How do investment DAOs challenge venture capital?

Original Title: 《How the first investment DAOs challenged Venture Capital》

Author: Jan Baeriswyl, Outlier Ventures

Translated by: Runsheng, Chain Catcher

In a previous article, we outlined why DAOs can represent a paradigm shift in human organizational structures. We also described the three most active types of DAOs today: protocol DAOs, investment DAOs, and worker/social DAOs. In this article, we will delve deeper into the use cases of investment DAOs.

The Current State of Investment DAOs

A key motivation for investment DAOs is the ability to make better investment decisions and/or gain more deal flow as a collective.

In traditional finance, joint investments across multiple countries are often challenging due to many issues, including:

• Establishing complex legal structures;
• Coordinating with banks;
• Sending notarized documents around the world;
• The complexity of unconventional target assets, such as blockchain-based tokens.

It can be argued that the greatest advantage of investment DAOs is the elimination of administrative friction in a globalized world. Participants can join and provide funding with just a few clicks in a Web3 wallet. Pooling funds into a DAO is often much easier than figuring out how to handle the associated funds, as evidenced by the following examples:

• Original DAO, whose faulty code split the Ethereum community;
• Constitution DAO, which raised nearly $50 million in an attempt to purchase an official copy of the U.S. Constitution.

Of course, there has been a surge of interest in DAO tools and frameworks (see our previous article), with their secure and ready-made components enhancing the credibility of smart contracts holding pooled funds. The best tools should make the coordination of investment decisions and deployments relatively simple and efficient.

In theory, trusted smart contracts like Gnosis Safe multi-signature replace the need for legal contracts and banks, along with other bureaucratic hurdles. However, while investment DAOs themselves do not require a legal structure, they still need to comply with local laws and regulations. DAOs often require legal entities to adhere to legal frameworks and interact with the off-chain world to execute tasks such as hiring employees and paying taxes.

DAOs without legal structures face many risks:

• If a DAO is profit-oriented, courts may view it as an "unincorporated general partnership." This implies that two or more people seem to be establishing a business relationship—even if they have never met.
• Each member's potential liability in an unwrapped DAO is unlimited. Therefore, investment DAOs are often launched in the form of "wrapped DAOs," which are launched under the protection of a legal entity.
• Further implications of complying with existing legal frameworks include KYC/AML requirements, which often limit investment DAOs to a small number of accredited investors (for example, the cap in the U.S. is 99 individuals).

Pioneers of Investment DAOs and Their Innovations

Let’s consider some of the most notable investment DAOs to date and some of the tools and mechanisms they are using.

MetaCartel Ventures

MetaCartel Ventures is the first venture/investment DAO, established in 2018. It now boasts a number of impressive Web3 pioneers, founders, and investors as its members. MetaCartel is very selective about its members, as they are highly focused on creating added value for their investments based on the organization. MetaCartel provides their open-source tools, enabling others to follow suit. Notable investments include Zapper and Rarible.

Moloch DAO

Moloch DAO initially focused on funding public goods on Ethereum (such as clients and wallets). MolochDAO invented the "RageQuit" mechanism, which has since been adopted by many other investment DAOs (such as Flamingo DAO). This mechanism introduces a time delay between investment decisions and fund deployment, allowing each member to choose to exit based on their proportion of assets in the treasury before an investment is made. RageQuit provides a new level of assurance for members of the investment collective, which was previously impossible in traditional finance.

LAO

LAO is another noteworthy participant that serves as a bridge between Web3 and the U.S. legal system. Founded by OpenLaw, it is the first DAO focused on compliance with U.S. laws and has played a significant role in the Wyoming DAO bill. LAO has not only been used as a framework for many subsequent DAOs but has also made Wyoming the first jurisdiction to legally recognize DAOs as entities. LAO shares have proportional voting rights, and accredited investors can purchase shares within a cap of 7.2% per member, with the price per share increasing with each investment. Notable investments include Zerion, Reflexer Labs, and Async Art.

Syndicate Protocol

There have also been various attempts to productize these core mechanisms and build infrastructure specifically for investment DAOs ("AngelList powered by DAOs"). Notably, Syndicate Protocol is building a framework for DAO investment syndicates that supports investment DAOs, allowing investors to collaborate on a deal-by-deal basis.

The Rise of NFT Collector/Investor DAOs

The popularity of NFTs in 2021 has gradually facilitated a new type of investment DAO aimed at collectively purchasing NFTs.

Some of the most significant successes in this field include Flamingo DAO, an investment DAO focused on NFTs that emerged from LAO. Flamingo DAO has an impressive track record, including investments in OpenSea, Fractional, Upshot, YieldGuild, and many individual NFTs. The NFT fund OneOf is connecting the investment DAO toolkit with processes that allow investor communities to share the utility of their NFTs. For these reasons, Mesha bets that the investment DAO use case is more appealing for NFTs. Their goal is to enable a group of friends to easily establish a DAO to collectively purchase and manage NFTs.

There are many differences between investment DAOs focused on fungible tokens and those investing in NFTs:

• The motivation to reduce risk and capital requirements is unique to (blue-chip) NFTs, which often have prices in the tens of thousands or hundreds of thousands of dollars.
• By pooling funds within a trusted group, a shared portfolio can hold more and more diverse expensive NFTs, while each individual commitment is much smaller.
• The utility dimension of NFTs is almost non-existent in fungible tokens (unless we count governance use cases): they possess artistic or aesthetic value (rather than "just" financial value) and sometimes have additional utilities attached (such as claimable physical versions, access to groups or events).

Current Investment DAO Toolkit

Early pioneers of investment DAOs have validated the foundational mechanisms that can be leveraged in the next wave. Now let’s turn our attention to some key tools proposed by investment DAOs.

Legal Setup

An important set of tools is the framework used to address legal compliance issues and protect members from liability. Notably, the legal setup of MolochDAO, particularly LAO, has been used as a framework for subsequent investment DAOs. The ZeroLaw framework (formalized by OpenLaw) includes a "legal wrapper" in the form of a Delaware limited liability company (legally registered in the U.S.). This limited liability company is bound by the DAO's decisions through its articles of incorporation, ensuring that decisions can be made on-chain but are legally represented by the limited liability company. Within this framework, a maximum of 99 accredited investors is allowed. Additionally, DAOs have more general legal wrappers, the most notable being Delaware and Wyoming limited liability companies. These entities provide independent legal status, limited liability for members, and a relatively flexible governance framework.

Tools for Pooling, Deploying, and Redeeming Capital

Many investment DAOs aim to establish a simple yet powerful set of functionalities, often combining the tools described here. We can think of these tools as being deployed along three processes of investment DAOs: pooling, deploying, and redeeming funds.

1. Tools for pooling funds (typically Ethereum or dollar-backed stablecoins) are at the core of any investment DAO. This is usually done through multi-signature (often Gnosis Safe), which is then connected to the DAO. If using the aforementioned legal framework, the pooling of funds is limited to a maximum of 99 addresses (for example, managed through a whitelist).
2. The second tool involves deciding where to invest. Most often, this is done through governance tokens allocated based on each member's contribution. From there, token holders can propose potential investments and vote on the outcomes. Typically, voting power is proportional to the number of tokens held ("Coinvoting"), and decisions are made based on a simple majority.
3. Finally, a mechanism or tool for redeeming capital is needed. The simplest method allows token holders to redeem their proportional amount of assets from the treasury, at which point the governance tokens are burned. In practice, this is usually only realized within specific time frames, as all assets in the treasury need to have a clear net asset value (NAV) (for example, this may be challenging for rare NFTs). As mentioned earlier, some investment DAOs utilize the "RageQuit" feature, allowing investors to exit with a certain proportion of their asset share before they disagree with an investment decision.

When it comes to capital allocation in today's investment DAOs, the tools currently in use still seem quite rudimentary, and innovators have significant potential to improve the status quo. This may be because most investment DAOs are still limited to a manageable scale of 99 members, so there is not much pressure to innovate on these tools.

Looking Ahead: Seeking Collective Wisdom

Reflecting on the current state, we can conclude that pioneers of investment DAOs have made substantial progress. The infrastructure for collecting and deploying funds in a Web3-native way has successfully deployed billions of dollars (for example, BitDAO alone reports having deployed over $500 million).

However, the road to fully realizing the potential of investment DAOs is long. First, many of the tools used (such as RageQuit) are not entirely compatible with existing legal frameworks. We will explore these legal challenges in an upcoming article. The existing decision-making mechanisms seem ill-suited for investment purposes, as they incentivize convergence on common points (and miss asymmetric opportunities). Existing mechanisms in Web3 may provide important primitives for this—such as quadratic voting, which allows us to measure belief and intensity, not just direction. We also need mechanisms that can scale beyond 100 members without compromising the quality of outcomes.

In the long run, the innovative engine of Web3 will undoubtedly provide relevant solutions to most of these obstacles. Once the challenges of mechanism design are in place, investment DAOs will be able to leverage collective wisdom at scale. Even if the potential of this collective wisdom is only partially realized, the degree and speed of transformation towards the venture capital industry will be astonishing.