DAO 101 - Introduction to Decentralized Autonomous Organizations

It is possible that DAOs will become the future model of any digitally community-governed project and decentralized network. Let's start with the basics.
Michael Schranz
Michael Schranz

This is part one of a DAO blog series. We start with the basics and will go deeper into details in future blog posts. 

A Decentralized Autonomous Organization (DAO) is a company or organization that is run through decentralized decision-making. This means that there is no central authority figure making decisions for the whole organization. Instead, decisions are made digitally by the collective group of people within the organization, who possess the right to vote. 

It is possible that decentralized autonomous organizations will become the future model of any digitally community-governed project and decentralized network. Many users are very happy with the autonomy and self-management model enabled by the DAOs. Through a decentralized mechanism, DAOs allow members to have a say without the possibility of, for example, simply disempowering them. However, the DAO governance is still far apart in theory and in implementation unfortunately.

The main goal of a DAO is to provide a way for people to cooperatively work together without the need for a centralized, hierarchical organization. This could potentially lead to more efficient and democratically run organizations.

The concept of a DAO was first proposed by Vitalik Buterin on May 2014 in his Terminology Guide about DAOs, DACs, DAs. However, the first actual DAO on the Ethereum blockchain was created in 2016. Buterin suggested that smart contracts could be used to create a decentralized autonomous organization. 

The rise and fall of “THE DAO”

In early May 2016, some members of the Ethereum community founded The DAO, which was initially also known as Genesis DAO. The DAO was developed with an open source smart contract on the Ethereum blockchain by the Slock.It team. During the creation period, everyone could send Ether to a unique wallet address in exchange for DAO tokens. During this successful creation period, 12.7 million Ether were raised very fast. 

The idea of the platform was that any member who had a project or idea could present it to the community and potentially be funded by The DAO. All The DAO token holders could vote on the project ideas and were rewarded in case the projects provided a positive return on investment. 

However, June 17, 2016 could be considered a black day for The DAO, because on that date a hacker found a bug in the smart contract that allowed him to withdraw funds. 3.6 million ETH were stolen in just the first few hours. This corresponded to a value of around $70 million at the time. 

The hack was possible by asking the smart contract to return the Ether multiple times before the smart contract could update its balance. The smart contract had two main problems: First, the DAO smart contract allowed the recursive call and second, the ETH funds were first submitted before the token balance was updated. 

Of course, this bug has nothing to do with the Ethereum Blockchain itself, but only the buggy smart contract which was built on top of Ethereum. The code written for The DAO had several vulnerabilities, and the recursive call was one of them.

The Ethereum community and the Ethereum team quickly submitted several proposals to fix the vulnerability.

However, the hacker was unable to complete his escape as the funds were transferred to a blocked account (blocked for 28 days). In order to recover the lost money and save Ethereum from a collapse, Ethereum was hard forked to subsequently send the stolen funds to an account available to the original owners. 

What are the Key Characteristics of a DAO?

A DAO is a decentralized autonomous organization that cooperates according to transparent rules. When it comes to DAOs, there are a few key characteristics that you should be aware of: autonomy, transparency, and immutability.

DAOs are powered by smart contracts, which are immutable computer programs that execute in a completely predictive manner when certain conditions are met. This means that once a DAO is created, its rules cannot be changed easily. This makes DAOs censorship-resistant.

DAOs are also transparent, all transactions and decisions made by a DAO are recorded on the blockchain, which is publicly accessible. This transparency allows anyone to audit a DAO and ensure that it is following its stated rules.

DAOs are autonomous, they enable a community to work towards a common goal, without the need for a central coordinating entity.

How does a DAO work?

A DAO works through a system of smart contracts on the blockchain that “govern” an organization. The code of the smart contract defines all the rules and regulations for the organization, and community-members can interact with the contract to make decisions or contribute resources.

While Ethereum was the first blockchain to use smart contracts, it is deployed on various other blockchains that allow for smart contracts.

Any member can contribute to the DAO by proposal and voting. The rules of a DAO are set by its creators and/or community members and can be changed by on-chain consensus. A completely trustless DAO is owned and operated by its members, who interact with each other through smart contracts.

A DAO’s purpose is to provide a shared service or product that benefits all of its members. For example, a DAO might be created to manage a decentralized marketplace or social network. The members of a DAO would then share the revenue generated by the marketplace or social network.

The idea behind DAOs is that they could be used to run organizations in a more efficient and decentralized way. For example, because there is no central point of control and therefore no central point of failure, decision-making could be more democratic and transparent.

The DAO Tension Triangle

Governance - Decentralization

There are some elements of the governance mechanism that are centralized by nature and pose a challenge to decentralization. We have listed some of them below. Modifying these centralized governance pieces over time will lead to greater measures of decentralization.

  • Taxation

  • Legal compliance with the land or lands if the DAO is registered in multiple nations.

  • Arbitration & conflict resolution

  • Off-chain compliance and transparency

  • Membership process

  • Profit Vs. Non-Profit

  • Dividend distribution

  • Fund repatriation (profit or loss) of funds impact on tax – DAO or individual?

  • DAO dissolution

  • DAO break-up value greater than DAO value (if ETH value goes up)

  • Contracting or hiring staff to do work – who and how is this done, recorded, records stored

  • Legally compliant – record keeping, lodging and storing

Decentralization - Individual

When a DAO gets bigger, the participation rate of the members in the voting process decreases. Usually, in larger DAOs, individuals get marginalized eventually, and they end up choosing not to participate or act passively in the voting process.

We can study this situation in the event of Steem It or Tron hard fork.

This can be seen via Dunbar's Rule and the Ringelmann Effect, which states that members of a group become lazier, disenfranchised, and more detached as the size of their group increases. This stems from the assumption that “someone else is probably taking care of that.”

Individual - Governance

The degree to which a DAO is truly open, is measured by the level of its decentralization. A fully decentralized DAO means any individual can participate at any moment and get involved in the voting process. But in practice, it does not work like that. If everyone was required to vote, it would be a tremendous scalability problem as DAOs are usually huge in size. If the DAO requires little interaction for decision-making, it wouldn’t be efficient because the decisions may not match the goals of the DAO.

And also, users will rage-quit if they feel they are not being represented and their opinions are not heard. In order to avoid these scenarios, the DAOs usually have many centralized functionalities on the method of participation, the contribution required for participation, and also the eligibility for joining.


Design Patterns (Components) and Technology of DAOs

DAOs are still a new concept, there is no one standard for what they should look like. However, there are some common design patterns and techstacks that most DAOs share.

DAOs are made up of three key design patterns: smart contracts, tokens, and voting. Smart contracts are the code that runs the DAO and ensures that it operates as intended. Tokens are used to represent ownership in the DAO and give holders a say in how it is run. Voting is used to make decisions about the direction of the DAO and to elect its leaders.

DAOs offer a new way of doing business that is more transparent, censorship-resistant, immutable and more secure than traditional organizations. They have the ability to revolutionize many industries and change the way we link with technology in future.

The potential of DAOs

Decentralized Autonomous Organizations have the potential to revolutionize the way we interact with technology and with each other. By eliminating the need for central authorities, DAOs can create a more democratic and transparent way of organizing ourselves.

DAOs are still in their infancy, but they have already shown promise in several areas. For example, they have been used to fund projects and businesses without the need for traditional investors or loans. They have also been used to decentralize decision-making power within organizations.

They could be used to create global cooperatives, like the Optimism Collective, that are not bound by geographic boundaries. There is also potential for DAOs to help us manage shared resources like energy or water in a more sustainable way.

The (potential) benefits of DAOs

The DAO approach for organization design and governance offers a "new" way of doing things compared to many traditional approaches. The idea is to give power back to the people who work for an organization and allow them to make decisions for themselves.

DAOs can offer some benefits over traditional organizations. First, because they are truly decentralized, they are not yet subject to the same regulations (this can also be a problem) and red tape as traditional organizations. This can make DAOs more agile and able to respond quickly to changes in the market or environment. However, it is pretty sure that within the next decade, many countries will also introduce legal frameworks for this form of organization. 

Second, DAOs are per se transparent. All decisions made by the DAO are recorded on the blockchain, which is publicly accessible. Finally, it is secure, as long as the smart contracts are designed and developed securely. Its code cannot be changed without the approval of all of its members.

The potential risks of a DAO

We think it is very important to make sure your are aware not only of the potential benefits, but also of the various risks associated with the creation and governance of any DAO. Below we elaborate on some of the most obvious ones.

1. Smart Contract Security Issues

Smart contract security issues are crucial when it comes to DAOs since these new (on-chain) organizations are built on top of the blockchain technology and rely (almost completely) on smart contracts to function. Generically, smart contracts are self-executing pieces of code that are stored on the blockchain and can be used to facilitate, verify, and enforce the negotiation or performance of a contract. However, because smart contracts are self-executing, they can be vulnerable to a variety of security issues, including errors in the code itself, hacking, and other malicious attacks. Some common security issues with smart contracts include:

  • Bugs and vulnerabilities in the code: Like any piece of software, smart contracts can contain bugs and vulnerabilities that can be exploited by attackers. These bugs and vulnerabilities can lead to the loss of funds, the unauthorized execution of transactions, or other problems.

  • Lack of testing and verification: Because smart contracts are often developed quickly and deployed directly to the blockchain, they may not undergo the same level of testing and verification as traditional software. This can increase the likelihood of bugs and vulnerabilities.

  • Lack of security best practices: Many smart contract developers may not have experience with developing secure code, and may not be familiar with best practices for securing smart contracts. This can make smart contracts more vulnerable to attack.

  • Lack of regulation: Unlike traditional financial systems, the world of blockchain and smart contracts is largely unregulated. This lack of oversight can make it difficult to hold individuals or organizations accountable for security issues.

Overall, it's important for DAOs to be aware of these security issues and take steps to address them in order to ensure the safety and security of their smart contracts and the funds and assets they manage. This may include implementing security best practices, conducting thorough testing and verification of smart contracts, and working with experienced security professionals to identify and address potential vulnerabilities.

2. Lack of engagement from the DAO community

Active commitment and involvement of the DAO members is absolutely central to the success of this organizational model. The idea of ​​a DAO assumes that members of an organization are driven by tokenomics and some altruistic incentives to get involved in decision-making and help shape all areas. Without an active community and engagement, there is no way for a DAO moderator to get the feedback needed to drive initiatives forward or make decisions collectively in a timely manner.

Depending on how the voting model was defined initially, a certain number (%) of DAO members must cast their votes for a valid decision. However, if the community does not take a long time to vote and thus make a decision, this can also have devastating consequences.

The most obvious risk here would be if an important adjustment proposal, e.g. for improving security (e.g. the governance protocol) does not receive enough voting participation for too long and an adjustment that is important from the security point of view cannot be implemented promptly.

We will write more about the different voting models and their advantages and disadvantages in a future blog post.

As a conclusion to this risk, community engagement is a requirement as well as the main benefit of decentralization and is fundamentally lost if the community is not willing to provide this engagement and involvement.

3. Regulatory Risks

DAOs are still a fairly new concept, and as such, the legal framework for regulating and taxing DAOs is still evolving. Wyoming (USA) has created a framework for DAOs which may be used as an example and foundation for other states and countries to do so as well. Depending on the country or even the region of a country in which a DAO is to be founded, there can be very big differences. In addition, new regulations and provisions for DAOs can also be expected if this form of organization becomes more and more established. You have to be aware of this risk and accordingly the activities and initiatives of the legislation should be continuously monitored and their influence on your own DAO evaluated accordingly.

4. Key Man Risk

The key man risk is the risk that key people or even an entire founding team of a DAO decides to abandon the project due to resentment, disappointment, anger or revenge. This "rug pull" is a nightmare scenario for a DAO, because in many cases the DAO moderation and parts of the governance structure are then completely eliminated. The DAO is left in the lurch and then has to reorganize itself with the remaining members, which in many cases is very difficult or almost impossible. How is the DAO supposed to control and "govern" itself then? How will important new changes to the current protocol standards be proposed and implemented? This risk must already be taken into account during the initial setup of the governance, tokenomics and the voting model.

5. Unilateral decision making through a dominance of governance tokens

The point of a Decentralized Autonomous Organization is to use the wisdom of the crowd. If a DAO issues ERC-20 governance tokens, but a few wallet addresses hold 51% of the voting rights in the protocol's governance, there is a risk that these individuals will collude in a so-called 51% attack. In order to avert this risk or at least greatly reduce it, so-called quadratic voting was developed, in which the wallet address with the lowest number of tokens (shares) receives a disproportionate voting right per token. More about the different voting systems and their advantages and disadvantages will be described in a future blog post.

6. Too little thought through governance and too early decentralization

The risks already described clearly show that it is very important to design the governance strategy and the optimal voting system for a project very well, to test it and to consider all possible risks before decentralization takes place. Without a functioning system in place, it is not a good advice to kickstart your DAO. 

Conclusion of Part 1 on DAOs

A Decentralized Autonomous Organization is a new type of organization model that has the potential to revolutionize the way organizations and businesses are run. They are borderless, decentralized, and can operate without a central authority. However, it is still a young concept and there are a whole bunch of risks associated with it. The difference between a DAO and a very flat and democratically organized company will be the use of technology and tools like dApps and smart contracts that help to execute votings and decision making in general. In the next posts of this DAO Blog series we will talk about different types of DAOs, explain the different voting models for DAOs and give examples of existing good and rather bad use cases of DAOs. 

Please feel free to send us your suggestions, feedback and experiences about this subject. If you consider creating a DAO, we are happy to get in touch with you and help your ideas and dreams come true.