents of the company, say, a manager or an employee. One key risk for shareholders is therefore that decisions will ultimately be made by an individual in opportunistic pursuit of a personal interest, rather than for the benefit of the company or the shareholders. Or indeed, that decisions will be made by incompetent or even fraudulent actors.
DAOs aim to solve this issue, or at least, better protect against it, by codifying governance rules and spreading powers across the persons with vested interests in the DAO itself, that is, the token holders. Advocates argue that, rather than needing to rely on trust in one another, token holders can trust in the autonomous code of a smart contract, set up to ensure that decisions are fair, transparent, non-hierarchal, and rooted in a shared objective to increase the value of the DAO’s tokens. Members’ shared interest in both the DAO itself and the objectives of the DAO means that members are all, at least in theory, focused on furthering the value of the DAO’s tokens rather than their own self-interests.
But relying on a DAO to eliminate managerial agency does not quite tell the whole story: consensus voting for all decisions – especially in the early stages of the development of a DAO – generally does not work. Rather, a centralised development team will usually be involved in the production of a ‘minimum viable product’. Developers can determine the objective, scope, and strategic direction of the DAO. And token holders must be able to trust in the framework code written by the development team. The upshot is that DAOs may still be susceptible to fraudulent or incompetent developers.
While shareholders are removed from the day-to-day management of a company’s business, shareholders generally have rights to appoint and remove members of the board, to adopt, alter, or revoke the constitution of a company, and to put the company in liquidation. Furthermore, shareholders with voting rights must be involved in the company’s decisions to enter into major transactions and typically have rights to distributions made by the company, including dividends.
Rights attached to tokens, on the other hand, flex with the DAO in question but are typically aimed at providing holders with governance rights and the right to participate in an incentive scheme. In theory, token-holders have a more direct and granular interest in the day-to-day running of the DAO than shareholders in a company since the performance of the DAO directly impacts on the value of the token. However, this is normally left to those with significant token holdings or who have established the DAO / developed the underlying asset. A typical crypto-investor is unlikely to be participating in DAO governance – at least in any meaningful way.
Unlike shareholders, token holders aren’t, by default, entitled to dividends. That said, the structure of a DAO doesn’t preclude distributions to token holders. For example, the liquidation of an asset purchased by the DAO could result in a return to token holders (depending on how the token and DAO in question were each structured).
Most tokens provide multiple benefits. By way of example, a token might confer:
Could DAOs really replace the traditional company in years to come? Or are DAO-fans simply technology idealists, divorced from ‘real’ business?
There are important questions and challenges yet to be addressed by the structure of a DAO. One major challenge is the legal indeterminacy of both DAOs and tokens, the latter of which is plagued by fears of instability and illegitimacy. How might regulators and lawmakers seek to apply securities and financial markets to initial coin offerings (the main vehicle through which tokens are originally issued)? The United States Government is currently grappling with this question of how best to regulate such crypto-transactions and DAOs. The recently announced Responsible Financial Innovation Act is a wide-reaching bill that aims to extend a comprehensive set of regulations across digital assets in the United States. The bill would carve out key powers for the federal watchdog, the CFTC, as well as classifying DAOs as legal business entities and requiring them to be registered.
The traditional company framework has the benefit of well-established and understood processes and protection. Companies and officers must abide by regulatory compliance obligations, and directors must abide by certain duties, in each case aimed at protecting shareholders, consumers, and the company itself. And shareholders and directors benefit from the ‘veil’ of separation between themselves and the company.
But legal indeterminacy means the same cannot be said for DAOs. And historically, this lack of legal status hasn’t been given primacy by DAO enthusiasts, some of whom consider that smart contracts will do away with the need for a legal framework altogether (so, why bother working with that framework now). This poses problems for the adoption of DAOs in the mainstream.
It also cannot be said that, by operating in the ‘grey area’, DAOs avoid regulation altogether – there is at least an argument that in the absence of incorporation and registration as a company, a DAO should be treated as a general partnership, which brings along fiduciary duties as between holders that are seemingly at-odds from the ‘coded’ autonomy of the structure of a DAO. Depending on the token’s characteristics, the offer of a DAO-related token to an NZ-based investor may also trigger the requirements of financial markets law. That’s all not to even mention the can of worms that might be opened from a tax perspective!
Ultimately, DAOs ask challenging questions of the traditional company structure and offer innovative solutions to age-old problems of mismanagement and fraud which plagued the likes of Enron. And DAOs provide much needed flexibility for web3 endeavours that do not neatly align with a more traditional framework.
In any case, while still (relatively) early days, this is a space to watch. And since DAOs exist in a very much unchart(er)ed territory, it would be a mistake for investors to treat an opportunity to purchase a token in any way like a traditional investment. What’s required is careful, considered, and up-to-date legal advice to help navigate your diligence process.
Originally published via the Institute of Directors New Zealand, republished with permission.
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