What is DAO?

A decentralized autonomous organization, or DAO, is a blockchain-based decentralized community having rules that are defined by encoded programs called smart contracts, and act in the best interest of the protocol. As a self-governing entity, DAOs do not require a central authority for regulation and all their operations are performed “on-chain”, hence enabling transparency and trust in the decision making process.

In this guide, we will take a walkthrough to understand DAOs, how do they work, benefits, limitations, and the future. Let’s get started.

Understanding DAOs

Decentralized autonomous organizations DAOs set out to be community-led entities and use a bottom-up management approach to coordinate themselves. The decision-making power is distributed among the members of a DAO holding the native tokens of the project with varying degrees, who collectively cast votes on matters put forward.

The original decentralized autonomous organization, simply called The DAO, was founded on the Ethereum blockchain and meant to act as a venture capital fund for the cryptocurrency sphere. DAOs lost face after The DAO’s infamous hacking and subsequent draining of ETH worth 50 million USD.

This guide explains how DAOs work in further detail, the problems they aim to solve along with their current limitations, and lists notable examples.

How Does a DAO Work?

DAOs (decentralized autonomous organizations) are regulated through smart contracts, computer programs that codify the terms and conditions of an agreement between multiple parties. By setting the foundation by which DAOs function and protecting their treasury, smart contracts help DAOs to remain functional and maintain integrity without a central governance system.

Smart contracts are immutable and self-governing, meaning that they can automatically trigger an action once a preset criterion is met. These qualities further emphasize the trust in a DAO’s operations as they render them transparent and publicly auditable. It’s virtually impossible for a bad agent to tamper with the financial allocations of a DAO (decentralized autonomous organization) as the rules are embedded in an immutable code, and no one can tweak the rules without anyone noticing. Any update or edit to the rules needs to be voted on by the members of the community.

As opposed to traditional organizations, which typically embrace a top-down model of management, authority in a DAO is distributed to its members. In a typical DAO, the participants post proposals regarding the future acts of the organization for each community member to come together and vote on each proposal. The accepted proposals are then codified and enforced by smart contracts (The firmness of a DAO is a smart contract.). The smart contract represents the rules of the organization and holds the Organization’s storage.

The majority of decentralized autonomous organizations DAOs have their own associated tokens, and the voting power is often allocated based on token ownership: a member with 200 tokens will have twice the voting power over a user with 100 tokens. The premise of token ownership-based allocation of decision-making power is that members who are more financially invested in a DAO are more likely to act in the interests of the organization.

What Does a DAO Do?

First and foremost, a DAO creates a basis for internet strangers to cooperate without a third-party intermediary by providing a secure environment. In practicality, DAOs can be seen as blockchain-based investment clubs where like-minded people come together to realize a shared mission. As per Ethereum’s guidelines, a DAO can act as,

• A charity — an organization can accept donations and choose causes to fund by voting,

• Collective ownership — a DAO may purchase physical or digital assets like NFTs, and can collectively decide what to do with them thereafter,

• Venture capital — an organization may create a venture fund that pools capital, fund ventures, and share the return on investment amongst each other.

DAO Membership Models

Membership models typically determine the voting mechanism and other key elements regarding the governance of an organization. There are three main types of membership models; token-based membership, share-based membership, and reputation-based membership.

Token-based Membership

DAOs with a token-based membership model usually operate within permissionless networks, meaning that any token holder is granted access to voting. This model is typically utilized in governing broad, decentralized protocols. The most notable example is the MakerDAO: anyone can purchase its token MKR, and thus, influence the future of the protocol thereafter.

Share-based Membership

Share-based DAOs are permissioned: the candidates have to submit a proposal to join the organization and typically offer a number of governance tokens as a tribute. The successful candidates are granted both voting power and partial ownership of the organization, or a share. MolochDAO and The LAO are notable examples of share-based DAOs, both of which raise funds to support Ethereum projects.

Reputation-based Membership

Reputation refers to the proof of participation, which grants members voting powers in a DAO. The reputation-based membership model is different from other models in the sense that mere contribution in any form doesn’t automatically grant ownership to the community members. In other words, it’s not possible to buy reputation, rather, it needs to be earned through participation. Prospective members need to submit a proposal detailing their contributions to joining the DAO.

Benefits of DAOs

Primarily, a fully functioning DAO is a testament to the possibility of an alternative method of governance where a central authority holding absolute control is not a necessity. This only could make a profound change in the understanding of the management of organizations of any sort. Besides hinting at an unorthodox governance model, DAOs (decentralized autonomous organizations) also encourage members of blockchain spaces to be more proactive and honest while providing them a basis with which they can build communities.

Solving the Principal-Agent Dilemma

Perhaps the biggest benefit of a decentralized management system is to relieve the principal-agent dilemma which is a potential liability in many business organizations or any legal agreements requiring a third party to oversee.

The principal-agent problem refers to the risk when a system allows an entity “agent” to make decisions or take actions on behalf of another entity “principal”. These two entities can be a corporate board (agent) and shareholders (principal), elected officials (agent) and citizens (principal), or brokers (agent) and buyers and sellers (principal).

A relationship as such has an intrinsic risk of conflict of interests: in an ideal world, an agent acts in the best interest of the principal. But in reality, an agent’s interests may be divergent from the principal’s interests, and the principals can be left in the dark about important information regarding the affairs they are financially interested in.

This deviation from the principal’s interests is called the “agency cost”. Decentralized management works to deter or completely eliminate this cost. Community members don’t necessarily have to delegate their ownership, and by extension their decision-making power, to a sole entity. Instead, they can actively influence the operations of their organization and be informed about all of the proposals and voting activity.

Transparency and Publicity

A DAO’s regulations, proposals, and voting activity is made completely public. Anyone can view the operations of an organization, along with the rules that regulate them. Theoretically, this encourages community members to be on their best behavior and carefully calculate their decisions to maintain a good reputation across the network. Simultaneously, it also discourages bad actors as they can potentially be publicly associated with their wrongdoings.

Community Building and Global Access

DAOs act as empowering agents allowing all sorts of individuals to have a voice in maintaining an organization. Citizens are also typically geographically limited in the organizations they can take part in. Decentralized autonomous organizations, on the other hand, are able to bring together individuals from all around the world. Its large scale makes it easier for community members to find like-minded folks to share and act toward their passions in life.

Limitations of DAOs

DAOs come with a set of challenges to get over, most notably some dire consequences of poorly coded regulations which may cause financial loss and jeopardize the reputation of blockchain technology based networks.

Problems with Voting Mechanisms

In theory, every community member has some sort of voting power albeit to different degrees. But the most common model of 1 token = 1 vote doesn’t align very well with the decentralized authority philosophy. In some extreme cases, this system creates a basis for a hostile takeover, or a disproportionate distribution of voting power where a minority holds a significant amount of power may result in passing votes that do not align with the majority sentiment.

Vulnerability Against Scams

DAO projects are particularly vulnerable to a new phenomenon called rug pulls, where a team raises funds for a project only to exit with the funds. The elaborate scam involves inflating the price of the token associated with the project and pulling out, making the token practically worthless.

One of the biggest rug pulls in history involved a DAO (decentralized autonomous organization) called Anubis. The organization was launched in 2021 and gained instant recognition and success, raising nearly 60 million USD with its own token ANKH. However, only 20 hours after its launch, the money raised was transferred out and completely disappeared.

Problems with Speed, Efficiency, and Competence

While the distribution of voting power to the broader community rather than a CEO or a board of directors in a traditional organization is a democratizing force with unique advantages, it also means a significant reduction in speed and efficiency.

First and foremost, it takes remarkably longer to reach a decision, irrespective of how major the problem is. This is not only caused by the sheer amount of decision-makers, but also the diverse backgrounds from which they come.

While diversity is an asset in an organization, it also means different levels of competency on issues like strategizing, communicating, or thoroughly understanding the problems an organization faces or proposals.

In order to remain fully functional, a DAO needs to invest in the education of its members and ensure that they have access to appropriate resources — which may mean extensive onboarding, time spent explaining the strategy, and so on.

Future of DAOs

Despite some creative examples like ConstitutionDAO, an organization that attempted to buy a rare edition of the US constitution, or Friends with Benefits, which was basically Tinder for the web3 folk, decentralized autonomous organizations today mostly act like venture capital firms or networks facilitating fee-free trades. Yet, it has the potential to revolutionize other verticals than the financial sector, including civil services and NGOs — and their importance is being recognized beyond the blockchain community slowly.

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