DAOs, short for decentralised autonomous organisations, are a new business structure, commonly found in the crypto and Web3 space. Here, we look into how they are created, from smart contract coding to governance token launch, and their pros and cons.
Key Takeaways:
- A DAO is an entity designed to be fully autonomous and, in theory, operating without a central point of control.
- Typically defined by a flat organisational structure, transparency, open access, democracy, and minimal human resources, DAOs are governed by smart contracts on the blockchain.
- Before coding a DAO, provide a purpose, voting mechanism, and governance token structure, and build a community and a system to manage funds in place.
- Advantages of this novel organisational structure may include transparency, neutrality, accountability, and alignment of incentives.
- Disadvantages to preempt before committing to forming a DAO include legal uncertainties, avoiding accidental concentration of power, an unreliable voting base, and safety loopholes.
What Are DAOs?
Vitalik Buterin first coined the term in 2013, laying the foundation for the concept. The first DAO was founded three years later, aptly named The DAO.
A DAO is commonly defined by these five characteristics:
- Flat organisation — A DAO, in principle, has no hierarchy, and decisions are made by its stakeholders or members instead of leaders or managers; although usually, in practice, certain spheres of decision-making may be delegated to a core or selected team.
- Transparency — A DAO must be open-source. Anyone can inspect the code on the smart contract or view the DAO’s transaction history on the blockchain.
- Open access — Anyone can, in theory, be a member of the DAO, as long as they fulfil the predetermined requirements, such as holding its governance token.
- Democracy — Depending on the voting mechanism, it may be the case that no single party can veto a request once it passes the voting process.
- Minimal human resources — DAOs operate mostly algorithmically, governed by code. Occasionally, members of the DAO may hire a person to fix issues on the smart contract, such as bugs or updates.
Learn more about the different types of DAOs here.
How to Create a DAO
Before sinking their teeth into the development of a DAO, its core team should have the foundations figured out.
These typically include:
1) a purpose
2) a voting mechanism
3) a governance token or structure
4) a community
5) a system to manage its funds
Once these parameters have been defined, there are four main phases for launching a DAO.
1. Creating the Smart Contract
Most DAOs start with the smart contract, as it dictates the rules of the group and its purposes. This stage requires the help of developers to write the code and perform extensive testing of the code to ensure they don’t overlook intricacies.
This is vital, as once the smart contract is launched, it becomes, in theory, immutable. The only exception is authorisation for changes through the governance system. This might mean that, if the smart contract has bugs, it would require a voting round where the majority of the members would have to agree to make amendments to the smart contract.
2. Testing
Once the code is written, the smart contract needs to be deployed on a testnet. This will allow for extensive testing for weaknesses, errors, and potential adjustments.
3. Funding and Governance Token Creation
Simultaneously, the DAO will want to work on its funding and governance structure. Typically, the governance tokens are distributed to purchasers or participants with an interest in the project. In return, these purchasers or participants receive voting rights, which are often proportional to the amount of tokens they own.
The DAO’s funds are typically stored in a built-in treasury. This cache of digital currency should be accessible only through an approval voting process.
4. Deployment
The DAO is now ready to be deployed on the blockchain. Once this is completed, usually the original creators, developers, and programmers no longer have control over the project, and any additional changes can be made only via collective voting by the stakeholders.
Advantages of DAOs
Why would one decide to form a DAO instead of a conventional start-up? Here are a few of the pros of this new business model:
- Neutrality — The autonomous nature of DAOs can help them to avoid or reduce certain management issues that involve humans, such as opinion- or emotion-based conflicts. With the help of smart contracts, DAOs, in their ideal form, aim to ensure that every member is independent and their proposals can be evaluated to a greater extent based on quality. A DAO is often described as an organisation where decisions are made from the bottom-up, as opposed to a traditional top-down structure.
- Transparency — Traditional organisations keep much of their decisions and discussions behind closed doors. DAOs, however, as they run on a blockchain network, allow anyone to view financial transactions or decision-making processes. This incentivises actions that will benefit the DAO and discourages acts against the community. Ultimately, it enables an environment that does not require its members to ‘trust’ each other.
- Accountability — With transparency comes the accountability of every participant within the organisation. Every on-chain activity of the organisation is documented on the blockchain permanently. Hence, each member must, to some extent, act in the best interest of the organisation if they wish to maintain their reputation.
- Aligned Incentives — Issuing tokens and allowing their holding helps to incentivise everyone that has influence over the organisation to pursue the best possible outcome for it. This enables the creation of vibrant communities, encouraging stakeholders to invest time and effort towards promoting the platform.
Risks of DAOs
DAOs, however, are a novel form of organisational management, as the crypto space is still testing out their limits. Here are the most important risks to consider before choosing a DAO as your organisational structure:
- Legal Uncertainties — One of the shortcomings of DAOs is the lack of definitive rules and regulations in managing them. In many cases, because this concept is relatively new, founders and committee members may not know which country’s laws are applicable or whether the organisation is within the remit of certain regulatory bodies, be it financial authorities or securities regulators. This can cause repercussions on a DAO, as it may require significant and complex changes to comply with certain regulatory bodies and their decisions.
- Accidental Concentration of Power — Another vulnerability of a DAO is the common reliance on its governance tokens as the foundation for its voting system. Although this system promotes engagement within the organisation, it can pose several issues:
- The participants of a DAO may have different preferences and perspectives to achieve the DAO’s purpose. Case in point, some members may prefer taking high risk, while others may prefer a ‘slowly but surely’ approach. The issue is, if a few members with large holdings of the governance token decide to take the high-risk approach, while other members do not agree, it may cause internal conflict.
- Voting Imbalance — Weighing the votes based solely on the number of tokens each member holds exposes the system to opportunistic behaviour amongst participants. For example, speculators who own a large number of tokens can vote for actions that drive up the price of the tokens in the short term. However, doing so may jeopardise the long-term prospects of the project. In comparison, a traditional company can better avoid this issue, as obtaining control over the board of directors is not a simple or quick process.
- Attacks — DAOs may be especially exposed to certain types of attacks. Parties with malicious intent and large capital can purchase the governance tokens from its existing holders and vote towards decisions that are detrimental to the DAO. From this perspective, critics have described DAOs as undemocratic or susceptible to governance attacks because a bad actor could potentially buy their way to influence and control over the organisation.
- Inexperienced Voters — Another aspect where a traditional corporation may do better than a DAO is in the general quality of the decisions. In a corporation, those who have the power to make decisions regarding the direction of the organisation usually are people with experience in the field. In a DAO, however, the members may not have as much practice or expertise to make informed decisions on governance issues.
- Inefficient Voting Process — In a typical DAO, no changes can be implemented without going through the voting process. Although it may be good in most circumstances, it is inefficient in other situations. This can be a security threat if the DAO required an immediate modification in the smart contract to resolve a vulnerability. If the members do not achieve a consensus in a short period of time, the DAO would be at risk of a security breach.
- Smart Contract Risks — While DAOs are able to execute their proposals through smart contracts, this can work as both a benefit and disadvantage. It is great because once a proposal has passed, the smart contract can execute it immediately. However, in the world of crypto, smart contracts are never guaranteed to be safe and may be subjected to exploits or hacks. While they may be very secure, a smart contract can never be 100% invulnerable.
Conclusion: Are DAOs the Future?
And there you have it, the four steps to creating a DAO and the business models’ most important pros and cons. We are expecting to see more DAOs as Web3 expands, but whether it’s a good match for your project depends on the factors listed above. Also read our introduction to DAOs to learn about some of the most famous DAOs in the space.
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