DAOs for Dummies: How Does a DAO Work?

DAOs for Dummies: How Does a DAO Work?

If you’re tired of working for a pushy and overbearing boss at a company that doesn’t value you, then why not join a DAO where you can have an equal say in running things?

DAOs for Dummies: How Does a DAO Work?
Darry Port

Published Mar 17, 2022Updated Aug 10, 2022

Crypto

Crypto

Technology

Technology

Global Markets

Global Markets

At one point or another, everyone has had a job they hated. You know the telltale signs. 

Struggling to get out of bed in the morning to sit through that dreaded commute. Putting off important tasks to re-arrange your file folders and scroll through Crypto Twitter. Counting down the micro-seconds until you can high tail it out of there and binge-watch Netflix until you fall asleep. Been there, pal.

Now imagine a place where you could meet up with all your favorite crypto influencers, work as much or as little as you wanted and have an equal say in how things are run with no boss to answer to—all while getting paid handsomely for being part of the club.

If that sounds like your dream come true, then you’re probably going to want to join a decentralized autonomous organization (DAO). Funding for DAOs exploded in September of last year, going from $1.5 billion to $8.5 billion in assets under management (AUM). As of writing this, there are over 4,800 DAOs in existence with a combined total of $9.5 billion in AUM. But what is a DAO, exactly, and how do DAOs work?

The simplest definition of a DAO is that it’s an internet community with a shared bank account. But this definition leaves out a lot of important details, starting with WTF “DAO” really means.

What is a DAO?

“DAO” is short for Decentralized Autonomous Organization. This is an internet-native organization that is collectively owned and managed by its members using blockchain technology. 

Just like blockchains play the same role as traditional banks by verifying and processing financial transactions, DAOs play the same role as traditional organizations by allocating funds toward a specific goal. 

The simplest definition of a DAO is that it’s an internet community with a shared bank account.

The use of blockchain technology allows DAOs to do things that were hitherto impossible with traditional companies and nonprofits. For one, decisions are made via voting proposals that are recorded and verified on the blockchain. Since DAOs are run by smart contracts instead of centralized leaders, every member has voting power. What's more, DAOs have built-in treasuries that can only be accessed with the approval of the group.

Examples of DAOs

While most DAOs are devoted to investment activities, like collecting NFTs or funding early-stage startups, just about any traditional organizational structure can be transformed into a DAO. Here are a few examples:

  • Freelancer networks that pool funds to pay for office spaces and software subscriptions. 
  • Charitable organizations where members decide how to spend donations.
  • Private clubs that host social events.

Additionally, DAOs can be are categorized by their membership types:

  • Token-based: DAO tokens can be bought on the open market and simply holding them grants voting rights. E.g. MakerDAO
  • Share-based: Users can't just buy access to the DAO. To join, they have to submit a proposal demonstrating their value in the form of capital or expertise. E.g. MetaClan DAO.

Why do we need DAOs?

Allow me to rephrase that question: Why have a minor equity stake in a company when you can hold tokens that grant equal voting rights? Many crypto enthusiasts and VCs believe that DAOs are the future of business. Billionaire Mark Cuban echoed this sentiment by tweeting that DAOs are “the ultimate combination of capitalism and progressivism." As such, DAOs have several advantages over traditional organizations.

DAOs are trustless

How do you trust a group of people you only know through the internet with your money? DAOs solve this counterparty risk by not requiring you to trust anyone in the group. 

For one, there’s no central leader. Two, since token holders have a financial stake in the DAO they are incentivized to be good actors. And finally, DAOs run on code that anyone can see and audit.

DAOs are flat organizations

Once a DAO has launched, every action it takes has to be approved by its community. The lack of hierarchy also means that all members, not just the largest holders, can submit proposals that get voted on. 

DAOs are (relatively) accessible

DAOs open up opportunities for everybody, not just wealthy individuals, to share in the upside of early-stage investments. 

The downsides of DAOs

Despite the trustlessness, flat organization and accessibility of DAOs, this new organizational structure has its share of legitimate criticisms. 

DAOs are not qualified

The people over at MIT Technology Review think that it’s a bad idea to trust a group of “unqualified” members to deploy millions or billions of dollars in assets.

DAOs might not be secure

Flaws in smart contracts can result in the loss of investor funds. For instance: one of the first DAOs in the world, simply called The DAO, was hacked for $50 million in ETH back in 2016. 

DAOs can be undemocratic

Not all DAOs are created equal. In fact, many of them skew voting power toward the largest token holders. Take for example, a DAO called Friends with Benefits (FWB), that grants one vote per token instead of one vote per person. At $52 per $FWB today, whales like VCs can easily buy up most of the influence inside this particular DAO. 

DAOs are a legal gray area

There’s no global regulatory framework for DAOs, which means that Individual investors could be liable for regional laws broken by the DAO.

Fortunately, DAOs are slowly becoming recognized as legal entities. ConstitutionDAO, for instance, registered itself as an LLC in Wyoming and raised over $40 million from 17,000 donors to buy the last privately-owned copy of the US Constitution. Alas, they didn’t win the auction — but still made history in the process.

How does a DAO work?

DAOs typically start off as an inspiring goal that a community can rally around, and proceeds through the following steps.

Development

A group of developers write the smart contracts underpinning the DAO, with Ethereum being the most popular blockchain for smart contract development right now. 

 

Smart contracts are simply lines of code on a blockchain that automatically execute when certain conditions are met (e.g. if X happens, then do Y). These smart contracts define the DAO’s rules, which can only be changed by community members post-launch. 

Funding

Capital is what aligns the incentives of every DAO member. If a DAO didn’t require any skin in the game, then it would quickly devolve into a spam-filled cesspool. 

To that end, the DAO’s creators will raise capital by selling tokens. So as a user, the first step to joining a DAO is applying for the token sale or buying tokens (if available) on a crypto exchange like Crypto.com or FTX.

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Governance

Post-launch, community members are in control of the DAO. A member’s voting power will typically be proportional to the amount of tokens they hold, and DAO’s creators should no longer have a disproportionate influence.

DAOs meet on chat apps like Discord and Telegram, with the former being the most popular choice. A DAO’s Discord server will consist of several channels dedicated to specific topics, like announcements, price speculation and governance proposals.

As far as voting goes, every member can submit proposals on how to deploy funds or govern the DAO. But a proposal will only pass once a majority of members approve it.

Rewards

There are three main ways that a DAO makes money for its community members. 

  • Price appreciation: MakerDAO, the issuer of DAI, one of the best stablecoins, has a DAO token called MKR that went from $24 to over $5,600 at its peak.
  • Dividends: DAOs that function as investment funds will distribute their profits among community members. 
  • Participation: Some DAOs incentivize members to keep participating in governance by rewarding the voters.