A Taxonomy For LAOs: Making Sense of the Emerging LAO Ecosystem

Interest in LAOs has been growing. We unpack why LAOs are useful and provide an overview of the types of LAOs that likely will be created over the upcoming months and years as the invasion spreads.

DAOs are turning organizations into software, bringing to life futuristic visions of digital organizations. The emergence of DAOs in the blockchain ecosystem is hardly surprising. They bring together all of the strengths of this powerful new technology. Blockchains serve as a universal reference point for social coordination and a blockchain’s natively digital assets can move nearly as fluidly as sending a text message, making the pooling of assets fast and easy.

The open nature of blockchains holds out the hope of creating truly permissionless organizations — organizations that know no jurisdictional limitations and operate natively on the Internet. Powered by hard-to-modify smart contract code, these organizations can exist in potential perpetuity, insofar as associated DAO members can keep signing votes with their private Ethereum keys.

In 2019, DAO development has accelerated as the Ethereum community has shaken off its PTSD from the original “DAO” experiment. We’re seeing a number of grant-focused DAOs summoned from the ether, projects like MolochDAO and MetaCartelDAO. These organizations operate efficiently and nimbly using smart contracts to create highly participatory corporate governance mechanisms coordinated through online forums and Twitter.

At a technical level, these organizations operate autonomously, with human decision-making pushed to the edges. Smart contracts defined and facilitate the onboarding of members, voting, and the pooling and transfer of digital assets, stored in each DAOs’ respective guild banks, which today hold over a million dollars worth of ether.

Coordination in DAOs is largely irreversible and therefore supports autonomous financial transactions. That’s because the use of Ethereum and smart contracts enable these organizations to operate via consensus and point towards a future where organizations are increasingly “consensus-directed” as opposed to board-directed.

The extent to which DAOs can be truly autonomous (i.e., operate without any human intervention) has been hotly debated since the launch of Ethereum. Today’s DAOs often coordinate human activity through participatory voting or are controlled by humans who provide input into key metrics or data needed for the smart contract to operate. That’s why many think a more accurate way to describe a DAO is not a decentralized autonomous organization, but rather a decentralized organization.

Because humans are still involved in the operation of DAOs, they create corporeal and practical attack vectors (outside of other threats like a hard fork or other infra extremis that might undermine the integrity of pooled funds or ability of DAO members to sign transactions), along with legal risks.

As we’ve explained previously, any human participating in a DAO has various different liability risks both to other members and to those that may be providing funding or receiving services from the DAO. This is particularly true for DAOs organized around profit-making endeavors, where — by default — these organizations will be presumed to be partnerships in most major jurisdictions, subjecting members to generalized liability for the debts and obligations of the DAOs and DAO-related actions of its members.

As a result, even though DAOs operate in the “ether,” its members still reside in “meat space,” where members will be subject to the laws and regulations of their resident countries, backed by courts and the government’s ever-present threat of force. If a DAO runs into problems, each member likely will be responsible for the actions of other DAO members.

Managing the Legal Risks of DAOs.

There are several ways to manage these risks. One way is to entirely rely on smart contracts and provide members with automatic rights to exit. We’ve seen this approach taken by MolochDAO and related projects. Strong exit rights, like ragequitting, are compelling protection for prospective harms that members of DAOs may levy against one another. If a member of a DAO is dissatisfied with the actions of the organization, they have the right to leave and take their assets with them. You are no longer bound to the actions of the DAO or its members.

However, ragequitting and other powerful “rights of exit” do little to manage liability that may have previously attached before a member has left a DAO and thus represent an incomplete solution; managing these legal risks are difficult solely with smart contracts. That’s because smart contracts primarily excel at memorializing objective promises between parties. Promises such as “I promise to transfer to you X number of tokens” and “I agree that if majority of token addresses (based on the number of tokens in each address) sign a transaction, assets from this address can be transferred to another address” are easily translatable in the cold, binary language of Ethereum.

Conversely, subjective promises or promises based on unforeseen events are currently difficult to embody in Solidity or another smart-contracting language, even with the use of oracle services. It’s hard to represent promises like “I agree in the future to not seek legal damages from you in a traditional court if the entity is found liable” or “I agree that if there is a dispute we’ll use this decentralized arbitration procedure.” These promises are best expressed in fuzzier natural language.

A second way to manage these risks is to connect a DAO to “meat space” using recognized legal structures as a liability shell for these organizations, supplemented by Ricardian contracts provided by services like OpenLaw. By doing so, distributed teams can manage a greater range of legal risks that may apply for members, along with more clarity as to their liability to potential parties that a DAO may engage with. The combination of legal entities and Ricardian contracts enable members to:

• Use natural language promises to define their respective rights to one another and to manage risks related to exogenous or future unexpected events; and
• Use smart contracts to create autonomous and hard to modify promises which help engender trust and lower operations costs.

The end result is that DAOs transform into LAOs — entities with governance and funding mechanisms occurring autonomously with liability and other rights limited via traditional means.

Through this approach, rights and obligations between members — including questions related to liability, agency, choice of law questions, and dispute resolution — can be defined in a Ricardian contract to deal with unexpected or unfortunate events and a DAO can enjoy the limited liability provided by existing legal entities. By using LAOs, DAOs can effectively hold assets, sign contracts in their legal name, with the efficient management of DAO governance and assets handled via smart contracts. DAOs and their members can limit risk and make these entities more predictable, without making them less programmable.

Take, for example, the following scenario:

Bob receives a grant of 10 wETH from niftyDAO, a collective of NFT enthusiasts who want to support Bob’s exciting application development for digital collectibles, with an additional 20 wETH DAI promised for his first milestone completion. Bob has been discussing his progress with Alice, who had first interviewed Bob on behalf of niftyDAO before submitting his grant request. Bob had felt pretty optimistic about his ability to juggle his other responsibilities during this assignment, as well as a rushed move to the pricey confines of L.A., after winning the grant, but begins to stop making scheduled Zoom calls with Alice to discuss his NFT app. About a year later, Bob announces he has completed the first niftyDAO milestone and demands the remaining 20 wETH contemplated in his initial grant award. niftyDAO members have all but forgotten about Bob and his erstwhile NFT app, and for that matter, they’ve basically moved onto a new NFT-grant DAO to coordinate. Bob is furious and brings a lawsuit for breach of contract against Alice and other members of the niftyDAO for 20 wETH, the price of which has appreciated against her favor in the last year. Bob wins his lawsuit, but Alice cannot pay the judgment.

If niftyDAO solely relied on smart contracts for its governance, the DAO in all likelihood would be characterized as a common-law partnership and Bob would be able to recover damages from other members of the niftyDAO (assuming that Alice’s actions around found to bound the niftyDAO). Even if a niftyDAO member rage quit, it would not prevent a court from entering a judgement against other members to compensate Bob for his loss. And, a court’s judgment will stand until it is satisfied in either crypto or other more traditional assets.

As a result, smart contract-based DAOs run the risk of creating a “market for lemons,” where the only participants are those with limited assets or exceptionally high risk tolerances. More traditional sources of financing and enterprises are disincentivized to join these types of DAO, due to a lack of basic legal protections.

Fortunately, the same conclusion would not hold if niftyDAO was organized as a “niftyLAO.” Alice would only be able to recover directly from the DAO and if the DAO did not have any assets each member of the niftyLAO would presumably not be liable, except under narrow circumstances. Even more, the ability of Alice to bind niftyLAO, in the first place could have been defined in various Ricardian contracts eliminating the potential for this type of dispute in the first place.

By relying on Ricardian contracts, LAOs can better manage legal risks and obligations than just DAOs managed and governed smart contracts. LAOs create more predictability for DAOs and thus are better able to manage risk and support more complex financial arrangements, such as investment contracts and other schemes to raise finances, distribute profits, and own profit-bearing assets. That means that people from all walks of life can participate in DAO structures, including more sophisticated actors and even traditional businesses.

Use Cases for LAOs.

Over the past several months interest for LAOs has grown. We’ve seen the launch of a growing ecosystem of LAOs. The first LAO was created by OpenESQ, followed by experiments from dOrg and Nexus Mutual in modeling legal DAOs. These early experiments point to a growing ecosystem of DAOs that will support not only grant-giving operations but also various different for-profit enterprises:

Currently, many DAOs are either organized as base level protocols (like Bitcoin or arguably Ethereum), decentralized dapps, or have been limited to providing grants for either protocol development, marketing, or other productive activity. While some of these projects are looking to build revenue-generating DAOs, they are limited due to the legal concerns outlined above, along with questions related to securities laws.

With LAOs, these questions narrow. LAOs can maintain a public corporate veil that cannot be pierced by liabilities, by relying on more legalistic formalities. At the same time, relying on a traditional legal structure, with associated Ricardian contracts, clarifies rights and obligations amongst members and the characterization of members’ interests.

Legal Forms For LAOs.

The legal forms for LAOs can take on a variety of formats. In general, DAOs vary from an open structure with flexible decision-making to a permissioned structure with precise decision-making. The permissionless structure can be seen most in the ICO projects, and notably in the Bitcoin and Ethereum networks. For many of these organizations, there is no precise social coordination, just a technical protocol open for individuals to participate in. Most of the DAOs discussed here will consist of the latter structure type and hold some sort of legally recognizable structure.

Decentralized Autonomous Corporations (or DACs)

DACs are registered C corporations, with tokenized shares and automated voting and dividend distributions. A DAC provides members with limited liability protections and is likely suitable for LAOs that seeks to accrue value to their ownership and position shares for public investment (especially those enterprises that may still want to seek traditional venture capital financing).

Filing to register a corporation typically involves submitting a certificate of incorporation by fax or mail to the relevant state secretary office in the unique name of such legal proxy, obtaining a registered agent in the organization jurisdiction to receive legal notices on behalf of the corporation, as well as certain annual taxes and other fees to maintain its effective liability-limiting shell and other positioning benefits. There are also a variety of corporate formalities that must be satisfied to qualify and operate a corporation.

By natively managing tokenized representation of corporate stock, a DAC can be used to better account and enact votes transparently among its various stakeholders, such as board members, principal shareholders, officers, and common stockholders, presenting a more clear path to reaching corporate consensus that might otherwise require great accounting and financial settlement resources. Further, with tokenized shares marking the distribution of ownership across public Ethereum addresses that themselves effectively represent bank accounts, there are opportunities to programmatically stream dividend profits straight from a LAO treasury address to corporate shareholders seamlessly as such decisions are recorded to trigger functions in LAO-governed smart contracts.

In terms of the operational efficiencies that can be realized by utilizing smart contracts for formal corporate governance, a LAO corp. might use a series of multi-signature digital wallets that are weighted with voting ERC-20 tokens to represent title or other legal authority within the official proxy hierarchy to record and execute financial transactions on public record, such as having a series of mini-DAOs within a LAO that effectively represent divisions of a company that may have different decision-making powers over separate pools of assets or functions represented in Solidity.

Primal ETH, Inc. (Primal), is an example of such a DAC in the wild, interfacing an Aragon DAO program to the governance of the Board of Directors of a registered Delaware corporation, with Primal Board resolutions recorded and executed on Ethereum after votes are signed by members holding designated ERC-20 digital tokens. Likewise, this DAC manages digital representations of Primal Common Stock (PECS) tokenized under the ERC-777 standard to maintain certain regulatory transfer controls on securities. Conducting an annual meeting of shareholders and related proxy voting with PECS is contemplated in the near future to continue demonstrating blockchain smart contracts for formal [L]AO governance.

LLACs

Many other LAOs will be organized as limited liability autonomous companies, or LLACs, which combine the benefits of a corporate veil with the flow-through taxation and flexible management structure of unincorporated partnerships. These types of structures will be favored for funds and other instances where members will want to distribute (potentially automatically) profits on a periodic or ongoing basis.

Unlike a registered corporation, LLACs do not need to have a board of directors — a fact that makes them a natural choice for more participatory DAO structures. Indeed, it’s even conceivable that an LLC can be memberless (at least in the US), enabling members to assign, convey, or otherwise divest their software into a legal entity that can operate with other commercial enterprises.

LLACs do not necessarily have to hold annual meetings or observe similar formalities to make effective decisions and (at least in Delaware) members can agree to keep the identity of members private (at least publicly). They are thus attractive for DAOs that want more privacy and direct involvement in management matters, and thus, are often preferred vehicles to limit the liability of founders who are staging an early-stage venture ad entering into contracts and other financial arrangements to bootstrap themselves.

Open, ESQ LLC and dOrg, BBLLC, are both examples of such living operating agreements paired to registered limited liability entities in New York and Vermont, respectively, and mark early models for DAOs operating for-profit ventures under LLC wrappers.

Other LAOs may choose to organize as Series LLCs, particularly if they want to segregate the pooling and distribution of assets based on the participatory rights of members. A Series LLC allows a single state charter registration to serve as the foundation for potentially an unlimited amount of derived limited liability shells, or “Series,” within such Master or Umbrella LLC by virtue of amending a private operating agreement.

With their legal novelty, however, comes certain lingering uncertainties on the full benefit of Series LLCs and the scope of public protections afforded to them by foreign jurisdictions. For example, judicial case law has yet to fully determine how other states that do not have Series LLC provisions on their books might treat these complex entities when they do business locally. Therefore, it is not clear how a single series within a Master LLC should file for foreign qualification to do business within a state without Series LLC legislation, or, if local courts would honor separate series liability if a dispute arose, or instead, hold the Master LLC and its whole portfolio of assets liable to defend claims it would like to confine to a single series. In any case, in the context of digitally-native Series LAOs that mostly engage in online business, there should be strategies in terms of contracting and managing physical assets to limit such jurisdictional “doing business” presence to supportive locales.

In collaboration with OpenLaw and OpenESQ, MetaCartel DAO is pioneering an incubator model around Series LAO registered in Delaware, MetaCartel Series LLC (LAO). The LAO team looks forward to documenting our progress utilizing the OpenLaw stack and other Ethereum-compatible software to maximize the effectiveness of the MC Series LAO.

LAOPs

Another potential avenue for DAOs is to organize as a cooperative. Cooperatives naturally align with many of the goals of DAO participants to jointly manage pooled resources and who might favor democratic governance and self-determination over more rigidly-structured entities primed for financing.

Cooperatives are a form of business association rooted in a history of democratic operation and mutual help around pooled resources and labor. They are commonly owned and operated by members who provide or use shared services. Where organizations are managed under formal cooperative rules, they may gain favorable IRS tax treatment or become eligible for certain government grants or antitrust exemptions. Given that many DAO participants may already align with such rules and favor democratic representation (one-member-one-vote) as well as operate-at-cost to build resources they want to collectively use, a formalized cooperative structure might be a useful structure to map to as legal proxy. However, cooperatives will likely not be suitable vehicles to attract outside investment, given that greater economic contributions will not garner greater voting shares in such member arrangements.

Forming a cooperative typically involves filing to register a corporation or LLC and preparing a private membership agreement to formalize cooperative management rules. In this fashion, cooperatives can enjoy the typical corporate veil benefits of a registered legal proxy. In order to use the word “cooperative” in their business name and enjoy such reputational benefits, a cooperative may also need to file under a state’s dedicated provisions for such organizations.

However, thus far, cooperatives have typically have struggled to attract outside investment given their usual requirement for 1-member-1-vote governance for favorable tax treatment.

In part, to address this concern, Wyoming established the “Limited Cooperative Association” (LCA) structure in 2001 that, among other business advantages, clarifies the ability of cooperatives to work more like LLCs by allowing investor-members to participate who do not otherwise patronize or support the business. The investor-friendly LCA model has since been adopted in other states, as well as proposed by the Uniform Law Commission (itself a coop.) for standardized state adoption.

While it remains uncertain how federal law largely developed on traditional cooperative models might accommodate LCA hybrid arrangements, these entities and the respective arrangement between ordinary and investor-member can be mostly handled through private contracts, similar to LLCs. It should be noted that many LCA statutes require that patron members (i.e., those who use or produce LCA output) retain primary control over material decisions. Therefore, an LCA probably makes most sense for DAOs that want a cooperative ethos but don’t necessarily want to foreclose capital opportunities from aligned investors who might not mind such arrangement. On the flipse, a more profit-driven LAO might therefore consider a legal proxy structured as an LLC or c-corp.

Contractarian DAOs

A last option for DAOs is to organize as a partnership and rely on Ricardian contracts to manage the relationship between members. A general partnership generally involves a mutual endeavor to generate profits and can be formed with something as informal as a handshake. In order to avoid default legal assumptions about how partnership profits should be split, terms of membership, and more importantly, how to leave such association, members could enter into one or more Ricardian contracts digitally signed by all members to reflect formal understandings and make them legally enforceable.

Many DAOs are likely considered unincorporated general partnerships under the law and therefore, each participating member may be fully liable for any claims brought on account of things going haywire with internal DAO management or to benefit DAO creditors. As discussed above, there are a variety of state-registrations to form LAOs that can limit DAO-member liability, rather than pose the uncertainties and chilling effects of potentially unlimited liability for such financial transactions.

However, a set of private Ricardian contracts could, in some instances, do the trick. These agreements could vary the rights and obligations of members, potentially limit their liability to one another, and clarify agency and dispute resolution procedures. The degree to which these agreements can limit liability and operate across a variety of jurisdictions, due to differences in partnership laws, may limit the applicability of this approach.

The Future of LAOs

Over time, as DAOs become acculturated and more widely adopted, we suspect the lines between LAOs and DAOs will blur. We imagine that responsible projects that are participatory, inclusive and that productively organization socially beneficial activity will create opportunities to pass, amend, or change laws to accommodate broader and more inclusive DAO structures.

That begins with initiatives like “The LAO,” along with other planned collaborations with teams like MetaCartel. The Ethereum ecosystem is building the future of not just money and finance, but also the future of organizations. LAOs represent the next meaningful step in that direction.

Learn More

To learn more about The LAO, sign-up and continue the conversation on our Telegram and follow us on our Twitter. We are looking for input and feedback to make sure that we can take the next step in the evolution of DAOs.

Thank you to Ameen Soleimani of MolochDAO and James Duncan of Metacartel for your contribution and review.