Introduction to DAOs
Mohammad Zia* and Daniel Oyolu**
In November 2021, Kenneth Griffin made history by spending the most money ever on a book, manuscript, historical document or printed text at an auction. He spent US $43.2 million to buy one of only two privately held first printings of the United States Constitution. Signed in 1787, the U.S. Constitution is the supreme law of the United States and it has influenced the drafting of fundamental laws of many countries. Kenneth Griffin almost missed this historic purchase due to fierce competition from ConstitutionDAO, a decentralized autonomous organization, or DAO, that raised US $40 million before losing the final bid to Mr. Griffin.
US $43.2 million is a lot of money, and the U.S. Constitution is also a very special document. But how did ConstitutionDAO come into the picture? How do you even pronounce DAO? What is it? And how did a DAO raise an impressive US $40 million?
Well, first, DAO is pronounced more like Down without the “n” at the end.
Check out this video on how to pronounce DAO.
I. What is a DAO?
Now that we know how to pronounce DAO, let’s dive into the acronym. DAO stands for decentralized autonomous organization. You may still be wondering “but what does that actually mean?”
Let’s illustrate with an imaginary DAO called BrazilBeanDAO, a group of Brazilian coffee warehouse owners that live across the world. They all have a shared mission which is a passion for Brazilian coffee. They created a DAO to manage their supply of coffee on their shelves. BrazilBeanDAO’s members all agree on a set of rules for governing the organization and managing its money. Once they reach agreement, they place these rules on a smart contract on the blockchain (we’ll talk a little more about blockchain below).
The smart contracts enable full automation of the DAO. For example, the members agree that they will have sensors in each of their coffee warehouses. When coffee inventory falls below 20% of full capacity, the smart contract will order coffee automatically at market-based prices. There will be no need for a middleman, because the DAO can act on its own. The group agreed on coffee quality and sourcing requirements that are now a part of the smart contract. They also all agreed that each member will receive one token which represents their voting power in the organization.
But what if after a few weeks, Pedro, one of the BrazilBeanDAO members, gets bored of his fellow members and the DAO’s rules? He decides it is time for some changes under his terms. First, he wants the DAO to be called DonPedroDAO. Second, he wants to be the majority owner of all the DAO’s financial assets. He also wants to oversee each and every rule’s implementation and authorize every move on the smart contract. He wants to buy coffee only from Dunkin Donuts because his cousin works there and he wants to help his cousin get more business. Pedro doesn’t want to follow the BrazilBeanDAO’s original rules on the smart contract for making changes and wants to make these changes without the support of any other members. He also wants the coffee warehouses to be refilled after they are at 50% capacity instead of 20% capacity as was initially agreed upon by all the members.
Unfortunate for Pedro, he can’t make these unilateral changes. In a DAO, there is no central authority. Also, the smart contract enables the rules of the DAO to be implemented autonomously without a central authority responsible for oversight. As a result, Pedro fails to make any of his grand changes to the BrazilBeanDAO.
With Pedro’s failures in mind, let’s clarify how a DAO functions. It is an organization, usually a group of people, working towards a universal mission. Members of a DAO usually need to buy their way into the organization. They usually do this by purchasing a governance token that comes with the ability to vote on decisions. A DAO functions under a decentralized set of rules and there is a flat hierarchy.
II. How do DAOs work?
A DAO uses blockchain technology and smart contracts to define the rules of the group members and to manage the group’s finances. (If you want to learn more about the basics of blockchain technology, check out, Introduction to Blockchain). Smart contracts are verifiable and publicly auditable. They allow any member to understand how the DAO operates.
DAOs receive financing and implement governance rules on the blockchain, usually through a token issuance method where the protocol sells tokens to raise funds. Token holders get voting rights that are proportional to their ownership. The most common ways to issue tokens are airdrops, a process to distribute tokens to members based on their contributions or their ability to achieve certain predetermined goals. Members gain ownership rights by earning more tokens.
Once the contract is placed on the blockchain, no one can change the rules unless there is a vote. If a member attempts to do something outside the rules of the smart contract, that person will fail. A DAO is also autonomous in performing its day to day functions. The organization makes decisions collectively and payments or other actions are automatically authorized once a vote is passed. There is no need for specific authorities or administrators to ensure the DAO is performing its functions. DAOs are not subject to top down decisions by corporate leaders or other third-parties.
Every DAO will set its own rules for governance but, generally speaking, a member can propose an initiative. That proposal will go on to voting and each member will vote with their governance tokens. Based on the outcome of the vote, the initiative may be added to the DAO’s smart contract.
The ConstitutionDAO, for example, was built on a shared goal of democratizing ownership of one of the original copies of the U.S. Constitution.
III. What are the benefits of a DAO?
As you can probably see, there are various benefits to forming and working with DAOs. For example, DAOs enable more transparent processes since members of a DAO can see what actions are being taken and when those actions go into effect. In other types of organizations, some members are able to choose what happens for the group and many members of the same organization end up left out of the decision-making process or unaware of what is happening.
Another advantage of a DAO is a lack of hierarchy which can simultaneous contribute to a feeling of community. There is no one leader of a DAO but rather a group of people coming together to achieve a common goal utilizing available blockchain technologies. Back to our previous example, Pedro couldn’t just take on certain actions alone. In fact, none of the members of BrazilBeanDAO could do that. Many DAO enthusiasts are excited by its potential to further democratize power by putting it in the hands of many more people.
Another cool aspect of DAOs is the way in which decisions are automated. Once the smart contracts are in place, members can trust that certain actions will happen automatically. This helps to make organizing and coming together more efficient for everyone involved. It’s also another way to provide transparency and build trust since no one person controls those smart contracts but rather they are programmed to perform the actions that the group decided. Once certain conditions are met, the actions take place immediately as was the case with BrazilBeanDAO and its coffee inventory.
IV. What are the different types of DAOs?
Now that we understand what a DAO is and its main benefits, let’s break down a few examples of DAOs. There are many types of DAOs ranging from social network DAOs to philanthropic DAOs. Three of the most common DAOs focus on protocols, collectors, and investments.
The most common type of DAO is known as a Protocol DAO. These types of DAOs are essentially voting metrics for implementing changes in the governance structure that represents the DAO. Examples include MakerDAO and Uniswap.
Common among artists, Collector DAOs are useful tools to help establish ownership of digital art. Collector DAOs are also useful for members to collect their funds and pool them to invest in high-value, rare collectables. Each member of a Collector DAO can own a share corresponding to their investment in a community collectable. ConstitutionDAO, mentioned at the beginning of this article, is an example of a collector DAO. Other forms of collector DAOs focus on attaining high value NFTs. FlamingoDAO is an example of an NFT focused DAO.
Investment DAOs allow individuals to pool their capital and democratize the process of investment for various goals. Often created by crypto rich investors, Investment DAOs allow non-accredited investors to build a team that makes investments or supports startups. Investments DAOs are generally more transparent as compared to traditional mechanisms such as venture capital funds. Investment DAOs also often seek to help their members and the startups they support use the DAO platform for advice on navigating regulatory hurdles, especially in the blockchain/web 3 sector. BitDAO is an example of an investment DAO that is focused on blockchain/web3 investments.
V. Challenges Ahead
We’ve previously discussed various ways DAOS can be beneficial but they still provide some challenges moving forward.
One challenge involves voting power. What if a DAO’s voting powers become concentrated among only a few people? If a really small group within a DAO acquired the majority of the tokens available, they would be able to override the desires of the greater majority of the DAO which would go against the ethos of community involvement and lack of hierarchy.
Another challenge is the vulnerability of the code itself. If hackers are able to attack a DAO successfully, they can steal millions of dollars of cryptocurrency. This could potentially make DAO members susceptible to losing their money too and consequently hesitant to participate in a DAO.
Regulatory and legal challenges present other roadblocks for DAOs in the years to come. Currently, there is no legal framework for recognizing DAOs. In fact, in the United States, Wyoming is the only state that recognizes DAOs. In light of the present legal realities, it may be difficult for one party to enforce a legal claim against another if a court does not recognize the validity of a DAO or the underlying protocols that support them. This may discourage people joining DAOs, because they may feel their stakes and interests are not protected. Plus, there is currently no timeline on when the U.S. Congress plans to legislate around DAOs.
Despite the challenges DAOs may present, it’s clear that they offer innovative solutions for several types of governance problems that organizations face. We should all be paying attention to see how these technologies and innovations evolve over time.
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** Corporate Associate @ Cleary Gottlieb LLP