Because Bitcoin came out of the cypherpunk movement and showed the power of a bottom-up movement not controlled by any single entity, one of the main ideals of crypto is decentralization. Crypto groups aim to be more democratic and often eschew the hierarchical structure of a standard company. In fact, many of them are set up as decentralized autonomous organizations (DAOs), which share power and information among members without central leadership.
What Is a Decentralized Autonomous Organization?
A DAO is an organization that’s collectively owned by token holders and governed by smart contracts. Instead of a central governing body, it is governed by members whose incentives are aligned through ownership of the same token. Members can introduce proposals and vote to change the smart contracts. (Here’s our guide to making DAO proposals.) This system ensures that no one can unilaterally change the code of the DAO.
In their ideal form, DAOs aim to be mini-democracies. However, Web3 projects often fall short of their democratic ideals. In many DAOs, voting power is proportional to the number of governance tokens someone has, giving whales (i.e., large token holders) outsized influence.
Additionally, many Web3 projects might call themselves a DAO when they are “decentralized in name only” (or “DINO”). In reality, it’s unlikely that an organization is 100% decentralized, since it’s difficult to run a project with no leadership. DAOs are also hardly autonomous. Even with smart contracts, managers need to be involved in some capacity. Plus, much of the discussion and surveying of public opinion happens off-chain, in discussion forums, or on Snapshot, which enables fee-less token voting.
Therefore, while specific features may characterize a DAO, the term describes an ideal, and many DAOs vary in terms of how autonomous and decentralized they actually are.
DAOs vs. Traditional Organizations
In traditional organizations, you might have a CEO and/or a board of directors making decisions. However, DAOs do away with this hierarchy and aim to give everyone in the organization equal access to information about the business plan, project management, and treasury in order to reduce the risk of mismanagement by a central leadership.
Below are a few ideals DAOs generally aim to follow:
While many crypto projects call themselves DAOs, they tend to follow a management structure closer to that of a traditional organization, with a core team making the decisions.
Members vote and participate in DAOs using their governance tokens. This is the Web3 analog to equity: token holders are incentivized to vote in a way that increases the value of the DAO, which will boost the value of their tokens. Token holders participate in management decisions by voting or introducing proposals about new policies, and these decisions and votes are publicly available to members.
However, the SEC has indicated that some governance tokens may be securities. (In the US, according to the so-called Howey Test, if the digital asset is an investment of money, a common enterprise, and there is a reasonable expectation of profit gained through the effort of others, the asset must be regulated as a security.)
Although there may be leeway for DAOs that are truly decentralized, it remains unknown which governance tokens are securities. Regardless of the democratic ideals behind many DAOs, these legal questions could put limitations on how DAOs operate.
Examples of DAOs
One of the largest DAOs is Uniswap, a decentralized crypto exchange on the Ethereum blockchain. Anyone can become a member by purchasing UNI tokens. (In February 2023, the Uniswap DAO saw a contentious vote over deploying a version of itself onto the BNB chain. One of the largest token holders, the venture capital giant a16z, voted against the proposal with a large number of tokens, momentarily swaying the vote in a different direction from an initial “temperature check” vote off-chain. Ultimately, a16z ended up on the losing side of the vote.)
Friends With Benefits is a social club for creatives who meet online and in person to discuss and exchange ideas about Web3. The DAO members hold $FWB tokens as a way to raise money to fund community projects.
Gitcoin DAO is a community of people who come together to allocate funding to public goods, such as open-source projects, budding media ventures, or climate change initiatives. Votes use quadratic funding (see below) in order to prioritize proposals with broad support. At the time of writing, it has allocated more than $70 million in funding.
Many NFT projects are governed by DAOs. For instance, Nouns DAO is a community that governs the Nouns NFT project. Ownership of a Noun gives the owner the right to participate in the DAO or to delegate their vote to another member.
Another popular DAO is Decentraland, which is a 3D virtual world. Users can buy virtual plots of land as NFTs via the Ethereum-based token MANA, which enables them to vote on specific Decentraland decisions.
Benefits and Limitations of DAOs
As a whole, Web3 projects may choose to operate as a DAO for a number of reasons:
- Financial records and transactions are recorded on a blockchain and can’t be changed privately, meaning all members should have equal access to information such as how much money the organization has and how that money has been spent.
- More people have a voice in the organization’s operations.
- A wide variety of individuals can come together from around the world to make decisions.
- Token holders are incentivized to act responsibly to increase the token’s value.
However, in practice, many issues have come up when operating a DAO. To start, DAOs are commonly run by a core team, and the most important decisions are made by a small number of people. In many DAOs, the core team of founding members holds the majority of votes.
A related issue is that, in a DAO, your voting power depends on the number of tokens you have. However, this leaves room for the risk that a few people will own the majority of the DAO’s governance tokens, introduce proposals, and vote on them — essentially taking over the organization’s decision-making or at least largely dominating them.
To reduce the risk of this scenario, some DAOs are experimenting with new methods of voting. Quadratic voting is a mechanism by which a vote for, say, choice A, is given more weight if a higher number of entities voted for choice A, even if whales were able to allocate more tokens to choice B.
History of DAOs
The first official DAO was known simply as “The DAO.” The DAO launched in May 2016, after a month-long crowdsale of tokens that raised over $150 million. At the time, it was the largest crowdfunding campaign ever. The DAO acted as a venture capital fund based on open-source code, without a traditional management structure or board of directors. Like many other DAOs today, it used the Ethereum network. However, in June 2016, The DAO was hacked, with $60 million worth of Ethereum stolen. To try to return the stolen funds, the community opted to create a fork of Ethereum. This created two blockchains that shared a history up to the time of the fork: Ethereum and Ethereum Classic.
There was limited activity in DAOs after that debacle, though people continued to experiment. In April 2021, Wyoming passed a law that allowed the state to recognize DAOs as limited liability companies. Advocates for the law believed it would protect DAOs from lawsuits targeting them as general partnerships. They also said an advantage was that Wyoming LLC DAOs would have the same rights as legal persons in court. However, having that status also comes with its own compliance burdens.
In November 2021, DAOs made headlines again when ConstitutionDAO was established as a single-purpose DAO with the aim of buying one of the original copies of the U.S. Constitution, auctioned by Sotheby’s that month. A community excited about the idea formed a DAO to crowdfund this goal and offered $PEOPLE tokens to contributors. The DAO lost the auction to a higher bidder, but if ConsitutionDAO had been successful, each $PEOPLE token holder would have become the de facto owner of a proportional share of the Constitution.
DAOs: An Emerging Form of Governance
DAOs are a popular method of governance among Web3 projects because they allow members to contribute and invest democratically and transparently. They also give people a say in the financial decision-making of the organization. DAOs offer people a way to find projects they believe in, contribute, and work together to build value.
Many DAOs have a strong sense of community. Without the limitations of traditional companies, people can join and work for DAOs more flexibly and are not restricted to authorization requirements in a specific country, formal degrees, or other requirements of traditional business that can limit collaboration, growth, and innovation.
However, despite the idealistic vision, many DAOs fall short of their democratic claims. While token holders might actually vote on important issues, barriers to decentralization can result in a DAO that differs little from a traditional organization.