DAOs: The “companies of the metaverse and Web3”
The metaverse and Web3 have become an attractive market for businesses and investors – increasing the need for organisational structures that are better adapted to the decentralised nature of the digital world than traditional corporate entities. This has paved the way for decentralised autonomous organisations (DAOs) to take their place as the “corporate entities of the metaverse and Web3” – and the opportunities they offer for efficient capital procurement have only added to their popularity. The following aims to provide an initial overview of DAOs.
1. What are DAOs?
Put simply, DAOs are blockchain-based virtual organisations with no central governing body. Instead, decisions are made by the DAO’s members. DAOs are similar to regular companies, but run digitally using a set of software programs known as smart contracts.
A DAO’s members are its tokenholders, who manage the DAO decentrally with the help of the smart contracts, which are stored and automatically executed on the blockchain when certain criteria are met.
2. Types of DAOs
DAOs can be used for a wide variety of purposes. Originally, DAOs became known as investment vehicles – like BitDAO, a decentralised investment fund that enables anybody to invest in Web3 and decentralised finance (DeFi) startups and initiatives. The entire DeFi sector is heavily influenced by DAOs, and MakerDAO is probably the best-known DeFi credit institution.
Over time, however, more diverse types of DAO have evolved:
- Social DAOs and creator DAOs such as Friends with Benefits and Developer DAO bring like-minded people together.
- Media DAOs such as Decrypt and BanklessDAO are a new form of social media. Individuals who are active on the decentralised network earn profits instead of the business entity.
- The virtual worlds of the metaverse are often run by DAOs. One example is Decentraland, a blockchain-based virtual destination that is rapidly becoming a leading platform in the metaverse and is already used by many international companies such as Morgan Stanley, Coca-Cola and Adidas. Decentraland also hosts Gleiss Lutz’s metaverse office.
- Grant DAOs usually function as a charitable extension of a larger project, and well-known examples include Aave Grants and Gitcoin.
- Philanthropy DAOs are organised around a common philanthropic goal. Big Green DAO, for example, is linked to the public charity Big Green, and UkraineDAO raised over EUR 3 million in ETH in one week to support the Ukrainian army.
- Collector DAOs allow tokenholders to pool their funds to invest in more valuable NFT artworks and other collectibles. Each tokenholder owns a share corresponding to their personal investment. ConstitutionDAO was a well-known example of a collector DAO. It was formed to buy an original copy of the United States Constitution at auction, an endeavour for which it raised USD 47 million in ETH.
- DAOs can also act as service providers: LexDAO, for example, builds smart contracts that can provide legal services.
It is even possible to create corporate group-like structures using subDAOs. SubDAOs comprise a subset of tokenholders who manage specific functions such as operations, partnerships, marketing, treasury and grants. They offer an effective structural solution for growing DAOs in particular, because not every proposal has to be adopted by the whole DAOs.
3. Setup and operation
You can either code a whole new DAO yourself, or build on existing infrastructure and open-source software. Platforms such as Aragon, DAOstack and DAOhaus offer ready-made templates that make it easier to enter the world of DAOs.
The DAO is “founded” by writing code, and membership acquired through equity tokens. The code controls the interaction between tokenholders: It contains the key governance rules of the DAO, in particular those on exercising voting rights, passing resolutions and how smart contracts are triggered.[k3] [nsch4] For the system to run smoothly, the code must set out all the tokenholders’ rights and the programmer must have developed smart contracts for all conceivable scenarios. Because it is recorded on a blockchain, the DAO code cannot be changed after it goes live without the consensus of the tokenholders. Any code stored on the blockchain is visible to all users and almost impossible to modify – making the DAO’s success depend on precise coding.
DAOs operate independently via a decentralised, digital structure. They are not supervised by regulatory authorities and have no managing body; instead, decisions are made bottom-up by tokenholders. Tokenholder interactions are regulated by smart contracts and cannot be (subsequently) altered. That creates complete transparency in the DAO and fewer opportunities for fraud and abuse than with human management.
In traditional investment DAOs, for example, all tokenholders vote on how to use the jointly raised capital. If a predetermined majority agrees, the DAO’s code automatically executes the desired transaction via a smart contract.
4. Legal classification
Legal questions start to arise when a DAO’s tokenholders or contracting partners want to enforce their claims in court, if not earlier: What law actually applies and which court has jurisdiction? Is the DAO a company, and if so, what is its legal form? Who is liable for the DAO’s actions vis-à-vis third parties? Can tokenholders’ liability be limited?
a) Applicable law
Before questions about a DAO’s legal classification and liability can be answered, it is necessary to determine which law applies – a difficult task, given DAOs’ decentralised structure. Applying the law of the headquarters’ location, for example, can be ruled out for several reasons: The key feature of a DAO is specifically that it does not have an administrative body whose place of business can be used as a basis. DAOs are managed automatically using smart contracts that do not have a specified location, because they are executed by a large number of nodes simultaneously. Basing choice of law on the place where a DAO’s decisions are made doesn’t make sense, either, because tokenholders are usually scattered all over the world. And because DAOs are established as autonomous organisations that exist on a blockchain in Web3, it doesn’t make any sense to link the applicable law to the place of establishment either – at least until Web3 legislation is passed. Given all these uncertainties, it currently seems likely that lex fori – that is, the law of the venue in which the legal action is brought – will apply. This ambiguous legal situation highlights the importance of jurisdiction and choice of law clauses. In practice, these can be incorporated into the DAO’s terms and conditions of use, which must be accepted when DAO tokens are purchased, or into general terms and conditions of business when dealing with contracting partners. (For more on civil procedure and arbitration law issues, see our article “Civil Litigation and Arbitration: A New World?,” 10 November 2022.)
b) Legal status
By buying tokens, tokenholders make a legally binding decision to come together for a common purpose – creating what is, by definition, a company under German law.
But DAOs are not yet recognised as independent corporate entities in Germany, Switzerland or Austria. According to prevailing opinion, DAOs are currently to be regarded as civil-law partnerships (Gesellschaft bürgerlichen Rechts (GbR)) or general partnerships (offene Handelsgesellschaft (OHG)) under German law. Some commentators consider DAOs to be unincorporated associations (nichtrechtsfähiger Verein), which are nevertheless subject to the provisions governing civil-law partnerships.
c) Limitation of liability
The main disadvantage of being classified as a partnership or unincorporated association is that the partners or members have unlimited liability. If DAOs are to succeed as a new form of organisation, however, it is vital that they be able to limit their liability risk – and the search for solutions is underway both in Germany and abroad.
In Germany, liability can currently only be limited if DAO members use limited liability holding companies as intermediaries to hold the tokens in the DAO and/or if the DAO agrees contractual limitations of liability in relation to third parties.
Particularly in Switzerland, there is a debate as to whether under currently applicable law, a decentralised and autonomous association can act vis-à-vis third parties and at the same time limit the liability of its tokenholders. An association is guided by its established purpose as well as its members, giving it a structure close to that of a DAO. At the same time, the liability risks of an association’s members are limited, which could solve one of the main problems of structuring a DAO as a partnership. Since Swiss associations have very flexible structures, this is currently one of the leading solutions for DAOs in Germany, Austria and Switzerland.
The U.S. approach to the problem of liability risks has been to create “limited liability wrappers”, combining traditional legal structures with a decentralised organisation. The first DAO with limited liability (LLC-DAO) was founded under the law of the State of New York. Vermont followed suit in 2018, introducing blockchain-based limited liability companies (BBLLCs), to which a DAO can be linked. Delaware created the LAO (Legal DAO) as another “legal wrapper”, where the DAO is structured as an LLC so that the company – and not the persons acting on its behalf – is responsible for contracts, taxes and violations of the law. The DAO LLC introduced by Wyoming in 2021 is especially interesting, being best adapted to the actual DAO structure as compared to the competing legal forms. This recognises the DAO’s legal status and puts it on a par with the American LLC. DAO LLCs are recognised in Germany as U.S. companies with the attendant limitation of liability. Businesses should however note that – unlike the traditional DAO – the various American legal wrappers go hand in hand with supervision by the SEC. Other jurisdictions will no doubt gradually follow suit.
As the metaverse and Web3 continue to grow, so too does the DAO’s importance as a “virtual company”. The various legal developments abroad also make it an especially promising organisational structure. This should encourage German and European legislators to make a limited liability framework available for DAOs and to amend corporate digitalisation provisions accordingly.