A “Killer App” for Crypto: Distributed Autonomous Corporations (DACs)
by David Grider
Currency Is Not the Only Fruit
Imagine an infinite diversity of crypto companies, each selling a unique product using blockchain technology. Why crypto assets are more than just currency.
THE MAJORITY OF CRYPTO INVESTORS are true believers.
They have to be. Navigating ICOs, exchanges, cold storage, citizenship restrictions, and unpredictable market movements — the information overload is a lot, even for our current generation of digital natives. So it comes as no surprise that the enthusiasts who have assembled themselves around blockchain technology are upbeat about the possibility of crypto startups supplanting traditional companies all together. To hear them tell it, the industry is only a few years away from a 100% crypto world of services and transactions effected through an infinite number of microcosmic blockchains.
The reality is likely to be very different. Not every company needs to issue tokens. Not every company’s business objectives are best served by decentralization. In all likelihood, a mature crypto space will occupy only a portion of the global economy, serving users in businesses for which decentralization is critical.
Crypto assets remain misunderstood by the vast majority of the financial public. Even informed investors have a narrow view of what an ICO is, what a token represents, and what the resultant network means.
DACs are Crypto Innovation Beyond Currency
As crypto evangelists know, ICO stands for ‘initial coin offering’ in analogy to a traditional initial public offering (IPO). Yet given the nature of digital assets, the public sale of a crypto asset is probably better captured with the term ‘crowdsale.’
The difference between the two is instructive. The ICO model of crypto startups emphasizes the speculative nature of the offering and encourages observers to think of tokens as merely different brands of cryptocurrencies fighting to replace bitcoin. Traditional analysts trot out the textbook components of fiat currency to discredit bitcoin and crypto assets in general. The thinking goes: Not enough usage, therefore not enough purchasing power — therefore not really a currency at all. Or: The ability to issue millions of crypto assets makes all of them fundamentally worthless.
But bitcoin was never intended as a one-to-one replacement for the U.S. dollar or the yen or the won, just as every crypto asset is not intended to be a currency itself. The true power of cryptocurrency comes from the blockchain business model of the network that powers it.
In the crypto space, the business model of many companies is the distributed autonomous corporation (DAC). In this report, we define the characteristics of a DAC, compare them to features of a traditional corporation, and argue that many tokens are best understood as products or equity signifiers rather than currencies. It therefore follows that the crypto market is fully capable of sustaining as many assets as there are traditional stocks or individual products — and unlike with fiat currency, the proliferation of digital assets is not inherently damaging to the utility of any one cryptocurrency.
These DACs are becoming a truly innovative application of crypto technology that offer the following advantages over traditionally organized corporations:
- Censorship resistance business models more capable of operating around regulation.
- Natural resistance to seizure of corporate financial assets and intellectual property.
- Improved fiduciary oversight, as smart contracts and transparent accounting flows on the blockchain reduce the risk that management will not pay shareholders appropriately.
- Improved human capital productivity and efficiency as rent-seeking middlemen are removed from the system and borderless workforces become highly vested and incentivized.
What does this mean for the adoption cycle? The DAC is one of the most powerful and disruptive killer applications of crypto assets.
The DAC vs. the Legacy Business Model
DACs and traditional corporations contain many of the same basic business components, including:
- Products. DACs offer products and services like any business, and their demand is rooted in classic economic utility. Product tokens are best understood as the purest form of utility token, generating no cash flows from ownership and providing only access to the products or services of a network. For example, the 0x protocol (ZRX) token — governance rights aside — is used solely to pay fees to order matching relayers for their help in facilitating trades on the network. In this regard, the token functions as a membership voucher to its holders that allows them access to the networks software platform, which is the product itself.
- Workers. Many staking blockchains allow users to function as masternodes or validators and compensate them for their efforts or computing resources with tokens. For example, many decentralized prediction markets require workers to perform the task of verifying outcomes of real world events and many consensus protocols require workers to validate transactions. Becoming a worker requires ownership in the network token which is staked as collateral to incentivize fair behavior. In exchange for these services, workers are rewarded with wages in the form of valuable network tokens, similar to being paid in equity compensation.
- Governance/Management. Voting users of the network achieve consensus on the use and allocation of network resources based on collective decision-making procedures established by the governance model of the DAC. For example, DASH masternode owners can vote on work proposals to govern how the 10% community budget of block rewards are spent to fund projects. EOS implements a model where token holders elect a group of block producers that validate all transactions on the network which is much like shareholders voting for a board of directors.
- Financial statements. The capitalization, expense/revenue, and functional cash flows can be calculated for many DAC’s just as they are for a traditional corporation.
- Traditional Equity Valuation Models. Depending on the network economics, tokens may represent equity shares in a DAC, which should be assessed using traditional valuation models.
Accounting and Valuation Models for DACs
Though DACs and traditional businesses are similar in many ways, the accounting flow of revenue and expenses through a crypto network represents a new business paradigm. In reality, distributed corporate token models reconfigure the traditional corporate business model to the point that even the flows of revenue and equity are affected. This reconfiguration of the financial accounting and value flow model is a central feature enabling the disruptive innovation DACs offer.
For example, consider Wagerr, a crypto gambling platform. Users place bets using WGR tokens, paying a fee for the privilege of accessing the gambling services provided by the Wagerr network. In a traditional company, the fee would be paid to the business, recognized as revenue, and eventually passed through as period-end net income to the equity section of the balance sheet.
However, a portion of gambling fees on the Wagerr network are not retained as tokens but burned instead. As we noted in our Fundamental Valuation Approach: DCF report, for a DAC, the value of the burned tokens is akin to an equity share buyback in a traditional corporation.
How can a token equity transaction be considered a functional cash flow? Imagine a business that issues 5 tokens. Assume that the business will generate lifetime sales of $5, it has no expenses and no cost of capital. The each token issued should therefore be priced at $1 for a market capitalization of $5. Per the business model, as tokens are used on the network to access the desired service, they are burned, reducing the supply in circulation. Per the economics of the network, no new tokens are ever minted.
Each year, the network experiences $1 of demand for the service provided, such that at the end of Year 1, one token has been purchased with a $1 cash flow. The remaining supply is now 4 tokens, and market capitalization is $4.
The tokens may be traded around over time between various parties, but eventually the process repeats annually through Year 5 until no tokens are left. Each holder has received $1, for a total market cash flows received of $5. This means that every purchased token that is destroyed in exchange for services also provides effective cash flows to the previous holders. (Not all tokens are acquired via purchase on an exchange, but DCF is only one of three components of fundamental valuation.)
Note that throughout the life cycle of these tokens, the price remains steady at $1, representing the amount that each token holder may expect to receive in the future. For this example, no discounting is required, as the cost of capital used to calculate net present value is 0%. In a real-world situation, of course, the future cash flows component of fundamental value would be determined using the desired hurdle rate while the exact future demand would likely be unknown.
In other words, one of the fundamental valuation components of a token is the future cash flows expected to be earned by current holders.
The implication for token burning is clear: The $1 value injected into the network as people purchase tokens to access products and services is an upfront functional cash inflow, much like revenue acts as an inflow to a traditional company. When those tokens are burned, it is equivalent to a company using an influx of revenue to buy back equity shares.
Similarly, the value of new tokens issued as part of scheduled inflation functions as an accounting expense in the network, lowering the value of each network token via equity dilution while leaving the overall network value theoretically unchanged. These particular outflows can be understood as a kind of stock compensation expense. In a burn and mint model, the new tokens are effectively paid for with the burning of used tokens — just as traditional companies may issue stock compensation grants by using existing treasury stock.
If token buybacks function as revenue and token issuances act like expenses, it follows that the net income of a DAC with this crypto economic structure can be calculated as the net value of the token supply change, where the change represents the net value paid to token holders. In this way, equity market capitalization should reflect the value of all discounted future cash flows.
The key difference between traditional and crypto accounting flows is this: In a traditional accounting cycle, inflows to the business pass through the income statement and are closed net of expenses each period to equity. But in a crypto accounting cycle, tokens are used to pay for the products of a company, and the token burning process passes those inflows directly to equity.
DAC Enabled Efficiency, Transparency and Fiduciary Improvements
None of this is possible in a traditional company, especially one that still relies on a stock certificate/broker model of equity sales. In purely transactional terms, the effects of clearing houses and current T+2/T+3 settlement cycles prevent any trades from having a direct and instantaneous impact on company equity that would make such payment flows impossible due to pure impractically. It’s only now that this free flows of value is possible as a result of the technology efficiencies gained from the crypto business models that are facilitated by blockchain technology.
The ramifications for the finance, audit, and accounting industries are likely to be severe. When every revenue and expense transaction runs directly through the company’s own equity token as facilitated and recorded by a blockchain, an auditor needs only a block explorer and some accounting software to validate entire swaths of the financial statements previously subject to greater fraud risk. While certain areas of risk such as asset and liability valuation may require subjective judgment, and there may still be significant need for accounting controls, the material accuracy of reported cash flows will become easier than ever to evaluate.
From a reporting standpoint, the consequences are even more disruptive. Instead of reporting quarterly financials, public companies will soon have the tools to disclose their operating results block-by-block on the public chain. One can imagine the pressure that up-to-the-minute financial reporting will exert on an audit industry that has historically resisted real-time opinions.
The traditional equity share model hinges on the efforts and decisions of individuals other than workers, users or investors to properly distribute the value generated by the organization. Those charged with governance, such as a management and the Board of Directors, must authorize and issue dividends and perform share buybacks to return value obligated to equity holders. These layers of decision-making responsibility coupled with the separation of the value capture and delivery mechanism is what necessitates the need for fiduciary responsibility and legal recourse rights between these agents and their shareholders.
In contrast, DACs that operate using the crypto economic financial incentive models embedded in the networks smart contract protocol eschew the use of a corporation as an value delivery clearinghouse and replace it with a participatory model.
DACs are innovation beyond security tokens
Those that are critics of crypto but proponents of blockchains should note — — much of the innovation described thus far could be accomplished through the application of smart contracts and security tokens representing equity in centralized entities.
These types of tokens would include digitized stock certificates or tokenized debt, which represent existing products whose sole crypto feature is having been put on the blockchain. It’s even possible that the same functional payment flows of value that DACs offer may be accomplished through use of smart contracts.
Leading from this, many assume that the primary disruptive innovation to traditional finance is that of the usage of blockchain for security tokens issued on public crypto networks. While this application of crypto towards traditional finance will have efficiency in the areas of improved clearing and settlement and transparency, it lacks the truly disruptive features DACs offer.
The use of DACs will have a transformative effect on capital markets due to their innate ability to facilitate more competitive censorship and seizure resistant business models.
Censorship and Seizure Resistant DACs are Disruptive
Bitcoin provided users with censorship-resistant currency. It makes sense that distributed company models will do the same for products and services of all varieties.
Decentralized casinos like Decent.Bet , Ubers, AirBNBs, or file sharing systems are prime examples of this applications. Traditionally, regulators have willful enforcement over central entities in violation of regulations but lack recourse to these organizations when structured in the form of DACs, due to the distributed nature of user participation and asset ownership.
Consider that for most traditional companies, the shares are not truly held by investors; they are retained by the Depository Trust & Clearing Corporation (DTCC) for the benefit of investors. As such, a government seeking to take control of an individuals company assets may elect to seize those shares for any number of reasons, including those legal and illegitimate. DAC equity ownership through user controlled private keys offers a safe haven from such attacks.
State authorities have been known to confiscate privately held cash from banks, as the government of Cyprus did in 2013. The crypto flow of accounting makes such raids much more difficult. A DAC inherently voids the need for a banking system to send, receive, and store cash, as the financial flows of value can instead be transacted in its tokens equity, which can be used as the currency for its business operations.
While a government may still take the physical infrastructure of a DAC, it cannot as easily capture the intangible components of the business that generate equity value and provide for its distribution to users. As an open-source movement, crypto intellectual property cannot be ‘seized’ in any meaningful way. Neither can brand power be curtailed merely by banning the legal entity that manages it. If a regulatory authority attempted to nationalize a DAC, the network could vote to move its value payment process and token equity by executing a fork and coming to consensus on a new token asset to be used, leaving the legacy state controlled operations worthless.
Increased Competitiveness of DACs
Open and permissionless DACs empower entrepreneurship by reducing the divide between business owners providing capital and labors facilitating the organizations value creation process.
Empowering users to bypass the traditional business model and participate directly in a company’s equity is a headlining feature of crypto technology. Anyone who wants to be a worker on a crypto network can purchase the token, instantly begin adding value through services provided and resources expended, and be compensated per the token economics model. These workers and users who invest capital in the network operate in a permissionless and decentralized model and are paid in tokens or service fee revenue that, assuming sufficient liquidity, can be sold for BTC or USD. Workers initiate the inflow of capital investment; workers directly earn the cash dividends that flow out.
Passively Invest At Your Own Risk
The traditional centralized corporate paradigme relies on the fiduciary responsibility of management to act in the best interest of investors in the value creation process. The DAC model of open source decentralized crypto projects re-engineers this paradigme by putting the responsibility of the projects success back into the hands of its investors.
Bitcoin allows users the ability to either “be their own bank” by maintaining ownership of their private keys or to place this trust in the hands of a third-party such as an exchange. Much like Bitcoin, financiers of DACs are free to passively invest in token ownership and entrust the projects success to its founders or a team of core community members — but this creates its own risks.
Open source means that these workers acting for the benefit of the project are free to stop contributing at any time. The consequence of this paradigme change is that investors must take ultimate responsibility for the outcome of their financial success. While it may be acceptable to rely on the efforts of others within a highly dedicated crypto community, investors must be willing and able to step up and contribute to the projects success when needed. The merging of investors and workers should over time create greater accountability among project stakeholders. We believe this will leave funds that are equipped with VC capabilities in the best position for investment success.
It remains to be seen whether large institutional players will recognize the potential of direct equity investment in DAC token models and adapt accordingly. While we are optimistic, we believe that adoption trends for DAC will likely follow market share capture process outlined in the classical theory of disruption.
Of course, not all industries run the same risk of government confiscation of assets or corporate bans. The enthusiasm of crypto adherents may drive hype and cycles of adoption, but the world economy will never be 100% decentralized.
Neither should it. The endgame of blockchain is likely to be one of stasis: crypto companies as a contributing pillar of the economy, their technological advantages keeping both top-heavy corporations and the threat of centralized state oppression in check. As crypto adoption widens and regulation solidifies, an integrated world economy may be closer than anyone realizes.