DAOs (Decentralized Autonomous Organizations) for Beginners by@toluajet
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DAOs (Decentralized Autonomous Organizations) for Beginners

September 2nd 2022
15 min
by @toluajet 1,114 reads
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An overview of DAOs, types, how they work, and a bunch of other things you need to know to understand them better.

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@toluajet

Tolu Ajetunmobi

Freelance Blockchain/Crypto Writer | I love writing about everything Blockchain...

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A Beginner's Guide to Understanding DAOs (Decentralized Autonomous Organizations)

DAOs (Decentralized Autonomous Organizations) offer a unique way to grow and build decentralized communities with blockchain technology. That makes it a great use case of decentralized governance with blockchain technology.

In this piece, I'll cover everything you need to know about DAOs and how they work.

What are DAOs?

According to Wikipedia, a DAO is:

"an organization constructed by rules encoded as a computer program that is often transparent, controlled by the organization's members and not influenced by a central government; in other words, they are member-owned communities without centralized leadership."

DAOs are coordinated through shared sets of rules (smart contracts) enforced through the blockchain. They operate totally online and use blockchain technology to record what goes in the organization.

At the most superficial level, a DAO is a group of crypto enthusiasts with a shared mission. It uses blockchain to make transparent and efficient decisions. Think of the DAO as a company, and the members as shareholders.

However, A DAO is not a company, and its members are not shareholders. DAOs are governed by smart contracts that can mimic real-life contracts. They are internet-native businesses collectively owned and managed by the members (they're community-led).

DAOs usually have their treasuries in-built. Nobody has the full authority to access it without approval from the group.

A DAO can be as simple as a group of friends contributing funds for a road trip/investing or as complicated as a high-profile non-profit with hundreds of board members.

Difference between Decentralized Governance and Traditional Governance

The significant difference between traditional governance (LLC and companies) and decentralized governance (DAO) is decentralization.

Traditional companies are governed by corporate regulations and laws with the board of directors and hierarchical roles. The board of directors and company management make decisions for the whole shareholders and the company.

On the other hand, DAOs are usually flat and fully democratized with no hierarchical management; members vote before any decisions are taken.

By using blockchain technology, DAOs remove the need for trust between members. The smart contract handles the voting process and implements the outcome automatically without any intermediaries.

Besides, all activities on DAO are transparent and fully public - available to all the members. On the other hand, traditional governance requires human handling, so they're prone to manipulation because most activities are private and limited to the public.

Why Decentralized Governance (DAOs)?

As internet-native organizations, DAOs have several advantages over traditional organizations. One of the most important advantages is that it eliminates the need for trust in an organization. Therefore, it allows strangers to collaborate and achieve a shared goal.

With DAOs, you don't have to trust anyone in the group; the smart contract is 100% and verifiable by anyone.

Also, the lack of hierarchy means that anybody can bring up innovative ideas for the group to consider. Since decisions are made by voting, nobody can shut down someone's idea.

DAOs make it easier for investors to pool funds, invest in different ventures, and make a profit. By pooling funds together, investors can share and mitigate risks associated with investing.

The History of DAO

Bitcoin can be loosely considered the first decentralized autonomous organization because it was the first use case of decentralization. However, today, Bitcoin doesn't qualify as a DAO, "the DAO" is usually considered the first case of a decentralized autonomous organization.

The First Decentralized Autonomous Organization (DAO)

The DAO, the first iteration of the modern decentralized autonomous organization, launched on April 30, 2016. It started as a form of venture capital fund; it sold shares as tokens to investors that wanted to join the organization.

Christoph Jentzsch, the Ethereum protocol engineer, released the open-source code for the Ethereum-based investment organization. Investors bought shares of the organization by moving ether to DAO's smart contract.

The project raised 11.5 M ETH ($150 million worth of ETH then, over $40 Billion with today's valuation), making it one of the biggest crowdfunding projects.

Investors with the token were supposed to profit from the organization's investments from the price appreciation of the token and dividends.

However, a few days into the token sale, there were some concerns about a bug in the project's smart contract that could be used to hack the system and drain its funds. Basically, the smart contract wasn't adequately audited, and there was a critical money-draining bug.

Although the governance was set to take care of that problem, a hacker took advantage of that bug. One month after its launch, a malicious actor was able to steal 3.6 million Ethers ($60 million at that time, worth over $1 billion now) from the DAO's wallet.

At that time, 14% of the ETH in circulation was invested in DAO, so the attack was a significant blow to both the Ethereum network and DAOs in general. The network was concerned that many Ethereum tokens were under the hacker's control and could pose a significant problem.

The Ethereum co-founder, Vitalik Buterin, proposed a soft fork that blocked the attacker's address and stopped them from moving funds. But the hacker responded and claimed that the stolen funds were obtained legally by the smart contract's rule. The hacker threatened to bribe the ETH miners to stop a soft fork attempt.

Eventually, the Ethereum network agreed on a hard fork that rolled back Ethereum history before the attack and reallocated the stolen funds to smart contracts that allowed investors to withdraw them. However, part of the network didn't agree to the hard fork rule, and the Ethereum Classic was created.

This attack led to the DAO failure and set the space back significantly until 2019 when new DAO projects and concepts emerged.

How DAOs works

DAOs are blockchain-based organizations with no headquarters, central location, or centralized decision-making authority. They operate by using smart contracts that self-execute when specific criteria are met. A DAO's rule is established by its smart contract, and it regulates voting power and decision execution.

Members with a stake in the DAO get voting rights and have a say in how the organization operates by voting or creating new governance proposals. To prevent proposal spamming, a proposal will only pass when most stakeholders approve it.

The way members vote varies from one DAO to the other and is specified in the smart contracts.

The Basic Structure of a DAO

To make it easier to understand, think about the structure of DAOs in two parts:

  • Autonomous
  • Governance

  • Autonomous

There is no centralized Legal Entity; instead, the smart contract moderates voting and implementing decisions.

The smart contract lays out the foundational framework by which the DAO operates. The best part is that it is visible and can be publicly audited.

Like normal organizations, the DAO community members have different roles within the group. There are also regular community meetings for members to connect and discuss possible ideas for the DAO.

  • Governance Tokens

The governance tokens are issued by DAOs to the community members, somewhat like the DAO's currency. The governance token gives community members several privileges within the DAO, including access to community events and voting rights.

Types of DAO memberships

DAO membership determines how voting and other vital parts of the DAO. There are broadly two models for DAO membership, namely:

  • Token-based membership
  • Share-based membership

Token-based Membership

DAOs with a token-based membership model are usually permissionless and used to govern decentralized protocols and/or tokens.

Depending on the token, the governance tokens can be traded broadly on DEXs (Decentralized Exchanges). For other token-based DAOs, their governance token is earned through "Proof-of-work" or by providing liquidity.

An example of token-based membership is the MakerDAO token (MKR) which is available on decentralized exchanges. Anybody can buy MKR and get voting power on the Maker protocol governance.

Share-based Membership

Shared-based membership models are more permissioned (closed); you can't buy access to the project on an open market like the token-based membership model.

Prospective members who want to join the DAO usually have to offer a tribute in work or tokens. If they are accepted, the prospective member then gets shares of the DAO treasury.

Share-based membership models are usually used in closer-knit and human-centric DAOs like investment DAOs or charities. Although share-based membership can also be used to govern protocols and tokens.

The shares represent a direct voting power and ownership of the DAO. Members can exit the project at any time with their share of the treasury.

An example of this is MolochDAO, a Grant DAO that focuses on funding Ethereum projects. To join the DAO, a prospective member must submit a proposal to the group to decide if the prospect has the necessary experience and capital to join the DAO.

DAOs Tension Triangle

The tension triangle in a DAO is the delicate balance between three unique and equally crucial components within the organization:

  • Voice (Governance)
  • Exit (The Individual)
  • Loyalty (Decentralization)

The tension triangle is different from the scalability trilemma and is based on Albert Hirschman's book "Exit, Voice, and Loyalty." According to Hirschman, organizations take shape based on the way stakeholders/members respond to the decline in the value of service/product and representation.

The governance is the legal structure, operation, off-chain, purpose, and on-chain voting that allow the DAO's existence and destruction. The governance mechanism covers the member's participation and activeness. The stronger the governance mechanism, the stronger the member's voice and the lower the exit incentives.

The Individual (Exit) is the freedom of the individual members to participate in decision-making. The individual is the members that believe in self-government and are willing to do things for themselves. The extent to which the DAO respects the sovereign nature of the individual is the extent to which it allows them to exit. The individual should be able to choose when to join, participate, or leave the DAO.

Decentralization is the combination of the technological and political elements that develop the belief system of the DAO. The extent of decentralization is the loyalty that influences if members will lean towards using their voice or exit. The degree of decentralization with the people (individuals) and their motives (governance) are the most critical factors affecting the DAO's credibility.

Like every other organization, DAOs must be able to balance the force of voice (governance), exit (individual), and loyalty (decentralization).

"Decentralization is neither binary nor costless. It involves trade offs. It's about achieving enough decentralization to meet the demands of your use case at whatever scale you're aiming for." - Reserve Protocol

Exit and Voice usually come at the expense of each other. A highly centralized organization may breed disloyalty and skepticism. For decentralized organizations, members will tend to lean towards using their voice rather than exiting. If it is easier to leave, then the voice mechanism loses some of its importance.

Types of DAOs

DAOs are broadly categorized based on their uses, mode of operation, structure, and technology. In this section, we’ll cover the main types of DAOs.

1. DeFi Protocol DAO

DeFi Protocol DAOs govern decentralized Finance protocols/projects like lending protocols or DEXs. DeFi projects use smart contracts to bring DeFi services to their users; therefore, they are fully decentralized. Consequently, they use voting to implement changes to the protocols.

Protocol DAOs allow the complete transition of power from the founding team into the community. Protocol token holders can propose, vote, and implement new changes to the network's underlying framework.

Community members can also vote on the protocol services like token distribution or opening up to liquidity mining or yield farming and fair launches. Protocol DAOs also introduced the concept of ERC20 tokens that have secondary market value and can be transferred from one platform to another.

Examples of Protocol DAO include MakerDAO, Uniswap, and Yearn Finance. MakerDAO uses MKR as its governance token, so MKR token holders can vote on changes to the Maker protocol, including shutting down the protocol, annual borrowing, or amount of collateral to collateralized debt positions.

Uniswap's governance token, UNI, gives the community members voting rights. UNI holders can control Uniswap governance, protocol fee switch, and managing the community treasury funds.

2. Grant/Launchpad DAOs

Grant DAOs are designed to facilitate non-profit donations and deploy the DAO's assets through the web3 ecosystem. Grant DAO can either be a charitable extension of a larger project in the DeFi or a separate entity on its own.

Grant DAOs were the first real application of DAOs; online communities donate funds for charity and then vote on how that money is allocated through governance proposals. The Governance of Grants DAOs used to be carried out through non-transferable shares. That signifies that the DAO was social capital-motivated participation and not for the financial returns.

Launchpad DAOs are focused on finding new and innovative projects in the DeFi and Web 3.0 space. Projects that need funding just need to submit applications to these DAOs, and members vote on the capital allocation.

Examples of Grant DAO include AAVE Grants DAO, Moloch DAO, and MetaCartel. Aave Grants DAO is a community-led project that powers the development of the Aave protocol. The DAO allocates a specified funding amount per quarter and accepts grant submissions from projects working on Aave development, developers' tools, integration, etc.

MetaCartel provides financial funding and operational support for projects working in the Web 3.0 space. The DAO's mission is to accelerate the creation of Web 3, and it awards grants from $ 1000 to $10,000 for projects that are in line with that mission.

3. Collector DAOs

Collector DAOs exist majorly to collect and curate NFTs; digital collector's team up and pool funds to buy NFTs that would have been otherwise too expensive. Collectors' DAOs find NFTs expected to increase in value and vote on which NFTs/collectibles to buy.

After investing treasury funds in blue-chip NFT or other collectibles, each member owns a share that is representative of their personal investment.

Examples of Collector DAOs include Flamingo DAO, Pleasr DAO, and Constitution DAO. The Pleasr DAO recently acquired the sole copy of Wu Chang's "Once Upon a Time in Shaolin '' for $4 million.

The Constitution DAO was formed solely to buy the United State Constitution. The Collector DAO raised around $47 million in ETH in an attempt to buy the first edition copy of the United States Constitution.

4. Social/Creator DAOs

Social DAOs, like creator DAOs, also focus on bringing together like-minded people such as artists, creatives, and builders. They aim to create digitally-native tribes that challenge the traditional social community setting.

You can consider social DAOs as evolving group chats where people come together to work towards a common goal. Social DAOs usually adapt the share-token membership model, with barriers to entry such as owning certain NFTs or a personal invitation.

Examples of Social DAOs include Friends With Benefits, Bored Apes, and Developer DAO. Developer DAO is a group of Web3 developers with the mission to build the future of Web 3.0. To join the developer DAO, you must have a genesis NFTs or get a personal invite to the discord group.

Friends With Benefits is also a Web 3.0 creator-focused DAO that aims to build a community while fostering creativity. To join the DAO, you need 75 $FWB tokens.

5. Service DAOs

Service DAOs act as talent aggregators that use on-chain credentials to allocate talent resources from one DAO to another. Service DAOs aim to establish decentralized working groups for creatives; they simply use on-chain credentials to allocate resources from one DAO to another.

Think of them as crypto-native talent agencies; these DAOs create the platform to contract web 3 professionals to work on different areas of a new project.

Service DAOs are exploring the future of work on blockchain. The work done by these professionals is usually rewarded with ERC20 tokens.

An example of a Service DAO is the Metaverse DAO; the DAO provides individuals and agencies with a talent hunting and support acquisition model.

6. Investment/Venture DAOs

Investment/venture DAOs allow their members to pool resources and invest in different projects at their earliest stages.

Investment DAOs make it easy for people to come together with a low entry barrier and get access to portfolios not readily available. It also helps mitigate risks associated with investing by sharing risk among members.

Investment decisions are made through voting, and members get to actively participate in deciding what to invest in.

Examples of Investment DAOs are MetaCartel and Krause House DAO. Krause House is a venture DAO made up of investors and basketball enthusiasts; the group is trying to buy an NBA team. MetaCartel, on the other hand, is a for-profit DAO that invests in early-stage dApps projects.

7. Media DAOs

Media DAOs are designed to break down how readers, writers, and streamers interact with the content. That is in contrast to the centralized approach of Web 2.0, where content is produced with a central approach and influenced by a group of people.

Media DAOs want to reinvent traditional media platforms by producing community-driven content. This type of DAOs aims to spread awareness/news and turn content consumption into a two-way street.

Think of them as social media but instead of corporate organizations governing the media, members of the DAO all govern and earn a piece of the organization's profit.

Examples of Media DAO include Decrypt DAO and Bankless DAO. Bankless DAO propagates and coordinates bankless media and culture. The goal of the DAO is to drive the adoption of a truly bankless money system.

Decrypt also empowers its users to vote on the types of content they want to see.

The Current Challenges with DAOs

DAOs face several problems, here are the biggest ones they face:

  • Master Nodes empowered centralization

Master Nodes are individuals with the most tokens in the DAO, and they are weighted higher in governance choice. Although that solves loyalty issues because stakeholders with a higher number of tokens stand to lose more, they act in the group's best interest.

However, this can eventually lead to centralization because decisions are made by a smaller powerful minority. Therefore, the majority of the DAO members are underrepresented.

DAOs are adopting new voting mechanisms like quadratic and conviction voting systems to avoid this problem.

  • The Governance Systems

Information dissemination and communication management can be a lot of work with DAO's government mechanism. Because the mechanism involves hundreds, thousands, or millions of people making decisions, it becomes a problem to disseminate information and findings to community members.

  • Shadow Voting

Shadow voting occurs when a token holder without any economic stake votes by borrowing a governance token from a lender to vote and then returning it to the lender after voting.

Furthermore, decentralized cartels or dark DAOs can illegally buy on-chain votes to influence their governance mechanism.

Are DAOs Legally Regulated?

DAOs are still in a gray area concerning legal regulation in most countries; they are not illegal or legally regulated.

That makes it easier to form a DAO compared to forming a traditional business entity or body. While this makes them flexible and easy to start, it also means that there is little to no oversight.

However, the situation is expected to change fast as Wyoming recently passed a law recognizing DAOs as LLCs. More states and countries are also expected to follow suit.

The Future of DAOs

The DAO landscape keeps evolving rapidly as decentralized organization and governance become more popular. DAOs are helping to transform the traditional model of centralized business or organization.

In the world of Metaverse, DeFi, and Web 3.0, DAOs are the future of work and business organizations. DAOs reclaim ownership from big corporations and put it in the hands of the community. This, in turn, enables a more democratic, participatory, and community-oriented (decentralized) business model.

DAOs are also expected to expand the faster adoption of DeFi. According to Akseli Virtanen;

"DAO+DeFi allows expanding the grammar of finance - freeing it from its narrow use right now - to making intangible, informational, relational values (native to the internet) recognizable and economically expressible - and thus exchangeable, liquid, consumable, spendable and stake-able - without necessarily reducing their information into one index of price and one measuring unit of profitability, without restricting their use by proprietary ownership, without hiding their source code, without needing to monetize them via advertising."

Steps For Launching a DAO

DAOs are created through three main steps, namely:

  • The smart contract creation

  • Funding

  • Deployment

The Smart Contract Creation

The smart contract is a vital part of the DAO; it must be fully developed before launching a DAO. After launching, the rules can only be changed through the governance system.

Therefore, the smart contract must be properly audited to ensure no bugs and essential details are overlooked. Smart contract audits are usually carried out by external developers to look for loopholes.

Funding

After the smart contract, a DAO project must also figure out how to receive financing. Most times, DAOs raise funds by selling their tokens' shares to investors who become community members and get voting rights.

Deployment

When the project is ready for launch, the DAO is deployed on a blockchain. After the deployment, the DAO's creators/developers can no longer influence the tasks alone. The DAO is managed by the community, and every stakeholder has a say in the governance.


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