To Blockchain, or Not Blockchain? DAO or SPV?

Inspired by the tale of decentralised finance, software engineers & computer scientists have come up with the idea of Decentralised Autonomous Organizations (“DAOs").

What is a DAO?

Characterised by their lack of hierarchy, funds are raised through crowdfunding-like methods (such as Initial Coin Offerings, Initial Exchange Offerings or Token Generation Events), with voting rights accruing to tokens associated with the investment amount. 

Each DAO has a fixed set of rules that govern how token-holders can influence the operations of the DAO (including the ability to earn more tokens through gamification mechanics like yield farming or liquidity mining). 

Crucially, consensus amongst such token-holders is required in order to effect a decision on any actions or operations of the DAO, including the purchase of an asset. Here we compare DAOs with SPVs for investors.

Regulatory Uncertainty: The Legal Headache

Given its status as being ‘on the blockchain’, DAOs may offer a degree of pseudonymity, with investors or participants being identified by a string of numbers (which is their wallet). 

Already, the SEC has stopped a DAO from registering two tokens, for failure to comply with traditional rules & regulations concerning securities issuance. While it is unlikely the SEC will be so wholly resistant to DAOs, as it is now becoming in vogue, the current lack of regulatory certainty is enough to be off-putting for some investors. Additionally, DAOs that have a cross-jurisdictional presence means that any future legal issues with DAO-owned assets can be overly complicated (and therefore expensive to resolve).

The Path to Decentralisation?

US$30b was invested last year in blockchain startups by A16z and other prominent VCs, with 65 unicorns being crowned.  This is very much an illustration of the strong growth from institutional capital in this nascent (but growing!) space. Investment into blockchain startups that exclusively service DAOs is expected to increase in the coming years. 

In terms of governance – some DAO are implementing “quadratic voting” mechanisms, where people vote to express their degree of preference rather than just their preference alone.The more votes expressed, the more costly in vote credits. 

Whilst in principle those who are more passionate about the topics get to sway votes more, this still gives the advantage to the wealthier. To avoid being out-voted by token-holders with significant holdings or preclude crowd participation, DAOs may move towards a model which would make membership contingent on contribution. If you prefer to be a passive investor, this will represent a marked shift from the previous model.

DAOs Lack Herd Immunity

While groups operating together may offer an additional layer of security in decision making, this may not be the case when it comes to DAOs. 

In a DAO, decision-making is pooled amongst individuals, rather than a manager in the case of an investment fund. 

In most Angel Syndicates that use SPVs as a way to coordinate investment, there is usually a hierarchical form, with a “lead” to whom the group trusts & delegates the operational & administrative decision-making to, alongside potentially the sourcing of the deal itself. For his/her role as the, they may takes a performance fee/”carry” on the exit. This semi-centralised approach model allows for the entire group to move quickly. 

Conversely, the lack of hierarchy and the need for consensus-gathering within a DAO arrangement means decisions can take an extensive period of time, which may not be compatible with the ever-increasing fast paced nature of venture capital. 

To combat this some have introduced quorum voting – where meeting a threshold is required – but even with this operational model, to effect a decision, the threshold would still need to be met. This can cost participants undue time and “gas fees”.

Alongside speed & efficiency considerations, the limitations of decision-making being public (as decisions and governance-related actions are visible on the public blockchain) can also affect the group’s ability to secure an asset, in the case of a contested sale. For example, in 2021, the “Constitution DAO” attempted to buy a copy of the US constitution, only to be outbid by Citadel’s Ken Griffin. Once a DAO agrees on a specified target, it is committed to only bidding as high as the amount of capital raised permits. If, however, they are targeting assets within a competitive context, the “perfect information” model of DAOs (alongside the slow(er) pace of decision-making) may result in a scenario where the DAO is outbid or out-allocated.

Work-In-Progress

The race is already on with multiple startups trying to develop easy DAO infrastructure that doesn’t require heavy coding. 

Until there’s a standardised format that can then be scaled exponentially, the core infrastructure – smart contracts powering the DAOs – can often be inefficient and open to mistakes. Bugs in their code are for all to see and hard to retrospectively fix, sometimes meaning DAOs have to start afresh to simply overcome them. As flagged by the MIT Technology Review, this can also raise some security concerns. The classic example is the hack of the original ‘The DAO’ in 2016, which ultimately resulted in Ethereum being hard-forked (spinning off Ethereum Classic as the more ‘ideologically pure’ chain).

Residual Long-Term Costs

One attraction of DAOs may be the perceived low-cost to set one up – after all, it would just be the initial founding members of the DAO sending to the relevant smart contract. However, there may be residual long-term costs. 

Examples of existing DAOs (either domiciled in the state of Delaware, or increasingly so, in Wyoming) structured with input from securities attorneys & regulatory lawyers, alongside CPAs & accountants, bear more similarity with your traditional fund structures and SPVs. This means ongoing accounting & tax compliance costs (such as generating Schedule K-1s for the participants), alongside the potential need to continually restructure, in line with the latest guidance concerning the latest regulatory treatment of DAOs, mean that DAOs structured with compliance considerations in mind may see significant ongoing running costs (whereas those who have less of a view towards compliance may see enforcement action, as the SEC turns its gaze towards the cryptoassets space). 

In terms of the European Union – DAOs are impractical or impossible under the current regulatory regime, with a much more rigorous & strict approach towards financial regulation. DAOs as constituted there may be seen more as an investment fund or a securities issuance. The shuttering of Neufund proves a case in point. 

Looking ahead, whilst there are some promising legislative developments in the European Union covering cryptoassets – namely MiCAS, which is intended to be a consolidated suite of rules & regulations covering cryptoassets and the blockchain sector – this is very much a long-term project. Additionally, there is a residual risk that DAOs (in the Web3 sense) may still fall within the laws regulating investment funds, and therefore hobble the implementation of a DAO in its purest intellectual form.

Wait-and-see:

In the context of investment vehicles, centralised vehicles such as funds and SPVs offer the advantages of centralisation – speed and efficiency,  and investment management & decision-making is delegated to an asset manager or an angel syndicate with a track record. 

Whilst institutional interest in funding blockchain building tools for DAOs and the wider decentralised finance space is steadily increasing, the funds are not setting up DAOs themselves just yet.


Bryan Cheung