DAO Structures and Potential Legal Considerations

Decentralized autonomous organizations, or DAOs, are projected to improve the performance of businesses by its core characteristics of decentralization. In 2022, the blockchain and Web3 industry has seen a surge in the number of these organizations. As of June 2022, a report by Snapshot Labs shows that the number of these organizations increased by 8.8 times, from 700 the previous year to 6000 currently. The number of DAO proposals increased by 745%, and the total votes by 525%. The top 20 DAOs currently hold nearly $14 billion in assets compared to the $6 billion from the previous year. This new species of corporate governance is presenting us with the opportunity to rethink what corporate governance should look like this century.

What are DAOs?

DAO is an acronym for decentralized autonomous organizations. DAOs are blockchain-based organizations fed by a peer-to-peer (P2P) network of contributors whose management is built on automated rules encoded in smart contracts, and their governance works autonomously.  Interestingly enough, DAOs can execute voting rights on-chain or off-chain.

Principles of DAOs operation

The first popular DAO was a venture capital organization that controversially served as an experiment to understand this new concept of organizational structures. The goal was to remove hierarchies from organizations by substituting managerial roles with a set of codes encoded in a smart contract. Founded atop the Ethereum blockchain in 2016, the vision was to draw in a community of investors that will develop the Ethereum ecosystem. Although unsuccessful, This development will later form the foundational principles of DAO operations, which include Decentralization, Automation, and Autonomous.

Decentralization: The operation of DAOs relies on a serverless public blockchain and decentralized governance. This principle is similar to the decentralized vision of Web3, and ushers in the possibility of collective decision-making on organizational operations. The blockchain itself is a decentralized governance system, and this allows for general governance where participants or contributors in an organization can reach a consensus through voting on operations such as investments in collaborative projects. DAOs are predicted to drive the emergence of a global stateless society, where central authorities have minimal interference.

Automation: Operational activities of DAOs are defined on a DAO whitepaper encoded on a programmable agreement based on computer codes known as 'smart contracts. This allows for the automation of operations regarding ownership, contributions, and transactions occurring in the organization to be executed automatically without the need for a central authority. The smart contract thus forms the foundational principle by which DAOs operate. This automation functions on a set of predefined rules that will not require human intervention. The smart contracts will ensure fair and even distribution of operations.

Autonomous: This principle is intended to remove the bureaucratic system of operation that is experienced with traditional organizations. Operations of DAOs are usually autonomous via the active participation of members in a P2P manner using democratic rules and direct voting processes based on several tokens. Each member shares a common goal to act in the best interest of the entity. The members usually consent to play by the rule book of the organization they belong, and these rules can be changed if it is no longer appropriate based on the voting powers of the community members.

Types of DAOs

1. Protocol DAO: This type of DAO is also known as the automated market maker (AMM) DAO. They are focused on using smart contract protocols to bring decentralized services to users. The decentralized protocol that it governs includes borrowing and lending exchanges, decentralized exchanges (DEXs), and other decentralized applications. Examples of popular protocol DAOs include MakerDAO, Uniswap, Compound, Sushi, and Yearn Finance. Protocol DAOs have a set of programs that allows users to build on top of their protocols. The governance of protocol DAO builds apps and tools that will generate revenue with every transaction on their protocol.

2. Social DAOs: This is a community-focused DAO that is made up of like-minded individuals with different traits, and an orientation towards a common goal. A social DAO usually will operate on its native token which determines the mode of operations and participation in the DAO. A popular example is the Friends With Benefits (FWB) DAO, which is a web3 creator DAO that encourages interpersonal networking. Another example is the Developer DAO, an NFT-gated DAO for developers focused on building the future of web3. The revenue generation model for Social DAOs is a bit complex, and mostly from sales of exclusive events.

3. Grant DAOs: This type of DAO is geared at facilitating crowdfunding for nonprofits. The DAO is built on a philanthropic nature, providing funding and support as part of a larger community-driven program. There are several projects in web3 with a well-established vision that usually go unfunded, this disrupts their productivity and potentially brings them to an end. Traditional processes of getting grants are usually cutthroat, as the funding rates of new proposals are reported to have dropped in the last decade. An example of a grant DAO is the Aave protocol, this DAO is focused on providing DeFi funding.

4. Media DAOs: Media platforms are recognized as important for the transmission and dissemination of information. Combining social interaction, crowdfunding, and blockchain-supported DAO technology provides a powerful symbiotic relationship. A popular media company that leverages this relationship is Bankless. It is built around the vision of bringing together a community of leaders in art, content creation, development, etc, with a single mission of getting everyone to go bankless. Most of their activities are designed at educating the public on the necessity of moving from a traditional organizational model to a decentralized structure

5. Collector DAOs: These organizations are focused on collectible digital arts like NFTs. Community members pool funds together to invest by purchasing NFTs, and each member has an opportunity to own fractions of expensive digital art. Big NFT projects such as BAYC and Crypto Punks are popular assets in web3 that are quite expensive to purchase individually. A collectible DAO can pool funds and invest in these projects, allowing members to benefit from the utility at a reduced financial risk. Popular examples are the Head DAO and Pleaser DAO that has mobilized community members to be part of joint digital investment.

Legal Considerations for DAOs

The blockchain community has begun to pay more attention to regulations and legal implications of operations, particularly in light of recent events that have shaken the web3 community to its core. The rules of operation in web3 can be implemented both off-chain and on-chain. On-chain governance is encoded in smart contracts, and they form the underlying infrastructures that guide the decision-making processes of DAO operations. The legal implication of this operation for the members will be unknowingly exposing themselves to personal liabilities based on their affiliation to a DAO. In addition, they do not have the advantage of protection in cases of personal liabilities.

In 2017, the United States Security and Exchange Commission (SEC) highlighted key federal security laws that DAOs should consider. Organizations that operate using a native token, usually DAO-issued tokens are required to comply with security guidelines, usually, the tokens have to be assessed using Howey's test to determine if the DAO-issued tokens pass for securities. There is also an investment compliance challenge with these organizations under the Investment Company Act. Particularly for DAOs investing in projects that have security tokens. Given these peculiar challenges, future consideration may be made to areas like organizational compliance and tax compliance at the federal level.

One of the major challenges to DAO adoption has been that of recognition as a legal entity in many states. This could account for the result of the difficulty in the formation of clear regulations that will guide the activities of DAOs by regulators. Wyoming became the first state in the US to recognize DAOs formation legally. The bill titled Decentralized Autonomous Organizations Supplement provides protection for Wyoming DAOs and allows them to incorporate as limited liability companies under Wyoming's Limited Liability Act. Some other places where DAOs are recognized include Malta, Switzerland, and Gibraltar.

Conclusion

DAOs are viewed as the means of bringing a promising paradigm for decentralized organization solutions. The hierarchical nuances of corporate organization structures have proven to be ineffective, particularly with the numerous challenges peculiar to the global market such as increasing price competition and meeting the demands of stakeholders. DAOs will usher in the solution to control, governance, and leadership at business organizational levels.

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