DeFi
Structuring your DAO correctly – DL News
HAS Otonomos we help our blockchain-native clients create and manage real-world legal entities. Few subjects interest us more than that of the legal structuring of the DAO.
DAOs are an essential part of DeFi and are growing rapidly. DeepDAO estimates that there are now 13,000 decentralized autonomous organizations (DAOs), with a total treasury worth $24.4 billion. Projects such as Uniswap, Compound, and MakerDAO show the success of DAOs in decentralized management and execution of on-chain financial protocols.
Others, like Decentraland and Friends with Benefits, demonstrate the role DAOs can play beyond decentralized finance. The promise of DAOs is vast and the gains are already all around us. But there are also pitfalls.
Radically democratic consensus mechanisms risk being ineffective, inert and apathetic.
- Ineffective governance hinders DAO projects: A poorly constructed DAO risks recreating many of the worst problems of pre-blockchain organizational life. Radically democratic consensus mechanisms risk being ineffective, inert and apathetic. Token-holding whales, meanwhile, can recreate the excesses of oligarchic control, using their voting power to disadvantage other members of the DAO.
- Catastrophic Legal Risks: DAO configuration issues can go far beyond creating an inefficient system: in the worst cases, they expose DAO creators and token holders to enormous liabilities. Unless proper structuring is put in place, DAOs risk being treated as unincorporated associations or partnerships, with potentially disastrous effects. In 2023, a notable US ruling held DAO token holders jointly and severally liable for the activities of the DAO itself. (1)
To be successful, DAO projects must consider our advice for real-world legal tools.
Legal structuring, yes. The packaging, no.
Sensing an opportunity and hoping to attract DAO customers, jurisdictions like Wyoming and the Marshall Islands rushed to create new types of entities like a DAO limited liability company.
As on-chain and decentralized entities, DAOs are currently somewhat at odds with traditional legal structures. Sensing an opportunity and hoping to attract DAO clients, jurisdictions like Wyoming and the Marshall Islands rushed to create new types of entities like DAO LLCs. However, such efforts are of limited use by transforming an essentially participatory governance protocol into a hierarchical and centralized legacy legal form. We therefore consider the notion of a DAO “wrapper” to be imperfect, because it limits new experimental forms of decentralized governance.
To be truly useful in the real world, DAO projects may need:
- Operational Capability: Create and issue tokens, manage and give real effect to on-chain voting decisions, and be able to distribute grants and rewards to real-world individuals and organizations that help grow the DAO.
- An adapted constitution: governance and consensus mechanisms that meet their needs.
- Legal personality: DAOs must be able to act as a unified entity, a single point of reference that can validly contract with real-world partners.
- Limited Liability: DAO projects must be able to limit the liability of project managers and token owners. Otherwise, each member of a DAO project is potentially responsible if something goes wrong.
- Effective decentralization: Unless DAO projects are truly decentralized, project members and token holders fall prey to a range of regulations, including at least one element of the SEC’s “Howey Test.”
Achieving all of this goes well beyond a single goal. Instead, DAO projects should proactively use entity stacks, which typically include interaction between a foundation, a token-issuing entity, and operating companies.
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Entities such as the Cayman Islands Memberless Foundation or the Panama Foundation, combined with entities in the British Virgin Islands or Panama, which issue and distribute the project token, as well as operational “lab” entities elsewhere, contribute greatly to minimize regulatory risk. As Web3’s leading entity assembler, Otonomos can help you integrate your DAO into a multi-jurisdictional entity puzzle to ensure your projects are both operationally efficient and maximally decentralized.
Book a call with Otonomos to find out how we can help you.