Reimagining Corporate Governance
Welcome back, everyone! The next step on our crypto journey are Decentralised Autonomous Organisations (DAOs).
Have you ever wanted to run an organisation with a bunch of online strangers? One where you vote on every decision, and your voting power is proportional to your ownership stake governance token holdings? [What do you mean, no?!]
Well, now, thanks to DAOs, almost anyone can give this a go. Welcome to the land where [computer] “code is law”.
POV: crypto fans during the bull market
DAOs are blockchain-native organisations so [in theory] they are not subservient to any particular legal system. Why? Because they are governed by smart contracts which become immutable once deployed, meaning they cannot be changed [yes, this only applies to fully algorithmic DAOs]. You may disagree with how a smart contract is executing, but no government would have the power to change how the DAO governance code runs on the blockchain.
The potential of DAOs is vast. If an increasing amount of economic activity shifts to the global border-less world of blockchains, then one day they may become more prevalent than the traditional corporations we are familiar with.
However, such a future is far from inevitable. While they present an easy way to quickly raise funds from a global audience, governance via direct democracy for all DAO decisions seems highly impractical.
So, let’s dig in and figure out how DAOs work.
What are DAOs?
A classical algorithmically-managed DAO incorporates all of these characteristics:
has governance rules which are encoded on the blockchain via a smart contract (computer code).
all token holders can initiate governance proposals
anyone who owns governance tokens or has governance tokens delegated to them can vote on governance decisions
token holders are allowed to vote on material decisions [aka things that matter] about the operations of the DAO
In practice, few DAOs are completely managed on the blockchain. Most lie on the scale between being fully algorithmically managed on the blockchain to being fully member-managed offline. However, even for offline-managed DAOs it is assumed [but cannot be enforced] that governance voting outcomes will be honoured by the DAO managers.
Are DAOs modern-day corporations?
Most DAOs would insist that they are not companies and the tokens they issue are not for profit-sharing, but to be used for “governance” instead. So their tokens are definitely not securities! Because, if they were, then some US government agency would be knocking on some non-anon DAO developer doors in the near future [yes, I am talking about the SEC].
There is one major difference between corporations and DAOs. While traditional corporations often have a digital presence via websites and mobile apps, they are forced to officially register in a legal jurisdiction and abide by its rules. In contrast, DAOs are blockchain-first, and may or may not also have a complementary registration in a physical jurisdiction [shout-out to Wyoming for leading the way on DAO legislation].
Therefore, in theory, government power over DAOs is limited. A government cannot change the behaviour of a smart contract or force an anon account to transact on the blockchain against its owner’s wishes. However, in practice it can threaten to fine and jail its citizens if they interact with a given smart contract that has fallen out of favour. Such efforts send clear message of government desires to control blockchain activities, even if their success is tbd [it did not work with PirateBay, did it?].
The current DAO landscape
There are many types of DAOs out there, built around major crypto use cases:
DeFi - these DAOs are created to manage Decentralised Finance protocols such as Uniswap, MakerDAO, Aave, and Compound
NFTs - used to govern and develop specific NFT projects or marketplaces - ApeCoin DAO, Nouns DAO, Decentraland DAO, SuperRare DAO
Gaming - DAOs for games or game platforms - Illuvium, Aavegotchi
Public Goods Funding -to manage projects such as ENS, GitCoin
Acquiring Physical and/or Digital Assets - similar to crowdfunding, groups of people get together to acquire assets in the physical world - ConstitutionDAO, LinkedDAO, CityDAO, PleasrDAO, Krause House DAO, UkraineDAO
Professional Guilds - these manage communities with similar skills, can also run skills training initiatives and coordinate paid projects - Developer DAO, SeedClub DAO, Bankless DAO
There is a lot of variety in the space!
Some are managing billion-dollar DeFi project treasuries [depending on how you do the counting], others are running crowdfunding campaigns to buy a copy of the US constitution.
Some are building a professional guilds to train and connect crypto developers, while others are managing public goods initiatives.
Some are communities membership organisations, others run specific projects with well-defined goals
Crucially, DAOs make it easier for people all over the world to pull together their financial and human capital resources and use them towards a common goal. They also help make collaboration and compensation across geographic borders more seamless.
The set-up costs to starting and building a DAO are rapidly approaching zero. For crowdfunding DAOs, all you have to do is set up and deploy a smart contract, create a website where you link to it and you are good to go. You can start collecting crypto contributions from people all over the world in a matter of minutes or hours [of course, depending on what you are crowdfunding for, you may face legal problems later on].
The perils of direct democracy
“Anything that can go wrong will go wrong”
Murphy’s Law
This all sounds great, but can you think of some issues that DAOs can face on their quest to world dominance? Let me help you out:
Theft due to code exploits
How would you feel about someone submitting a governance proposal to award themselves a lot of DAO funds, and then borrowing enough governance tokens to be able to win the vote [see the Beanstalk exploit] ? Don’t worry, they will return the borrowed tokens after they have finished pillaging your treasury, and they will use a flash loan so they don’t actually have to put any of their assets at risk.
This is a known exploit vector, that DAOs have learnt to have protections against. But when “code is law” you never know what other undiscovered exploits may be out there that your DAO governance code could be vulnerable to. However, code vulnerabilities are so lucrative that hackers tend to exploit them without delay. So governance codes should become more robust over time as more issues come to light and are fixed.
Lack of minority token holder protections
1 TOKEN = 1 VOTE sounds fair. But small token holders can be exploited by large holders voting for actions that personally favour them. For example, insiders with large voting power can vote for extremely high compensation packages for themselves. These can often coincidently slowly drain the DAO treasury until the project becomes unviable. Quadratic voting mechanisms are a possible solution to give minority holders some protection but these need to be battle-tested and work less well for binary yes/no questions.
Extreme visibility is a liability
All transactions and balances are visible on the typical blockchain, so your competitors could anticipate your actions from examining DAO votes and treasury funds and then work to counter them. For example, ConstitutionDAO was narrowly beaten by Ken Griffin [yes, him] in their quest to purchase a copy of the US Constitution, with his winning bid being just above the funds that they had at their disposal.
Lack of accountability
Who is responsible for the DAO being successful? If all decisions are managed via a referendum this can create a lack of accountability for outcomes, and make it harder for DAOs to be managed effectively. If everyone is responsible for a decision then effectively no-one is. Solutions include engaging DAO contributors to be responsible for specific tasks that they have expertise in [such as MakerDAO’s risk teams]
Short-termism
Token holders with short investment horizons may vote for DAO actions that increase their token value in the short term but destroy long-term value [check out Cobie’s thoughtful critique of an unsustainable token “staking” proposal].
Free-riding
The incentives to participate in governance are low if you believe that others will put in the work instead of you. So you can indirectly benefit from a well-run project, at the expense of other people’s effort. This can lead to resentment and may not be sustainable long-term. Some solutions include incentivising voting participation, but these can easily be gamed. Designing a well-functioning vote delegation system seems more promising.
Verdict
Many of these issues may seem familiar to you if you have ever taken a corporate finance class, done a group project, or invested in the public or private markets. The non-crypto world is not immune to governance issues.
Ultimately, each problem presents a valuable opportunity to find a solution, which has contributed to the creation of a large number of DAO governance tools.
The case for social legitimacy
While we tend to think of DAOs as digitally-native organisations ran on the blockchain where “code is law”, social legitimacy can often be similarly if not more important to their success. How come? Let’s take a trip down memory lane and examine the DAOs of yesteryear.
The OG DAO and the Ethereum Hard Fork
The first-ever blockchain DAO on Ethereum had an ominous ending - it suffered a major hack, and almost drove the Ethereum protocol off a cliff only a year into its inception.
When the initial dust settled, the DAO hacker had stolen 31% of DAO funds an 5% of all ETH supply. However, due to the particulate smart contract the DAO team used, there was a delay between the theft and the ability of the hacker to move the stolen funds freely in the network.
In a controversial rejection of the “code is law” rule, the Ethereum protocol underwent a “hard fork” to relieve the hacker of their stolen ETH. They rolled back Ethereum’s history until before the hack and continued onwards with the previously-stolen funds moved to another smart contract that the thief could to access.
This was very contentious at the time and led to the creation of Ethereum Classic, a blockchain where the hack was not reversed. The DAO hack response is to this day used to argue against Ethereum’s legitimacy. However, Ethereum’s market cap is about 40 times higher than that of Ethereum Classic, so the market/social consensus has spoken, and ETH was the clear winner.
This happened early in Ethereum’s history. If your finance protocol gets hacked today there will be no Ethereum hard or soft fork to save you. However, if community is your largest strength, you may be able to save yourself.
The Steem gang vs [His Excellency] Justin Sun
Back in 2016 [centuries ago by crypto standards], Steemit was a popular a social media platform built on the Steem blockchain, using the STEEM governance token. As a decentralised application (dapp) with real traction, it stood out among many other [less impressive] crypto projects. Steemit got the attention of then millionaire Justin Sun, who bought 30% of its governance tokens, effectively giving him voting control over the application.
But the community did not like the direction in which he was planning to take their platform. So they retaliated. First they managed to upgrade the application code to lock Justin’s coins out of governance decisions. He then seemingly prevailed over them after teaming up with exchanges to use the STEEM tokens on their platforms in voting decisions and rescue his funds.
But the community did not relent. Instead, they “escaped” to a newly created blockchain named “Hive”, with a governance token named HIVE, and started rebuilding their social community app. More drama ensued but ultimately they bested Justin by “exiting” the platform he had acquired.
You don’t need to feel too bad for Justin though. He is now one of the largest ETH holders and a billionaire. Also, Justin recently became a WTO Grenadian ambassador, coincidently gaining diplomatic immunity in the process [and who in crypto wouldn’t want one of those?]
The bottom line
Sure code matters, but when a significant part of the value of a DAO comes from its membership base, social legitimacy matters more. Yes, you may hold a lot of voting power on [digital] paper due to owning [or stealing] a large portion of governance tokens. But you should be careful not to offend, dismiss or override your community’s desires.
Because if you push them too hard, in many cases they can easily move to an equivalent dapp where they do not have to deal with you. So, paradoxically, in the land of crypto, where the rules are written in dispassionate computer code, frequently one can only govern with the consent of the governed [yes this fungibility has implications for dapp valuations].
Conclusion: The promise of DAOs
So where does this leave DAOs? Thinking from first principles, if blockchains prosper, DAOs will likely gain more popularity too. But even if general blockchain adoption stalls, the ability to quickly raise large amounts of funds globally in a permission-less way is an innovation that is not going anywhere. Constitution DAO raised USD 47mn in a week. UkraineDAO raised over USD 135mn to support their country’s defence efforts. How much will the next big project collect?
DAOs will need to get better at governing themselves. I, for one, am quite optimistic that we will figure out how to make them work [eventually]. Sure, some of the current DAO experiments are ambitious, and can fail in many different ways. Yes, they are often encountering corporate governance issues that corporations have faced historically, and have contributed to an evolving corporate governance legal body [that DAOs like to ignore].
As a result, to many crypto outsiders some of the governance pitfalls DAOs fall into may seem obvious. But this is ok. “Fail fast and learn fast” works in startup land, so why not for DAOs? Experimentation can lead to discovering new ways of governance which the previous systems haven’t stumbled upon yet. This is partially because most existing organisation they have already settled on a model that works well for them, and partially because they must operate within tight legal constraints.
But do we really believe we have already arrived at the optimal governance rules and that corporations embody this ideal? Likely, there is still a lot to explore about governance mechanisms. In the age of remote work, being able to organise and collaborate effectively over the internet is crucial. Governance mechanisms deserve to be fully battle-tested and optimised. DAOs, that anyone can create at the expense of a few mouse clicks, can provide a valuable playground.
In the future we may end up looking at them as the next evolutionary step in human collaboration efforts. Some DAOs [likely the community-based ones] may even evolve into Balajian network states, organisations which resemble nations more than they do corporations. And wouldn’t that be fun?
PS
So, what do you think of DAOs?
My next post we will cover stable-coins, both the ones that are stable and the ones that haven’t lived up to the promise. Buckle up!
For the hobbyists
Look at some of the DAOs categorised by DeepDAO
Examine several DAO governance proposals on snapshot
Read the discussions on ApeCoin DAO governance proposals
Check out Vitalik post on legitimacy being the most important scare resource
Have a look at Cobie’s post on ApeCoin DAO’s staking initiative
Examine Hasu’s post on DeFi treasuries
Learn more about the dramatic Steem Wars