How Coinbase Views DAOs: Types, Defects, Future Prospects

Original Authors: Justin Mart, Connor Dempsey (Coinbase Ventures)

Original Title: "DAO: The Social Network That Can Reconnect the World"

Translation Editor: Baize Research Institute

The internet has done wonders for communication, and DAOs can do the same for capital.

The emergence of the internet and social networks has made it easier for like-minded individuals to communicate than ever before, regardless of geographical location. Against the backdrop of the rise of digital currencies and finance, a new type of social network has emerged today, allowing like-minded people not only to communicate but also to coordinate around capital. Like social networks, these new networks are not limited by geographical boundaries and can attract large-scale participation.

Some thinkers believe that DAOs (Decentralized Autonomous Organizations) can reshape the way humans organize themselves and ultimately surpass the scale and scope of the world's largest companies and even nation-states.

In this article, we will explore the current landscape of DAOs and the issues they face in the future.

What is a DAO?

DAO stands for Decentralized Autonomous Organization, representing the Web3 structure of enterprises or organizations. DAOs allow people to pool resources towards a common goal and share the value created when that goal is achieved.

Just as LLCs (Limited Liability Companies) have been the preferred organizational structure since the Industrial Revolution, Web3's DAOs can serve a similar purpose. Businesses are rooted in traditional financial systems and organized through legal contracts, while DAOs operate on public blockchain networks like Ethereum, organized by tokens with rules encoded in smart contracts.

DAOs are not limited by geographical location, enabling them to be established quickly and attract talent from around the world. This was exemplified by the recent Constitution DAO, which raised over $40 million from 17,000 contributors in less than a week, although it ultimately failed to purchase one of the original copies of the U.S. Constitution.

But DAOs can do more than just mobilize people around the world to bid on historical documents; they can change the way we organize any economic activity.

What Can DAOs Do?

According to DeepDao, there are currently over 180 DAOs managing more than $10 billion in assets, attracting nearly 2 million members. The scope of DAOs ranges from large DAOs that help manage crypto protocols to smaller DAOs organized around investments, communities, media, and charitable causes.

Protocol DAOs

The rise of Ethereum smart contracts in 2018 led to an explosive growth of new crypto assets and protocols. At that time, developers created protocols that allowed people to trade and lend assets (such as Uniswap, Compound, and Aave). However, these protocols aimed to be decentralized, and how to manage the growth and evolution of the protocols became a challenge at that time.

The emergence of Protocol DAOs was not about handing every decision over to the development team but rather providing a way for users to have collective governance rights over the future direction. Typically, protocols distribute governance tokens based on user activity and contributions, granting users corresponding voting rights. More tokens = more voting power.

For example, Uniswap token holders are currently voting on which Layer 2 the protocol should deploy on. Additionally, token holders can propose and vote on anything from marketing plans to how to manage Uniswap's $2 billion in funds.

As of December 20, the largest protocol DAOs by asset management scale are Uniswap, Lido, Radicle, Compound, Olympus, and Aave.

Investment/Collective DAOs

The second major category is investment or collective DAOs. These DAOs allow members to pool funds to invest in specific assets. Their scope ranges from venture capital in DeFi protocols or NFTs to increasingly ambitious goals, such as purchasing rare historical documents or even professional sports franchises.

Similar to other forms of crowdfunding in the crypto industry, DAOs provide a quick and simple way to pool capital compared to the complex legalities associated with traditional venture capital funds. These DAOs are also more transparent than traditional venture capital funds, as members can audit all transactions on-chain.

PleasrDAO, MetaCartel Ventures, Flamingo, and Komerabi are excellent examples of DAOs that pool resources, make investment decisions collectively, and share profits as these investments appreciate. Similarly, Syndicate is a tool that allows anyone to easily launch their own investment DAO.

Social DAOs

Social DAOs aim to bring like-minded individuals together in online communities, coordinating around tokens. One example is Friends With Benefits and its token FWB. To join this DAO, users must apply and send 75 FWB tokens (understood as a membership fee). Once approved, users become members of the organization and gain access to a community filled with renowned developers, artists, creators, and exclusive events.

By organizing around tokens, members are incentivized to create a valuable community where they can share insights, host gatherings, and throw grand parties. For instance, as more people join the FWB community, the token appreciates in value, with FWB's price ranging from $10 to $75, meaning the required membership fee varies from about $750 to $6,000.

Other social DAOs use NFTs as a mechanism to unlock community access. For example, owning a Bored Ape NFT can unlock access to the Bored Ape Yacht Club's Discord, events, airdrops, and derivatives. In this case, the perceived value of the community drives the value of the NFTs.

Currently, social DAOs are still in their infancy and will need time to validate which models work and which do not. However, the rapid rise of these communities indicates that they represent a powerful new form of social organization.

Service DAOs

Service DAOs resemble online talent agencies that bring together people from around the world to build products and services. Clients can offer bounties for specific tasks, and once the tasks are completed, a portion of the fees must be paid to the DAO's treasury before rewarding individual contributors. Contributors typically also receive governance tokens from the DAO.

Most early service DAOs, such as DxDAO and Raid Guild, focus on gathering talent to build complete ecosystems. Their clients include crypto projects or protocols that need software development, graphic design, and marketing.

Service DAOs can reshape the way people work, allowing global talent to work on their own schedules and gain governance rights within the DAO. While early service DAOs focus on the crypto industry, we can envision a scenario where future Uber is replaced by UberDAO, which pairs drivers with passengers while granting drivers governance rights within the DAO (though it will take a long time for DAOs to be integrated into traditional industries).

Media DAOs

Media DAOs aim to reshape the way content creators, consumers, and media interact. These DAOs no longer rely on ad-based revenue models but instead use token incentives to reward creators and consumers.

The idea of decentralized media can be traced back to the "Let's Talk Bitcoin" podcast in 2013, but we can take the popular 2021 project BanklessDAO as an example. Bankless is a media outlet focused on Ethereum that frequently produces podcasts and newsletters. Recently, the Bankless team airdropped BANK tokens to readers. Additionally, readers can contribute to Bankless by writing articles, conducting research, graphic design, translating articles, providing marketing services, and voting on key decisions to earn more BANK.

As many believe the current ad-based media model is broken, media DAOs offer an appealing alternative that can realign the interests of readers, creators, and media.

Funding/Charity DAOs

Funding/charity DAOs, similar to investment DAOs, pool funds and deploy them to various causes. The only difference is that funding/charity DAOs invest without expecting financial returns.

Gitcoin is a pioneer of this model, providing funding for some key open-source infrastructure projects that might otherwise struggle to secure development funding. Similarly, large protocols like Uniswap, Compound, and Aave have specific DAO functions that allow community members to vote on how to allocate funds to pay developers to promote the long-term development of the protocol.

Charity DAOs are also slowly emerging, aiming to rethink how charitable donations are made. For example, Dream DAO issues NFTs to raise funds and then allows NFT holders to vote on how to allocate those funds to causes (such as funding civic leaders).

Challenges Facing DAOs

The increasingly diverse DAOs can become the organizational structure of Web3, reshaping how we govern, invest, work, create, and donate. At the same time, we expect to see significant changes in the categories, numbers, and quality of DAOs in the future.

However, DAOs still have a long way to go. Given that the primary task of DAOs is to change the lessons learned from centuries of corporate governance, the challenges are evident. Today, we have identified four major flaws in DAOs:

• Lack of legal/regulatory clarity
• Lack of effective coordination mechanisms
• Lack of infrastructure
• Risks related to smart contracts, fragmentation, and sustainability

Lack of Legal/Regulatory Clarity

Traditional companies have specific physical locations, and their operating rights are granted by governments and municipalities. Accordingly, governments establish regulations that companies within their jurisdiction must comply with. Since DAOs lack a physical location and do not operate like companies, they cannot fully integrate into the existing regulatory framework.

While protecting members from risks, DAOs must also address various tricky regulatory and legal issues. How should DAO tokens and financial activities be treated from a tax perspective? How should income paid to members be reported?

In the U.S., DAOs currently face the situation of being classified as either limited liability companies or general partnerships in specific jurisdictions. Being classified as the former undermines the ability of DAOs to be governed by the rules encoded in smart contracts, while being classified as the latter may expose members to liability through the partnership.

The uncertainty of regulations makes it difficult for DAOs to interact with traditional companies, which is a disadvantage. While Wyoming has pushed legislation allowing DAOs to operate on the same legal basis as traditional LLCs and to be governed by their own smart contracts, this has faced resistance from the U.S. Securities and Exchange Commission (SEC).

Although A16z and OpenLaw have proposed a clear legal framework for DAOs, it seems that DAOs will have to continue operating in a gray area for the foreseeable future.

All this uncertainty underscores the point that, in the short term, the growth of DAOs may be entirely concentrated in the crypto industry—when DAOs attempt to cross over into traditional industries (such as UberDAO), the legal complexities will be magnified.

Lack of Effective Coordination Mechanisms

There is a reason why companies do not involve every employee in every decision: it is a highly inefficient way of working, and not everyone is qualified to participate in decision-making. The existence of corporate hierarchies eliminates the need for a large number of qualified individuals to make difficult decisions together.

Many DAOs today exist under rough governance structures, where 1 token = 1 vote. In large DAOs with thousands of token holders, this can lead to chaotic decision-making processes, and "malicious" members may skew the decision-making away from what is right. For DAOs to be truly effective, they must delve into governance structures, such as shifting to a delegated model where token holders can vote to elect qualified leaders to make key decisions transparently.

Thus, in the short term, DAO governance is likely to remain chaotic until a truly effective governance model is identified after trying many different models.

Lack of Developed Infrastructure

Just as companies benefit from clear legal frameworks and efficient decision-making processes, they also benefit from highly developed operational infrastructure. However, DAOs need to build similar infrastructure from scratch.

The tools for governance, reporting, fund management, and communication for DAOs are still in their infancy. Fortunately, the field of DAO tools is gaining traction, with hundreds of teams working to address these shortcomings.

There are many excellent teams, and while we won't mention them all here, we are excited about Messari's tool aggregator for governance, which can monitor various DAOs and facilitate participation in governance through a single interface.

Risks of Smart Contracts, Fragmentation, and Sustainability

It is hard to discuss DAOs without referencing "The DAO." The DAO was the first DAO on Ethereum, but 40% of its funds were hacked, resulting in a loss of nearly $60 million. As recently expressed by BadgerDAO's $130 million exploit, DAO treasuries remain vulnerable to smart contract risks.

Some large blockchains also have fragmented histories caused by internal community splits. The Bitcoin and Bitcoin Cash fork was triggered by a technical dispute over block size. The Ethereum and Ethereum Classic fork resulted from disagreements on how to respond to the aforementioned "The DAO" hack. Therefore, it is likely that we will see large DAOs face similar "splits" in the future.

On the other hand, what about the sustainability of DAOs when a crypto winter arrives? Will people continue to be excited about DAOs when token prices are falling, treasuries are tightening, and participation and membership are declining?

Reconnecting the World with DAOs

While there are many obstacles facing DAOs, they represent a shift in organizational structure. If Web3 is to become an internet collectively owned by users, then DAOs will be the organizational structure that embodies governance rights.

In mid-2021, we witnessed the rise of new DAO experiments and models. Meanwhile, the integrated tools for building DAO functionalities and the overall prospects for DAOs remain among the largest in the crypto industry.

Image: DAOs invested in by Coinbase

If this trend continues, we may one day truly see massive organizations, venture capital firms, media, and institutions built not on regulations but on open blockchains. Similarly, as the user experience in crypto improves, DAOs are likely to replace LLCs as the preferred organizational form in an increasingly digital world.