The Basics of How DAOs Operate
A DAO is software code, so to make a DAO you need to write that software. The rules and policies of the organization are coded into that software. At the time of writing, DAOs make use of the Ethereum blockchain. Ethereum is designed to do more than create cryptocurrencies and facilitate transactions. In fact, a core feature of Ethereum is smart contracts.
For our purposes here, all you have to know is that a smart contract, once activated, enforces the rules written within it and makes sure all the entities who are party to the contract adhere to the rules.
The idea is therefore to write your DAO as a smart contract, removing the need for centralized authority when managing the people, money, and other resources of the organization.
In order to be a member of the DAO, you need to hold a token that represents your stake in the organization. These tokens allow members of the DAO to vote on decisions. The smart contract tallies the votes and then approves things like salary payments, capital expenditure, investments, and other similar actions.
Tokens are also a primary way for DAOs to receive their initial funding. Members invest in the DAO and get the token as a representation of their stake and voting rights. The initial funding phase is essentially identical to an ICO (Initial Coin Offering). This phase happens before the DAO is deployed, but after the smart contract is drafted.
Imagine a corporation where all of the employees own equal shares, there is no CEO, and a computer program announces what’s going to happen next after taking the opinions of every employee into account. That’s a DAO, except the computer is a blockchain-based virtual machine that runs on the distributed computing power of crypto miners.
The Benefits of a DAO
DAOs have a few purported benefits, although it being such a new organizational model, only time will tell if those benefits materialize in a meaningful way.
The first is that DAOs are transparent. The code in a DAO’s smart contract can be publicly audited. It’s not possible to commit the types of fraud that are far too common in traditional corporations. Once the smart contract is activated, it cannot be altered. Amendments must be added as a new smart contract and then members vote to have funds transferred from the old DAO contract to the new one.
Additionally, the creators of a DAO have no more power than any other stakeholder once the smart contract is activated. Central authority is anathema to DAOs, and DAO design effectively gives it a “flat” organizational design. There is no need to have trust in other humans if you trust the code, which you can peruse before investing. There’s no way that the organization can work against the interest of the stakeholders, as sometimes happens when a CEO goes their own way.
Another benefit of DAOs is that they reduce the cost of managing an organization such as an investment firm. There is no need for most of the administration and management departments traditional organizations have; the code takes care of those tasks automatically.
Any member of a DAO can put forward a proposal, whether it’s a new project idea, a proposed investment, or anything else. The entire group then considers the proposal and votes whether the organization should pursue it and make funds and resources available.
DAOs tap into the phenomenon known as the “wisdom of crowds” which is the uncanny tendency of groups of decision-makers to make better decisions than individuals. Of course, sometimes the crowd can be less wise than an individual!
The Drawbacks of DAOs
While DAOs sound wonderful in principle, there are still many challenges to overcome before they’re broadly feasible.
One major issue is security. Since the code for the smart contract is publicly viewable, it makes it easier for hackers to come up with exploits or to discover vulnerabilities. DAOs are tested before they are deployed, but bugs and errors happen to all programs in one form or another.
Since all stakeholders must vote to accept any amendments to the code, including bug fixes, it can take a long time to plug security holes. The result of this can be devastating. One of the most infamous attacks happened to a DAO named (rather confusingly) The DAO. Hackers exploited a weakness in The DAO’s code and drained millions of dollars in Ethereum from it.
Organizations with a flat structure are also not suitable for every sort of enterprise. It may work well for a collective of freelancers, group investors, charities, and creative organizations such as film production companies. It’s hard to see something similar to Apple, however, with a strong emphasis on decisive leadership, working as a DAO.
The final major drawback with DAOs is that their legal recognition is limited to nonexistent. They are legally recognized in the State of Wyoming, for example, but in most of the USA and the world, they don’t have legal standing. DAOs may even be seen as illegal securities trading, circumventing the financial controls in place that govern public companies.
The Future of DAOs
Whether the blockchain-powered version of a DAO we’ve seen so far represents the future of the concept is an open question. The broader idea of having an organization managed by transparent software and equitably owned by its members, however, is likely to remain compelling. With the rise of virtual organizations that only exist as a network of contributing individuals, there’s space for a centralized version of the idea to take root or a version that uses a different type of decentralization not based on blockchain concepts.
In the long run, there’s unlikely to be anything untouched by automation, and organizational governance and management will likely be no different.
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