What Is A DAO? Everything About These Community-Oriented Organizational Structures

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Blockchain enthusiasts believe 2022 will be the year of the DAO. The potential of decentralized autonomous organizations to change business and investment transactions with its single-purpose, all-digital structures is immense. The promise of a system ruled by open-source code instead of humans could unleash new and more efficient forms of collaboration, provided these leaderless institutions can deliver in the real world. And, equally pressing, if they are legal. 

One could argue, DAOs are already delivering. The ConstitutionDAO raised $47 million dollars to buy an original copy of the United States Constitution in just 7 days. Sadly, they lost the bidding war to Citadel in a Sotheby’s auction. The company ShapeShift, an old-school cryptocurrency exchange, morphed into a DAO and is now controlled by the community. And the art-focused PleasrDAO accomplished the impossible and acquired the only copy of Wu-Tang Clan’s studio album “Once Upon A Time In Shaolin’s” in existence.

And then, of course, there is THE DAO. The incredibly successful first iteration of the idea that ended up breaking Ethereum in two, arguably staining their legacy. More on that later. 

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What Is A DAO, Though?

Nowadays, most Layer 1 networks that can execute smart contracts are engaged in fierce competition against one another. However, to this day, most decentralized autonomous organizations run over the Ethereum network. Taking that into account, let’s quote Ethereum’s DAO definition:

“Think of them like an internet-native business that's collectively owned and managed by its members. They have built-in treasuries that no one has the authority to access without the approval of the group. Decisions are governed by proposals and voting to ensure everyone in the organization has a voice.”

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So, governance is decentralized and democratized, usually controlled by the DAO’s own token. The community votes on most decisions, and everyone has a voice. At their center, there’s a smart contract with hard-coded agreed-upon rules that are both hard-to-change and completely auditable. 

Participants don’t have to trust other participants, only the open-source code needs to be trusted. 

Through DAOs, participants can coordinate their efforts and collaborate to solve problems. They combat the potential for human error by reducing their reliance on mere mortals. There are no unilateral decisions by people in charge; there are discussions, crowdsourcing, and voting. The community is in charge and settles on which actions to take. DAOs are a way to channel collective intelligence.  They produce more efficient organizations using less costly methods.

Returning to Ethereum’s definition:

“The backbone of a DAO is its smart contract. The contract defines the rules of the organization and holds the group's treasury. Once the contract is live on Ethereum, no one can change the rules except by a vote. If anyone tries to do something that's not covered by the rules and logic in the code, it will fail. And because the treasury is defined by the smart contract too that means no one can spend the money without the group's approval either. This means that DAOs don't need a central authority.” 

Smart contracts are akin to legal agreements, but fully digital and fully automated. If a vote passes, the system executes payments or other actions automatically. However, they have an embedded security mechanism to keep participants out of sticky situations. As Better Programming explains:  

“Once a vote has passed, it actually doesn’t go into effect right away, there is a delay between passing and execution. The reason for this, is so that if you don’t like a vote that has been passed, it’ll give you time to “get out” of whatever situation the vote would put you in.”

Smart.

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How Does DAO Governance Work?

So far, DAOs have proven themselves as a way to rally and assemble people around a big idea or project. In general, though, these kinds of organizations struggle to make small, fast decisions. Still, every DAO has its own rules. And each one, every day, carries the possibility of a breakthrough that will benefit all of the others. DAOs are evolving as you read this paragraph.

In general, DAO governance revolves around their own token. DAOs fund themselves by exchanging the native currency of the blockchain that hosts them, ETH in this case, for said token. Then, in a process akin to the Proof-Of-Stake consensus mechanism, the weight of each member’s vote is proportional to the size of their stake. This formula might vary from DAO to DAO.

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In Ethereum’s creator Vitalik Buterin’s words:

“A project that launches as a "pure" DAO from day 1 can achieve a combination of two properties that were previously impossible to combine: (i) sufficiency of developer funding, and (ii) credible neutrality of funding (the much-coveted "fair launch"). Instead of developer funding coming from a hardcoded list of receiving addresses, the decisions can be made by the DAO itself.”

The governance token creates an interesting incentive structure. If the DAO succeeds and achieves its goals, it's only logical that the token might increase in value. So, it’s in the best interest of all the DAO token holders to put their best foot forward. With the token’s profits, the DAO can cover its expenses and fund further development. The organization can create bounties and members can get paid for their contributions.

DAOs provide a solution to what it’s called the principal-agent dilemma. Cointelegraph defines it as:

“...a conflict in priorities between a person or group (the principal) and those making decisions and acting on their behalf (the agent).

Problems can occur in some situations, with a common one being in the relationship between stakeholders and a CEO. The agent (the CEO) may work in a way that’s not in line with the priorities and goals determined by the principal (the stakeholders) and instead act in their own self-interest.”

This is not a problem for DAOs, because of their decentralized nature. Its members don’t have to put their trust in any agent. The incentives and rules are there, embedded in the protocol, to keep anyone from putting their own self-interest over the organization. Since they have a stake in the network, they will want to see it succeed. Acting against it would be acting against their own self-interests. 

However, Vitalik identified two problems with DAO’s community governance:

“There are two primary types of issues with coin voting that I worry about: (i) inequalities and incentive misalignments even in the absence of attackers, and (ii) outright attacks through various forms of (often obfuscated) vote buying.”

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Possible Problems With DAOs

Besides the ones Vitalik identified, DAOs face several known problems. For example:

• If the smart contract has a flaw, it’s fatal. Their hard-coded nature makes smart contracts hard to fix once deployed.
• In blockchains like Ethereum, every transaction costs a gas fee. This is partially done to prevent attacks. If your DAO’s governance is 100% on-chain, every vote will have a price tag. The cost can be a heavy load for small communities. 
• They’re not inherently “sybil resistant.” That means members can’t be sure that an agent is not creating multiple wallets to earn multiple votes.
• Are members and token holders liable for the DAO's actions? The jury’s still out on that one. 
• Could those tokens the DAOs are selling be considered securities? If they are, they would be unregistered securities.
• Are these organizations even legal? Nobody knows for sure.

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The DAO’s Legal Status

So far, only the US has pronounced itself on this matter. In 2017, following THE DAO’s disastrous situation, the SEC issued a press release announcing they decided that the tokens they sold were in fact unregistered securities. However, DAOs continued operating and evolving. And now, we’re apparently in the year of the DAO.

In 2021 the state of Wyoming basically legalized DAOs by treating them as LLCs. However, “unlike a standard LLC which is managed by human members/managers, a DAO can be managed either by human members/managers or algorithmically.” The state legally recognizes the organizations, and “you can register a DAO regardless of where you reside.”

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Finally, the story of THE DAO

What follows is a short summary of an extremely complex story. This is what could happen. DAOs sound useful and futuristic, but, if something goes wrong, they could even break the hardest blockchain in two. Or so it happened that one time.

Back when Ethereum was one year old, in April 2016, the original DAO raised $150 million in a few days. At the time, that was roughly 14% of all the ETH in existence. Someone audited the code and found possible security holes, anonymously alerted the developers and got nowhere. As we previously said, their hard-coded nature makes smart contracts hard to fix once deployed.

In June 2016, a hacker attacked. He or she exploited the mentioned vulnerabilities and got around 3.6 million ETH. Back in the day, those were worth around $50 million. Nowadays, they would be worth around $9 billion. However, the hacker doesn’t have them. At the time, Vitalik proposed a soft fork that would blacklist the attacker’s wallet. The hacker replied that “code is law,” and that he or she obtained the bootie by legal methods contained in the smart contract.

The whole situation led to a radical hard fork that split the Ethereum network in two. Those who were with Vitalik rolled the blockchain back to before the hack and withdrew the stolen funds to another smart contract that allowed them to secure them. Those who were opposed to the roll back ended up with another blockchain altogether called Ethereum Classic. In that chain, the hacker’s funds did exist, but that’s a story for another time. 

To this day, bitcoin maximalists and blockchain-focused free thinkers point out the incident as the “moment Ethereum lost its credibility.” If the Ethereum bosses could change and roll back the protocol once, they could easily do it again in the future. It set a dangerous precedent. However, Ethereum people don’t see it that way. For them, justice was made. 

Who’s right and who’s wrong? That’s for you to decide. However, read a more detailed version of the story first, this summary is lacking in details that could persuade you in one direction or the other.

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Bonus: Tools To Build A DAO

If a DAO is the organizational structure you were looking for, we have good news for you. There are several tools to easily create one, for advanced users or newbies alike. 

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For non-programmers, No Code Tools:

• DAOhaus
• Aragon
• Colony.io
• DAOstack
• xDAO

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For Programmers:

•  Contracts Wizard - OpenZeppelin Docs
• Zodiac
• Tally

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Extra Tools To Make Your Life Easier:

• Gnosis Safe, the multisig wallet of choice for DAOs around the world.
• ‍Mirror.xyz, a complete “web3 toolkit for sharing and funding anything.”