What is a DAO? How Do They Work? And Why Should You Care?

Blockchain technology is a hot topic these days as more people become interested in cryptocurrency and non-fungible tokens (NFTs). However, blockchain technology isn’t just about how you can buy Bitcoin and which NFTs are popular. In fact, blockchain technology forms the underpinnings of what many people call the next evolution of the internet — Web3, also known as Web 3.0.

Part of that takes the form of decentralized autonomous organizations or DAOs. So, what is a DAO? Let’s take a look at this type of organization and where it might fit as the internet continues to grow and change.

What is a DAO?

A DAO, or decentralized autonomous organization, is just what it sounds like — an organization without a central authority. Many people are so excited about crypto, and the idea of decentralized finance (DeFi), because it allows people to perform transactions that are otherwise generally handled by intermediaries. With a DAO, it’s not just a payment system. It’s an organizational entity that operates without the need for a top-down hierarchy.

Instead of having a structure similar to traditional organizations — a CEO, a board of directors, and various officers at different levels of the organization — a DAO instead has a flat structure. Members of the DAO all have a say in running the organization and voting to approve governing decisions.

A DAO can also serve as a joint bank account of sorts, with a treasury controlled by all the members. The treasury can be used to invest in other projects, potentially creating a situation where investment returns could be shared among members.

On top of being decentralized, DAOs are also autonomous, meaning the outcomes of votes are tallied without the need for human vote-counting, and the resulting action is automatically carried out. DAOs are built on blockchains that use smart contracts so transactions can be completed quickly and easily.

Because a DAO is built on code that can’t be changed without the consent of the members, it can be trusted. On top of that, the DAO’s code is transparent, and everyone can see it. This makes it easier to work with people you don’t know, no matter where they are in the world. You don’t have to worry about whether they’re trustworthy, and you don’t need to add layers of intermediaries and escrows to reduce fraud.

DAOs can be useful as charity organizations and even venture capital funding. In general, they are built using blockchain technology designed to handle decentralized finance transactions and smart contracts. The Ethereum network is probably the most well-known blockchain for DAOs, but Solana is another smart contract blockchain compatible with DAOs.

Because they function similarly to for-profit and nonprofit businesses, Wyoming passed a law earlier in 2021 recognizing DAOs as limited liability companies. This paves the way for a DAO to be recognized as a legitimate type of business.

How a DAO works

A DAO works based on the concept of smart contracts. These contracts are set up to automatically fulfill the terms when certain actions are completed. This includes how the treasury, or pool of assets, is managed. The treasury itself is governed by smart contracts, so no one can spend or take the money represented in the treasury without a vote from all the members.

Getting voting rights is usually a matter of becoming a member. Two of the main types of membership in a DAO are:

1. Token-based: All you need to become a member of this type of DAO is to own a token. Most blockchain technology makes use of tokens for completing transactions. With a token-based DAO, you have access to voting based on your token ownership. It’s sometimes possible to buy these tokens on one of the best cryptocurrency exchanges, making it easy to become a part of the DAO. You might also be able to “earn” the token through the proof-of-work model that requires your computer to contribute to solving the cryptographic puzzles that power blockchain technology.
2. Share-based: With this model, you must have a proposal. You gain shares in the DAO by contributing something, usually tokens or some type of work, and your vote is based on your shares. Additionally, your proportion of the treasury might also be based on your shares.

A token-based DAO is easier to join. You just need to buy or acquire the appropriate token. All you have to know is how to buy cryptocurrency. However, it’s important to note that sometimes the governance token is different from other tokens on the blockchain.

For example, MakerDAO issues a token, called a Dai (DAI), that can be used in transactions as a stablecoin. However, the governing token is Maker (MKR). So, if you buy Dai on an exchange, you’re purchasing a stablecoin that is designed to remain pegged to the U.S. dollar, but you’re not earning the ability to vote.

Joining a share-based DAO can be more difficult, especially if it requires existing members to vote on your acceptance.

DAOs often choose their structure based on their purpose. For example, a share-based DAO might make sense for venture capitalists looking to find interesting projects to invest in. Later, when leaving the DAO, an investor could take a proportion of the treasury based on their shares.

Examples of DAOs

• MakerDAO: This blockchain was built with a stablecoin (DAI) equal to $1. The token for governance is Maker (MKR) and can be bought on exchanges. As a member, you can generate Dai as needed for various applications. However, there’s a protocol that must be followed, and the rules are voted on by token holders.
• AAVE: The point of AAVE is to provide a way to borrow money and earn interest on deposits.
• MolochDAO: Based on the Ethereum blockchain, members of MolochDAO help build and support the infrastructure. The idea is to fund projects built on Ethereum to promote its use in society. However, you have to be accepted to the DAO after submitting a proposal that indicates you understand Ethereum well enough to make informed judgments.
• xHashtag.io: This DAO is Solana-based and designed to help blockchain-based communities grow and encourage activities. It’s meant to build infrastructure by providing a way for project owners to distribute their tokens and reach wider audiences.
• Honey DAO: Another Solana-based DAO, this one focuses on venture capital. It provides backing to entrepreneurs with decentralized finance projects that have promise.
• PleasrDAO: Designed to acquire collectibles of cultural significance, and test out the concept of community ownership. One of the most important items purchased by PleasrDAO is “Once Upon a Time in Shaolin,” the one-copy album released by the Wu-Tang Clan.

Pros and cons of DAOs

Pros

• Democratized governance: All members of the DAO have the opportunity to participate in governance. There’s no way to make changes without a vote.
• Trust those you work with: You can trust those you work with, even if you don’t know them. The smart contract structure makes it possible to collaborate with confidence.
• Automatic execution: Transactions are managed automatically, and voting and other decisions are made quickly and easily, without the need for a human intermediary.
• Potential for wealth: Depending on the project, the token associated with a DAO could potentially become valuable. You might be able to sell your tokens for more than you paid. Additionally, if a DAO earns returns on projects it invests in, you might be entitled to a share.

Cons

• Problems with the code can mean problems for the DAO: While you don’t have to trust individuals, you do need to trust the code. Poorly written code can end in disaster for a DAO.
• Decision-making can take time: Even though voting is handled autonomously, it can still take a long time to make decisions. The more stakeholders a DAO has, the harder it can be to get something done.
• Potential to lose money: The flip side of wealth potential is the chance you could lose money. Tokens could drop in prices, or a project could lose money or never turn a profit.

DAOs: The next trend or a smart investment?

DAOs could potentially be a big trend, especially if more people become interested in decentralized finance. While there are other functions for a DAO, right now, many of those who participate in them use them for financial projects. They have the potential to change how we think about organizational structure, collaboration, and conducting business around the world.

On the other hand, if they don’t become popular enough, they could fade quickly. NFTs were popular for a while during the first half of 2021, but now the excitement has faded. If DAOs can prove their practical use, they are more likely to stick around.

Investing in a DAO is fairly straightforward. You find a project you like and put your money into it. For some DAOs, that simply means buying governance tokens. Some projects have their tokens listed on public exchanges, making it easy to participate.

In other cases, you might need to submit a proposal. You can only join the DAO if your proposal is accepted. When deciding to join a DAO, make sure you compare different organizations and consider the mission.

FAQs

Bottom line

It would be great to be able to predict the future and see if DAOs catch on. So far, though, they look like they might offer an interesting alternative to the “traditional” way of running a business or handling paperwork.

Learning how to invest money in DAOs can be one way to grow your portfolio. However, it’s important to remember that DAOs are part of something new. Digital assets like cryptocurrencies and NFTs are unknown territory, and DAOs are even less known. If they don’t catch on, you could potentially lose money. While they have their potential upside, they also have vulnerabilities like any other investment.

Carefully consider your situation to determine if you can afford to lose the money you want to invest in a DAO. Depending on your circumstances, you might want to concentrate on other asset classes, like stocks, bonds, and real estate, before you turn to digital assets and opportunities like DAOs.

Disclosure: The author owns positions in Bitcoin, Ethereum, and Solana, which are mentioned in this piece.