The Organizations of Tomorrow: Understanding DAOs
This article explores the concept of decentralized autonomous organizations (DAOs), their essence, and approaches to their implementation.
Have you ever heard about an organization that operates without a central figure of authority, where owning a few tokens can grant someone the power to shape the future of a company? Chances are, you're thinking of a DAO. In this piece, we'll dive into what decentralized autonomous organizations (DAOs) are, how they can exist, and look at successful examples.
A decentralized autonomous organization (DAO) is an entity that functions without a centralized management structure, relying instead on blockchain technology. It operates through smart contract calls, enabling participants to influence decision-making processes.
When someone suggests, "You should join a DAO," it implies becoming part of a community (team, project, protocol, or another collective endeavor) that leverages DAO software to coordinate decision-making within the organization.
One of the pioneer DAOs was "The DAO," established by developers to automate decision-making within a venture fund. After its launch in April 2016, it became one of the largest crowdfunding campaigns in history, later ceasing operations due to a hack that led to significant financial loss.
From Smart Contracts to DAOs: A Bit More on Terminology
There's often confusion about the terminology of various acronyms: DA, DO, DAO, DAC. In his article "DAOs, DACs, DAs, and More: An Incomplete Terminology Guide," Vitalik Buterin expressed frustration over the lack of coherent terminology.
We recommend giving this article a read. Below, we'll provide the basic definitions discussed in the piece. Prepare for some statements that might be controversial or unfamiliar to your understanding of the world.
Let's start with the general concept of smart contracts. The term was introduced by Nick Szabo in 1990, with Vitalik narrowing its scope to the realm of web3.
Smart contracts
Smart contracts represent the simplest form of decentralized automation, executing agreements among multiple parties for the distribution of digital assets. A prime example is an escrow contract, which holds assets from one party until a certain condition is met, then releases them to another party.
Decentralized applications
Decentralized applications (DApps) are a type of distributed software that operates on a blockchain or peer-to-peer (P2P) network. BitTorrent, for example, functions as a decentralized application. DApps are similar to smart contracts but differ in two main ways: they can involve an unlimited number of participants from all market sides and aren't necessarily financial, meaning they don't have to manage the distribution of digital assets.
Decentralized organization
A decentralized organization (DO) comprises a group of people interacting with each other according to a protocol defined in code and implemented on the blockchain. This often refers to transferring an organization's management from the physical world to the blockchain. For instance, a company might hold a vote to elect a board of directors. A DO implies that this process is carried out on the blockchain.
Decentralized autonomous organization
A decentralized autonomous organization (DAO) combines aspects of DApps and DOs, with the distinction that:
Beyond DApp features, it holds capital or an internal property of value that can be used as a reward mechanism. For example, while BitTorrent is a DApp because it doesn't possess such property, it does have a reputation, which, however, isn't an asset that can be sold.
Beyond DO features, it has an autonomy characteristic. That is, decisions in a DO are made by specific people, whereas in a DAO, decisions are made autonomously by the organization itself. This concept might seem counterintuitive. To understand it, consider that a wrong decision in a DO falls on the leadership's responsibility and could be seen as erroneous or even criminal by the organization. However, in a DAO, a wrong decision represents a path consciously chosen by the majority of participants and, even if mistaken, is considered entirely legitimate.
Decentralized autonomous corporations
Decentralized autonomous corporations (DACs) essentially fall under the DAO category, with the term predominantly advocated by Daniel Larimer. He suggests that DACs pay dividends. While DAOs are non-profit entities that allow earnings through participation in the ecosystem without direct investment, they possess internal capital that can increase as the organization grows, making DAOs somewhat similar to DACs in certain aspects.
If attempting to organize these terms hierarchically from the simplest to the most complex, I would arrange them as follows:
Smart Contract -> Decentralized Application (DApp) -> Decentralized Organization (DO) -> Decentralized Autonomous Organization (DAO)
This discussion navigates through abstract reasoning, and while I don't claim absolute truth, it's important for readers to ponder and form their own opinions on the proper use of these terminologies in various contexts.
How does DAO work?
Smart contracts form the backbone of DAOs, setting the operational rules of the organization. Once these contracts are deployed on the network, the rules cannot be altered except through voting. Any attempt to act outside the predefined rules and logic of the code will fail due to the immutable nature of blockchain technology, which prevents any stealthy modifications to the DAO's code (or editing its rules).
In an ideal world, a DAO would be entirely self-governing, with community members interacting with a DAO governor system fully implemented on smart contracts. This system outlines the rules under which the organization manages the decentralized application (DApp) and implements changes.
However, particularly in the early stages of a project when decentralized management is still developing, some protocols might adopt a hybrid model. Here, community members continue to influence the organization's management through interactions with DAO governor contracts, and voting takes place publicly and transparently on the blockchain. But, the final decision might be executed by the protocol developers or delegated to trusted community members.
It's not always necessary to aim for a fully-fledged DAO from the start. An alternative approach could involve externalizing the voting system beyond the blockchain, with the development team implementing the community's decisions.
This approach ensures that decisions continue to be made collectively, following a vote, with varying levels of decentralization.
Membership in a DAO
DAOs can have two types of membership: open and closed.
Open membership allows anyone interested to join the DAO, granting them access to manage the organization.
Closed membership means that adding a new member to the DAO requires a specific verification process. This could involve approval by existing organization members or meeting certain joining criteria, such as having sufficient capital or expertise in a relevant field.
The choice of DAO membership type depends on the organization's goals. An open membership is used when the aim is to attract as many participants as possible for decentralized management. If the DAO's success relies on the involvement of only qualified participants, a closed membership model is preferred.
Tools for Organizing a DAO
The range of tools for a DAO to function effectively is vast. Here are some of the most popular, in my opinion.
Web3 Tools:
Blockchain: The environment where the DAO's software code executes to enforce the organization's rules. Examples include Ethereum, Polygon, Solana, etc.
Voting System: It must control membership, vote distribution, and decision-making within the organization. All proposals must go through this system. This can be uniquely implemented, for instance, membership could be determined by ownership of an ERC-20 or ERC-721 token.
Bank: It should control the organization's assets, which can include non-financial assets valuable to the community, such as ETH, tokens, NFTs, artwork, and more that the community wishes to collectively own and that represent value within the organization.
Important! For a DAO to operate, the voting system and bank should mostly be implemented on smart contracts.
Traditional Tools:
Chat: Often, this is where the audience and community begin to form. Examples include Discord, Slack, Telegram, etc.
Forum: A tool for more detailed discussions, where the history of posts can be highly valuable. It can be set up before the DAO starts operating. Examples include Discourse, Reddit, Medium, etc.
Calls: At some point, it might be useful to use a tool for group calls to organize weekly sync-up discussions on key topics for decision-making or to conduct training and immerse the community in the subject matter. Examples include Discord, Zoom, etc.
Planning: For transparently sharing the organization's development plan with the community, task management software can be very useful. Examples include Trello, ClickUp, Asana, Airtable, etc.
Other External Communications: Over time, there will be a need to tell the rest of the world about the organization's work. For this, Twitter, a website, a blog, etc., can be suitable.
Application Scenarios for DAOs
DAOs can be utilized across various domains:
Decentralized Finance (DeFi): DeFi protocols often employ DAOs for managing key protocol decisions, such as interest rate adjustments and the introduction of new features. This inclusion empowers community members in decision-making processes, fostering a more equitable and decentralized financial ecosystem.
Collective Investment and Fund Management: DAOs enable pooling of resources by participants, allowing them to invest in diverse projects, manage funds, and distribute profits based on predetermined rules.
Content Creation: DAOs help content creators secure digital ownership and enhance their engagement in the ecosystem's life through decision-making influence within the organization.
Decentralized Governance: A fundamental aspect of DAOs, supporting a democratic approach to resource management within the organization. DAOs ensure greater transparency and accountability in governance processes.
Advantages of DAOs:
Participants unite to act collectively towards organizational goals.
Full voting rights for all members in planning the organization's strategy and activities.
Voting results on the blockchain are public, promoting responsible action among participants due to the transparency in vote distribution.
DAO participants can interact with others sharing similar goals within a community.
Challenges of DAOs:
Decision-making can be time-consuming due to the larger number of participants involved.
Training and immersing participants in the organization's domain may require more time and resources due to the diverse backgrounds and levels of expertise.
The decentralized nature of the organization can lead to longer times for voting or gathering participants.
Vulnerability to security risks if DAOs do not adhere to safety standards, such as asset storage hacks.
Risks
Poor Code
DAOs heavily depend on smart contracts. Any vulnerability can lead to a total loss of assets, potentially leading to the organization's closure. Security must be prioritized, with experienced teams developing and auditing DAO smart contracts across several qualified companies.
Plutocracy and Vote Concentration
Influence within DAOs can become skewed, leading to a concentration of power among a minority. Addressing this involves designing a balanced token economy and educating members to decentralize power effectively. Technical solutions to mitigate "whale" influence are also being explored.
Legal Aspects
The lack of a formal legal status for DAOs presents unlimited liability risks for participants. The regulatory body responsible for DAO activities, taxation, and whether DAO assets are considered securities remains unclear. However, some jurisdictions (like Vermont and Tennessee in the US) have begun recognizing DAOs as legal entities, offering potential legal frameworks.
Weak Governance Structure
Involving all community members in decision-making can slow down the implementation of decisions and lead to conflicts, further delaying processes. Solutions include enhancing participant education, information dissemination, incentivizing voting participation, and possibly involving a third party to resolve conflicts.
What is DAO Governance?
DAO Governance is the decision-making and management process within a DAO.
This system enables decision-making within DAOs, ranging from simple democratic voting to complex multi-stage decision-making processes involving various stakeholders.
Key Features of DAO Governance:
Voting System: Implements mechanisms for discussion and decision-making within the organization to manage activities and assets.
Delegation: Allows transferring the voting rights to other ecosystem participants.
Automatic Transactions: Changes to DAO rules can be executed automatically if a sufficient quorum of participants votes in favor.
Multisignature for Management: While thousands of DAO members may participate in voting, the direct execution of the community's will is entrusted to a few trusted (public or known to the community) participants.
Deferred Execution: Decisions are deferred for a predetermined period after being made, allowing organization members time to prepare and adapt to new rules.
The distinction between a DAO and DAO Governance lies in that a DAO is an entity or organization operating autonomously on the blockchain, while DAO Governance refers to the internal management and decision-making process. In other words, DAO Governance is the tool or system allowing participants to collectively manage the DAO.
Governance Structure
The governance structure in a DAO is determined by the influence each participant has on decisions, which can be democratic, meritocratic, or a hybrid of the two.
Democratic Structure: Implies equal voting rights for all participants in decision-making.
Example: In a decision-making process involving 1000 people, each participant has one vote. This way, all members have equal influence over the organization's management.
Meritocratic Structure: Some participants have more significant influence over decision-making.
Example: In a decision-making process involving 1000 people, any participant can purchase votes in unlimited quantities. The more votes purchased, the greater the participant's influence within the organization. If 999 people buy one vote each and one person buys 100 votes, their decision will have a more substantial impact than the others.
Hybrid Structure: Combines democratic and meritocratic structures.
Example: In the DAO, a basic rule is established that all participants have equal votes, but those who joined the organization over 10 years ago have the opportunity to use an additional vote.
Important: Aragon serves as an example of a democratic governance structure in DAOs, while MakerDAO exemplifies a meritocratic structure.
Depending on the goals and requirements of a DAO, one governance structure may be more effective than another. For instance, a meritocratic structure can incentivize participant engagement in the DAO but may lead to centralized control.
Types of Voting Models
Voting systems can support various models:
Token-based Voting
Allows participants to vote on proposals by owning or staking tokens, thus the voting power is directly proportional to the number of tokens held.
Example: If Alice has 100 voting tokens and Bob has 200, Bob’s vote counts twice as much as Alice’s in any election.
Quadratic Voting with Tokens
Enables participants to distribute votes across multiple proposals, with the cost of each additional vote increasing quadratically.
Example: If Alice allocates 2 votes for "Proposal A" and 3 votes for "Proposal B", it costs 4 tokens (2^2) and 9 tokens (3^2) respectively, totaling 13 tokens. This system discourages participants from allocating all their votes to a single proposal, promoting a more balanced decision-making process and mitigating the influence of "whales" (holders of a large number of tokens).
Futarchy
A governance model using prediction markets for decision-making. Participants bet on the outcomes of proposals, with the proposal predicted to be most successful being implemented.
Example: The Gnosis chain employs a futarchy model in its DAO. A proposal to implement a GNO token with its own tokenomics is made. Community members vote on whether they would buy this token post-implementation. With 60% voting in favor, the forecast indicates that the token's implementation is viable, leading to its realization.
Liquid Democracy
A hybrid voting model. Participants can either vote directly or delegate their voting right to someone they trust.
Example: An organization member, Alice, may lack sufficient knowledge about a protocol development proposal. Instead of voting blindly, she can delegate her voting right to Bob, a trusted community member with protocol development expertise. For any other proposal, Alice may choose to vote directly.
Reputation-based Systems
Distributes voting rights based on the reputation earned by a community member. Reputation can be earned in various ways, from participating in discussions and completing tasks to purchasing reputation. This model aims to reward active and valuable organization members with more significant decision-making powers.
Example: Alice, an active community member, contributed to code development and earned 400 reputation points. Meanwhile, Bob wrote less code and has a reputation of 200. Due to her higher reputation score, Alice’s vote carries more weight than Bob’s. This system encourages active participation and rewards contributions to the DAO.
Delegation
Delegation is the transfer of voting rights to a trusted representative, allowing them to vote on the delegator's behalf.
Reasons justifying delegation include:
Efficiency and Expertise: Enables the transfer of voting rights to those with the experience or deep understanding of specific issues. Not everyone has the time, knowledge, or resources to make informed decisions on every DAO matter. Delegating voting rights to knowledgeable participants leverages their expertise for more informed decision-making.
Active Participation: Delegation encourages broader participation in DAO governance, allowing less engaged members to contribute to decision-making by choosing a delegate.
Scalability: As a DAO grows, delegation enables participation in community life only in needed development areas, maintaining scalability.
Flexibility: Delegation can be dynamic, allowing the right-holder to change their delegate or participate in voting personally at any time.
Important: Some DAOs may introduce the concept of self-delegation, meaning that by default, rights holders cannot vote independently until they delegate the right to themselves.
Rage-quit
Rage-quit is the process by which a DAO member decides to exit the DAO (partially or wholly) for various reasons in exchange for the DAO's assets.
Important: It's noteworthy that this term applies to DAOs that offer investment opportunities for the assets of organization members.
The mechanism was first introduced as a key feature of the Moloch DAO V1 platform, a framework for providing Ethereum grants.
Moloch can store various ERC20 tokens in its treasury, allowing any member to burn their voting tokens in exchange for treasury assets.
This feature has also been implemented on other platforms, such as Tribute DAO and Flamingo DAO.
TimeLock
TimeLock is a simple mechanism that delays the implementation of changes for a specified period.
TimeLock is an effective addition to the DAO system. Introducing temporal restrictions on decision execution allows community members to exit the DAO if they disagree with the decision before its actual implementation.
It's worth noting that using the TimeLock mechanism as a separate contract means this mechanism acts as the executor of the decision. However, this mechanism can also be natively integrated within the DAO governor contract.
The TimeLockController contract from the OpenZeppelin library can be utilized for this purpose.
Conclusion
In the context of web3 development, the foundational rules of DAOs are embedded in code and are immutable. This immutability, coupled with the transparency provided by blockchain technology, positions DAOs as the next level in the decentralization of protocols. The potential applications of DAOs are limited only by human imagination.
It’s crucial not to conflate the concept of DAOs as organizations with DAO governance as a management tool.
Clearly, the blockchain-based DAO concept demands developers pay particular attention to security against external attacks and inadvertent code errors.
Utilizing DAOs can offer promising and effective solutions for many projects and organizations, but only with the right approach and meticulous focus on security and reliability.
Reflecting on the beginning of this article, it's pertinent to remember: "Behind every DAO are people! And it's beneficial to have more of them!"
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