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Can you explain what a Decentralized Autonomous Organization (DAO) is?

A decentralized autonomous organization (DAO) is a management structure that uses blockchain technology to automate some aspects of voting and transaction processing.

DAOs are a key component of important blockchain applications, including cryptocurrency, as well as Web 3.0, a proposed architecture for the next generation of the web that relies on the decentralization enabled by blockchain.

The grand vision is that DAOs could make it easier to create decentralized organizations that respect the interests of stakeholders outside the control of any one party. They have been used to raise money for specific projects and form new kinds of business structures. They can also automate many financial processes on blockchain platforms like Ethereum to ensure that stakeholders are compensated according to rules that everyone agrees to. They are also good at automatically facilitating shared votes based on a particular level of investment, support or engagement.

Diagram showing how DAOs work
A blockchain-based smart contract governs a DAO's decision-making and execution.

Proponents talk about using DAOs to replace trust that's based on personal relationships or a central authority with a type of specially crafted blockchain program called a smart contract. However, the goal of replacing trust with code is still a work in progress. DAOs don't directly automate physical and legal processes or the communications with government entities required for filing papers, paying taxes and getting permits. Furthermore, the smart contracts that govern DAO decision-making and execution are software code, not legally binding contracts. In most cases, the consensus reached must be carried out by human agents who the participants are willing to trust. And the DAO organization itself must be incorporated to support the desired legal, business and tax structure independent of the actual code.

Looking at them from another perspective, DAOs could automate the Hollywood model for making movies. The movie industry pioneered a model that enables hundreds of participants to quickly come together and develop a new film with uncertain prospects. Each participant, from A-list actor to costume designer, gets immediate compensation and a stake in the long-term success of the project. DAOs could help automate this model for other industries. People could get compensated not just at a labor rate but also for the business's success as a whole, even after they stopped actively working on it.

How do DAOs work?

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To start, programmers code the smart contract to describe the process for automating financial transactions, minting new coins and allocating votes. For example, should votes be allocated by total investment, grouped by cryptocurrency wallets, or based on some logarithmic curve that reduces the risk of super investors dominating the voting process?

A DAO also needs a legal structure, and the U.S. Securities and Exchange Commission has declared that selling crypto tokens in a DAO requires registering them as securities. States including Tennessee and Wyoming have begun designating DAOs as entities having legal status. Investment firm Andreessen Horowitz developed a guide to the benefits and limitations of various DAO legal structures.

A DAO's proponents then have to get the word out to interested investors and participants. Depending on the structure, people can participate through direct cryptocurrency contributions or by performing work that is validated through a portal or some other kind of resource. For example, a new environmental monitoring app might reward participants for contributing sensor data. A storage service might reward users for providing storage space using the interplanetary file system protocol.

Once the business is running, participants may at least feel good about helping to buy some rare thing or support the legal effort for a cause they believe in. But it's also possible for a DAO to both positively impact the world and earn returns that get converted into the core cryptocurrency underpinning the token. In this case, participants would either see an appreciation in the token's value or realize some payment in the token itself or a disbursement via Ether or another cryptocurrency.

Benefits of DAOs

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A DAO can do the following:

  • automate the financial processes associated with a distributed organization;
  • speed up the fundraising process for a new idea;
  • ensure that everyone gets a fair vote in the organization;
  • streamline distribution of returns and gains; and
  • improve visibility into rules for allocating investments and decisions.

Downsides of DAOs

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However, a DAO carries these downsides and risks:

  • Automated smart contracts can be difficult to change when a problem is discovered.
  • Hackers can discover loopholes to legally misappropriate funds against the interests of shareholders.
  • Participants can pay high transaction fees of up to $100 per transaction in early DAOs.
  • Humans are still required to execute physical and legal processes, which can thwart the intent of the DAO.
  • Governments are still sorting out the legal status of DAOs, which presents tax and legal risks for investors.

DAOs' effects on organizations

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DAOs are still a work in progress. In the near term, they will likely have the most significant impact on fundraising for specific goals. Today, services like GoFundMe can help individuals participate in causes they find worthy to pursue. DAOs could further guide such initiatives by allowing participants to vote on strategies that align with their intentions.

DAOs could also soon facilitate new kinds of investment organizations and automate the process of returning funds to participants. For example, people in a particular city could commit to a decentralized loan app for their city and guide some of the decision-making about the types of loans or advertisements they want to support. If the project is successful, they could be rewarded based on the financial investment, labor or expertise they contribute to the project.

Down the road, DAOs could enable the decentralized Hollywood model of investment and support. For example, participants could earn tokens for their financial support, specific expertise or the success of marketing programs as measured in user engagement.

Examples of DAOs

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A DAO starts with a great idea to change the world, open a new business or support an important cause. This is where DAOs shine. A good cause can attract significant investment, with the DAO processing the transactions on a blockchain.

The first DAO, called The DAO, was about creating a decentralized organization for a venture capital fund and quickly raised $150 million. The Ethereum community rallied to reimburse investors after The DAO was hacked.

ConstitutionDAO, an effort to buy an early copy of the U.S. Constitution, raised $47 million in a week. After losing the auction bid, each participant was offered a refund minus a $100 transaction fee.

Other DAOs raised money to fund spaceflights, lend money or hire a legal team for a person or issue.

Here are other examples:

  • CityDAO bought 40 acres of land in Wyoming.
  • FreeRossDAO created a legal fund to win clemency for Ross Ulbricht, the imprisoned creator of Silk Road, a website for selling illegal goods.
  • AssangeDAO bought non-fungible tokens (NFTs) to fund legal defense for Julian Assange, the WikiLeaks founder charged with violating the U.S. Espionage Act.
  • MakerDAO created a new kind of decentralized bank guided by consensus voting.

DAOs are an intriguing idea for using cryptocurrency to enable a new kind of organizational structure, but they are just a start. In the long run, they could provide a powerful alternative to other business management structures.

However, it could take a few years for the governance, risk management and security issues to catch up with the vision. DAO creators must also consider the technical side of programming smart contracts, the legal side for addressing tax and liability issues and governance models.

This was last updated in January 2023

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