What is a DAO?

What is a DAO and how does it work? We’ve got the answers to all your questions about decentralized autonomous organizations (DAOs) in our complete guide. 🏢

What does DAO stand for?

DAO stands for decentralized autonomous organization. Sometimes, they’re referred to as decentralized autonomous corporations (DACs).

What is a DAO?

A DAO is an emerging organizational structure where instead of a traditional hierarchical structure with a leader, there is no central authority or leader making all the decisions. Instead, DAOs are managed by members through collective governance.

This is most often achieved through blockchain technology, including smart contracts and governance tokens. Token holders can vote on proposals for the DAO's development.

Although DAOs have only recently gained traction, largely thanks to a wider interest in blockchain technology and its use cases, the term first emerged in the 1990s to describe potential digital organizations in the Internet of Things (IoT).

To understand DAOs, it can help to simply break down each word in the phrase:

• Decentralized: These organizations are community-owned. While there may be developers creating the technologies necessary, all members share power collectively.

• Autonomous: Rules, treasuries, and more are automatically encoded and enforced by smart contracts.

• Organizations: A group of people with a specific purpose(s) or goal(s) in mind.

How do DAOs work?

So if we understand what DAOs are now - and the typical structure - we can delve further into how they work.

Generally, collective members own a DAO, and this is most often achieved with the ownership of a given token - also known as a governance token. For example, Sky (formerly MakerDAO) members hold SKY tokens.

The actual functions or actions of a DAO are generally executed using smart contracts. These are pieces of code that automatically execute whenever a set of conditions are met. Smart contracts manage the rules of a DAO, and the rules are established by governance token holders' votes.

What is the purpose of a DAO?

Just like traditional organizations have various purposes and goals, so do DAOs. DAOs can be set up by anyone, anywhere, for any purpose.

If you’re asking why someone would set up a DAO as opposed to a traditional organizational structure, then it can help to compare the key differences between the two.

DAO examples

There are many different types of DAOs, like protocol DAOs, social DAOs, investment DAOs, and grant DAOs - but examples of some of the largest DAOs include:

The DAO

The DAO, or GenesisDAO, was one of the first DAOs to emerge, back in 2016, but the project didn’t have a happy ending. The DAO was supposed to operate similarly to a venture capital fund for the crypto market.

After its founding, The DAO had a funding or creation period in which the project raised more than 12.7 million ETH, with members sending ETH in return for DAO tokens in the future. These funds were then going to be available for anyone with a project to pitch a proposal to the DAO community and potentially receive funding.

But in June 2016, a hacker exploited a loophole in the code that allowed him to drain funds, stealing more than 3.6 million ETH. In the end, Ethereum hard-forked in order to send the hacked funds back to the original owners, leading to the creation of Ethereum and Ethereum Classic.

Uniswap

Uniswap is a protocol DAO for trading and automated liquidity provision on the Ethereum network, with more than $3 billion TVL. Uniswap DAO is governed by UNI token holders, who vote on proposals and the development of the overall protocol. So far, there have been four iterations of Uniswap, and the protocol has expanded to many other blockchains, including Polygon and BNB.

ConstitutionDAO

ConstitutionDAO is one of the more weird and wonderful stories from the Wild West of crypto. The DAO was formed in 2021, with the simple goal of purchasing an original copy of the United States Constitution. The DAO raised more than $47 million in ETH, but lost out to a bid of $43 million at a Sotheby’s auction as the organizers believed they would have insufficient funding to properly insure and secure the document if a higher bid was made. The DAO disbanded and refunded members shortly after, although many users reported receiving partial refunds due to high gas fees at the time.

Decentraland

The Decentraland DAO owns the popular metaverse game Decentraland. It makes all the decisions about the development of the game, including issuing grants to creators, banning users, controlling the LAND and Estate smart contracts, and more. Anyone who holds MANA tokens, NAMES, or LAND NFTs can vote.

Sky (MakerDAO)

Sky, formerly MakerDAO, governs the Sky protocol, the protocol that issues popular stablecoin USDS (formerly DAI). SKY (formerly MKR) holders are members of the DAO and can vote on policy issues for USDS, accepted collateral, and other governance issues.

Why would people choose to join a DAO?

People join DAOs for the same reason they join any other organization, whether that’s commercial or non-profit, because they believe in the vision or goal the project has.

What are the benefits of DAOs?

There are many benefits of DAOs, including:

• Decentralization: There is no central authority in a DAO, meaning everyone has equal skin in the game. Each member is incentivized to do the best thing for the DAO and to put forward votes and proposals that will benefit the development of the project. In traditional structures, one participant with more power is potentially able to make decisions based on their own self-interest.

• Transparency: This is a general benefit of blockchain technology, but it applies equally to DAOs. Everything about the project, including every single transaction made, including treasury transactions, is available for anyone, anywhere to view. It’s all recorded on a public ledger for members, or anyone else, to see. This helps root out those who might be acting in bad faith.

• Borderless: Unlike traditional organizations, which may have limited membership based on location, anyone, anywhere in the world can join a DAO.

• Automated efficiency: Smart contracts execute the actions of a DAO. This means there’s a much lower risk for human error - as long as the code is sound.

• Neutrality: The decentralized nature of DAOs, combined with the automated efficiency of smart contracts, means that DAOs are very neutral. Whereas traditional organizations may see conflicts over discrepancies in rules, DAOs are neutral. All rule proposals are put to all members, and all members get a vote on whether that rule is deployed.

What are the risks of DAOs?

While DAOs have many benefits, there are also disadvantages to consider, including:

• Concentration of voting power: Decentralization in DAOs only works if the voting power is equally distributed. This is usually achieved through token allocation and supply. However, in poorly managed DAOs, the voting power may become unevenly distributed as the majority of the tokens may end up with key stakeholders - for example, founders, developers, or even whales interested in the project. Research by Chainalysis found that for 10 major DAO projects, less than 1% of holders have 90% of the voting power, suggesting that many DAOs have a long way to go before they can truly be considered decentralized.

• Speed of decision-making: Any member in a DAO can put forward a proposal for the development of the project, provided they have enough tokens. Each proposal will then be put to other members, who will vote on it, usually within set time periods to make sure everyone has enough time to vote. While this often ensures a more democratic decision-making process, it also means that decisions may take longer to make, and actions longer to implement.

• Accountability: As there’s no central authority involved in DAOs, when things go wrong, it’s often unclear who to blame.

• Code vulnerability: Automation through smart contracts is an excellent idea, provided the code is sound. Smart contracts have unique technical vulnerabilities that need to be thoroughly assessed by experienced developers before they’re implemented to ensure nothing goes wrong.

How do DAOs make money?

The most common way to raise funds for DAOs is to issue governance tokens. These can then be purchased or distributed to members. For example, early adopters of the Uniswap protocol were rewarded with the first release of UNI tokens.

Alternatively, depending on the type of DAO, they can also work as a kind of venture capital fund or have funds raised through crowdfunding.

How do I join a DAO?

To become a member of a DAO, it’s usually as simple as buying the governance token. For example, if you went and purchased MKR tokens, you’d become part of the MakerDAO, and you can vote on proposals.

It’s worth noting that while most DAO voting mechanisms are as simple as one vote per token, some put in weighted voting mechanisms (for example, quadratic voting mechanisms) to better allow members to show support for issues they believe in. As well as this, some DAOs require members to hold a certain amount of tokens to put forward proposals.

How do I start a DAO?

Wondering how to start a DAO and what steps might be involved? Well, it’ll vary a little depending on the type of DAO you're establishing, but in general, setting up a DAO is as simple as:

1. Pick your goal: A DAO without a clear and unique mission, purpose, or goal will struggle to attract members and investment. Point and case, a dozen projects are promising to be the next Ethereum killer, but they often struggle with mainstream adoption due to a lack of innovation or originality.

2. Define tokenomics: How do members join and vote? Is there a fixed supply of tokens, and how are tokens issued? Tokenomics matters for DAOs. Poor tokenomics often lead to project failures.

3. Build your community: Through Reddit, Discord, Twitter, and other spaces - you need to reach the people who would be interested in becoming a member of your DAO.

4. Define your governance: How are protocols proposed and managed? How many tokens do members need to vote, and how will you avoid power concentration through vote mechanisms? Better still, if you can let your community democratically decide on your governance protocols to build trust.

5. Build your DAO: Time for the devs. Whether you’re doing it yourself, you’ll need a solid team to build the smart contracts to deliver your solution on your chosen blockchain, as well as a period on a testate to highlight any code vulnerabilities.

6. Deploy the DAO to the mainnet: Once everything’s working, it’s time to deploy. Make sure to allow time for member feedback so you can develop accordingly to your members' needs.

How are DAOs taxed?

Tax offices aren’t the best at keeping up with the pace of innovation in the crypto market, so it should come as no surprise that the vast majority of tax offices have not issued guidance on the taxation of DAOs just yet.

This said, given that DAOs are not registered entities in any jurisdiction and have no central control, DAOs cannot pay taxes themselves. The most similar kind of existing entity in tax legislation is a flow-through entity - a kind of entity that passes any income it makes straight to owners, shareholders, or investors. With flow-through entities, any income passed on is subject to Income Tax.

So if your DAO is paying out rewards to members as part of its tokenomics in the form of new tokens, these may be subject to Income Tax.

Meanwhile, if you’re trading or selling tokens, any gains from these tokens may be subject to Capital Gains Tax. However, a select few tax offices have made it clear that some tokens - like governance or utility tokens - are not subject to the same tax rules as other crypto tokens and coins.

Want to learn more about crypto tax where you live? Check out Koinly’s crypto tax guides.