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DAOs Can Revolutionize Corporate Governance

blockchain

March 1, 2022

Entrepreneurs are experimenting with a new form of organization called a DAO — a blockchain-based structure that draws upon the transparency of blockchain technology and the community participation of open source software development. Recent years have brought increasing focus on corporate responsibility and democratization of capital markets; and, on face, DAOs dovetail nicely with these goals.

A decentralized autonomous organization (DAO) is an organization that is collectively owned by its members and governed by “smart contracts,” which are simple rules implemented in a blockchain. Smart contracts are logic elements (computer programs) that take actions automatically when certain conditions are met. Think about a vending machine — you put in money, you get a snack. It’s not a legal contract in the conventional sense, but once you take the required action (put in money, choose your item), the transaction proceeds without human intervention.

While traditional corporations are run via bylaws, voting agreements and board meetings, DAOs operate largely without human decision making. While corporate boards are usually small elites, DAOs can be governed by many participants — possibly hundreds or even thousands. The policies and finances of a DAO can be verified via publicly visible transactional activity on a blockchain. DAOs replace the legal power of corporate bylaws with a “zero-trust” system that ensures transparency and makes it hard to break the rules.

In other words, DAOs are bottom-up decision making, and corporations are top-down.

There are other differences. Ownership of a DAO can change fluidly. Tokens representing voting rights in a DAO can be traded without centralized permission on an exchange, similar to the way corporate stock can change hands. But corporations usually limit the rights of investors to trade interests via restricted stock purchase agreements. Free trading of corporate shares only comes about after a public offering — a step most corporations never reach. On the other hand, DAOs voting rights can be earned by work, much like employee stock options.

Corporations are time-honored structures that offer many advantages: limited liability, liquidity for investors and a stable structure to operate a business. A corporation benefits from a corporate veil, a legal construct by which the owners cannot be held liable for the actions of the entity. For instance, if a corporation goes into debt or gets into legal trouble, the owners’ personal assets are insulated from loss. This is a significant incentive to invest.

If you start a business and don’t create any formal entity, the baseline relationship between the principals is a legal partnership. But in a partnership, each of the partners is liable for the actions of the business, including the actions of the other partners. So partnerships are a risky way to do business, and forming a corporation is a common way to formalize control of the entity and allow investors to participate without great risk. DAOs, without any formal entity, are essentially partnerships.

Corporations also offer stability. Many DAOs implement in their smart contracts a function called “ragequit,” where any investor can withdraw and receive its pro rata share of DAO assets on demand. In most corporations, exiting is not so easy, because businesses want to avoid sudden withdrawal of capital that can hamstring operations.

Running a DAO also incurs other risks. Tokens sold by DAOs are subject to SEC regulation, just like shares of a corporation. Most private corporations raise capital via a private placement legal exemption. But that requires qualifying accredited investors, which is a far cry from the anonymity and egalitarianism of a DAO. Investors participating in unregistered offerings of a DAO can be liable for token sales that violate the securities laws.

HYBRID ORGANIZATIONS

To cherry-pick the old and the new, entrepreneurs and investors have begun creating alternatives to pure DAOs. Wyoming, long a crypto-friendly state, in 2021 became the first U.S. state to recognize DAOs as a special kind of LLC. Unfortunately, the first DAO LLC registered under this law has already run into trouble. The SEC recently began administrative proceedings against the DAO company due to allegedly misleading statements in its registration filings.

Another alternative is a DAO corporation, which states in its formation documents that certain decisions will be delegated to a DAO, and that the corporation will abide by those decisions. In a sense, this is nothing radically new. Corporations often have voting agreements on behalf of minority owners. But DAO corporations are a very new structure, and still uncommon.

By Heather Meeker

Heather Meeker is a General Partner at OSS Capital, which invests in companies engaged in commercial open source development. Her practice focuses on intellectual property and technology, with a particular focus on open source software, including open source-related business models. She is a former M&A Partner in the Silicon Valley office of O’Melveny & Myers LLP.

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