Are decentralized autonomous organizations (DAOs) the future? The rise of DAOs as part of Web3 is just beginning, and it remains unclear whether, and how, DAOs might supplant traditional organizational structures. To explain what DAOs offer and who currently uses them in unique ways, the authors answer three key questions: What are DAOs? How are they built? And how do they work? They also discuss the potential for and limits of DAOs, using CityDAO, a 6,000-person collective that recently purchased land in Wyoming, as an example.
In November 2021, a group of individuals formed a legal entity that bought 40 acres of land in Wyoming. This kind of thing happens all the time, of course. But the closer we look at this particular real estate transaction, the stranger it becomes.
The purchasing group included approximately 6,000 people. They met via online discussion platforms such as Discord and bought the land not with dollars, yen, or any other fiat currency, but instead with cryptocurrency. It’s not clear exactly what they bought: Individuals’ legal claims on the land itself and the proceeds from its use or sale are not yet settled.
But the strangest part of this deal is that no one runs the entity that purchased the land – it doesn’t have a CEO, a board of directors, managers, or other decision-makers. No people at all were involved. The group votes to make decisions, but this process happens automatically, triggering important activities like releasing the money to purchase the land. And the vote is truly binding: No one person has the ability, let alone the authority, to overturn it. Human intervention isn’t required or even possible.
Confused? Welcome to the world of DAOs.
Introduction To DAOs
DAO (pronounced as “Dow,” like the Dow Jones Industrial Average) is the acronym for decentralized autonomous organization. A DAO is a new type of digital-first entity that shares similarities with a traditional company structure but has some additional features, such as the automatic enforcement of operating rules via smart contracts (we’ll explain more about these and why they are so interesting). DAOs come in many structures, but all operate as collectives in which members make decisions democratically. No single person exerts control in the way a conventional CEO or senior management team would.
Like most other Web3 technologies, DAOs are currently in an experimental phase. The forms, structures, legalities, and use cases are all still emergent. While the United States has seen tens of millions of corporations registered over the past two centuries, there are fewer than 5,000 DAOs worldwide today according to industry-tracking site DeepDAO, and fewer than 100 have assets of more than $1 million. DAOs attract interest not because of their current scale but because of the novel activities they’re undertaking: making investments, establishing new kinds of communities, acquiring items of historical or cultural importance, and engaging in philanthropy.
How DAOs Are Built
DAOs are often formed by congregations of strangers who are geographically dispersed but share a common goal. It’s not unusual for individuals to float the initial ideas on platforms such as Twitter or Discord first; if there’s enough appeal, others join the online conversations, as they would on a traditional messaging board or in a chat room. DAOs have formed to collect digital artwork, raise funds for the Ukrainian military, distribute grants to fund biotech research, and even try to buy an NBA franchise.
Taking a concept from the initial idea to a functioning DAO requires a group of developers to create a set of smart contracts that form the DAO’s core operating system. Smart contracts are self-executing computer programs used to enact decisions by establishing principles such as voting mechanisms (more on these later). These programs can also complete a trade such as moving a digital currency like bitcoin from one wallet to another without human involvement.
These contracts-as-code automatically go into effect once certain criteria have been met. They always perform as written, with no room for misinterpretation (although they don’t always perform as intended, given the potential for human coding error). Getting these codified rules correct from the outset is important. Even small errors or omissions can cause large headaches and operational failures later on, such as security vulnerabilities that allow hackers to siphon off money.
Once the DAO has established a core set of rules and embedded them into smart contracts, it needs to raise funds. DAOs typically raise funds by issuing tokens, a form of digital currency tied to the smart contract. Sales happen through public or private offerings, and the money raised goes to the DAO’s treasury. The tokens represent a form of ownership but are not the same as traditional equity and do not function as investment contracts; rather, they are akin to contributions that bestow governance rights but not ownership. Most DAOs are not directly owned by anyone in the traditional sense.
After the DAO completes the funding phase and becomes operational on blockchain, its original creators have no more influence on the project than any other stakeholder. From this point on, decisions are made by all of the members, who must reach a consensus on proposals, and no central authority exists in the way senior managers or directors run a company.
DAOs In Practice
Typically, token owners put forward proposals about the DAO’s operations, then the community votes on each idea. It’s not unusual for a lot of discussion and ideation to occur around these proposals on messaging platforms such as Discord. If the final vote is in favor of the proposal, the smart contract will enforce the activity.
Voting procedures differ between DAOs, ranging from simple majority to quadratic voting (in which a person gets an allocation of votes and can place more than one vote for a proposal they strongly support). Information related to issues such as currency transactions and internal decisions is available for everyone to see on blockchain. This transparency forms the basis for trust among members.
An important feature of this process is that voting mechanisms are defined in advance and not easily modified. This differs from what happens in traditional organizations, where a CEO or CFO can ignore consensus when making a decision. In a DAO, the community votes on activities such as spending money. Although the scope of decisions that can be made this way is more limited than in a traditional organization, once everyone agrees to the rules, there’s no ambiguity or wiggle room in how they are applied.
Adhering to smart contract–enforced decisions means a DAO is less suited to commercial situations with more ambiguity or those in which success comes from organizational dynamism – the ability to adapt to subtle changes in market conditions, including the early stages of markets being formed for innovative products or services. During this period, entrepreneurs must make judgments using incomplete data and iterate at speed; writing detailed smart contracts to support this work would be difficult, if not impossible.
That said, communities are forming DAOs around a wide range of concepts, including investments, management of other blockchain-based projects, and content production. Most people putting money into DAOs understand that they might not see this investment again. They are usually participating in a pet project with funds they can afford to lose, not unlike backing a Kickstarter project. To support the development process, new firms are springing up to empower those wishing to create DAOs by simplifying technical processes, removing friction points, and providing templates and tools. The startup Upstream, for example, offers a “no-code, full-stack platform,” supplying tools that it claims will enable anyone to start and run a DAO. The firm recently raised $12.5 million in venture funding.
The Limits Of DAOs
As an emergent form of commercial organization, DAOs are not yet fully accounted for in a legal sense, and many are pushing traditional boundaries. For most jurisdictions there are questions around issues such as how a DAO should file and pay taxes or sign legally binding contracts. The majority of existing DAOs are unregistered and have an uncertain legal status, and they are perhaps viewed as “alegal” rather than illegal. This uncertainty could be detrimental to the development of DAOs, but conforming to existing rules is also difficult. The very nature of a decentralized organization means there’s no need for officers and directors, but these are important roles within corporations, especially when things go awry. The transnational membership base of DAOs adds to the legal complexity of these groups.
Knowing who you are dealing with is an important foundation for most economic activity as well. This foundation makes it possible for an entity to sue or be sued and to enter into contractual agreements, as well as to acquire, hold, develop, and dispose of property rights. Traditional corporations meet this identifiability standard and have long been recognized as “right-and-duty bearing units” – meaning they are the subjects of rights and liabilities as defined by the legal system in which they operate. Most jurisdictions around the world require a company to provide a unique name, a physical office address, and the name of at least one director in order for the company to receive its own identification number and be entered into the formal business register.
These requirements are challenging for DAOs to meet, especially because many participants operate on the basis of pseudonymity. But what’s happening in Wyoming may be motivation for DAOs wishing to formalize their relationship with legal institutions and interact with a jurisdiction on a more solid footing.
CityDAO: A Peek At The Future?
In July 2021, Wyoming became the first state in the country to explicitly codify rules around DAOs wishing to become domiciled in that jurisdiction. This rule change means that DAOs in Wyoming are considered a distinct form of limited liability company (LLC), which grants them a legal personality and confers a wide range of rights, such as limited liability for members. Without this protection, a DAO could be viewed as a general partnership, exposing its members to personal liability for any of the DAO’s obligations or actions. Each DAO must have a registered agent in Wyoming, and the agent must establish a physical address and maintain a register of names and addresses of the entity’s directors or individuals serving in a similar capacity.
One of the first entities established after this legislation was born as an idea in a tweet by Scott Fitsimones. A small group of founding citizens from countries including Germany, the U.S., Ireland, and Canada then came together to create CityDAO in July 2021 with the objective of “building the city of the future on the Ethereum blockchain.” To do this, the group would need to decentralize asset ownership by tokenizing land, rights, and governance. Since CityDAO’s founding, the aforementioned approximately 6,000 investors have joined them, contributing nearly $7 million.
CityDAO’s first investment (named Parcel 0) was the 40-acre plot of land in Wyoming. This purchase was seen as low-risk by the members and as a first step CityDAO could take as it experimented and figured things out moving forward.
For now, CityDAO citizens get a non-fungible token, or NFT, which is a digital asset without a direct share in the ownership of real-world land. The NFT strictly represents governance rights (proposing and voting on activities). Members can vote on what the DAO should do, but they don’t have a direct return on those activities in the form of anticipated earnings. This arrangement is intended to help ensure that the DAO and its members don’t run afoul of federal securities laws. When ownership comes with a reasonable expectation of profits to be derived from the efforts of others (part of what is known as the Howey test), the U.S. Securities and Exchange Commission views the activity as an investment contract and requires strict standards to be met, including registration of the security and detailed information disclosure. All of this might change in the future, but such rules remain a challenge for most DAOs today.
Members of CityDAO see their activities as very much in the experimental phase at this time. They are willing to figure out potential futures through trial and error. Going forward, communication and collaboration will be important for the group to achieve its broad-based objective of “building the city of the future.” To enable the sharing of information, members voted to give $24,000 to one of their own, Eric Gilbert-Williams, to produce CityDAO Podcast, which features leaders in the community discussing topics related to CityDAO.
Although the Wyoming legislation moves the legal status of DAOs forward in that state, uncertainties remain around tax treatment, legal standing outside Wyoming, the nuances of applying securities laws to tokens, and other issues.
It’s unlikely that DAOs will replace traditional organizations, or at least they won’t anytime soon. But their current shortcomings should be viewed through the lens of early-stage innovation: It’s not clear exactly what they will become and where they are most beneficial, but DAOs have obviously created a lot of interest and excitement in the Web3 community. Will DAOs take the place of traditional organizations for some types of group-level activity? Will we see hybrids form, where, for example, “normal” companies use smart contracts to make ironclad, irrevocable commitments to a constituency? Imagine using something like a DAO to let your employees vote on which philanthropies to support or users decide which features to incorporate in the next version of an offering. With Web3, there’s plenty to imagine.
originally posted on hbr.org by Jonathan Ruane and Andrew McAfee
About Authors:
Jonathan Ruane is a lecturer in the global economics and management group at the MIT Sloan School of Management and a research scientist at MIT’s Initiative on the Digital Economy (IDE).
Andrew McAfee is the cofounder of the Initiative on the Digital Economy in the MIT Sloan School of Management. His next book, The Geek Way: The Radical Mindset Transforming the Future of Business, will be published by Little, Brown in 2023.
