How to Structure a DAO

Sirus Knight is the Co Founder of SocialKapital.Co, a decentralised organisation (DO), remaking how start-ups are incubated and accelerated.The opinions expressed here are mine alone and are not intended to be legal advice

DAO, DO are acronyms that describe flavours of a new organisational form made possible by blockchain technology, in particular smart contracts. Decentralised Autonomous Organisations (DAOs) encode the “entire” business process as smart contracts. Once the codebase is deployed on the blockchain, the organisation goes into auto pilot. Hence the word autonomous. Remove auto pilot and you get a DO (Decentralised Organisation). To DAO or DO, really depends on the purpose and business model of the organisation. With regards to legal structure, the same challenges apply. For simplicity, the rest of this article will refer to DAOs.

On the blockchain, DAOs contain internal assets which must be owned for the organisation to operate effectively. These assets are embodied in blockchain tokens. In the majority of cases, these tokens are sold through some sort of crowdsale.

Granted it is difficult but not impossible to sue a DAO that exist and operate entirely online. However, it is easier to charge the promoters of such a DAO with securities law violations. If you are planning to set-up a DAO that operates partly offline and the organisation needs to sale blockchain tokens in some sort of crowdsale, then you need to structure the DAO in a manner that protects token holders from been sued for the actions of the organisation. Keep in mind that there are other benefits to be gained by using the right legal structure. The right structure enables the organisation to conduct commercial activity offline as well as avoid the violation of securities laws during the crowdsale.

Legal Form

When you strip out all the technical finery of a DAO, this organisational form has the hallmarks of a partnership. The preferred type here is a Limited Liability Partnership. In a Limited Liability Partnership (LLP), one partner is not responsible for the negligence or misconduct of another partner. Incorporating the DAO as a Limited Liability Partnership limits the Liability of its members, it also enables the DAO to conduct business offline. Furthermore, LLP’s are tax efficient. Each partner is responsible for their own tax affairs. There are quite a few offshore jurisdictions offering different LLP variants. The choice of LLP and jurisdiction will depend on a DAO’s business model and purpose.

Fail the Howey Test

To determine whether a DAO crowdsale offer is a security, substance trumps form. It doesn’t really matter how many disclaimers the promoters put on the crowdsale documentation or what they call the DAO token. It doesn’t matter whether the token is called shares, fuel, reputation, energy etc. What matters is the substance. That substance was defined in a four part test by the US Supreme court in Sec. & Exch. Comm’n v. W.J. Howey Co . The Howey test states that a transaction constitutes an investment contract (therefore a security) if there is (1) an exchange of money (2) with an expectation of profits arising (3) from a common enterprise (4) which depends solely on the efforts of a promoter or third party.

The definition of money in this context is quite broad, hence most DAO crowdsales probably pass test 1 to 3. The promoters have to design the DAO business model to fail test 4. The way to do this is to involve token holders as practically as possible (thus put the failure of test 4 beyond reasonable doubt) in the value creation process.

For example, if the promoters want to launch a DAO that provides cloud computing capacity. The promoters have to design the DAO in such a way that the token holders provide the computing capacity and earn a substantial part of the profit through the provision of said capacity. Remember the substance versus form rule. The rewards of the enterprise should be channelled (verifiably on the blockchain) to token holders who participate in the value creation process.

This design paradigm has incredible power. Firstly, it conforms to the implicit reasoning behind Howey test 4: a group of people cannot defraud themselves. In this scenario, fraud becomes possible when there is technical or governance failure. Secondly, it offers a new way for people to come together and create value. Will the DAO and DO become the dominant organisational form of the 21st century, only time will tell.