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What Are DAOs and How Do They Work?

The transformation of the traditional financial system through blockchain technology has led to the possibility of creating autonomous organizations made up of individuals who may not know each other personally. Decentralized Autonomous Organizations (DAOs) have become the most effective way to manage investments and projects with like-minded people around the world.

Let’s take a closer look at what they are, their basic operating principles and global advantages. We suggest you check out our glossary of terms before reading the article.

Principles of DecentralizedDecentra-lized Autonomous Organizations

A DAO is an organization without a management hierarchy, and any actions and transactions are based on smart contracts stored on a blockchain. Such an approach prevents unilateral changes in the "playing conditions" and makes the rules of the organization's management transparent to all participants.
«Decentralized» «Decentra-lized»
Decentralization in DAOs involves the absence of a single decision-making center. Any actions taken by the organization, whether a simple transaction or a change in the rules, are executed only after voting and reaching the necessary quorum. Any member of a DAO with management rights can bring an issue to a vote.
«Autonomous»
This type of organization implies complete renunciation of trust in third parties because all the DAO's program codes are in the public domain and can be checked by any participant. Thus, the responsibility for the organization's activities lies equally on all participants.
In this case, the importance of relying purely on the trust factor (as is quite common in traditional companies) decreases thanks to the use of smart contracts of DAOs, which are transparent for all participants and cannot be changed unilaterally.

“Today, the DAO allows uniting the two most important factors of production, finances and people, without being limited by geographical and jurisdictional aspects.

The principle of consensus, which underpins the DAO, is achieved through voting. XDAO uses a quorum voting model. All DAO participants who agree with the proposal being put forward vote; if a quorum is reached, the proposal is accepted. For example, a quorum of 51% means that an absolute majority takes decisions,” explains Zurab Shavlidze, CAO and Co-Founder of XDAO.

The technology behind DAOs is actively used in the following areas:

  • Charity. The DAO enables the activities of a charitable foundation to be performed in a completely transparent way. Thanks to blockchain, any donator can check where and how much money has gone. Charity DAOs accept donations to the DAO account and decide where to send the money through a vote of a group of participants.
  • Investment Funds. Creating for-profit DAOs that aim to generate profits allows a team of like-minded individuals to pool investments and put them into any project that the DAO members vote for. Profits in such organizations due to smart contracts are distributed in proportion to members' contributions.
  • Buying Collectibles. The DAO makes it possible for thousands of enthusiasts to unite to buy and jointly own collectibles or NFTs. For instance, in 2021, several thousand people became members of the Constitution DAO, whose goal was to purchase one of the first copies of the US Constitution offered at Sotheby's. Even though participants failed to win the lot, the DAO raised $47 million and brought together very different people worldwide.
  • DeFi Protocol Management. The finalization of the protocol takes place with the participation of the DeFi community around it. Participants can collectively decide on changes, thereby influencing its development.
Smart contracts, as mentioned above, are the backbone of DAOs. They define the rules of the organization and the capabilities of its participants. Any changes to the smart contracts can only be made by voting.

"Actually, a DAO is a set of smart contracts on a blockchain that defines some of the rules: the number of participants in the organization, the number of votes each participant has, and what they can vote on."

Zurab Shavlidze, CAO and Co-Founder of XDAO.

DAO Advantages

The decision-making process in any DAO involves voting among the holders of governance tokens, i.e., the organization's members. Most DAOs use the principle of voting power depending on the number of tokens. Membership in the DAO can be of two types:
Based on native tokens, also known as DAO tokens. DAO tokens can be received when creating a smart contract, by voting, by purchasing them on a DEX, or by getting them as payment for providing DAO services.
Based on a special governance token. Governance token-based DAOs are not available to everyone. You can only get such a token at the time of the organization's creation or after other members of the DAO approve the participant's candidacy. This type of DAO is suitable for managing an investment fund, for example, when the circle of persons handling the fund's assets is limited to its partners and employees.
The main advantages of decentralized autonomous organizations are:
No hierarchy. Every member of the DAO, no matter how strong their vote, may vote on any issue related to the organization of the community. Also, any member of the community can vote on all topics. No decision can be made individually, only collectively.
Transparency. Because DAOs are open source and blockchain-based, all changes, transactions, and even proposals put to the vote are transparent and publicly available. For example, the organization's algorithms cannot be changed without the community's awareness.
Openness. Anyone can become a member of the DAO, regardless of age, gender, financial or social status.

“This form of an organization significantly speeds up the decision-making process and makes the management system as transparent as possible. For instance, on the XDAO platform, any vote is recorded on a blockchain, thus allowing information about it to be stored. The same applies to the agreements between the project participants — everything is recorded on a blockchain, managed by smart contracts and cannot be compromised.”
Vladislav Shavlidze, CEO and Founder of XDAO.

The main difference between DAOs and traditional companies is their democratic nature. Decentralized autonomous organizations are based on the principle of collective decision-making, while the management of traditional companies often comes down to a one-man decision made by the manager or the board of directors.

Investors or employees of a corporation may actually not influence such decisions or even simply have no reliable information about the organization’s activities.

Management Features of DAOs

Classical corporate law loses its relevance when it comes to DAOs. As the main element of the DAO, smart contracts change the usual rules in the traditional corporate sphere. The code is the basic law for the DAO and its participants. Smart contracts shape and enforce the “laws” within the organization. Thus, DAOs embody crypto-anarchism, as they wholly or partially abandon the influence of public authorities, using an autonomous digital structure.

At the same time, a new task appears: a) to encourage participants to take an active part in DAOs and b) to motivate investors to invest their money.

Voting incentives can be implemented through voting rewards. Meanwhile, the main incentive for investors is the transparency and ease of use of the DAO model.

“Such a system is ideal for investment funds, for example. In this context, the key problem that the DAO solves is the trust between investors who invest money in the fund and fund managers,” explains Vladislav Shavlidze.

Investors in DAOs receive a liquidity provider token (LP token — refer to the glossary). This token guarantees that the investor has really invested his funds in the DAO and claims a share of the total AUM (refer to the glossary).

“DAOs are well suited for collective management of cryptocurrencies, eliminating the risks associated with the loss of a private key from the fund or project wallet,” says Egor Gavrilov, CTO and Co-Founder of XDAO.

Despite all the advantages of this type of organization, the legal aspects of DAOs and all the legal aspects of working with cryptocurrencies remain rather unclear.

“There are no clear variants of DAO registration legally right now,” explains Egor. — “For the most part, they are registered as an LLC, that is, a limited liability company with partnership elements. But different jurisdictions provide different conditions, so each case has to be worked out individually. There is no general world practice so far.”

Future and Prospects of DAOs

The future of DAOs depends on the resolution of several important issues for the industry, namely:

  • Legal regulation. The widespread adoption of DAOs in traditional business first and foremost faces regulatory uncertainty. Massive regulation is required for the more widespread adoption of DAOs. DAOs, just like traditional companies, need to interact with counterparties — other companies or other DAOs. Such interaction without registering as a legal entity may violate the law.
  • Protocol security. Decentralized and open protocols often attract the attention of hackers, looking for errors in the code and taking advantage of them. If the DAO is hacked, it's almost impossible to recover the stolen funds.

However, regardless of all the challenges and problems to be solved, DAOs can fundamentally overturn existing management methods in organizations, corporations, and communities. The traditional vertical system can be replaced by a more horizontal, open, accessible and decentralized system.

Decentralized autonomous organizations, according to Messari, could compete with the metaverse platforms for the title of the leading trend in the crypto industry in 2022. In particular, the structure of the DAO could be used within the Internet of Things. With the help of DAOs, every electronic device has the opportunity to become a full-fledged participant of the global economy. And the automation of everyday life through smart contracts and blockchain technology could take the software infrastructure of DAOs to a new level.

“The DAO is now an experiment in more democratic and productive organizational management. After The DAO case, the bright ideas of joint management had to be put on hold for a while. Only five years later, the subject of the DAO is back again, but with more conservative management models.

In the short term, more DAOs aimed at a small circle of individuals will emerge. In the medium and long term, DAOs will develop as multi-level systems, for example, company management systems with multiple departments and even city DAOs. Why not? One step from dream to realization! In any case, such organizations will be more and more integrated with the real world.” Anna Godovnikova, CMO of the XDAO project.

DAO is a vast concept. In order to start understanding decentralized autonomous organizations, there are some terms you need to grasp first. We joined up with the XDAO team to prepare a small glossary that will help beginners understand how DAOs work.
Decentralized Autonomous Organization (DAO) — a form of organization where participants' activities are based on rules set in smart contracts, and any decisions are executed only when consensus has been reached.
Governance Token (GT) — a governance or native token that allows its members to create and participate in votes. GT has no economic value, cannot be sent to another wallet like a regular token, and can only be created or sent as a result of voting in a DAO.
Assets Under Management (AUM) — all funds managed by a DAO.
Liquidity Provider Token (LP) — an investment token or liquidity provider token. An ERC-20 standard token, backed by DAO assets and varying in price depending on the total issue of the LP and AUM of a DAO. When an LP token is burned, a holder receives a proportional share of the AUM of a DAO. The total supply of an LP token depends on its economic value.

For example, if 10 LPs were issued and the project's AUM is $1,000, then the value of 1 LP is $100.
Consensus — a principle according to which any transaction, change of the DAO management rules or other actions allowed by the conditions of a particular DAO, is carried out only after creating a vote and reaching a quorum.
Quorum — the number of votes required for a decision to be executed.
On-chain voting — every participant's vote is "recorded" on a blockchain, and the result of the vote is executed automatically after a quorum is reached. This type of voting is characterized by high gas costs.
Off-chain voting — all participants' actions, including the voting result, do not interact with the blockchain. This type of voting is usually used for project community voting, as it does not entail the binding execution of a decision.
Hybrid voting — participants vote off-chain using a unique signature, while the execution of the voting results is done on-chain. This type of voting allows you to significantly reduce gas costs without compromising security.
Absolute majority voting — 50+1% of the votes must be reached to achieve a quorum.
Module — a special smart contract providing some additional function for a DAO.