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What Are DAOs and How Do They Work?

What Is a DAO?
Crypto and the democratization of the web have brought about several new business and trade concepts, including that of DAOs. We explain what they are and how they work.

If you’re just getting into crypto, you’ve probably heard the term “DAO” a few times. Or maybe you’re a fan of Bored Ape Yacht Club and wondered what its creator meant when it publicly “encouraged the DAO to start thinking about” developing its own blockchain after Yula Labs’ massive digital land sale temporarily crashed the Ethereum network.

If you don’t know what a DAO is yet, you’re not alone.

The revolutionary democratization of the internet brought about by Web3 has given way to several new business and trade concepts. One of these is the concept of a DAO, or decentralized autonomous organization. 

As the name suggests, DAOs aim to offer an alternative to the traditional corporate structure and democratize organizational governance. As of May 11, 2022, DAOs held a staggering $11.8 billion in their treasuries worldwide. With new DAOs being launched every day, it’s clear that they could portend a long-term shift in how assets, rights, and enterprises are managed. 

But what exactly is a DAO, and how does one work? In this article, we equip you with the basic knowledge you need to start exploring these new-yet-powerful online entities, including:

What Is a DAO?

A decentralized autonomous organization is an entity formed on the internet by a group of people who pursue a shared goal according to rules encoded into the blockchain. DAOs distinguish themselves from traditional organizations by claiming self-governance. They are governed by smart contracts on the blockchain that are executed automatically. All members of the DAO make collective decisions toward an end that ultimately stands to benefit the DAO. 

DAOs can be established for various reasons and are used to coordinate activities relating to a protocol or project, including the management of digital assets and funds. The barriers to entry are also usually low, allowing virtually anyone to create a DAO for any purpose. There is no minimum size requirement; a group of friends could come together and build a private DAO for their purposes. These are digitally native organizations, meaning they originate and primarily exist online. Being a member of a DAO allows like-minded individuals to gather across physical boundaries.

DAOs are predominantly managed by lines of code (smart contracts), with humans only chipping in when necessary—like to set goals or establish rules.

If this all sounds a bit ambiguous, it’s because the commercial and other applications, industry customs and practices, and laws and regulations that will guide the development and use of DAOs are only beginning to take shape.  

The History of DAOs

DAOs started as arrangements for giving participants in a blockchain project an equal say in the direction of the project. The first DAO, called The DAO, was established in 2016. In its creation phase, it received funds in Ethereum and offered funders DAO tokens to indicate membership. Members could subsequently pitch ideas, and these were voted on for funding. Unfortunately, The DAO was hacked soon after, and the reputation of DAOs took a hit. In 2017, the SEC announced that the tokens of The DAO were securities and therefore should not have been offered except in accordance with relevant securities laws.

Recovering from that fiasco, MolochDAO paved the way for most of today’s DAOs. Their goal is to crowdfund infrastructure projects in a sustainable, democratic way. In addition, it has been a trailblazer in using ERC-20 tokens for smart contracts. Following the establishment of MolochDAO, the landscape has expanded to about 4,800 DAOs belonging to various sectors.

How Do DAOs Work?

Any formalized collaborative attempt benefits from having rules and processes that govern its functioning. Hiring people to perform specific tasks, allocating resources, and reaping benefits are part and parcel of any such endeavor. DAOs can maintain and carry out many organizational and transactional functions autonomously and entirely online, while at the same time conducting activity through teams of people, both online or offline. 

Participating in a DAO

The primary feature of DAOs is the members’ shared decision-making capacity. DAOs differ from traditional organizations because they do not subscribe to a top-down hierarchical management model. In the absence of central authority, the hierarchy is flattened, and members vote to form a consensus on all decisions. Voting perks are exclusive to members, with membership representing a certain level of commitment to the DAO’s larger goals. Generally speaking, DAOs require a majority of votes to implement a proposal.

Organizations require funds and resources, and DAOs are often built on members’ contributions. The proliferation of DAOs has lent itself to governance-related experimentation, but below are two of the more common methods of inducting new members:

  • Token-based membership: A DAO-specific token or cryptocurrency grants individual access to voting rights or other perks. Depending on the DAO, these can be obtained via various means, including direct purchase of the token or in exchange for some form of labor. Governance tokens, for example, can also be bought on an exchange.
  • Share-based membership: Although also largely open, these require prospective members to submit proposals and demonstrate a higher level of commitment than a token-based, permissionless membership model. These DAOs are usually centered around specific objectives and used by smaller human-centric organizations like charities, worker collectives, and investment clubs. Shares offer voting privileges and a partial stake, sometimes allowing members to leave with their portion of the DAO assets should they wish.

In some cases, the weight of a member’s vote is directly proportional to the number of tokens they possess compared to other members. Members’ contributions at the time of induction are added to the DAO’s treasury to be used by the DAO for any of its activities. Based on the needs of the DAO, members may be required to make contributions in the form of cryptocurrency or may choose to contribute in non-monetary ways. These contributions can range from helping with management tasks to offering marketing skills.

At the time of its conception, the rules and aims of the DAO are written into the code of the DAO’s smart contracts, built upon a blockchain network. They execute certain actions or transactions automatically whenever a defined set of prerequisites are met. To make any changes to the smart contract, members must collectively consent to them by vote. The developers no longer exercise sole control over the smart contract code.

Running a DAO

In theory, participating in a DAO should require little to no trust of any other individual member, as the smart contracts make it nearly impossible for any one member or small group of members to misuse or steal the DAO’s assets. Consequently, DAOs with properly programmed smart contracts and rules are considered transparent and efficient, which is part of their appeal. 

The intelligent contracts exist on an open-source blockchain, allowing anyone to access the code. Any proposals, modifications, or audits are also recorded. When such a comprehensive record is maintained, fraudulent transactions and other wrongful activities are harder for any single stakeholder to hide. Smart contracts also help ensure that DAO funds cannot be accessed or used in violation of the DAO’s organizational and operating rules. By delegating most management activities to smart contracts, DAOs increase trust among members.

What Are the Different Types of DAOs?

While DAOs primarily focus on replicating offline organizations and traditional company models, their motivations and systems are wide-ranging. Here are a few common types of DAOs:

  • Protocol DAOs: Protocols like Uniswap allow community members to propose and vote on decisions directly impacting the protocol. This is done using ERC-20 tokens, and changes are implemented after a consensus among members is achieved.
  • Service DAOs: These DAOs are talent pools that collectively offer their skills to those looking for high-quality services. Individual members can leverage these networks when looking for work. Often, work for other DAOs is compensated with ERC-20 tokens that can be used to gain a stake in the created product.
  • Product DAOs: Most similar to a traditional company, its members work together on building a product. Profits earned are usually fed back into the treasury to continue sustaining the project.
  • Social DAOs: Groups with primarily social goals are gaining traction. Driving home the community aspect of DAOs, these focus almost exclusively on fostering collaboration and connection among members. They are also attractive in that they give members access to certain perks.
  • Collector DAOs: Collector DAOs have emerged with the rise in the popularity and value of NFTs. These allow people to own fractions of an NFT instead of buying an entire one.
  • Investment DAOs: Members of these DAOs pool their resources to invest in projects of collective interest. They receive voting rights in exchange for monetary contributions. They are usually strongly aligned with a mission or objective and will pick projects accordingly.

Why Are DAOs Important?

DAOs have immense potential to restructure and reimagine existing models of collaboration. Here are a few reasons that highlight the importance of DAOs:

  • Their reliance on smart contracts allows for minimal human error and little room for disagreements at every level. Members can direct their energy toward other, more pressing decisions with a few basic rules. They can, however, propose changes to these rules if they strongly feel the need.
  • Being digitally native, they are open to individuals worldwide. This opens up opportunities for access that traditionally-structured organizations do not or may struggle to offer.
  • Transparency increases trust between members, encourages accountability, and helps DAOs maintain their reputations.
  • Power and responsibility are distributed among members, motivating them to maintain their interests and work with others to achieve the DAO’s goals.

How to Invest in DAOs Using an IRA

The legal and regulatory landscape relating to DAOs is only beginning to take shape. A few states like Tennessee are embracing the DAO structure by recognizing their status as a kind of limited liability company. But that means a token representing membership in a DAO may be treated under federal or state law as an equity security (like a share of stock), a partnership interest, an LLC interest, or something else. Keep in mind if you are considering an investment in a DAO, it’s up to the issuer of the token to comply with applicable law relating to the offering and sale of those tokens. Further, because DAOs and smart contracts are so new, extra care should be taken to conduct proper due diligence regarding the protocol, purpose, rules, smart contracts and tokens, as well as the development team and investors behind a DAO before deciding to participate. 

But DAO tokens, like other property, securities, contract rights, digital assets and other intangible assets, can be held in an IRA.  

If you use an IRA to invest in a DAO, it is very important to ensure that you personally (outside your IRA) receive no benefit from your DAO investment (other than the potential growth of your IRA account). That means you personally should not receive—by virtue of your investment—any tokens, NFTs, smart contract rights, dividends, perks, or other property or rights associated with the DAO. You should never accept payments personally from an investment in your IRA. You also should never personally provide management services or other services to a DAO in which you’ve invested using your IRA. To qualify under the U.S. tax code and avoid prohibited transactions, IRA investments must grow and be used only to benefit your retirement account, not benefit you or your family before you withdraw the investment from the account.

Invest in DAO Tokens and Other Digital Assets with an Alto CryptoIRA®

Alto makes it easy to use an IRA for investing in cryptocurrencies including DAO tokens. Through integration with Coinbase, an Alto CryptoIRA enables you to buy and sell 200+ coins and tokens using tax-advantaged retirement funds—including DAO tokens like: 

  • ApeCoin
  • Badger
  • Curve
  • DerivaDAO
  • Maker
  • Shapeshift FOX

Why put crypto in an IRA? Whether you’re rolling over funds from an old 401(k) or making a direct contribution, a crypto IRA allows you to allocate a portion of your retirement funds to crypto and receive potential gains on a tax-deferred (traditional) or tax-free (Roth) basis, and without the annual tax reporting hassles typically associated with crypto.  

Open a CryptoIRA today and invest your retirement funds in things you’re actually interested in.