Crypto enthusiasts envision that DAOs will one day replace traditional corporations. So let’s take a look at what DAOs are, how they work, and the advantages and challenges of this new token-based governance system.
What Are Decentralized Autonomous Organizations?
Decentralized autonomous organizations (DAOs) are digital governance organizations powered by smart contracts running on blockchains, enabling automation and distribution of authority based on token incentives.
Issues such as lack of transparency, inability to access investment opportunities, censorship, and fraud persist in traditional organizations.
DAOs promise to address such issues by making decision-making in organizations more transparent and democratic, involving even the smallest stakeholder rather than a few rich folks in the upper echelon.
The approach taken by most DAOs can change the way we view businesses today. Imagine a regular customer or a member of staff having a real stake in a business and a say in its future activities.
How Do DAOs Work?
Although the underlying mechanism of most DAOs differs based on purpose, they all rely on the decentralized and immutable nature of blockchain networks (or distributed ledgers) to effectively function.
In a typical DAO, a group of people with common interests gather online (often via Discord) to agree on certain goals and objectives that form the basis for the organization. The rules of the DAO are established by this group and encoded in a smart contract for all potential members to audit and verify so they can understand how the organization is to function at every step.
The next step is the funding process where members pool funds together to the DAO Treasury in exchange for governance tokens. These tokens represent the share of voting rights within the DAO usually proportional to the funds an individual contributes. The higher your amount of tokens, the higher your voting rights.
After all these processes, the DAO goes live on a blockchain network where all its activities are publicly recorded on-chain. At this point, the rules and structure of the DAO can’t be changed or adjusted except when token holders decide to do so via a consensus.
Members of a DAO make proposals about the future activities of the organization such as treasury allocation, protocol fixes, etc., and then vote collectively on these proposals. Proposals that pass a certain threshold of votes are automatically executed by smart contracts.
Some DAOs utilize structures where members assign their voting rights to more experienced individuals that can make critical decisions. The incentive to vote unbiasedly ultimately favors token holders as the growth/success of a protocol results in an increase in the value of its tokens.
Types of DAOs
Now let’s take a look at the different types of DAOs you may encounter in the budding world of web3.
Protocol DAOs are formed to oversee the future of decentralized applications (DApps). For example, DeFi protocols wouldn’t be effectively decentralized if their developers are solely responsible for executing upgrades. To solve this challenge and foster decentralization, protocol DAOs allow users to collectively manage a protocol using tokens.
Governance tokens are often awarded to users based on their usage of a protocol, by providing liquidity, and holding some particular tokens.
Social DAOs are organized around a group of people with similar interests who come together to form online communities managed through a governance token.
The focus may be to build a network of people who are like-minded in a particular area like arts, sports, or music. To join such DAOs, you usually have to hold a certain portion of their native tokens, fill out a questionnaire, or even be voted in by other members.
These are DAOs that democratize the investment process by pooling resources from members to invest in assets or start-ups (mostly crypto-based).
Investment DAOs allow average investors to access investment opportunities that are typically reserved for the top rich folks. This could be investing in DeFi protocols, buying rare NFT pieces, or even purchasing a sports team.
In this type of DAO, members pool funds together to fund charitable organizations. Unlike investment DAOs, where members solely pool funds for investment purposes, expecting a return on their investments, members of philanthropy (or grant) DAOs may not get anything out of their efforts.
An example is the Ukraine DAO, which was able to raise $8 million in ETH for the Ukrainian army in their war against Russia.
Similar to online talent acquisition firms, service DAOs consist of a group of talents worldwide that builds products and services. Contributors to such DAOs are usually assigned a governance token that they use in managing the DAO Treasury.
Clients of service DAOs include other crypto projects like DeFi protocols, GameFi projects, and other DAOs.
Media DAOs aim to restructure media platforms by using token incentives to reward consumers and content creators.
Users who contribute via articles, graphics designing, marketing activities, research, podcasts, etc. receive a reward in the governance tokens of the DAO. This allows them to have a stake and contribute to decision-making in the DAO.
Notable Real-World DAOs
Now, let’s take a look at a handful of high-profile DAOs.
Notable for causing the Ethereum hard fork, The DAO was the first attempt to create a decentralized autonomous organization. The DAO was supposed to be a kind of decentralized venture capital fund that allowed investors to pool funds in exchange for tokens that allowed them to vote on how to spend funds in its treasury.
The DAO was able to raise about $150 million in ETH within a month in an effort considering the largest crowdfunding campaign at the time. However, a malicious entity exploited some vulnerabilities in The DAO’s code to drain about $50 million.
Considering that The DAO held about 14% of ether in existence at the time, it could have signaled an end for the Ethereum network. Hence, Ethereum miners decided to implement a hard fork that moved the stolen tokens to a new contract address allowing members to withdraw their tokens in ETH.
In November 2021, a group of Twitter users pooled about $47 million worth of ETH in a smart contract to participate in an auction of a rare copy of the original US Constitution by Sotheby’s.
The group eventually lost to a bid of $43.2 million in the auction as they believed a higher bid wouldn’t be possible considering the extra funds they would have spent on moving and insuring the artifact. The group later refunded members their money by allowing them to redeem their tokens at a rate of 1 ETH: 1,000,000 $PEOPLE – the same rate at which they contributed.
Dash DAO is considered one of the earliest DAO projects. Dash structured its mining rewards in a way that 45% goes to miners, 45% to Masternodes, and 10% to a treasury. Masternodes vote on proposals for spending funds in the Treasury by locking up 1,000 DASH tokens. This is to ensure that voters have a significant stake in the effect of their decisions.
The Dash DAO says it has used funds in the treasury to hire developers and designers, purchase a domain name – Dash.org, sponsor conferences, purchase development hardware, and more.
Pros & Cons of DAOs
While DAOs could help in improving traditional organizational structures, they also come with their fair share of challenges. Let’s take a look at both the benefits and challenges of DAOs.
- DAOs allow for a more transparent way of managing organizations.
- The structure of most DAOs is designed to favor stakeholders rather than a single entity.
- DAOs allow for the fractional ownership of large-scale investments that average investors can’t ordinarily afford.
- DAOs are proving to be a faster way for capital formation.
- DAOs are partially free from human intervention as decisions are automatically executed via smart contracts
- DAOs are could be somewhat slow in decision-making compared to traditional organizations.
- Smart contracts are prone to attacks that may result in the loss of funds.
- Some technical decisions require expertise that ordinary DAO members may not possess.
- Most countries lack regulatory frameworks for operating DAOs.
While it’s still early days in the world of DAOs, proponents are convinced that decentralized governance models will play an essential role in the next iteration of the internet.
What is a DAO?
A DAO, which is short for decentralized autonomous organization, is essentially a decentralized, digital company where members make decisions that are voted for and automatically executed via smart contracts, with voting power linked to the amount of DAO tokens a member holds.
Can Anyone Take Part in a DAO?
Typically, anyone can take part in a DAO by purchasing the DAO’s token during a public token sale or on the open market (if available). Once an individual or a company holds tokens in a DAO, it can contribute to the project’s decision-making process by voting using their tokens.
However, if the DAO’s tokens are not available for sale to the public, joining a DAO may involve getting to know the team and building a relationship with members of the team before you are provided with access.
Are DAOs risky?
DAOs are built on self-executing smart contracts that can – at times – contain faulty code that could be exploited by a hacker.
Unfortunately, this has already happened before. Anyone interested in joining a DAO by purchasing the DAO’s tokens needs to be aware that there is a risk that the DAO’s smart contract could end up getting compromised, which could lead to a loss of funds.