What is a DAO? Underlying technology, forms of DAOs, legal structures, critics and more

Definition

In short, Decentralized Autonomous Organizations (hereafter "DAOs") are how humans come together as a group to make decisions in the digital world.?Theoretically, all sorts of work structures can be created as DAOs. Investment companies, consulting companies, engineering companies. Maybe born because of Covid, where larges communities gathered online and needed organization.?A DAO is an entity with no central leadership or control (decentralized) and is self-governing without outside influence (autonomous). Decisions get made from the bottom-up, governed by a community organized around a specific set of rules enforced on a blockchain. Incentives are tied to native tokens (currency tied to the DAO project) and active participation by all members of the DAO in governance*.

Why DAO?

First DAOs appeared in 2016.?Being internet-native organizations, DAOs have several advantages over traditional organizations. One significant advantage of DAOs is the lack of trust needed between two parties. While a traditional organization requires a lot of trust in the people behind it — especially on behalf of investors — with DAOs, only the code needs to be trusted, the smart-contract being in principle the governing law. Trusting that code is easier to do as it’s publicly available and can be extensively tested before launch. Every action a DAO takes after being launched has to be approved by the community and is completely transparent and verifiable. DAO structure is thus transparent and incorruptible as the code in smart contract is publicly available and maintained on a blockchain.

Such an organization has no hierarchical structure. Yet, it can still accomplish tasks and grow while being controlled by stakeholders via its native token. The lack of a hierarchy means any stakeholder can put forward an innovative idea that the entire group will consider and improve upon. Internal disputes are often easily solved through the voting system, in line with the pre-written rules in the smart contract.

Whilst traditional corporate law embraces the separation of ownership and control — that is, the dominion of managers/directors, not shareholders, in the operation of the firm, in the DAOs, ownership and participation (and the prospect of control) are mutually dependent, ensuring thus democratic control and ownership.

By allowing investors to pool funds, DAOs also give them a chance to invest in early-stage startups and decentralized projects while sharing the risk or any profits that may come out of them.

How does a DAO work?

Organic growth:

• small community with a particular mission or goal.
• members communicate on platforms like Discord and Telegram.?
• As the DAO grows, members may choose to launch a token and potentially raise capital for the DAO’s treasury by having members contribute assets. DAOs commonly also leverage blockchain technology to implement governance over the DAO, a process that can involve using any number of open-source tools and dapps that have preset and customizable organizational structures or protocols. DAOs operating in this model tend to start small, and legal forms are often only considered as DAOs scale.

Mature projects:

• DAOs are launched with the intention of decentralizing mature projects that have developed enterprise grade protocols. In this context, founders may start by creating an entity through which they receive outside investment which they use to hire and pay for the development of a particular protocol. This entity will issue investors equity in a development company or “DevCo” as well as the right to receive a portion of future tokens the DevCo or an affiliate may create. Once the DevCo has developed a functioning version of the protocol, it can deploy it on-chain and issue tokens to its employees and investors, as well as set aside a portion of the token supply to be distributed to the “community,” including through vehicles like foundations and trusts, with the ultimate goal being incentivizing future contributions to the protocol and turning over its governance to the token holders*.

Underlined technology - Blockchain & Smart Contracts?

• DAOs utilize smart contracts to automate decisions and conduct operations and to govern members’ relationship to each other.
• membership in DAOs is often transitory and tied to ownership of a freely tradable token.
• DAOs of smart contract-based protocols are typically facilitated by a set of governance-related smart contracts that have specified control rights with respect to the smart contracts making up the underlying protocol, all of which are built on distributed ledger technology, most commonly the Ethereum blockchain. These governance smart contracts disintermediate transactions between counterparties by automating the decision-making and administrative processes typically performed by traditional management structures. Decentralization of a given protocol occurs when control (e.g., governance) of the non-immutable aspects of a protocol’s smart contracts is passed from the developers to the members of a DAO via the activation of governance smart contracts.

Forms of DAOs

There are various types of DAOs, examples are Protocol DAO, Maker DAO, Philanthropy DAOs, Collector DAOs, Investment and Venture DAOs, Grants DAOs, Lobby DAOs, Media DAOs*.?

Set-up/formation?

1. Unincorporated DAOs?

• Entityless structure, without any legal wrapper, lacking a formal legal identity;
• Usually used for Layer 1 blockchain networks without token-based governance and pure cryptocurrencies with no associated network or protocol, can include a multisig wallet;
• No formality, have a high degree of autonomy through the execution of immutable code,?permit membership to be denoted by token ownership, enabling efficient transferability, and does not require members to disclose their identity.??

2.??Legal forms

By way of example, DAOs can take the form of:

i)?Foreign Foundation?

• most common structure currently in use by Network and protocol DAOs (most commonly structured as a Cayman Islands HoldCo), including subDAOs (groups focused on specific projects within the broader DAO, which are usually separate entities set up for certain purposes - ie to mitigate tax obligations or other liability risks associated with certain activities, such as a token issuance or sale).
• provide an “ownerless”/orphan legal entity structure for DAOs in which the fiduciary obligation of the entity is to the purpose specified in the formation documents rather than to shareholders.?
• Best suited for Network and protocol DAOs; Example: the developers want to mint a token that will decentralize the protocol’s governance by allowing holders to vote on certain aspects of the protocol. The project's activities will be on chain. Projects could use an offshore corporation, formed in a jurisdiction such as BVI or the Cayman Islands, to act as the direct token issuer, and then allocate a portion of the tokens to a Foundation (or a Special Purpose Trust), which in turn distributes those tokens over time to promote future development of the protocol.
• Complex structure, difficult to achieve overall decentralization since the board of the Foundation acts on behalf of the DAO (as opposed to DAO acting for itself), independence requirements between the corporation and the Foundation.

ii)?Limited Liability Company (LLC)

• Operates similar to a partnership.
• Wyoming and Tennessee have recently adopted laws providing for modified LLCs?????????that specifically contemplate use by DAOs.?

They are best used for Investment DAOs. DAO members bear limited liability with respect to any DAO actions.

iii)?Nonprofit entities?

• Private Foundations, Public Charities. etc.?
• DAOs must usually demonstrate that they have been incorporated for charitable, educational, or scientific purpose.

The Top Legal- frameworks for DAOs around which the above services can be rendered:

Switzerland

a. The Swiss Foundation Law

b. Swiss Association

Cayman Islands

a. Foundation company as a legal wrapper

b. Foundation company as a legal wrapper with a subsidiary

Guernsey Purpose Trust?

The United States of America (not analyzed in this article)?

a. Limited Liability Company; Delaware & Wyoming

b. Unincorporated Nonprofit Association; Siloed & Wrapped entity structure

Switzerland

Over the last few years, Switzerland has established itself as an attractive destination for cryptocurrency and blockchain projects, with the small town of Zug nicknamed as “Crypto Valley”.

Progressive?DLT regulations , Favourable tax regimes, friendly regulatory structures, and limited liability, has made Switzerland, one the most sought-after countries to incorporate a DAO.

The total number of companies in Crypto Valley alone is 960+ with a market valuation of $254.9bn. Crypto Valley now has 11 unicorn crypto projects with a valuation of over $1bn including Ethereum, Cardano, Polkadot, Aave, Cosmos, Solana, Tezos, Dfinity, Near, Nexo and Diem (formerly Libra).

The Swiss Foundation:

The Swiss foundation is an ideal legal form for long-term infrastructure projects, such as protocol development. Examples include the Ethereum Foundation and the Dfinity Foundation, all of which are based in Zug, Switzerland, and aim to support the development of new open decentralized software architectures.

1. The Swiss foundation law once set up, requires registration in a public registry, supervision by a federal authority and most importantly, a foundation deed that cannot be easily changed (often likened to a smart contract).
2. For those that need more flexibility in their operations, this has to be “coded” into the deed and made public.
3. The foundation structure has its own legal personality, no beneficial owners, and is transparent/public and difficult to change.
4. Since the primary goal of a Swiss foundation is to implement the purpose defined at its formation, blockchain developers can use a foundation to ensure that their projects are in line with their core values, such as decentralization, inclusivity and non-profit technology development.
5. This structure is not very appealing for decentralized organizations whose activities evolve and mature over time.

The Swiss Associations:

1. When it comes to Governance, an Association offers a very high degree of flexibility compared to a Swiss Foundation, and its formation as well as its governance.
2. The Swiss Association is a very attractive entity for decentralized projects. Associations have separate legal personalities, just like companies or foundations.
3. Associations are not required to have a resident board member and its members can be individuals or legal entities, and their liability as Members is limited. This allows for much greater flexibility in how an Association can be managed, especially for those projects that are largely run outside of Switzerland.
4. Provided the articles are drafted inclusively, they provide a participation mechanism for geographically dispersed blockchain projects, with the Swiss structure providing a limited liability wrapper around a common goal.
5. This common goal can be political, scientific, artistic, religious or any other non-economic purpose.
6. As long as the Association is non-profit, there is no filing requirement in Switzerland. Though an Association must be registered if it conducts a commercial operation.

On Taxation:

a. In Switzerland, income taxes are levied on federal, cantonal and communal levels. b. Swiss Associations offer DAOs potential tax savings regarding their treasuries. c. A tax exemption may also be possible for Swiss domiciled associations that conduct the majority of their activities abroad to the extent the other conditions for a tax exemption – in particular the charitable purpose – are still met.

b. Associations that run commercial enterprises and may still be granted a tax exemption provided that the business is a subsidiary and subordinated to the charitable objectives and serves to meet the latter’s goals.

Traditionally, the Association has been the entity of choice for non-profit organizations (NPOs)/ non-governmental organizations (NGOs) and may apply for an exemption from income and capital taxes under certain conditions.

Some prominent nonprofits that are incorporated as an Association include,Amnesty International, the World Wildlife Fund, and FIFA— the International Football Association.

Associations have the following main bodies:

a. the General Assembly

b. the Board of Directors

c. the Auditor (only required, if certain thresholds regarding balance sheet, revenue and full-time employees are exceeded).

The general assembly is the governing body of the association. It appoints the board of directors, decides on the admission and expulsion of members and resolves all matters not assigned to other corporate bodies in the articles of association.

The board of directors has the right and duty to manage the affairs of the association and to represent it in accordance with the powers conferred on it as set forth in the association’s articles of association.

A business organization can incorporate as an Association, given that they operate a number of independent offices, each of which has limited liability vis-à-vis the others. This way, they can operate globally under one brand whilst maintaining separate profit pools and ring-fencing liability in each country in which they operate. Doing so does not bring the Members themselves within Swiss regulations: since control of the Association is decentralized, Members are only bound by regulators in their country. A more recent use case for the Swiss Association was the?Libra ?(now Diem) association. Find more on Swiss Associations?here *.

Cayman

The Cayman Foundation Company:

In addition to Swiss the entities seen above, for DAOs is often used a Cayman Foundation Company, which offers like the Swiss ones, the advantages of separate personhood and limited liability associated with a typical corporation. Once the KYC checks have been completed, Foundation Companies can be created in just a day. While managed by a board of directors, the Foundation Company does not have any owners or shareholders; it can be “ownerless.” Instead of being directed by fiduciary duties towards shareholders, Directors and managers have a duty to act pursuant to the foundation company's governing documents. In this sense, the Foundation Company functions similar to a mix of a corporation and a trust. Even without shareholders, Foundation Companies can undertake critical functions for DAOs, including hiring developers, offering a vehicle for early stage funding, marketing DAO projects, holding treasury assets and more. Ownerless foundations like the Foundation Company provide a flexible governance structure that allows for persons other than directors to exercise control. Therefore, the board can be directed by the vote of the DAO token holders to a greater extent than under other regimes. Meanwhile, one or more “supervisors” can be tasked with ensuring that the directors of the foundation company observe their obligations to the DAO pursuant to the foundation company's governing documents. They also have standing to bring suit against the directors if needed.

The Foundation Company can, given the favorable tax treatment in the Cayman Islands, also provide potential tax advantages. However, tax benefits will not be the primary appeal for DAOs. DAOs with US operations or with US actors that exercise control over foundations even if located offshore may still be subject to US taxes. Furthermore, offshore foundations can be relatively complex and expensive to set up, as they will typically require advice from lawyers across multiple jurisdictions and often employ independent directors.

It is also important to highlight that the offshore foundations do not typically “wrap” the DAO, but rather act as an affiliate of the DAO, or even an independent entity, that is directed by the DAO’s token holders for a specific purpose. This relationship has important implications for the potential liability of DAO members (who may not themselves be shielded from liability by a legal entity) and for the directors or managers of the offshore foundation, who may be directed to act by a third party (within the confines of their fiduciary duties).

Guernsey

Guernsey Special Purpose Trust:

Several DAOs have recently employed special purpose trusts formed in the island of Guernsey as part of their legal structure.

These trust structures are not limited to charitable purposes.

A Guernsey trust separates a person’s ownership of property from the right to benefit from that property. It involves a person or entity (settlor) transferring property to another (trustee) who is then charged with holding it for the benefit of a specific purpose.

As such, they can be useful for DAO community treasuries earmarked for a given DAO’s growth and development (like grants)–and clarify the existence, or lack thereof, of any US tax payment and reporting obligations.

Guernsey trusts are governed by trustees, who have general fiduciary duties to act in the best interest of the trust and are subject to removal by other trustees, which can in turn be directed by vote of DAO token holders. Special purpose trusts also have an “enforcer” with broad rights to monitor the trustees and standing to bring suit. DAO token holders can exercise a range of control over actions of Trustees, including to require them to terminate the trust and transfer the assets to a different entity.

One possible advantage this wrapper may have over some other structures is that the Guernsey special purpose trust wrapper does not require any governmental filing to be formed. Instead, as a special purpose trust subject to Guernsey law, it is formed by contract between the grantor and the trustees. It thus may be more resilient to post-hoc charter revocations, and offer the prospect of more clarity and legal finality

Successful DAOs

Today we can already count many DAOs established but to name a few of the most known and successful: Uniswap - The DAO - Decentraland.

Critics/challenges

In a pure organizational theory standpoint they work. But let’s see the challenges in practice*.?

General:

• excessive disclosure requirements, premature operational decisions, discrepancies between operating agreements and smart contracts, and unrealistic quorum requirements;
• discrepancy between De-Fi’s desire to escape regulatory burdens and the need to create a safe environment to incentivize users;
• questions of (potential unlimited) liability and taxation considerations amongst members;
• critical question of fiduciary duty - matter of national/local law;
• whether the activities of DAO could create potential scenarios for disputes or litigation.

Incorporated DAOs:

• considerable practical limitations relating to the structure that can make decentralization more difficult to achieve in light of the specific legislation governing the legal form.
• scrutiny from regulators all around the world, especially when combined with a no-tax or blacklisted /greylisted reporting jurisdiction.??
• difficulties for blockchain-based DAOs with fluid, constantly changing participants who seek to remain pseudonymous - certain operating agreements require amendments for new members.
• inability to meet formalities could result in loss of limited liability protections.
• Potential classification under specific regulation, ie Venture DAOs - whether they may constitute an investment company under the Investment Company Act. The SEC warned of this risk.
• challenges under specific securities laws, i.e. the treatment of the governance tokens (potentially considered securities).

Entityless DAOs:

• the developers and members could be at risk of potentially being (i) restricted from engaging in operations, (i) held liable for any harm resulting from DAO activities and (iii) held liable for income tax liabilities associated with a protocol’s operation and issuances of a treasury’s governance tokens.
• No vehicle to (i) hold interest in IP, hold real property or contract without a member taking on individual responsibility, (ii) sue to enforce a right or (iii) provide a structure conducive to expanding any real-world operational interactions: hiring employees, contracting with services providers, opening bank accounts and paying taxes.

Truly decentralized?

• Governance rules written in smart contract by techno-legal experts, which may not be easily accessible to or understood by general public.
• Possibility that the majority of token holders of the DAO are initial investors/VC funds with substantial investment, which could effectively provide them with control.
• Groups of token holders may decide to pool in resources and try to manipulate the policies and rules governing the DAO*.

Check Oana's article outlining other issues of DAO based on a case study. Link in notes*.

*Notes

https://cointelegraph.com/decentralized-automated-organizations-daos-guide-for-beginners/what-is-decentralized-autonomous-organization-and-how-does-a-dao-work

https://consensys.net/blog/blockchain-explained/what-is-a-dao-and-how-do-they-work/

https://www.youtube.com/watch?v=tbO-tfZX3sc

Legal Wrappers and DAOs by Chris Brummer, Rodrigo Seira

https://101blockchains.com/types-of-dao/

https://cult.honeypot.io/reads/everything-wrong-with-daos/

https://www.dhirubhai.net/posts/metaverselegal_can-blockchain-communities-vote-to-confiscate-activity-6924254899127914496-SgZP/?utm_source=linkedin_share&utm_medium=member_desktop_web ?

https://mirror.xyz/0x43d06b9eBFB0c76A448fBd5B6faa2cfba81901d6/CYm-hNaniW0C1Mn9KR677jn4o9okGugkKC3C8iD9k28

https://www.forbes.com/sites/bernardmarr/2022/05/25/the-best-examples-of-daos-everyone-should-know-about/?sh=7aa44ba540c3