This article is primarily for those trying to understand decentralised-autonomous organisations (DAOs), considering building a DAO, or becoming a member of an existing DAO. These questions are all very relevant from a legal perspective, as a DAO serves as a vehicle for economic activity that has real-world implications for stakeholders.
What are DAOs?
With the emergence of blockchain technology, a new form of human organisation has been realised, known as a DAO.
DAOs are internet-native businesses that are collectively owned and managed by their members. Any decisions affecting DAOs are governed by proposals and voting of its members to ensure everyone has a voice. In other words, they are businesses without bosses!
DAOs are community-led entities with no central authority.
The nuances between traditional business structures and DAOs
To unpack DAOs through a legal lens, a good starting point is to compare them to traditional juristic entities. It is trite that DAOs have taken a fundamental departure from traditional business structures and the implications of this shift are significant. The three key differences are that:
- All legally recognised business structures are regulated by government-enforced laws (in South Africa this is the Companies Act) to ensure, amongst other things, that all stakeholders are sufficiently protected. On the other hand, DAOs do not operate within a legal framework and are therefore free from regulatory oversight.
- Most legally recognised business structures are hierarchical in structure and are therefore exposed to a flaw known as the ‘agency-principal’ dilemma (i.e. the problem of a conflict in priorities between a person or group and the representative authorized to act on their behalf). DAOs, by their very design, have a flat structure which in turn means that they are able to make decisions in a coordinated, collective manner, without the red-tape of executive oversight. While this might sound a lot like a co-op recognised in terms of the Companies Act, the differences will become clear once we unpack the mechanics of a DAO and how it has cryptomonetized a co-op.
- There are various levels of privacy in traditional business structures, such as accessing corporate documents and financials. DAOs are, as the name suggests, decentralised and thus anyone can view the activities, funds, and mechanics of how it is structured ((Etherscan is a tool that you can use to look at smart contracts on the Ethereum Mainnet).
How does a DAO work?
A DAO is underpinned by a tamper-proof, decentralised smart contract. You could consider a DAO’s smart contract to be sort of analogous to a company’s Memorandum of Incorporation (MOI). Like an MOI, a smart contract defines the rules of the organisation. A key difference, however, is that a smart contract goes a few steps further than an MOI. In addition to defining the rules, a smart contract is able to hold the organisation’s treasury and therefore automate financial activity. The members of a DAO make decisions collectively and payments are authorised automatically by the DAOs smart contract when votes pass.
Cryptomonetization is the application of a cryptocurrency in a cooperative organization as a means of exchange, store of value, and unit of account.
A smart contract will be deployed on a blockchain like Ethereum. Once it is ‘on-chain’, the rules in the contract can only be changed by a vote of the members. So the group makes decisions collectively.
It is important to note that not all the decisions of a DAO are automated in a smart contract as this is just simply not feasible. Generally, the pivotal decision rules of the DAO are encoded, with all the less-significant ‘day-to-day’ decisions happen off-chain on platforms like Discord and Twitter.
Smart contracts
The question might arise as to what actually is a smart contract? A smart contract is a “tamper-proof computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract without a middleman.” The ability of a smart contract to remove middlemen has significant utility in the business world as it streamlines the organisation’s activities. For example, a member who holds a governance token (i.e. a share in the traditional sense) can sell it to another person without having to jump through the normal regulatory hoops of transferring shares.
A simple way of understanding the fundamentals of a smart contract is to compare it to a vending machine. Much like a vending machine, a smart contract is essentially logic (i.e. if I put R10 into the machine and click the Coca Cola button, the machine dispenses a Coca Cola). Here is an example provided by the Ethereum foundation of how a vending machine smart contract would look in the Solidity coding language:
pragma solidity 0.8.7;
contract VendingMachine {
// Declare state variables of the contract
address public owner;
mapping (address => uint) public cupcakeBalances;
// When 'VendingMachine' contract is deployed:
// 1. set the deploying address as the owner of the contract
// 2. set the deployed smart contract's cupcake balance to 100
constructor() {
owner = msg.sender;
cupcakeBalances[address(this)] = 100;
}
// Allow the owner to increase the smart contract's cupcake balance
function refill(uint amount) public {
require(msg.sender == owner, "Only the owner can refill.");
cupcakeBalances[address(this)] += amount;
}
// Allow anyone to purchase cupcakes
function purchase(uint amount) public payable {
require(msg.value >= amount * 1 ether, "You must pay at least 1 ETH per cupcake");
require(cupcakeBalances[address(this)] >= amount, "Not enough cupcakes in stock to complete this purchase");
cupcakeBalances[address(this)] -= amount;
cupcakeBalances[msg.sender] += amount;
}
}
Smart contracts help you exchange anything of value in a transparent, conflict-free way while avoiding the services of a middleman.
The legal uncertainty of DAOs
Unlimited liability
Unlike organisations recognised in the Companies Act, the legal status of DAOs is opaque. The relationship between members of a DAO and their investors is likely by default a common-law partnership. This means that every member of a DAO is liable for any debts or legal actions that the DAO may face.
The concern of liability is exacerbated when we consider the fact that most DAOs are not governed entirely on-chain, meaning many DAOs have a few active members who handle these off-chain actions. For example, funds are often held in what’s known as a multisig, wallet (i.e. more than one of the signers is required to authorize any transaction). These more active members approve DAO transactions using their individual cryptographic signatures, or keys. This means the multisig signers have the most liability of all.
Employee protection and recourse
When it comes to labour law enforcement, DAOs are operating in a grey area which is potentially concerning from a DAOs member’s perspective. DAOs are businesses and they need to look after the well-being of their members. In the traditional business world, disgruntled employees have the backing of regulatory bodies to uphold their rights (eg. the CCMA in South Africa).
The Web3 community has noticed this gap in the DAO infrastructure, which has triggered a wave of DAO tools (such as Coordinape) hitting the market. These tools seek to provide a robust framework for DAO member management, rewards and recourse. This is a welcomed innovation in the space, but the law still needs to play catch-up in being able to recognise these novel forms of employee/DAO member laws.
Are DAOs the future of business structures?
DAOs are still very much a novel phenomenon and legal frameworks will need to evolve to accommodate them. There is increasing momentum in the US to provide DAOs with legal wrappers so that the benefits of DAOs can be brought to fruition while also fully protecting stakeholders and other potentially liable parties who are members or participants in a DAO. We at Michalsons are bullish on the future of DAOs and we believe that lawyers have a big role to play in shaping the future of these novel business structures.
Lawyers need to be ready for a paradigm shift in how businesses are structured and governed
