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What is a Decentralized Autonomous Organization (DAO)?

A decentralized autonomous organization (DAO) is a business organization that operates around a common objective and coordinates via smart contracts on the blockchain. Cryptocurrency holders vote on important matters related to the DAO. DAOs are also transparent, self-governing, and independent of a centralized government, lending to their decentralization.

A DAO is a new type of legal business entity becoming increasingly popular in the Ethereum blockchain ecosystem. Essentially, they represent a shift in collaboration since the company decentralized away from third-party influence.

Here is a web page that also defines decentralized autonomous organizations.

How do Decentralized Autonomous Organizations Work?

In a nutshell, DAOs are designed to hard-code specific rules into programs that will govern the company from the start. They operate on the foundation of decentralized democracy, while smart contracts aid in decision-making.

Smart Contracts

One of the most valuable ideas to understand is that smart contracts serve as the hub of all decisions in a DAO. It establishes the organization’s rules and safeguards its cryptocurrency. Once the contract is live on Ethereum, no one can alter it except by a majority vote.

Essentially, Ethereum smart contracts are tamper-proof once they are live. For example, no one can edit the code without drawing attention since all edits are publicly available and encoded on the blockchain.

Decentralized Democracy

Many see DAOs as a way to ensure democracy more rigorously. Stakeholders can vote on issues, such as adding new rules, amending existing ones, or removing a member. The DAO will simply be incapable of changing unless a sufficient number of people vote for the change.

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DAOs vs. Traditional Organizations

There are significant differences between DAOs vs. traditional organizations, including structure, transparency, voting rights, processes, and contracts. However, the decision-making process is what makes DAOs unique. DAOs utilize the principles of democracy and couple them with the fail-safes that technology provides.

Below, we’ve outlined five characteristics that make DAOs different from traditional organizations:

  • Structure. Token holders make executive decisions versus a centralized group of leaders
  • Transparency. DAO code is open source, making it accessible to anyone who wants to search the history of blockchain transactions
  • Rights. Anyone with internet access can own or purchase DAO tokens, granting them voting rights
  • Processes. Investors can change DAO rules democratically by voting on new proposals
  • Contracting. A DAO could automatically hire vendors and place orders upon the conclusion of a vote

DAOs are not suitable for every project or business. For example, MIT believes that a DAO may not yield returns since some voting rounds may not have the company’s best interests at heart. Another issue is that there could be programming bugs and errors that a human would otherwise notice in a traditional organization.

Examples of DAOs

DAO tokens are a critical component of the design and are required when establishing a DAO ecosystem. Today, several of the largest DAO tokens and organizations operate in the blockchain space.

Here are five examples of DAOs and their backgrounds:

Example 1. Aave

Aave tokens are used in the third-largest decentralized application in the world and the second-largest lending protocol on Ethereum. It enables lending and borrowing through the Aave platform.

Example 2. The DAO

“The DAO” was launched in 2016 and failed within months. However, it remains the most prominent example of what blockchain technology envisions.

The original plan was for investors in The DAO to receive tokens proportional to their ether token investment. Investors could use those tokens to vote on which projects to fund. Unfortunately, an exploit in the code allowed hackers to steal the organization’s funds.

Ethereum reversed the transaction history to return funds to their owners, a contentious decision since the hacker was operating within the bounds of the program.

Example 3. Dash

Founded in May 2015, Dash is the PayPal of the cryptocurrency world, enabling users to store money, receive payments, and shop instantly for less than a cent per transaction. It is as user-friendly as PayPal and is a rapidly growing payment platform.

Example 4. Maker

Maker is a cryptocurrency incorporated into MakerDAO, DeFi’s largest lending platform. It empowers users to vote based on MakerDAO’s parameters, including business logic and risk management systems.

Example 5. Uniswap

The Uniswap token and the Uniswap Decentralized Exchange (DEX) are extremely popular. Users who own the UNI token can vote on new proposals. However, Uniswap retains a powerful developer voice in decision-making, making it less decentralized than others.

How To Create a Decentralized Autonomous Organization

The formation of a DAO is not unlike a traditional organization. A legally compliant DAO operates as a registered limited liability company (LLC), which limits an investor’s financial and legal liability to the DAO LLC. Forming a DAO LLC entails a few additional steps that other LLCs do not, including establishing rules before writing the code and funding the startup.

Here are 4 steps to creating a decentralized autonomous organization:

Step 1. Form a DAO LLC

Wyoming is the only state that recognizes DAO LLCs specifically. You can form a Wyoming DAO LLC or form a traditional LLC in another state. Still, you will not be able to conduct business in Wyoming. Founders can register an LLC by filing their Articles of Organization with the secretary of state’s office.

Step 2. Create Smart Contracts

Developers must create the DAO’s smart contract rules and functionality. They can only modify the regulations established by these contracts after launch via the governance system. This means that the DAO’s code must be tested and any potential bugs or security issues addressed before system deployment.

Step 3. Obtain DAO Funding

After the smart contracts are created, the DAO must determine a method of funding and governance. Typically, tokens are sold to raise funds; these tokens confer voting rights on holders. A popular fundraising vehicle for DAOs is a simple agreement for future tokens, or SAFTS, which promise early investors discounts in future financing rounds.

Step 4. Deploy the DAO

Upon configuration, the DAO must be deployed to the blockchain. From this point forward, stakeholders make decisions about the organization’s future. The founders of the organization no longer hold sole influence over the project.

DAOs and Real Estate

DAOs also solve several critical issues associated with real estate investments. Investment properties are costly, creating barriers to entry for many people. Friends, family members, and acquaintances have been pooling their money together, ruining relationships when someone doesn’t meet their end of the agreement.

A DAO solves this problem by implementing the following protocols for real estate instead:

  • Protocol 1. Investors send their share of funds to a smart contract wallet
  • Protocol 2. All investors are signers
  • Protocol 3. Utilize strict quorum rules
  • Protocol 4. Use tokens to confer voting rights and ownership percentages
  • Protocol 5. Set up an LLC

The legal framework for DAOs is still in its infancy, though this is beginning to change. As such, questions will continue to arise around accountability should a breach or negligence claim arise. But, again, technology lawyers can guide you through the formation and governance process.

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ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.


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