Business is changing.
Traditionally, a business had one goal: to make money for its shareholders. In the last decade, however, entrepreneurship has been shifting its focus and articulating new goals.
The latest generation of entrepreneurs want to create community value -- stakeholder capitalism, public benefit corporations, open cap tables, token economics. These are the modern methods to achieve positive sum market dynamics.
In parallel, the technology world has absorbed the community-driven ethics of open source development, which pays attention to the needs of the community, and gives them a voice in how software is developed.
Today, entrepreneurs are starting to explore new ways of running businesses -- ways that fit with new goals of community service as well as prosperity. They seek to create sustainable businesses, while contributing to the community at large as well. So, it's no surprise that they have begun to draw from notions of distributed power, first advanced in blockchain projects, where the community, and not a top-down pyramid of managers, makes decisions.
So, should your next business be a DAO? The TL;DR: DAOs can be flexible and efficient, but attracting professional investors will probably require a hybrid corporate and DAO structure, to manage liability and avoid instability. For more, read on.
|Transparency||Decisions are made in a confidential setting||Decisions are transparent and auditable||Collaboration and Community engagement are key|
|Investment||Investors prefer corporations||A pure DAO may have trouble attracting professional investors||Professional investors expect limited liability structures|
|Liability||Limited liability and corporate veils||Partnership liability||Considered a hybrid entity|
|Decision- making||Human decision making is inefficient and enforced by law||Automated decision making is quick and accountable||DAOs are "Internet boardrooms"Human brakes may be valuable|
|Banking||Traditional corporate accounts||Crypto/Token Transactions||DAOs are more efficient|
|Documentation||Prose formation documents||Smart contracts||DAOs are more efficient but bugs may be hard to fix|
|Regulation||Stock issues regulated||Token issuance regulated||DAO token holders can be liable for violation of securities laws|
1 Throughout this article, we will refer to any formal organization as a corporation, but an LLC or LLP is often a possible substitute.
What is a DAO?
A decentralized autonomous organization (DAO) is an organization that is collectively owned by its members, and governed and operated by rules implemented via a blockchain. These smart contracts are created by software developers. While traditional corporations have governing rules that are embodied in bylaws or voting agreements that are drafted and implemented by humans, via board meetings and Robert's Rules of Order, a DAO goes by rules that are implemented automatically in a blockchain via smart contracts, without relying on human decision-making.
Smart contracts are actually neither smart nor contracts. They are simple logic elements (computer programs) that take actions when certain conditions are met. Think about a vending machine -- you put in money, you get a snack. It's not a legal contract in the conventional sense, but once you take the required action (put in money, choose your item), the transaction proceeds without human intervention. For example, DAOs on the Tezos blockchain self-govern and implement arbitrarily complex coordination logic that improves over time.
DAOs also differ from corporations in that their control is decentralized. While corporate boards are usually small -- say, three to 15 people -- DAOs can be governed by many participants. There is often no central leadership within the DAO. DAOs are fully transparent, because all of their policies and finances can be verified via publicly visible transactional activity on the blockchain.
Put another way, DAOs run on bottom-up decision making, and corporations are top-down.
Ownership of a DAO can change fluidly. Tokens representing voting rights in a DAO can be traded without permission on an exchange, or can be earned through work -- similarly to the way corporate stock can change hands, or be earned via employee stock option plans. In contrast, conventional corporations and LLCs usually limit the ability of investors to trade their interests -- via restricted stock purchase agreements, for example. For a conventional entity, free trading only comes about after a public offering.
Differences Between Corporations and DAOs
Most people assume that when they start a business they should create a corporation. It's such a common practice that it's easy to forget why we do that. There are three main reasons: limited liability, liquidity for investors, and a stable structure to operate the business. These reasons play out quite differently for corporations and DAOs.
A corporation separates the entity and its owners via something called a corporate veil. The corporate veil is a legal construct by which the owners ordinarily cannot be held liable for the actions of the business. For instance, if a corporation goes into debt or engages in wrongful actions, the shareholders' personal assets are not at risk. This is a significant incentive to invest, because it reduces risk, and reducing risk raises the value of the investment. In fact, in many countries, owners or investors cannot avoid the debts of their company. Their personal assets can be seized, and they can even be jailed. So, in the US, the corporate veil of limited liability is an essential tool of entrepreneurship, and a significant reason for the easy movement of capital to drive innovation. A pure DAO with no entity behind it does not enjoy this privilege.
If you start a business and don't create a corporation, the baseline relationship between owners and principals of a business is usually a partnership. In a partnership, each of the partners is liable for the actions of the business, including the actions of the other partners. This requires a lot of trust, and can be an impediment to finding investors. And this is why people investing together usually create corporations. This points up two things:
- Partnerships are a very risky way to do business, so they are almost always replaced by corporations. DAOs alone do not address this.
- DAOs can be a transparent way to clarify which actions are authorized by the business at large. They replace the legal power of corporate bylaws with a zero-trust system. DAOs handle the policing of company decision making differently.
Another reason to create a legal structure to run a business is to ensure reliable outcomes in business operations. A corporation has rules for voting on decisions of the business. In this respect, a DAO can be an attractive alternative -- it just places the decision making in different hands.
But it's not entirely clear that smart contracts are a better way to make decisions than human process. As anyone who has run a business knows, it can be difficult to make decisions when large groups must agree. In business, management always has to balance efficiency against transparency and fairness. So, for example, a business that requires large numbers of voters to agree in a traditional corporate structure is unworkable. DAOs can help address this problem by making decisions in an efficient way. They allow wider participation without enmiring the business in process.
On the other hand, DAO decisions often don't involve live discussion. In fact, their stakeholders may be far-flung and not communicate with each other at all. We've all learned during the COVID pandemic that some decisions are easier to make face-to-face. Corporate decision-making can benefit greatly from the presentation and live discussion that takes place in board meetings, and DAOs do not capture this human interaction.
The jury is still out on whether DAOs are likely to result in better quality of decision making. While crowd-sourcing decisions can be an alluring idea, it can subject the business to the tyranny of the mob. At least one article in the MIT Technology Review posited that DAOs do not result in good decision making -- however, this article was focused on using the DAO for investment decisions. In any case, it's likely there will be differing opinions on this subject for quite a while. DAOs are relatively new, and their rules are still being refined. And because their smart contracts are transparent, it's easy for each DAO to learn from the last.
A DAO can function as a general partnership with its members as general partners. Many DAOs implement in their smart contracts a function called "ragequit" where any partner may withdraw from the organization and receive that partner's pro rata share of assets. In most traditional partnership arrangements, however, exiting is not so easy -- and for a reason: companies purposely limit the ability of investors to exit in order to avoid instability and sudden withdrawal of capital, which can hamstring the business.
So, entrepreneurs and investors have begun considering alternatives to a pure DAO, to gain the benefit of limited liability while preserving some of the efficiency and transparency of a DAO. One alternative is to create a DAO LLC. This is a new idea, but lawmakers are starting to recognize it. Wyoming, long a crypto-friendly state, passed a law in April of 2021 that recognizes DAOs as LLCs. To form the DAO LLC, the articles of organization must contain a specific statement that the entity is a DAO. The DAO rules and funding must be established before forming the LLC.
Another alternative is a DAO corporation. DAO corporations can state in their formation documents that certain decisions are delegated to the DAO, and that the corporation will abide by those decisions. Regular corporations often have voting agreements on behalf of minority owners, so in a broad sense this is nothing new. But best practices for implementing the DAO in corporate formation are a work in process.
Another possible legal hurdle is that the US Securities and Exchange Commission (SEC) considers tokens sold by DAOs to be subject to federal securities requirements-- just as shares of a corporation might be. This does not mean that every DAO token issuance must register as a public offering, but to avoid this obligation, a legal exemption must apply. For example, most private companies raise capital via a private placement exemption -- but that requires qualifying "accredited investors" -- which is a far cry from the decentralized idea of a DAO. (Other exemptions, such as crowdfundingor A+ exemptions, do exist, but usually will not work with a DAO.) Investors participating in unregistered offerings of a DAO can actually be liable for violations of the securities laws, if the offering is not done correctly. So, it's crucial that DAO investors understand the legality of token offerings in which they plan to participate.
How to Plan a DAO-Based Business
Here is an outline for how to plan a hybrid DAO structure:
- Set up the DAO (see below for more information on the nuts and bolts).
- Developers create a smart contract that will operate the DAO.
- The DAO establishes a funding source, such as tokens, usually via crowd funding.
- The DAO establishes rules for altering the smart contract as necessary in the future.
- The smart contract is deployed on a blockchain (such as Ethereum)
- Set up a corporation or LLC to backstop the DAO.
- Be sure the bylaws or operating agreement of your entity are consistent with DAO rules, and properly delegate voting to the DAO.
- Form your entity.
- Be sure you follow corporate formalities to avoid losing your entity status.
- Create your community and business
And overall, keep in mind you are breaking new ground. Work with investors and advisors who can think creatively and adaptively. Learn from your mistakes -- and those of others -- until you get it right.
Further reading and sources for this article:
For the nuts and bolt of setting up a DAO, see Ingamar Ramirez, How to Create & Run Your Own DAO, March 10, 2020, https://medium.com/bitfwd/how-to-create-run-your-own-dao-5e3eadd96962
For examples of DAOs see Brian Fakhoury, The Future is DAO: A Primer on DAOs and Their Explosive Growth, Underscore.VC, https://underscore.vc/blog/the-future-is-dao-a-primer-on-daos-and-their-explosive-growth/
For an explanation of "ragequit" see https://daohaus.substack.com/p/rage-quit-exit-rights-and-real-skin
For the hack that affected the first Ether DAO, see What is a Decentralized Autonomous Organization and How Does a DAO Work?, Cointelegraph, https://cointelegraph.com/ethereum-for-beginners/what-is-a-decentralized-autonomous-organization-and-how-does-a-dao-work
For a discussion of the pros and cons of distributed decision making, see Rahul Nambiampurath, A Beginner's Guide to Decentralized Autonomous Organizations, https://beincrypto.com/learn/decentralized-autonomous-organization/#h-dao-pros-and-cons
For information on token-based DAOs and share-based DAOs, see Decentralized Autonomous Organizations (DAOs), Ethereum, https://ethereum.org/en/dao/
For the SEC report stating that DAOs are subject to securities laws, see Securities and Exchange Commission, The SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities, July 25, 2017, https://www.sec.gov/news/press-release/2017-131
For a summary, and examples of DAOs, see What is a DAO LLC? Discover your Complete Guide to DAOs, Start Pack, June 2, 2021 https://www.startpack.io/blog/what-is-a-dao-llc-your-complete-guide-to-daos
Wyoming Bill No. SF0038, https://www.wyoleg.gov/Legislation/2021/SF0038
With thanks to Kate Camp for her contributions.