Fintech

DAOs are running crypto. Can they replace the corporation, too?

Decentralized structures like ConstitutionDAO are fast, simple to spin up, democratic and global. The problem is getting regulators to recognize them.

An illustration of 3D letters spelling "DAO"

DAO stands for "decentralized autonomous organization." Crypto advocates believe it can replace traditional forms of corporations.

Image: Christopher T. Fong/Protocol

Decentralized autonomous organizations are the way that much of the crypto industry is ostensibly organized today.

But some critics are asking whether these groups offer a new world of crypto coordination, or just a more risky way to do things that already exist in traditional finance.

Put more simply: Do DAOs work as promised?

DAOs enable people to form organizations with no central leaders in control, run on top of a cryptocurrency, for some collective purpose. They're often described as a way for people to avoid the hierarchical centralized systems in corporations or other large organizations.

They also offer transparency through the recording of transactions on a blockchain and are often run through rules enforced by a smart contract. They can be designed to be more loosely organized and easier to join than companies. (This also makes it easier for people to drift in and out.)

Jonesing for a DAO

DAOs aren’t new. Many large crypto protocols operate using DAOs to vote on the direction of their protocols. One of the earliest was The DAO, which fell victim five years ago to someone stealing one-third of the group's capital — some $50 million. That resulted in a hard fork of Ethereum into two blockchains.

Today DAOs are being used across a range of purposes, such as social groups, collector groups, investor groups, talent agencies, research groups and media organizations. There’s now an industry that provides services such as starting a DAO, providing tokens to DAO contributors, running DAO votes on proposals, handling disputes and managing DAO treasuries.

But can DAOs fund startups, replace crowdfunding campaigns or take the place of the trusty LLC? Advocates say that emerging tests of the model show it could bring more transparency and inclusiveness to businesses. Critics say that DAOs are not really doing much new, are often not legal and often rely on an assumption of never-ending growth to fuel themselves.

Crowdfunding is a popular use of DAOs. It also shows the many ways that DAOs can go wrong. People can spin up a DAO for virtually any financial goal — from buying a basketball team to trying to address climate change. ConstitutionDAO infamously raised over $40 million, lost its bid for a copy of the Constitution and descended into chaos.

The best-known crowdfunding sites, Indiegogo and Kickstarter, offer rewards, not equity. Others that rely on the SEC's Reg CF to do equity crowdfunding have to stay small and within the U.S. to adhere to regulations. Both of those models allow refunds if a project turns out to be a scam.

DAOs generally don't have such protections, but with DAOs people could "raise money from millions all over the world for a global cause like buying tracts of rainforest or cleaning up part of the ocean," said Adam Jackson, co-founder of Braintrust Network and a crypto investor. There are some legal questions with crowdfunding DAOs and challenges with trusting who is running the projects, he noted.

A printing of the United States Constitution on display The ConstitutionDAO bid on the first-edition printing of the Constitution at a Sotheby's auction. Photo: Alexi Rosenfeld/Getty Images

For startup investing, successful founders or investors can form their own DAOs to use for their angel investing where a small group votes on how to invest — and some of this is already happening, said David Pakman, managing partner at CoinFund. Groups like The LAO and MegaCartel have gotten into early-stage crypto deals.

But DAOs won't replace traditional venture capital, Pakman said. "Early-stage founders are looking for more than money, they want experience on their team to help them succeed, and I am not sure a DAO model does a good job of providing both capital and experience in growing companies," he said.

Social clubs hold the potential to enable coordinated action that wasn’t possible before, ConstitutionDAO notwithstanding, Jackson said. While he believes ConstitutionDAO was "doomed to fail," offline clubs are forming DAOs to invest as a group through a token. Syndicate.io, which Jackson has invested in, is one site used to do this. In the future, even your typical offline bake sales or charity fundraisers will use DAOs to raise money, Pakman predicted.

The DAO of social

The coordination and social elements of DAOs, often done in part on Discord, are a key part of DAOs. They lower the barrier to entry and facilitate decentralized decision-making. Or, as in the case of ConstitutionDAO, they help fuel the chaos.

The difference is that there’s ownership and a profit motive attached. It’s one thing if tokens are used for a social group to fundraise for some purpose. But will financial incentives become de facto required for social interactions? Friends with Benefits, the social club that uses tokens that must be purchased for everything from in-person events to editorial projects, is one experiment testing this out.

That said, DAOs are being created to generate profits in surprising new ways from online connections. Crypto gaming often requires the purchase of currencies or NFTs to participate. So Yield Guild Games, a DAO, lends NFTs to gamers to split in-game profits.

DAO Inc.?

DAOs could be another way to form LLCs, but can they really replace companies? Crypto-friendly Wyoming passed a law in July allowing people to create an LLC with a DAO that has an Ethereum address. If a conflict arises in a DAO, a judge in Wyoming could rule on a dispute. But this wouldn’t work if one of the parties is outside of Wyoming, Jackson said: That aspect of the law hasn’t been tested.

It’s not either/or. Some DAOs need to register as LLCs and have done so. The LAO is a Delaware-registered LLC that is “primarily administered via an online application (a 'DApp') and related smart contracts,” its website says. In other words, the DAO structure provides coordination and voting, but sits on top of the LLC structurally.

One group, CityDAO, purchased 40 acres of land in Wyoming under the law seeking to build a blockchain city. However, after Wyoming recognized another DAO, American CryptoFed, the SEC in November blocked the DAO’s token registration due to a “materially deficient and misleading registration form.” In other words, even if a state recognizes a DAO, it may still need SEC approval to register its tokens.

The best use of DAOs are when actions are transparent, typically through voting on the blockchain, with community treasuries held on chain and voting actions enforced on chain, Jackson said. One model for this is Governor Alpha, which is used by Compound and Uniswap, he said.

"These are fairly traditional capital structures, but on the blockchain," said Parker Thompson, a partner at TNT Ventures. DAOs have simpler share structures, with fewer or no share classes, and are able to manage decision-making using tokens rather than shareholder votes. But the concept of pooling capital for collective effort isn’t new, he argued.

The biggest challenge for DAOs may be their legal status, which is still unclear. "As with many 'innovations' in crypto, the primary novelty here seems to be ignoring laws," Thompson said.

That may mean that for some time, the DAO won’t replace the LLC: Instead, it will ride on top of that structure’s established protections. Expect a growth industry in legal advice for starting your DAO LLC.

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