As part of our new Stateless initiative, we’re excited to present a guest deep dive on DAOs by Nick Naraghi, in which he explores the four key motivations for building Decentralized Autonomous Organizations
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Across the board, DAO builders today are impassioned by a vibrant future they have seen and cannot shake. It’s a future that is fairer for everyone and resistant to capture by bad actors. A future where platforms aren’t inevitably destined to maximally extract data, money, and attention from users because of their incentives.
However, building a DAO today is hard. Choosing the right tools, filling in the technical gaps, designing incentives, and engaging a community each come with their own challenges. With a high level of both uncertainty and difficulty, building a DAO is reminiscent of building startups in the days of the early Internet.
It isn’t only the hardships that call back to the beginning of the Internet. Today’s DAO builders emphasize the same values as the earliest pioneers of the web: open, permissionless, collaborative, and mutually beneficial for its contributors.
But since its inception, the Internet has moved towards privatization, transformed by powerful business entities into a kingdom of walled gardens. And these entities have fiduciary responsibilities to compete rather than collaborate in the war for market share.
Chris Dixon articulated this dynamic in his seminal piece, “Why Decentralization Matters”:
Early internet protocols were technical specifications created by working groups or non-profit organizations that relied on the alignment of interests in the internet community to gain adoption. This method worked well during the very early stages of the internet but since the early 1990s, very few new protocols have gained widespread adoption.
Cryptonetworks fix these problems by providing economic incentives to developers, maintainers, and other network participants in the form of tokens. They are also much more technically robust. For example, they are able to keep state and do arbitrary transformations on that state, something past protocols could never do.
We are on the precipice of a new paradigm for online coordination. And in this new paradigm, DAOs are the atomic unit of collaboration — the nodes in the network.
There are four major themes of why people are building and demanding DAOs today:
Each of these stands on its own as a reason to build a DAO, but many DAOs today are inspired by multiple or all of these factors. They are each essential to understanding how the ecosystem of decentralized organizations will evolve over time.
The number one reason to build a DAO is to ensure long-term incentive alignment amongst all stakeholders — founders, investors, contributors, creators, and users.
In comparison to the rewards for founding or investing in a traditional startup, DAOs offer a built-in “exit to community” strategy. This means founders and investors reap the reward for their work much sooner in the project’s lifecycle (more like 2-3 years, instead of 7-10).
The decentralized nature of a DAO necessitates a more even distribution of economic incentives across all stakeholders in the ecosystem. This means there is more opportunity for non-founder contributors (people helping to build the protocol or platform) and creators (people creating content on the protocol or platform) to grow meaningful token holdings.
Some DAOs implement ownership decay models that aim for meaningful allocation amounts even for contributors that join later in a project’s lifecycle. Further, tokens have significantly more liquidity than equity, making token-based compensation more valuable to contributors in the short term.
Additionally, since contributors and creators rely on a protocol or platform, they can leverage and coordinate their voting power to influence the project in their favor via governance. This is particularly important in the later stages of a project when the platform could choose to compete with stakeholders in its ecosystem to gain a larger share of the profits.
In a similar way, giving users a voice in the organization’s decisions allows them to speak for their own best interest. With sufficient representation, this can help to avoid undesirable rent-seeking behaviors from the platform or misaligned third parties, ideally keeping costs as low as possible.
Imagine a DAO that operated a ridesharing service. Over time, riders might vote to minimize fees as much as possible while (hopefully) maintaining the sustainability of the network. This is in stark contrast to the Web2 model: VC-subsidized pricing to get the network established, with prices that increase alongside market dominance and user lock-in.
Due to the nature of the smart contracts that comprise a DAO, the rules, and expected behaviors are transparent and cannot be changed without consent from the community. This creates security, trust, and ultimately fairness for users in entirely new ways.
Savvy project communities are even starting to demand decentralization via DAOs. In the future, it will become clear that in some cases a project’s level of decentralization is an advantage as overlapping projects compete for users and their capital.
Last but not least, decentralizing an organization often brings with it a fundamentally open-source approach to building. This creates alignment with the Web3 ecosystem at large, where teams frequently fork existing projects and build off them. As the ecosystem matures, teams will increasingly be able to solve problems with existing tools, niche down, and achieve their goals more efficiently.
Many Web3 projects are highly motivated to decentralize so they can avoid having their tokens being classified as a security by the SEC. Even if a project is aligned with the other motivations to build a DAO that are listed here, regulatory compliance is often what pushes the organization to commit considerable time and money to a DAO-creation effort. It’s also worth noting that new regulation will likely be developed over time, creating new restrictions for DAOs with varying degrees of impact.
When a project's token is classified as a security, it is subjected to significant trading restrictions and reporting requirements. At a minimum, it restricts who can trade the token through rigorous compliance practices that highlight who the purchasers and sellers are (a process called “Know Your Customer” onboarding). It also places restrictions on the exchanges and geographies in which a token can be sold. Needless to say, many projects avoid this as it reduces liquidity and increases costs in a way that can be crippling in their early days.
To avoid this classification, the guideline from the SEC is that a project needs to be “sufficiently decentralized.” More specifically, this breaks down into distributed operations, absence of reliance on the founding team to create value, and an absence of information asymmetry between members of the network.
The underlying test is affectionately referred to as “The Howey Test”. At its core, it defines a security as requiring an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. Historically, this dates back to a precedent set in 1948 where a hotel owner sold interests in an orange grove to its guests and claimed it was selling real estate, not securities (tangentially, a very fun origin story to dig into).
Web3 protocols and platforms want to become sustainable in a way that does not rely on any individual node in the network. This kind of centralization would be an attack vector on the network for bad actors, as well as regulators. The best networks will take this a step further, and seek to build an ecosystem that strengthens itself in response to each attack that inevitably occurs.
For these projects, long-term project success means being unstoppable. Kain Warwick, founder of Synthetix, said it best in his 2019 announcement of decentralized governance for the Synthetix protocol (emphasis mine):
Once the project has reached the point where it improves with each new attack we will no longer fear attempts at censorship but welcome them, as each attempt will ensure the protocol is more resistant to capture. Ultimately this is the dimension on which every decentralised protocol must be measured: is it unstoppable?
In contrast, Web2 companies (such as FAANG) have faced significant pushback and attempts at regulation from governments around the world in response to their massive acquisition and centralization of power. Through decentralization into DAOs, Web3 projects seek to make this type of censorship and regulation impossible.
In both theory and practice, it is evident that centralization of power creates instability and fragility in a network. From the network science perspective, “the transmission of shocks—and therefore the vulnerability of the system—is related to structure, with highly centralized networks being the most fragile,” (Picardi and Tajoli).
A DAO’s structure needs to be both decentralized and stable, and it also needs to maintain these requirements through transitions of power. It must outlast the founding team, and be able to self-govern longer than a single governor’s term .
From the other direction, in order for a project to be successful, it cannot fail because of one important member being crushed under the immense burden of stress. Founders need to be able to unburden themselves of responsibilities they don't want or feel equipped to deliver on as well as others in the community.
Kevin Owocki, founder of Gitcoin, synthesized this brilliantly on the Bankless podcast: “I’m excited about the decentralization of stress [...] I don’t want to be the single point of failure, antifragility is an important part of this mission. [...] Over time I would like to have the same privileges as everyone else in the network.”
DAOs today are still in an experimental phase. Playbooks and best practices on how to better coordinate people, automate work, and make decentralized decisions are being drafted live. However, the long-term opportunity for DAOs is to be wildly more efficient than Traditional Organizations (TradOrgs) at applying their resources toward their goals.
As introduced in our first article on “Operational Efficiency Parity”, I believe that DAOs will quickly reach Efficiency Parity with TradOrgs, and be able to outcompete them shortly after.
This is made possible by the combined exponential learning rate across the DAO ecosystem. The primary factors for the learning rate are 1) large amounts of funding that has enough risk tolerance for experimentation, 2) the ability to fork successful experiments to propagate them throughout the ecosystem, and 3) multi-layered network effects both within and between DAOs. Once DAOs are ahead, there will be no way for TradOrgs to catch up.
Human organizations are complex systems. Past a certain scale, any complex system cannot be controlled well by an individual — it goes beyond one person’s sensemaking capacity. Thus, putting one person at the helm of an organization is destined for limitations.
Think about the changes in an organization as it grows past 8, 25, and 150 people. There are new breakdowns at each stage: siloed knowledge, attrition problems, issues with trust.
One of the potential upsides with DAOs is that a network can command more resources than an individual at the helm of a hierarchical model. It can scale more efficiently, and handle larger scales more effectively.
In 1986, Meir Dan-Cohen published the idea of an ownerless and artificially intelligent organization that would repurchase all of its outstanding shares and govern itself. Today, this vision is slowly beginning to come to life via DAOs.
Today, many of the processes in DAOs are manual. Human input is required for things like making proposals, voting, and enacting proposal results. Like coordinating any group of humans, this is often slow, and in many cases, still relies on trusted parties instead of robust cryptographic mechanisms.
The first opportunity for automation in DAOs is to create the mechanisms and algorithms that manage decision-making and decision implementation. As DAOs evolve, more and more will be automated: sales and marketing, recruitment, coordination of teams, value creation, even editing the DAO’s code. In this way, Dan-Cohen’s vision will become more and more apparent.
Overall, this is great for DAO members. This type of automation will bring internal costs down, which in turn will decrease platform costs for users. At the same time, increased profits will be reinvested or distributed to stakeholders — completing the virtuous cycle of aligned incentives.
With a rapidly increasing number of DAOs, DAO participants, and assets in DAO treasuries, it’s no wonder why there is so much excitement around DAOs right now. The builders are impassioned, and they are building for the long-haul.
Breaking down the themes of why people are motivated to build DAOs right now, we see four major ideas: incentive alignment, regulatory compliance, antifragility, and operational efficiency. While some of these benefits are immediate, all of them will be realized in the long-term.
Ultimately, I believe that DAOs offer an opportunity to level up humanity’s capacity to coordinate and self-organize. Just like the Internet, the implications of this will be massive. But this time, we will have unstoppable protocols with strongly aligned incentives and increasing amounts of automation. It’s a recipe for success; we will see how it plays out this time around.
Thank you to Marcus Phillips, Tyler Whirty, Skylar Bantley, Michael Gasiorek, and Charlie Johnson for reviewing early drafts of this work.
Why Decentralization Matters - Chris Dixon (2018) https://cdixon.org/2018/02/18/why-decentralization-matters
Startups Need a New Option: Exit to Community - Nathan Schneider (2019) https://hackernoon.com/startups-need-a-new-option-exit-to-community-ig12v2z73
Blockchain Can Wrest the Internet From Corporations' Grasp - Chris Dixon (2019) https://www.wired.com/story/how-blockchain-can-wrest-the-internet-from-corporations/
Why Progressive Decentralization is blockchain's best hope - Arthur Camara (2019) https://www.freecodecamp.org/news/why-progressive-decentralization-is-blockchains-best-hope-31a497f2673b/
The DeFi Holy Grail: Synthetix Dissolves Foundation, Hands Platform Control to DAOs - Camila Russo (2020) https://newsletter.thedefiant.io/p/the-defi-holy-grail-synthetix-dissolves
Introducing GTC -- Gitcoin's Governance Token - Kevin Owocki (2021) https://gitcoin.co/blog/introducing-gtc-gitcoins-governance-token/
It's Time to Decentralize Gitcoin - Kevin Owocki (2021) https://gitcoin.co/blog/its-time-to-decentralize-gitcoin/
Digital Asset Transactions: When Howey Met Gary (Plastic) - William Hinman (SEC) https://www.sec.gov/news/speech/speech-hinman-061418
Securities and Exchange Commission v. W. J. Howey Co. - United States Supreme Court (1946) https://caselaw.findlaw.com/us-supreme-court/328/293.html
D(?)A(?)O - Decentralization and Autonomy in "DAOs" - James Duncan (2021) https://boardroom.mirror.xyz/N0kJ-y_5wvPR0H1MMNFb531MOKEE4LKWxepzQLj18sw
Transition to Decentralised Governance - Kain Warwick (2019) https://blog.synthetix.io/transition-to-decentralised-governance/
Complexity, centralization, and fragility in economic networks. PLoS ONE 13(11): e0208265. - Piccardi C, Tajoli L (2018) https://doi.org/10.1371/journal.pone.0208265
Gitcoin DAO & $GTC token, with Kevin Owocki - Bankless SotN #47 (2021) http://podcast.banklesshq.com/sotn-47-gitcoin-dao-gtc-token-with-kevin-owocki
DAOs and the Pitfalls of Progressive Decentralization - 0xMiel (2021) https://gardens.substack.com/p/daos-and-the-pitfalls-of-progressive
Complexity rising: From human beings to human civilization, a complexity profile, in Encyclopedia of Life Support Systems (EOLSS), developed under the Auspices of the UNESCO (EOLSS Publishers, Oxford, UK, 2002) - Yaneer Bar-Yam https://necsi.edu/complexity-rising-from-human-beings-to-human-civilization-a-complexity-profile
When will DAOs overtake Traditional Orgs? - Nick Naraghi (2021) https://governors.substack.com/p/governors-1-when-will-daos-overtake
Blockchain and the Law: The Rule of Code. Harvard University Press. De Filippi, Primavera, and Aaron Wright. (2018) www.jstor.org/stable/j.ctv2867sp.
Rights, Persons and Organizations. Berkeley: University of California Press. Meir Dan-Cohen (1986) https://www.cambridge.org/core/journals/canadian-journal-of-philosophy/article/abs/meir-dancohen-rights-persons-and-organizations-berkeley-and-los-angeles-university-of-california-press-1986-pp-xi-271-us-3250-isbn-0520047117/5634A34B3E63A7C383039136B24B4E8B