DAOs - a new model for funding and governance
Updated: Nov 8, 2022
At a recent Perth Angels event I got to talk about Decentralised Autonomous Organisations (DAOs). As well as hosting pitch nights, Western Australian angel group Perth Angels runs the Angel Investing Series, a program of educational events covering topics of interest to our members. In early September we held a session on crypto, blockchain and web3, for which I invited friend and client Ben Simpson from Collective Shift who flew over specially from Melbourne to deliver his awesome keynote. We also had the awesome Tracey Plowman from Bamboo and Ian Love from Blockchain Assets.
I had a go at explaining how DAOs work, and where they sit along the governance spectrum and fund-raising ecosystem, in relation to private companies, venture capital, public markets and crowdfunding. Hey, someone's got to tackle the sexy topics!
Before getting into the weeds on DAOs, a good place to start is my previous post on the future of funding, which covers how web3 companies and tokens might better align stakeholders and democratise fundraising. I think it's important to view DAOs not as a standalone innovation emerging out of blockchain technology, but rather in the context of the evolving themes of governance and fundraising - understanding where they sit alongside crowdfunding, venture capital and member-owned organisations. Sure, DAOs are about more than just governance and fundraising, but it's a convenient point to start exploring from.
What is a DAO?
A DAO is an organisation that is run using smart contracts, or rules that are prescribed by computer code, using a blockchain. These entities are decentralised in the sense that they are not centrally-led like a company is led by a CEO and a management team, instead they are collectively run through a combination of community votes and the smart contracts. A bit like the direct democracy equivalent of governance: stakeholders are voting for individual decisions rather than appointing directors as their representatives to make the calls. Proposals are put forward, debated and voted on, all in an open and egalitarian way.
At inception the DAO raises funds by issuing tokens to backers, consequentially ownership of the DAO is in the hands of those token-holders, and only they can vote on proposals, with their voting credentials verified on the blockchain by the smart contract. A proposal is documented into a smart contract, such that if it receives the requisite number of token-holder votes, the proposal automatically executes itself onto the blockchain. This is on-chain governance. (Incidentally, Bitcoin does not have on-chain governance: as a proof-of-work blockchain, core users need to agree and implement updates in unison in an 'off-chain' process. And when this doesn't work, it leads to a fork, which is how you end up with Bitcoin Cash. Also see the below story about the fork that led to Ethereum Classic).
As such the organisation functions autonomously: the process is self-organised in reliance on the smart contracts, with no central authority, human hierarchy nor third party required to administer the decision-making process. This leads to the concept of DAOs being ‘trustless’: no human intervention is required, and no third party regulator nor mediator is required for resolving disputes. Theoretically at least, no legal system is required to enforce rights, these are enforced by the smart contracts. This is either exciting or alarming - depending on your appetite for trying new things.
In fact, DAOs are, for the moment at least, not recognised as legal entities - with some minor exceptions like the Marshall Islands and a couple of US states. Though it's just a matter of time before more jurisdictions begin to recognise and regulate them as an entity class. One of the recommendations from the Select Committee on Australia as a Technology and Financial Centre's report last year was for the government to establish a new DAO company structure. Having a recognised legal status as a DAO is useful if you want to limit your liability as a DAO operator or token-holder (are token-holders liable to the actions of the DAO? this is being prosecuted by the Commodity Futures Trading Commission in the US currently). But not so attractive for the DAO purist, for whom a DAO provides a sovereign, independent structure which doesn't owe its existence to any state nor regulator.
Trustless - or the 'rule of code'
The organisations are trustless in the sense that no trust is required in any individuals or institutions. The use of the word 'trustless' is perhaps misleading: in reality DAOs have replaced trust in counterparties and institutions with trust in the infallibility of the underlying computer code. There is a burgeoning industry of code auditors, increasingly required to lend a project credibility. I'd expect in time we'll see regulation and registration of code auditors, and it will become increasingly difficult to raise money without an accredited auditor's sign off on the code.
This concept of trustlessness appears more relevant in the context of dealing with 'strangers online' than in the context of replacing trust in immediate counterparts you have an on-going relationship with. The value proposition seems less pertinent when dealing with say, a group of angel investors who regularly meet in person and have a track record of collaborating on deals. On the other hand, a large distributed global network of investors operating anonymously with no social linkage - then it makes more sense. In an interview last year ASIC chair Joe Longo said: "As the corporates and markets regulator, I have to admit a certain fascination with DAOs. No boards of directors or employees in sight and the rules of engagement are encoded in smart contracts. Indeed, it has to be said to a large extent [that] DAOs work on the basis that the 'rule of code' replaces the 'rule of law'."
When talking about DAOs I wanted to come up with a visualisation to highlight where they might fit in. I've come up with the below framework of governance and ownership/fundraising, which I think may be useful for contextualising DAOs.
DAOs provide a means to raise funds from large, distributed communities (decentralised ownership), while sitting at the direct democracy end of the governance spectrum.
If there was a third axis here, it might be one for globalisation. DAOs seamlessly operate across borders, whereas private and public companies are not set up to easily accommodate global ownership. Equity crowdfunding across countries is possible, but awkward and administratively cumbersome. At least rewards-based crowdfunding allows borderless campaigns, by bypassing national securities regulations.
Just because you can, doesn't mean you should decentralise everything
While a big deal is made about the decentralised nature of decision-making within a DAO - in fact it's one of its key value propositions - the practical implications and logistics of this often prove challenging. Getting every member to vote on every decision sounds great in principle, but may not lead to better outcomes or better governance.
In the same way that direct (or 'pure') democracy has not proved very sticky as a system of government, completely decentralised governance is not going to prove the holy grail for all organisations. In particular when it comes to building products and innovating: running a startup 'by committee' is unlikely to foster a culture and operating environment in which product development cycles are short and business models quickly iterated upon.
Decentralised governance is arguably better suited to more stable organisations operating in more simple environments, not startups. Decentralised decision-making doesn't make great sense when the decisions being made are short term critical or require fast turnarounds in complex, uncertain environments. Startups and DAOs make strange bedfellows; it's just that startups attract one kind of money, crypto attracts another kind of money, and DAOs kind of sit in the middle and get shoehorned into joining the dots.
A good old private company remains the most adapted structure with which to build products. Once a focused and nimble core team of hustlers get the project off the ground and humming, then (depending on the product) there could be a case for pivotting into a DAO. Or it could be a case of running a DAO alongside the company, with the company holding part of the tokens in the DAO, in a hybrid structure.
I feel more excited about the prospects of deploying DAOs - and perhaps DAO hybrids that involve committees with delegated decision-making powers - as a form of consumer-owned organisation. On the above diagram, these would sit somewhere between the not-for-profits and mutuals and cooperatives, in close proximity to crowdfunding. We're only starting to scratch the surface of how powerful DAOs can be in empowering communities to rethink how they buy, work and interact.
DAOs are often deployed as investment funds, as the collection and allocation of capital is arguably a relatively simple business model with few moving parts, and so it's comparatively straightforward to implement smart contracts and community votes to automate the process in a self-governing way.
This fits into the theme of democratising investment: DAOs allow a new generation of micro investors to by-pass the gatekeepers of traditional finance, opening up opportunities to a broader audience - much like crowdfunding can. They also bring community ownership and engagement into the process - which is what's lacking in crowdfunding.
On my continuing journey of self-education in this space, I've recently created a type of venture DAO, called AngelDAO. It's a small angel investment club, designed as a small scale proof of concept to provide members (no more than a dozen or so angel investors from my network) with the opportunity to learn 'hands-on' about DAOs and gain more exposure to web3 dealflow. To be clear, AngelDAO is firstly an educational experience, any financial upside will be a bonus.
I've made use of the awesome (and free!) platform provided by Syndicate.io. Syndicate has positioned itself as an off-the-shelf solution for investment clubs to pool funds on-chain and invest, creating a venture DAO in a matter of minutes. They've also partnered with Doola to allow a venture DAO to establish its legal status in the US and handle regulatory filings etc.
I find the story of The DAO fascinating. The DAO, which happens to be the name of one of the early DAOs, was created in 2016. It's an exemplar in the study of DAOs and their perils. If you've read until now and find yourself scratching your head, wondering can you really entirely replace corporate governance with tech governance, then this cautionary tale informs that reflection. For the true governance nerd I recommend a read of this paper by Morrison, Mazey and Wingreen for a deep dive into what went wrong.
The DAO was set up as an investment fund, with its 11,000+ investors contributing US$150m in cryptocurrency and voting on investment proposals to allocate the funds. Early on concerns were flagged around some vulnerabilities in the code, that might allow someone to divert The DAO's funds to their own wallet. While the community debated how to fix the bug, a community member exploited the vulnerability and transferred US$60m to their own wallet.
In the words of Morrison, Mazey and Wingreen, "the complexity of the smart contract code meant the features designed to support its decentralized decision-making framework were in fact its Achilles' Heel. The rapid deployment of such complex code meant it behaved sporadically and in ways that were not intended. The risks this created were then exacerbated by its decentralized decision-making model which, in effect, was slow and cumbersome in responding to the threats which were subsequently realized."
While the event is commonly described as a hack or a theft, there are some (including the anonymous hacker who argued as such in an open letter) who argue that it was no hack, but simply a member exercising their rights under the smart contract that The DAO had agreed to be exclusively bound by. So technically valid - but unethical. One could also argue it's simply a member claiming a 'bug bounty'.
The blockchain is immutable - unless we vote otherwise
How was the controversy ultimately resolved? While it was far from unanimous, a majority of community members voted for a new copy of the blockchain to be reinstated, rewound back to before the hack. As this was not unanimous it created a 'hard fork', and so we ended up with two parallel blockchains. While a majority of users agreed to adopt the 'no hack' version, a minority of contrarian users refused to and instead continue using the 'pure' version. From that point onwards, not only was The DAO split into two, but the entire blockchain (Ethereum) that The DAO was built on was split into two. To this day, we still have a dominant Ethereum blockchain, as well as a separate Ethereum Classic blockchain.
This was a momentous occasion in the history of blockchain generally. It implies an acknowledgment that one of the fundamental and philosophical tenets underpinning blockchain - that transactions and records and immutable, is in fact reversable, if the community consensus supports that reversal.
In the words of Morrison, Mazey and Wingreen, "many would see it as unethical and illegal to persuade people to invest large amounts of money in a product whose key selling point is its immutability, then when it goes wrong to claim that it wasn't ready for release and needed to be changed."
Clearly these were the early days and we can't realistically expect paradigm-shifting innovations to get it right first go. A trial-and-error phase is to be expected, should even be celebrated (as long as it's someone else's money being lost). Even today, six years after The DAO, we are still fumbling in the dark.
Venture capitalist / journalist Packy McCormick has written extensively on web3 and DAO governance, in particular this on web3 use cases and this on leveraging forking to improve governance. His enthusiasm is contagious and I regularly devour his Weekly Dose of Optimism newsletters.
For McCormick, "DAOs are experimenting with the same governance models – from direct democracy to representative democracy, from direct shareholder vote to boards and management – that local and national governments and corporations have tried. They’re just doing it really fast, compressing thousands of years of experiments into less than a decade."
It's tempting to find yourself picking a camp, either all-in drinking the web3 Kool-Aid, or opting for unqualified cynicism, but that doesn't leave much space for an evolving and nuanced discovery process. Reading content from both sides of the spectrum is useful to keep your position grounded and educate a questioning mind. Skepticism is a reasonable perspective, and from that side of the fence, this is a good place to start.
Blockchain-based governance is still in its infancy, and we need a bit of patience as innovators and early adopters do the heavy lifting of figuring out its place in the world. As advisors, investors and board directors, we need to educate ourselves in readiness for mainstream adoption.