What is a Decentralized Autonomous Organization (DAO)?

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Updated: 8th Oct 2021
Written by Andrew
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October 8, 2021
Written by Andrew

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DAOs, or decentralized autonomous organizations, are essentially businesses, charities, and other operations that operate decentrally via a blockchain.

A DAO is an internet-native organization that uses rules embedded in blockchain code to govern the behavior of the organization and its members.

Many DAOs leverage existing decentralized networks like Bitcoin or others in the DeFi space.

Pros and Cons of Decentralized Autonomous Organizations (DAOs)

Pros:

  • All rules and activity are transparently encoded and recorded
  • No centralized leadership or governing body
  • Use smart contracts to automatically act based on preset conditions
  • Participants can receive native tokens as incentives with legal obligation
  • Speeds up network decision-making
  • Lowers management and other business costs

Cons

  • Both token- and share-based membership involve a buy-in or proof of work requirement, which theoretically benefits those with the most money
  • The rules that govern DAOs can be complex and difficult to change after deployment due to the consensus-based network
  • The inability to react quickly to bugs and flaws leaves DAOs vulnerable to bad actors
  • DAOs may cross multiple countries and legal jurisdictions, placing their operations at the mercy of local and international laws and cross-border contractual relationships

Understanding DAOs

DOAs use smart contracts to govern their organization and to encourage cooperation.

The smart contract code is transparently inserted into the blockchain so that anyone can view the DAO’s rules or activities.

DAOs can operate on a native token and built-in treasury, with members buying or earning tokens that confer voting rights.

Members can put forth proposals subject to a vote by everyone in the organization, leading to a bottom-up decision structure.

This enables DAOs to be governed by the community of its members. However, all decisions are still subject to the rules enforced by the given smart contract.

Decentralized organizations bypass the need for central leadership, addressing the principal-agent dilemma found in most traditional organizations.

With all the rules embedded in a code that acts on an if/then principle – if X occurs, then the code triggers Y action – DAOs can effectively remove bureaucratic hurdles common in many traditional organizations.

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Solving the Principal-Agent Dilemma With DAOs

The principal-agent dilemma occurs when one individual or entity (the agent) can decide or act on behalf of another (the principal).

This leads to the possibility of the agent acting antithetical to the goals, priorities, or available information of the principal.

The agent might act in their own self-interest irrespective of their obligation to the principal’s interests.

This dilemma crops up in public and private entities ranging from corporations to government bodies.

But by removing the power from either party and encoding the rules of engagement within a “trustless” system like a DAO, you can reduce, eliminate, and bypass the need for human intervention, bias, and corruption.

When properly coded and executed, DAOs can align the goals of founders, members, and users together to govern the organization in everyone’s best interests.

How Do DAOs Work?

DAOs use crypto-enabled smart contracts, or snippets of code in the blockchain that act on if/then principles, to automatically act when conditions are met.

For instance, if a smart contract says that Party A will send $100 when Party B sends a file, the code will automatically transfer the funds as soon as Party B sends the file.

This system removes the need for trust in a relationship by ensuring that both parties uphold their side of the bargain.

DAOs use these contracts to establish the rules that govern their organizations.

They also operate a built-in treasury with a native token. Because the entire organization operates on open-source blockchains, anyone can view the code and audit the treasury.

This both guarantees transparency and ensures that the ledger can’t be tampered with due to the immutable timestamp.

Members who buy or earn these tokens are said to have a stake in the DAO and can enjoy voting rights and influence in directing the DAO’s activities.

The larger a member’s majority, the more sway they hold, though what determines the “majority” varies based on the underlying smart contract.

To prevent bigger players from voting against the goals of the DAO, participants are incentivized by native token rewards for acting in the network’s best interests.

Decentralized Autonomous Organizations: Funding, Smart Contracts, & Deployment

A DAO’s underlying mechanisms can vary substantially from other blockchain projects.

However, all organizations have to undergo three essential phases to get off the ground.

Assuming all goes well, the resulting DAO can eventually operate independently of its creators.

On the other hand, flaws in the code or structure can jeopardize the DAO’s autonomy.

Smart Contracts

The first step in setting up a DAO is writing the rules in a series of smart contracts. This is the basis on which the entire organization rests.

If any function, from incentive structures to operational workflows, is improperly coded, the entire project can suffer.

Not to mention, even if a mistake is the result of bad code, members will have to vote in agreement to fix the issue, requiring both time and a majority ruling.

As such, the creators often put their code through numerous stress tests to address any overlooked issues.

Funding

After the creators establish the underlying smart contracts, it’s time to find funding.

The smart contracts must outline the creation or distribution of internal property – such as tokens or coins – that can be spent, used in voting, or given as incentives.

Individuals and entities can also buy these coins or acquire them through proof of work activities.

This process raises funds, confers voting rights, and ensures the DAO’s sustainability.

Deployment

Once the DAO is created and funded, it’s time to deploy the organization.

At this point, all token holders become stakeholders – similar to owning a stake in a company by buying stocks – who can make proposals regarding the organization’s activities.

Then, members can vote on proposals, with the consensus determining the DAO’s future.

Assuming that the organization was well-designed from the ground-up, stakeholders will naturally vote for the most beneficial outcomes.

DAO Membership

DAO creators can authorize two methods of membership: tokens and shares.

Token-Based Membership

Token-based memberships confer voting and member rights to users who own tokens. This is considered a permissionless system, meaning that members can buy and sell tokens at any time.

Typically, token voters can govern broad decisions about the DAO’s protocols or the tokens themselves.

DAOs may let members purchase tokens or require members to earn them with proof of work mechanisms.

Many organizations operate with some variation of a hybrid model.

Share-Based Membership

Most share-based DAOs crop up as charities, investment clubs, and worker collectives.

Prospective members submit proposals for membership, usually offering tokens or work as tribute.

Current members can then grant shares that represent voting power and ownership. Members can exit anytime with their share of the treasury.

DAOs and Security

DAOs are designed to be secure from the inside-out. By operating on the blockchain, their ledgers and activities are entirely transparent, leading to reduced fraud or corrupt activities.

However, the rules that govern DAOs must be complex to be effective – and they’re difficult to change after deployment.

The combination of required consensus voting and code writing leads to an inability to quickly react, meaning most DAO’s can’t respond to threats in real-time.

The most notable example occurred in one of the first DAOs, known as “The DAO.”

This crowdfunded organization was launched by German startup slock.it in 2016 to support a decentralized version of Airbnb.

The campaign raised over $150 million in ETH – but due to flaws in the code, a hacker group siphoned off $50 million.

As a result, Ethereum forked into two tokens – Ethereum and Ethereum Classic – which still persists today.

Are DAOs Safe?

DAOs are as safe as the code and voting members make them.

While the blockchain ensures transparency and the token system spreads risk and responsibility, code flaws can often be exploited before a vote concludes.

And the reality of government jurisdictions leads to legal questions when organizations cross international borders.

Examples of Decentralized Autonomous Organizations (DAOs)

DAOs can exist as any type of internet-based organization, including freelancer networks, charities, venture capital firms and investment clubs, and more.

But most DAOs take some form of DeFi organization, including:

  • Bitcoin. Bitcoin is often considered the original DAO, though it no longer fits the modern definition due to its lack of complex governance mechanisms. That said, it does operate on the open-source blockchain and uses consensus-based participation protocols enabled by mining
  • MakerDAO. This decentralized lending network is built on Ethereum using the stablecoin DAI. The MakerDAO Foundation, which has guided its development, has worked to push the DAO to full decentralization by shifting its supply of governance tokens, establishing paid contributor elections, and improving voter participation in favor of smaller stakeholders.
  • Uniswap. Uniswap released UNI, its native token, in late 2020 to transition into a decentralized protocol. However, this organization also struggles with community ownership and voting regulations, as no one with less than 1% of the total UNI supply can submit governance proposals, disproportionately benefiting wealthier investors.

Decentralization exists on a spectrum, and some “organizations” are more decentralized than others.

You’ll note that none of these famous examples have achieved absolute decentralization, but the more stakeholders a DAO has, the more decentralized it becomes.

Organizations tend to sacrifice some degree of decentralization in exchange for scalability.

Why Do We Need DAOs?

DAOs provide a method for internet-native entities to break free from the traditional hierarchy of modern organizations.

They come with significant advantages, such as removing trust in contractual arrangements, dispersing decision-making authority, and empowering their members.

Bottom Line: Decentralized Autonomous Organization Definition

DAOs have the potential to upend current business models by injecting accountability, trust, and decentralized responsibility into centralized systems.

That said, the challenges of designing, deploying, and sustainably truly self-sufficient, value-generating, non-wealth-dependent decentralized DAOs are very real.

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Andrew
Andrew
Andrew is an editor-writer living and working in Southern California. While he’s previously focused on editing for financial publications, he’s now dabbling in the writing pool as well. Hobbies include listening to podcasts, and learning about all things financial. (Just don't ask him about logarithms.)