The Problem With DAOs - 5 Challenges to Consider Before Investing

Decentralized autonomous organisations (DAOs) are gradually gaining traction in the Web3 space and even beyond as many are beginning to explore possible ways of investing in one.

Considering how bitcoin and DeFi have rewarded early investors handsomely, web3 enthusiasts are looking to jump on the DAO ship with the aim of making huge returns on their investments in the near future.

According to DeepDAO, there are already over 216 DAOs in the market with about 10 billion in assets under management (AUM) and around 2 million members across them.

DAOs have also grabbed the attention of big-name investors like popular billionaire, Mark Cuban, who considers them "the ultimate combination of capitalism and progressivism." Peter Thiel, Naval Ravikant, a16z, and Paradigm are also some big names with investments in DAOs among many.

These DAOs cut across several purposes such as managing crypto protocols, venture capitalist funds, social media, philanthropic efforts, social clubs, etc.

However, it's important to explore some of the challenges that DAOs face before putting your money in them, especially for those getting in with a long-term approach.

Without much ado, let's get into them.

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Five Challenges with DAOs

While DAOs look promising, they are still a young invention with several uncertainties that need to be addressed. In no particular order, the five challenges that rock most DAOs currently are:

1. Poor Infrastructures
2. Legal Battles
3. Navigating Smart Contracts - Risks and Un-immutability
4. Effective Coordination or Complete Decentralisation
5. People (Community) Over Profit or Just a bunch of rich folks combining to increase their earnings

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Poor Infrastructures

Since DAOs are purely digital and decentralized, they often lack a well-developed and efficient infrastructure their traditional counterparts enjoy. Many DAOs have to design the right tooling and infrastructures by themselves before launch, and a bulk of these tools are quite 'quirky'.

DAOs suffer from having the right infrastructures for reporting, treasury management, governance, payroll, communication, identity management, etc. Without the right infrastructure to handle these duties, many DAOs may lose members and eventually fail to gain traction.

However, the increased rate of innovations and collaborations in the Web3 space is gradually helping to solve some of these problems.

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Legal Battles

DAOs share similarities with many organisations of today like corporations, non-profits, partnerships (both general and limited liability), and cooperatives. But these organisations are all regulated and governed by the rules of the different terrains they are rooted in.

DAOs, on the other hand, are purely decentralized without a particular location, and the rules governing them are not specific to that of any existing legal framework. In many regions of the world today, DAOs battle with regulatory issues such as taxation of DAO tokens, treasuries, and investments, how to get insurance on investments, implementing AML and CFT policies, and who takes responsibility for a DAO's actions. Without a clear system to solve these legal challenges, it'll be hard for DAOs to gain ground in the physical world.

Wyoming, a U.S. state, is solving this problem, through legislation that allows DAOs to operate with the same legal approach as LLCs under the Wyoming Limited Liability Act. This act recognises smart contracts as the legal documentation governing a DAO. Whether other states in the U.S. or countries of the world will follow Wyoming is uncertain.

Some other firms have proposed different legal approaches for regulating DAOs. However, for now, DAOs can only operate freely within the confinement of the crypto ecosystem, as attempts to push beyond can lead to fierce scrutiny from legal authorities.

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Navigating Blockchains and Contracts - Risks & Un-immutability

Blockchains may almost be impossible to hack but the smart contracts that run on them do not completely share the same level of security.

Many smart contract networks have faced a series of attacks with some protocols drained of millions of dollars sometimes. For example, the first DAO known as "The DAO" is a typical example of the impact of such vulnerabilities. A more recent event is the $120 million hack of BadgerDAO.

Division within a DAO can lead to fragmentation and result in splits which we have seen with popular crypto networks:

The Ethereum/Ethereum Classic split was caused by disagreements in responding to The DAO attack. The response of the Ethereum community puts the immutability of blockchains in question. The Bitcoin/Bitcoin Cash hardfork was caused by a disagreement in block sizes.

Additionally, DAOs can stand against the "code is law" crypto ethos many enthusiasts project. An example is the JUNO Network DAO which voted to revoke the tokens of a whale. While the decision was to safeguard the future of the project, it breaks the foundation of immutability on which Web3 is built.

Other events include Cooper Turley's removal from the Friends With Benefits (FWB) DAO with the most popular being Brantley Millegan who was voted out from his position as ENS Foundation director.

All these situations break the censorship resistance feature which attracted many to the web3 space. On the flip side, this can help in scaling many projects beyond the limits Web3's "good feature" of immutability has placed on them. The current success of the Ethereum network is a testimony to this effect. Or what do you think?

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Effective Coordination or Complete Decentralisation

The governance structures in most DAOs are the typical democratic system of one man, one vote. While this structure has many advantages, it's not the best way to actively manage corporations especially when decisions that need to be taken require expertise.

Traditional organisations function with certain hierarchies because getting every employee or member to vote on decisions is highly ineffective and can prove disastrous. Imagine if everyone in an organisation needs to vote on the SEO strategy that needs to be employed or the code base a developer needs to use. A large token holder without adequate experience can negatively influence decisions.

People with experience are needed to make hard and technical decisions. However, many DAOs didn't anticipate the challenge.

Some DAOs like the ENS DAO, for example, navigate this problem by exploring a governance structure where members vote in qualified and experienced personnel to handle critical decisions transparently.

However, this compromises the complete decentralized vision of DAOs and may face strong criticism from hardcore web3 enthusiasts.

Another important challenge DAOs have to deal with is the absence of token holders to vote on proposals. Inactive token holders can disrupt the functionality of a DAO. And while many may quickly resolve to vote delegation, it also poses the issue of centralization as stated above. Some DAOs are exploring the usage of incentives to solve this by rewarding active token holders and punishing inactive ones. 

It will be quite a tough one for DAOs trying to get the right governance fix. The approach employed by different organisations will prove vital in determining the future of DAOs.

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People (Community) Over Profit or Just a bunch of rich folks combining to increase their earnings

Even with the possibilities DAOs are bringing to the web3 space, some critics argue that many DAOs are just a bunch of average rich folks combining wealth to increase their earnings without any regard for the fundamentals of decentralisation and community.

According to web3 proponents, DAOs are supposed to remove the barrier of entry in hierarchical organisations by democratising their structures so that the average individual can participate in the decision-making process and receive the same empowerment as the traditionally rich class.

But the minimum capital that qualifies one for membership in most DAOs of today serves as a barrier for many average individuals. Some DAOs set the requirements for membership at $100,000 or more as the case may be. And such figures may be quite expensive for some people to afford.

Also, many DAOs are currently funded by venture capitalists which are tangential to what DAOs are supposed to represent. Many DAO proponents say DAOs will replace venture capitalists with a focus more on decentralisation and community. However, the irony is that VCs are beginning to fund the DAOs that are supposed to replace them.

On the other hand, this may not be entirely seen as a 'bad' considering the operational expertise of venture capitalists. VCs can help DAOs to navigate the legal terrains and challenges they may face in the physical world. As this Coindesk piece puts it, DAOs of today are subscribing to "combining the community-driven ethos with the deep pockets and operational expertise of venture capitalists."

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Conclusion

These challenges show that DAOs are not all rosy as they seem to be on the surface. While the governance tokens of some DAOs have given investors good ROI, you should know that DAOs are not typically investment properties. Rather, they are means of effective coordination in a decentralized environment without the need for much trust.

Considering the issues we treated above, it may seem like a tedious process to start or invest in a DAO. However, our dedicated team of experts can help you to navigate your most pressing needs. Contact us here.

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This article is an excerpt from our upcoming report on the web3 space.