What Is a DAO?

What is a DAO? 

DAO is a term used to describe a virtual organization embodied in computer code and executed on a distributed ledger or blockchain. DAOs have a variety of uses, from passive investment vehicles to operational businesses, and the added benefit of transparent management governed by smart contracts rather than individuals. 

DAOs are seen often in the DeFi space as investment protocols creating exotic financial products for crypto investors.

A DAO may consist of the following: 

• Members entitled to vote on governance questions 

• Non-member investors who fund the DAO but may lack governance rights 

• Users who interact with the DAO or its business offerings 

• Stakeholders who are impacted by the DAO  

Given its virtual existence on a distributed ledger, the governance, investments, and business activity of a DAO are public.   

All DAOs share two primary characteristics: 

• The overall direction and purpose of the DAO is governed by its members rather than a board of directors or small group of decision makers.

• The direction set by members is executed through rules encoded in smart contracts on the blockchain. 

How does a DAO work? 

Members of a DAO vote on decisions and then execute those decisions through smart contracts. 

Typically, members hold a certain number of tokens and need to meet a certain threshold before they’re allowed to create proposals that other members can vote on. The tokens grant the members voting rights proportionate to their token holdings. 

For example, a proposal on Apeswap in February 2022 allowed members to vote on the amount of treasury fund usage for the growth and continuing planning of its decentralized exchange platform.

DAOs can be multipurpose and serve a number of functions; some DAOs vote on how pooled funds will be allocated and others vote on the distribution of charitable donations. There are also DAOs that function as venture capitalist firms and exist for the specific purpose of funding certain investments.

What is a smart contract?

Smart contracts are transactional protocols or computer programs that automatically execute when relevant events tied to the agreement take place.

How do you become a DAO member? 

Members need to demonstrate ownership in the DAO by making a financial investment in the network or receiving airdrops of a network token to vote on its protocols. The individual investments help to ensure that all DAO members have a stake in the network and an incentive to take the process seriously. Becoming a DAO member often takes place through the purchase of governance tokens; this is known as on-chain governance.  

Some governance tokens can only be obtained during a specific funding round, and if an individual holds more tokens, then their vote owns more weight.

What are governance tokens? 

A governance token is a type of crypto that’s tied to a specific project; it allows the holder certain privileges such as the right to vote on protocols.  

Governance tokens can hold other value aside from voting rights. For example, Uniswap DAO has a governance token UNI that allows holders to vote on development proposals. Because these tokens carry specific rights and privileges, they have inherent value and can be traded.  For example, UNI can also be sold or traded on exchanges like other forms of crypto.

How does a DAO make money? 

Most DAOs will make money from a return on operations or investments. 

Depending on the nature of a DAO, the ways to collect and make money vary. 

Here are a few examples:

• For a DAO whose main purpose is business longevity, it could make money through profits on operations or investments made by the DAO itself. 

• For a DAO whose main purpose is to achieve a short-term vision, it could obtain a share of collections from the individual wallets that invested in the DAO’s mission and receive voluntary donations.

• For a DAO whose main purpose is to aid its organizations, DApps, protocols, and more, it may receive a portion of the grants from the projects it supports.

What are the potential advantages of a DAO? 

DAOs don’t rely on the standard structure of most corporate organizations; there isn’t a board of directors or selected group of leaders. DAOs rely on collective decision-making, and the overall health of a DAO rests on its members ability to govern. 

Since the rules of a DAO are recorded in a smart contract, they are public to everyone in the organization and can’t be changed or edited without transparency to all members. 

They have the potential to be more democratic than a traditional business.

What are the potential disadvantages of a DAO? 

A DAO could have several disadvantages: 

• Hierarchy still exists within its structure. 

• Votes require time even in a crisis situation. 

• Laws and treaties haven’t yet formalized how or where a DAO legally exists. 

• Logistical and communication issues still subsist.

• Potential legal concerns could arise.

Hierarchy

An advantage can also be a disadvantage.

One advantage of a DAO is the direct influence a member can exert on the organization through voting rights tied to governance tokens. However, this advantage isn’t foolproof because voting power can often be stacked through the accumulation of tokens. If certain holders have more governance tokens than others, they could have the power to sway decisions and undermine the influence of the minority.

A DAO’s structure doesn’t completely eliminate hierarchy. 

Voting Length

Since DAOs function on a community-based model, no changes can be made without a vote even in dire situations. 

For example, if an error in the code allowed a security breach, no action could be taken without the organization’s consensus. The error would have to remain, and valuable time would slip away, while the community organized a vote on how to fix the breach.

Location

DAO members and investors can be spread all over the world, so what happens if they have a legal obligation? Whose jurisdiction does the DAO fall under if it doesn’t have a central location? 

Because of the novelty of DAOs, laws and treaties haven’t yet formalized how or where a DAO legally exists. Legal jurisdiction over a DAO could be based on where its members are physically located, but the anonymity of DAO members could cause an issue with this approach. 

These uncertainties impact the regulatory rules a DAO needs to comply with or what taxes it might be required to pay 

More authoritative guidance is needed and lack of such guidance creates uncertainties for members and investors.  

Logistics and communication

Many DAOs operate via communication platforms like Discord and Telegram, making communications more difficult than mainstream avenues. 

Because of their virtual and autonomous nature, DAOs have practical hurdles in conducting transactions with traditional businesses or individuals. For example, a DAO can’t appear at an auction to bid on an item nor can it execute a business transaction.

Potential legal concerns

Given their decentralized existence, issues can arise as to governing jurisdictions or law if disputes occur internally between members or externally with regulatory compliance. 

As a novel organizational structure, liability questions can arise for members. Although Wyoming passed a law limiting member liability, in many jurisdictions a DAO may be treated as a general partnership with unlimited liability flowing to its members and investors.

What are the real-world implications of a DAO? 

Back in 2016, a massive hack occurred to a DAO on the Ethereum blockchain—known simply as The DAO—where $60 million worth of ether (ETH) was stolen. The hack resulted in a controversial hard fork of the Ethereum network to restore members’ investments; a hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.

Given the nature of DAOs and distributed ledger technology, the hard fork was the only method for recovering the stolen ETH. No real-world remedy existed, leaving the victims with no recourse in response to a hack exploiting a programming bug in the smart contracts governing The DAO. Even now, there’s no guarantee that the smart contracts and DApps behind DAOs aren’t susceptible to programming bugs or hacks. 

While the real-world implications of a DAO are very evident in the situation described above, their full potential has yet to be realized.

Much like crypto and DeFi, DAOs are still becoming established structures in current financial systems; they’re constantly fluctuating and ever-changing—which is also why their potential is so exciting.

How are DAOs taxed? 

As of March 2022, there’s no specific guidance on the taxation of DAOs.

Because DAOs aren’t well defined as a business entity, it’s difficult to apply specific tax rules to them as an entity.  

If you’re a member or investor in a DAO, you may want to seek assistance from a tax professional on how to report any taxes that result from your DAO involvement. Although investing or acquiring governance tokens are likely non-taxable events, disposing of these tokens or receiving an airdrop of governance tokens likely have tax implications. 

If you interact with a DAO as a user, there may also be tax implications. If you bought or sold crypto through a swap pool offered by a DAO, you’d have taxable transactions. If you received crypto from a DAO in return for goods and services, that activity also has tax implications. To read more about taxable crypto transactions, please explore our Crypto Tax Guide. 

While we wait for more clear guidance on the taxation of DAOs, its members, and investors, it’s important to keep track of your own individual transactions within your DAO activity.

More Resources

If you want to continue learning about the crypto space, explore other articles in our DeFi and crypto education series: 

• What Is DeFi and How Does It Work?

• What Is Ethereum 2.0?

• What Are Crypto Airdrops and How Do They Work?

• Blockchain 101: Learn the Basics of a New Technology

• The Infrastructure Bill Has Passed: What’s Next for Crypto?

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