What is a DAO, and how does it work?

Key takeaways

• DAOs don’t need a central point of authority, rather relying on smart contracts and group voting to make decisions together and openly.
• Using a blockchain ensures transparency and allows all members to propose and vote on initiatives.
• Smart contracts automate the processes and decision executions, reducing bureaucracy and increasing efficiency.
• DAOs can be tailored for various purposes such as investment, governance, social causes and services, each adapting to different needs and goals.

A decentralized autonomous organization, or DAO, is an innovative way to structure and manage groups without centralized control or traditional leadership. DAOs, which have come about with blockchain technology, provide a way for communities to function independently and transparently, with decisions being made by the members collectively. 

Imagine you and your friends plan to start a fitness club, but you all want to make decisions together instead of giving one person decision-making authority. As a resolution, you decide to put every decision to a vote, and the majority will determine the outcome. This way, no single person holds all the power, and everyone has a say.

If you need more input from members or interested joiners to your fitness club, you could use the internet to make these decisions instead of meeting in person. This decentralizes the decision-making more and makes it more efficient. In essence, this is what defines a DAO: Everything runs automatically based on the rules you all agree on.

This article explains what a DAO is, how it works, its benefits, its history and its challenges.

DAOs explained

A DAO is a new way of allocating resources and people without depending on a central authority, like a traditional government or a CEO.

Traditionally, boards or leaders manage organizations and act as their representatives. 

Now, think of DAO as an organization where no one person or group is in charge of overseeing operations. Instead, the members decide together using computer code — like a set of rules written into a computer program — that everyone in the organization agrees on. 

These rules are often stored on a blockchain, a digital ledger that tracks everything transparently and securely.

How DAOs work

Let’s say your fitness club wants to buy a new treadmill, but you need to decide how to spend the money. In a traditional setup, the treasurer handles the funds and makes such purchases. But in a DAO, everything is managed by smart contracts, self-executing contracts where the terms are directly written into the code.

The below steps explain how it might work in a DAO:

• Proposal: One of your friends posted an online proposal to buy a new treadmill. All members can see it.
• Voting: Your voting power may be influenced by your level of involvement or contribution to the club. The DAO’s mechanism facilitates this automatic voting.
• Execution: If the majority agrees, the smart contract automatically releases the funds and makes the purchase. No one needs to handle it — the code does everything.

Did you know? DAOs, especially those involved in fundraising or investment, have attracted regulatory scrutiny. For example, the United States Securities and Exchange Commission has scrutinized DAOs to determine whether they should be classified as securities, which could subject them to additional regulations.

DAO vs. traditional organizations

DAOs operate through decentralized, collective decision-making processes powered by smart contracts on a blockchain, while traditional organizations rely on a hierarchical structure with centralized decision-making.

Here’s a quick comparison between DAOs and traditional organizations:

Purpose and benefits of DAOs

DAOs aim to create a fair and transparent system where no party makes decisions on behalf of other members. Everyone involved in a DAO can participate, propose ideas, and vote on important matters. This democratic approach ensures that the group’s direction reflects the will of its members rather than just a few individuals at the top.

Using a democratic approach, the group’s direction is ensured to represent the will of all its members, not just a few individuals at the top. Ultimately, this approach offers numerous advantages:

• Inclusivity: Everyone has an equal opportunity to contribute and influence the organization’s direction, as DAOs allow all members to propose ideas and vote.
• Decentralized control: Decisions are made collectively with DAOs, reflecting the will of all members of the entire community.
• Transparency: The entire process remains open and accessible for all members’ review, as every decision and transaction is recorded on a blockchain. This reduces the risk of corruption or hidden agendas.
• Efficiency: Managed by code and smart contracts, DAOs operate with minimal bureaucracy, streamlining processes and reducing the need for traditional administrative structures.
• Global participation: DAOs do not require physical meetings and can involve participants worldwide, allowing for diverse perspectives and ideas.

Types of DAOs

DAOs come in various forms, each designed to tackle different needs and goals. They specialize in managing investment, governance, services and more, much like fitness clubs, which may have distinct committees for different responsibilities. 

• Investment DAOs: Suppose your club wants to pool money to purchase trendy exercise equipment — an investment DAO could be an ideal option. Members would vote on where to invest the money they contribute.
• Social DAOs: If your club’s goal is to build a community or support a social cause, you may consider creating a social DAO. Members collaborate and make decisions to benefit the community or achieve a common goal. 
• Service DAOs: Let’s say your club wants to offer services like organizing fitness events or providing resources to other groups. A service DAO does just that. Members contribute their skills and resources to provide services and receive rewards in return.
• Governance DAOs: In your club, you might want to have a say in how things are run — like choosing new fitness classes or setting club rules. A governance DAO works similarly; members vote on decisions that affect the organization.
• Protocol DAOs: These are like the techies of the DAO world. For your fitness club, a protocol DAO could help you develop and manage rules for a new fitness app. This DAO would be responsible for updating and maintaining the app’s core systems or protocols. 

Did you know? DAOs can fundraise in novel ways, such as through token sales where contributors receive governance tokens, giving them a stake in the organization’s decisions and future profits.

History of DAOs

DAOs have been a fascinating part of how digital communities can come together to make decisions without traditional intermediaries.

Major milestones in the history of DAOs include:

Examples of DAOs

DAOs can be used in various ways, from managing investments to running financial platforms, each focusing on community governance and transparency.

Here are some notable examples of DAOs:

• The DAO: Back in 2016, this was one of the earliest DAOs, and it was quite a big deal back then. It was like a venture capital fund that was fully managed by its members. Voters could invest in it and choose what initiatives to support. Although it faced some challenges and ended up being hacked, it effectively demonstrated how DAOs could function.
• ConstitutionDAO: It was a decentralized group that pooled funds to buy a rare copy of the US Constitution. They didn’t win the auction despite raising millions and engaging thousands of supporters; however, it showcased how DAOs can mobilize collective action for a common cause.
• MakerDAO: The Dai (DAI) stablecoin is powered by MakerDAO, a DAO managing a significant financial product. Members can vote on changes to the DAI’s stability and collateral requirements, among other aspects of the system’s operation. 

Did you know? In 2016, The DAO was hacked due to a flaw in its code that allowed the attacker to repeatedly drain funds through a recursive withdrawal loop, resulting in about $60 million being stolen. This led to an Ethereum hard fork to recover the stolen assets.

Challenges and limitations faced by DAOs

Despite their innovative approach, DAOs face several challenges and limitations:

• Scalability: Decision-making and coordination can become slower and more complex as the number of participants grows.
• Complexity: Setting up and managing a DAO can be technically challenging and require significant expertise.
• Security risks: Digital assets and smart contracts are vulnerable to hacking and coding errors.
• Participation fatigue: High voting and DAO governance levels can lead to voter fatigue and lower engagement over time.
• Legal and regulatory issues: DAOs often face uncertainty regarding their legal status and regulatory compliance in various jurisdictions.
• Immature concept: DAOs are relatively new, with limited real-world experience and legally accepted models.

The future of DAOs

Even though DAOs are still a relatively new idea, they can completely alter how individuals view companies, governance and decision-making. DAOs provide a novel approach to global resource management and collaboration by eliminating the need for central authorities and making everything visible and automated.

Like every technology, DAOs have their own set of risks and challenges. As they develop, you might witness more creative applications and answers to the issues that currently exist. Whether you’re managing a small fitness club or a large-scale project, DAOs could one day provide a more democratic and efficient way to achieve your goals.

Written by Onkar Singh