DAOs are a relatively new type of company that is progressively gaining traction among crypto enthusiasts and blockchain innovators. What is DAO? It’s a decentralized and autonomous organization that functions thanks to blockchain and smart contracts. It doesn't rely on a central authority, but it’s community-driven and governed through a transparent voting process executed securely on the blockchain.
The concept is quite intriguing and DAOs can become widely adopted in the future. However, currently, there are still many risks and complexities in creating and running a DAO, and many DAOs have failed in the past years. One of the most well-known examples is The DAO, a venture capital fund DAO launched in 2016. It became one of the largest crowdfunding campaigns in history but failed due to a significant portion of its funds being stolen in a hack in June 2016. To return the stolen funds to the legit owners, the blockchain forked in Ethereum and Ethereum Classic. In this in-depth PlasBit analysis, we'll understand what is DAO, what the most popular are, and the main reasons for their failures or successes.
What is DAO and how does it work?
A Decentralized Autonomous Organization is a company managed in a community-driven way, without a central authority, and the infrastructure is based on blockchain technology and smart contracts.
Blockchain Smart Contracts
Before analyzing the complex concept of DAO, let’s understand the revolutionary technology behind this new governance model. DAOs use blockchain technology to function, and blockchains are online distributed ledgers that rely on multiple nodes (servers that maintain a complete copy of the ledger history) to work in a decentralized way. Blockchain allows people to use decentralized, secure, and transparent financial and governance systems for the first time in history, and smart contracts are the underlying code programs that govern the blockchain and its functions, in a semi-automatic way. They are basically self-executing contracts with terms directly written into code, and the terms of the contract code are automatically executed based on predefined parameters. They ensure transparency, since every blockchain coder can read their details.
What are the advantages of Smart Contracts?
- Automation: They can help automate processes and remove intermediaries like notaries.
- Transparency: Once deployed, the terms and conditions are visible to all on the blockchain explorer and are immutable.
- Efficiency: Smart contracts reduce the time required to execute transactions.
- Cost Reduction: They reduce costs by removing the intermediaries
How do Smart Contracts work?
- Code and Conditions: The blockchain dev writes the smart contract code and specifies the predefined parameters under which specific actions are executed.
- Blockchain Deployment: Once written, the contract is deployed on a blockchain network, such as Ethereum or Solana.
- Triggering Events: When the specified predefined conditions are met, the contract automatically executes the agreed-upon actions, such as transferring funds, issuing assets, etc.
Dapps (Decentralized Applications)
The Dapps (Decentralized Applications) are the key elements of the DAOs since they are the technology bridge between smart contracts and people. They are basically normal websites but allow users to execute some operations on the blockchain through underlying smart contracts. For example, a DAO can create a DApp to vote on the next proposal, and holders can use the website interface to connect their external wallet and operate some transactions on the blockchain without coding. However, doing so with untrusted Dapps can bring risks, and it's always recommended to use multiple wallets to reduce your personal security risks.
Pros and Cons of DAOs
As you can imagine, this new form of organization can bring various advantages and disadvantages since DAOs can bring decentralization but also more risks. Let's explore them in detail.
Pros of DAOs
Decentralization
Blockchain and smart contracts are the perfect combination to create decentralized organizations, with governance power automatically divided equally among members based on their token holdings. This is a new concept both in business and finance since communities and people from all around the world can now create autonomous organizations online, registering them on the blockchain and writing terms and conditions in the code, making some operations automatic and not relying on third-party intermediaries. It allows DAOs to reduce costs, create censorship-resistant organizations, and manage governance power and funds in an automatic and weighted way based on token holdings.
Transparency
The smart contracts behind DAOs contain terms and conditions that are executed when some predefined conditions and parameters are met. For example, you can code that "1 token=1 voting power" and create automatic motions where users can vote proportionally based on their token holdings, interacting with the smart contract that verifies it automatically. Even if you need coding expertise to read smart contracts, they are public, shared open source on the blockchain, and every developer can analyze them to verify their security. Additionally, coding smart contracts is becoming easier to increase adoption and improve the user experience, and some programs and tools already help you create smart contracts with no-code solutions.
Tokenization
Just a few years ago, cryptocurrencies were considered just a speculative asset without underlying value or utilities. However, in recent years, most people and corporations have changed their approach and have embraced cryptocurrencies. For example, Larry Fink, CEO of Blackrock, one of the biggest financial companies in the world, recently embraced cryptocurrencies and defined tokenization as inevitable, underscoring the advantages of using blockchain and smart contracts to improve financial and governance systems. Tokenization of assets, such as stocks, bonds, currencies, real estate, and more, can increase transparency and trust in the system, reducing corruption and costs.
Effective Democracy
DAOs can improve the voting process by authenticating voters and assigning a multiplier based on token holdings. It means that there could be an automatic voting system that reads the holdings of the voter and assigns a multiplier based on it, empowering an effective weighted vote based on holdings. This means that people's voting power is automatically proportioned to their tokens (and interest) in the company. The processes are automated, transparent, and relatively immutable, ensuring that the organization can be easily governed online in a community-driven way but relying on secure blockchain systems.
Community-Driven
Communities can create very structured DAO projects and businesses relying on blockchain technology, ensuring efficiency, transparency, and security. It also allows DAOs to increase the adoption and the mass support of the people, creating a sense of involvement that can lead to more innovative and committed participation.
Easy Access to Crowdfunding
When creating a DAO, people usually raise funds through token public sale, offering tokens and governance in exchange for early investments. In this way, DAOs can now attract funds from a global pool of investors without relying on third-party infrastructure or traditional funding methods. In this way, DAOs, through blockchain and smart contracts, can democratize investment opportunities and provide easier access to capital for startups and promising businesses.
Cons of DAOs
As we've just discovered, DAOs bring various benefits compared to traditional companies. However, there are also some disadvantages that you need to evaluate carefully.
Conflicts of Interest
Conflicts of interest are common in DAOs since members can have different opinions, goals, visions, time horizons, and funds. Some people might be more conservative, while others might take higher risks, and it's difficult to coordinate so many people. For example, speculative traders might prioritize short-term gains, while investors might prioritize long-term value appreciation. Even if DAOs bring more democracy, there must be a clear hierarchical structure to make the best decision for the company and not for the short-term interests of specific individuals.
Slow Decision Process
As you can imagine, in centralized, traditional companies, the key decisions are taken by a small group of people, sometimes even single individuals. In DAOs, on the contrary, decisions require agreements among a large number of members, and it can be a slower process compared to traditional companies. Extensive discussion and different interests can bring slow decisions and make the companies less dynamic and adaptable. Clear rules and decision-process methods can help DAOs to increase the speed of the decision and the dynamicity of the company.
Smart Contracts Vulnerability
Smart contracts can increase the transparency and efficiency of the processes. However, since the blockchain is immutable, if there are some bugs or vulnerabilities in the smart contracts, it's difficult to repair. If hackers recognize a vulnerability in the code, they can probably try to drain the funds of the ecosystem, leading to heavy financial losses and problems. For example, one of the most famous Decentralized Autonomous Organizations, The DAO, failed in 2006 due to a smart contract vulnerability: A notable portion of the funds of the platform had been stolen due to a security issue in the smart contract code. It's always important to implement the highest security measures and execute periodic external audits to verify the effective security of the infrastructure.
Regulation Issues
Since DAOs are not recognized in all the countries in the world, the rules and regulations can change based on the jurisdiction. It's also not easy to register a DAO as a legal entity, since regulators are still working on defining the best approach for DAOs in most parts of the world. Without a clear international framework, it's difficult to work with peace of mind since ambiguity regarding securities laws, taxation, and liability can bring stress and discourage innovation in the crypto sector. DAOs should work in jurisdictions that encourage crypto innovation and decentralized blockchain experiments. However, only a few countries are currently crypto-friendly.
Crypto Market Dependence
Since DAOs are based on blockchain technology, smart contracts, and tokens, they are inherently tied to the oscillations of the crypto market. Being the crypto market highly volatile and cyclic, a bear market (decreasing prices phase) can lead to problems in financial operations and the stability of DAOs since the value of their treasuries drops. In the most tragic cases, bear markets can cause DAOs' failures. However, failures are not always negative: They stimulate competition and innovation and allow recognition of the projects with the best fundamentals that are here to stay and grow in the long term.
Psychological Factors
Psychological factors in DAOs cannot be overstated. They are a key element since communities are often irrational and commit the wrong decision without carefully evaluating the situation. One of the most common cases of psychological bias is the FOMO (Fear of missing out): When there is a lot of hype around a project, and you feel that adrenaline that tells you that you're losing a possibility if not investing now, that's the FOMO. Never rely on emotional factors and always analyze the project rationally. In the same way, the DAO members should avoid being trapped in irrational decisions executed due to cognitive bias and mass psychological factors.
Inexperienced Board
In DAOs, the community members have governance rights based on token holdings, and the vote is proportional to tokens. Consequently, it may happen that a completely inexperienced group of investors/traders must manage substantial amounts of funds and make key decisions, often without having concrete experience or skills. The reliance on community governance means that critical decisions might be made by individuals without the necessary background, potentially leading to suboptimal outcomes. On the contrary, in centralized businesses, the key decisions are often made by a small, highly experienced, and skilled group of managers and investors.
Scalability Issues
Scalability can be another significant problem for DAOs. Depending on the blockchain, there could be high transaction fees, slow transactions, difficulty in handling numerous operations, and more problems. The Blockchain Trilemma says: In blockchain, it's difficult to get optimal results contemporary in security, decentralization, and scalability. Consequently, you should always make careful considerations before choosing a blockchain for your DAO because it may affect your project' scalability, security, and costs. Interoperability solutions are often the best choice for DAOs that want to bridge the real and digital world since access is granted to a larger number of people, ensuring inclusivity, larger adoption, and improved user experience.
Practical Applications of DAOs in Case Studies
DAOs can become effective governance models in various industries and sectors, revolutionizing the current traditional models in finance, companies, communities, and more.
Decentralized Finance (DeFi) Case Study: MakerDAO
A lot of DAOs focus on developing and offering products and services in DeFi (Decentralized Finance), and a famous and active DAO is MakerDAO, our first case study. MakerDAO is built on the Ethereum blockchain, and was founded in 2014, making it one of the earliest DAOs. Basically, the ecosystem creates value by issuing and managing DAI, a collateral-backed stablecoin pegged to the dollar, allowing DAO members to govern its ecosystem by voting based on tokens holding.
Governance of MakerDAO
MakerDAO governance is a good case study to understand how a “typical” DAO works. The DAO is governed collectively by MKR token holders through voting rights and participation in decision-making processes. By voting on key decisions and parameters, such as fees, accepted collaterals, collateralization ratio, and other risk management and strategic decisions, MKR holders are effectively governing the DAO in a community-driven approach.
Among blockchain's many revolutionary benefits are its transparency and code-trust. All the key operations are executed on-chain, ensuring transparency and allowing to submit and vote proposals by the MKR holders and the Maker Foundation. In this ecosystem, the token is the key element of the infrastructure since it converges the interests of the DAO holders and the DAO Foundation, allowing the business to grow by providing value. This is a great case study of DAO, since MakerDAO has created an effective decentralized governance while providing useful and valuable services by issuing a collateral-backed stablecoin.
Venture Capital Case Study: The DAO - Failed
Another notable case study is “The DAO”, launched in 2016 on the Ethereum blockchain. This DAO focused on creating a venture capital fund through community crowdfunding, raising over $150 million in ETH and making it one of the most funded projects in crypto and DAO. People, by funding the project, were entitled to vote on promising crypto projects to invest collectively in them, pooling the funds of the holders. However, even if the idea was great, security vulnerabilities in the smart contracts caused the failure of the projects. Some hackers, having found the vulnerability of the DAO, attacked the system and stole approximately $50 million worth of ETH. This event is known as “The DAO hack”, and was a turning point in the history of the Ethereum blockchain. Reverting the blockchain to its state before the attack was the most logical and relatively easy solution since blockchain is immutable and irreversible. Consequently, the blockchain has been hard-forked, and a precedent version of it was restored on the Ethereum blockchain (ETH), while another part of the blockchain became Ethereum Classic (ETC). The failure of The DAO reminds everyone of the importance of implementing and verifying security measures with numerous tests before deploying the final smart contracts on the blockchain since a single small vulnerability brings enormous risks of losing funds.
What is DAO and what will it be?
Even if DAO could be revolutionary, currently, creating a DAO is still difficult, and it also brings some underlying risks that do not allow the exploitation of the true potential of this new governance model. In fact, regulatory challenges, security issues, market cycles, and the complexity of DAO models limit the expansion and adoption of this new kind of organization. Additionally, we must consider that some businesses are actually better managed in a centralized way since there is more control and autonomy over decisions, allowing for dynamics and straight approaches. Just like cryptocurrencies that fail for multiple reasons, in the same way, DAOs have a high risk of failure since they are still basically "social and financial experiments" that still have little practical use in the real world. However, the potential of DAOs is interesting, and the tokenization of assets and contracts is still in the beginning stages.
The Future of DAOs: Applications and Real Use Cases
As we mentioned, at PlasBit, we believe that the concept of DAOs is really interesting and might be increasingly used in the future. There are various possible case studies, and it's likely possible that we will see a lot of new DAOs in the next years in various sectors, such as:
- Charity and Fundraising: Since the blockchain is immutable and transparent, DAOs can be useful for securely donating funds to charity, and this also allows for tracking their future use with blockchain explorers.
- Open Source Development: Creating a Dev DAO, developers can collaborate online on projects only relying on smart contracts code-agreements, managing funds securely while maintaining transparency and trust among stakeholders.
- Community Projects: DAOs are also particularly suited for communities that want to create a community-driven business. For example, they can be used to create companies related to fan clubs, paid memberships, events, brands, and more, ensuring democratic and transparent resource allocation.
- Investment Funds: It’s possible to create advanced crypto investment funds managed collectively by a community through a DAO. Holders can vote on asset allocation and share profits and responsibilities, increasing gamification and participation while fostering innovation and growth.
- Real Estate: By investing collectively in real estate assets, DAOs can raise funds easily and create an effective real estate business only using cryptocurrencies, purchasing and selling properties, renting, and more, with decisions made collectively by token holders on a Dapp (Decentralized Application)
- Supply Chain Management: It’s now possible to integrate IoT, blockchain, and smart contracts in the supply chain, and DAOs could be the intermediary needed to ensure trust in the system. They can oversee supply chains, ensuring transparency and accountability in tracking goods and services.
- Gaming Guilds: DAOs are particularly suited to create new videogame companies and manage in-game assets, organize tournaments, and distribute rewards. They can incentivize participation through token rewards and governance rights, giving a central role to players.
- Content Creation: Influencers, content creators, and ambassadors can create their own DAO to establish a legal collective business, managing intellectual property rights, distributing earnings, and making key decisions together voting on the DAO’s Dapp.
- DeFi Platforms: DAOs can govern decentralized finance platforms and create new protocols, ensuring community involvement in the Web3 evolution.
A Final Overview: Traditional Companies vs DAOs
In conclusion, we think that a short recap of the main differences and similarities between traditional companies and DAOs can be useful.
Structure and Governance
In traditional companies, small groups of experienced people make key decisions, while in DAOs, the people make key decisions depending on their token holdings. In this case, from the point of view of structure and governance, traditional companies can be defined as more functional and efficient since the board is smaller and more experienced.
Transparency and Trust
From the point of view of transparency, DAOs are the winners against traditional companies, since they ensure transparency through blockchain explorers, allowing to track transactions. Traditional companies, on the contrary, have limited transparency and don’t disclose all the financial data in detail.
Efficiency and Costs
In traditional companies, the processes are usually clear and efficient, but there are higher hidden costs for the infrastructure. In DAOs, there are lower costs, but there could be intrinsic problems in the governance. We can say that DAOs can be more suited to projects that are looking for low costs and community-driven innovation, while traditional companies are more suited for solid private businesses.
Flexibility and Innovation
While significant changes can be difficult for traditional businesses due to the leadership of a small group of people, they could be more dynamic in adapting to market trends and more stable in progressive growth. On the contrary, DAOs often prioritize innovation and big changes/revolutions over sustainable growth. With DAO, there is a high possibility of failure, but also higher potential rewards.
Legal and Regulatory
Traditional companies can follow a clear legal framework and be compliant of international rules, paying regular taxes based on their jurisdiction. On the contrary, regulation for DAOs is not well defined worldwide, and can be difficult to be compliant, increasing inherent risks. From the point of view of legal regulations, traditional companies are still better than DAOs since they can operate with peace of mind.
In conclusion, from this PlasBit insight, we highlight that DAOs are currently not the best solutions for all kinds of businesses, and you should understand the underlying risks and complexities before investing, participating, or creating a DAO. Traditional companies might be more suited for structured, efficient, legally compliant businesses that focus on profits by selling products or services. On the contrary, DAO might be more suited to enthusiast crypto communities that want to experiment with a new form of governance model, focusing on innovation, transparency, cost efficiency, and "high-risk high-rewards." At PlasBit, we hope this blog post has given you all the information you need to experiment in Web3 and explore DAOs and blockchain solutions. Happy crypto journey!
