Understanding the Basics of a Decentralized Autonomous Organization (DAO)

A decentralized autonomous organization or DAO is a member-owned group that operates without centralized leadership using blockchain technology.

after reading this, you'll understand:

  • A decentralized autonomous organization (DAO) enables people to join together for a common cause without ever needing to meet in person and also have a say in how the group functions.

  • Both joining a DAO and voting on its activities and operations is usually based on token possession.

  • The DAO landscape continues to evolve quickly as new technologies and ideas emerge while regulatory bodies define it from a legal and tax perspective.

after reading this, you'll understand:

  • A decentralized autonomous organization (DAO) enables people to join together for a common cause without ever needing to meet in person and also have a say in how the group functions.

  • Both joining a DAO and voting on its activities and operations is usually based on token possession.

  • The DAO landscape continues to evolve quickly as new technologies and ideas emerge while regulatory bodies define it from a legal and tax perspective.

A decentralized autonomous organization, or DAO, is a member-owned organization or company that operates without centralized leadership using blockchain technology. DAOs can operate across borders without difficulty, bringing members together across geographic boundaries.

Rather than a president or executive director guiding things, as they do at traditional companies, DAO members vote on operations. This is made possible by the use of self-executing smart contracts that can carry out predetermined functions. All of the DAO’s records and program rules are fully decentralized and maintained on a public network, such as Hedera. Organization members likely never meet in person, but the workings of the group are transparent to every participant.

People have formed DAOs to fundraise for charity, buy an original copy of the U.S. Constitution (an attempt that failed), invest in NFTs, and form companies that enable members to exchange funds for equity. Examples of well-known DAOs include Dash, Augur, Steem, Uniswap, Synthetix, and ConstitutionDAO.

Each DAO has a similar structure and can carry out a variety of activities. For example, Synthetix incorporates six DAOs that each has its own rules and elected representatives to govern its proposals, smart contracts, and treasury. SushiSwap is a unique kind of DAO that uses off-chain voting rather than typical on-chain voting. It has a supply of SUSHI tokens that are distributed according to member proposals. Even Bitcoin can be considered a DAO, where nodes operating the Bitcoin network vote on proposals to code changes, weighted by their hashing power.

Unlike traditional organizations or companies, there’s no top-down, hierarchical structure with layers of bureaucracy. Instead, DAOs are governed by people who make decisions collectively and implement those decisions using secure code.

A traditional organization is also bound by an employee’s legal contracts, which establish their rights and obligations. DAOs, in contrast, are held together by an open-source protocol that both keeps the network safe and carries out functions in exchange for native tokens. Thus, there’s no need for layers of management or lawsuits to uphold bargains between members.

How does a DAO work?

Decentralized autonomous organizations go hand in hand with crypto and decentralized finance, which uses code to eliminate the need for a third party or centralized government in a transaction. DAOs use blockchain’s secure, transparent digital ledger to track and verify transactions. Thus, software allows members to reach consensus around a DAO’s tokens, governance, and makeup while also carrying out its functions. Typically, launch occurs in three steps: DAO smart contract creation, funding, and deployment on the blockchain.

Protocols, or groupings of smart contracts, are used to formalize and carry out the functions of the DAO. This can include carrying out the results of a community poll or automatically dropping tokens to members.

DAO governance

The governance rules posted by Maker DAO give a good picture of how a DAO operates. The two forms of governance are off-chain, for administrative duties, and on-chain. Off-chain voting is done through forum signal threads that measure sentiment. On-chain voting is done through Governance Polls and Executive Polls.

Members can stay up to speed on what's going on through forum threads, chat rooms and other options. Voters are expected to weigh in on things like:

  • Determine governance and DAO processes outside the technical layer of the Maker Protocol.

  • Form consensus on important community goals and targets.

  • Measure sentiment on potential Executive Vote proposals.

  • Ratify governance proposals originating from the MakerDAO forum signal threads.

  • Determine which values certain system parameters should be set to before those values are then confirmed in an executive vote.

  • Ratify risk parameters for new collateral types as presented by Risk Teams. These include numerous forum threads that go into the details of various issues and topics of discussion, key votes, write-ups, data dashboards, and Governance and Risk meetings.

Voting periods usually last for three or seven days. There are regularly scheduled voting times, but also as-needed polls.

Its voting system requires members to commit MKR tokens to vote on a poll and pay a transaction fee. The fee is paid in gas and amounts to a few cents. The total value of tokens decides the winner. As the site explains: "For example, if 50 stakeholders hold a total of 600 MKR and vote for proposal A, while 100 stakeholders hold a total of 400 MKR and vote for proposal B, then Proposal A would win [600-400] with 60% of the vote. Notice that the number of voters is irrelevant, only the amount of MKR tokens voting for each proposal."

If a voter unlocks the tokens before the end of the voting period, the vote does not count. The complexities and questions involved in DAO voting involve such things as the optimal use of wallets, using IOU tokens to lock in votes, how long a token holder must posses it before being eligible to vote, governance tokens vs. utility tokens, how to unlock votes, what happens to the value of tokens in a volatile market while they are locked into a vote, and the danger of whales. That last item refers to voters who amass large amounts of DAO tokens. Since voting power is based on the commitment of tokens, whales can exert an outsized influence on the DAO. That would defeat the purpose of an organization designed to be decentralized.

DAO use cases can range in complexity based on the number of stakeholders and the processes within the organization. Overall, the essential components of the DAO’s network include the exchange, which hosts transactions; the validator, who verifies transactions; the user; who participates in the community; and the developer, who builds the code.

Does a DAO make money?

Like other web3 projects, DAOs can make money through the sale of their native tokens. These tokens can be sold on major crypto exchanges around the world. These tokens give their holders voting rights within the DAO and sometimes other benefits, like token drops.

Investors in a DAO also give it capital in exchange for buying into an early-stage project that will share its profits with investors and members. DAOs are often seen engaging in funding rounds or crowdfunding to raise their initial funds.

DAO membership

A DAO offers a bottom-up organization where members collectively own the organization. With this basic principle as a foundation, DAOs can take many different shapes and structures. One common structure is token-based membership, which we have just described.

Another type of autonomous organization is a little more restrictive. Share-based membership requires possession of tokens, but members can't just buy their way in. They also have to submit a proposal that indicates they have the expertise or passion to help make valuable decisions.

What was "The DAO"?

Perhaps the most well-known example of this structure is one of the first, The DAO. Founded in May 2016, it set out to enter the world of venture capital funding. The DAO launched on the Ethereum blockchain with a website and crowdfunding campaign. It raised $150 million, which set a record for the largest crowdfunding campaign at the time. This allowed it to begin trading on major exchanges that month. Like today's decentralized organizations, The Dao had no board of directors or management structure, and the code was open-source.

It ended after hackers exploited a weakness in the DAO's code and robbed it of $50 million in June 2016. Though the funds were restored, The DAO was unable to recover. By September of that year, the DAO’s token had dropped in value and was dropped from major crypto exchanges. As a result, it was effectively dissolved.

The future of DAOs

The structure of a DAO continues to draw a steady stream of people willing to experiment with it. They are drawn by the chance to pool resources with others for a common purpose while maintaining a say in the group's governance. They also appreciate how it attacks the principal agent dilemma. That refers to the way managers make decisions for shareholders or politicians decide how to spend citizens’ money. Because the manager or politician makes decisions while shareholders or citizens bear the risks, they take more risks than usual and act in their own self-interest.

Legislative bodies around the world are coming to grips with the legal status of DAOs. Their decisions could cause tremendous upheaval or help prevent abuses of the system – or both. One troublesome question involves how governance tokens should be treated for tax purposes.

Advances in distributed ledger technology can bring other possibilities to light for DAOs. Hedera's Smart Contracts 2.0, for example, offers full layer 1 programmability to applications built on Hedera. Developers building on Hedera can expect efficiencies and performance, low costs, and scalability with Smart Contracts 2.0 across DeFi applications, including DAOs, oracles, network bridges and many other types of decentralized applications.

For an in-depth exploration of how HashioDAO can revolutionize your approach to decentralized governance, visit our solutions page here.