The LAO has generated tremendous interest since it was announced several weeks ago. We address some common questions and criticisms below.
Several weeks ago, OpenLaw announced that it will be providing software to help create The LAO, a for-profit limited liability decentralized organization, which will enable its members to invest in early-stage Ethereum ventures and share in the profits. So far the response has been tremendous, and we’re deeply gratified by the coverage and offers by members of the Ethereum community to help bring this exciting idea to life.
At its core, The LAO aims to resurrect The DAO — the first grand experiment of Ethereum — but in a way that limits the liability of LAO-members and complies with US law. Just like how Coinbase legitimized cryptocurrency exchanges in the US — in the wake of Mt. Gox — we hope to do the same thing with for-profit DAOs, bringing digital organizations to the masses.
The history of DAOs is just beginning, but we believe the general approach of blending together traditional legal agreements with smart contract-based governance mechanisms hits the right tone and will ensure the responsible development of the greater DAO ecosystem. By way of analogy, from the beginning, Netflix wanted to bring streaming video to the masses, but it needed to start by sending DVDs through the mail (due to technical and legal restrictions — i.e., it needed to obtain licenses from content owners). We believe in open and permissionless DAO structures but will start by supporting a structure to a limited number of accredited investors through a public sale, which hopefully blossoms into an ecosystem of independent, member-managed LAOs that can rapidly make funding decisions.
Despite the promise of The LAO — and what we believe is a measured approach to delivering such structures — The LAO has already generated some responses, most notably from Preston Byrne’s in his article, “The LAO, demystified,” as well as other more measured critiques like “The Uphill Battle LAOs Will Face” by Mohamed Fouda.
The LAO is a Familiar Structure With Novel Smart Contract-Based Governance.
The LAO will (hopefully) be a large-scale experiment in using a limited liability entity managed by smart contracts to organize for-profit commercial endeavors. We’re bringing to life ideas that have been percolating around the Bitcoin and Ethereum ecosystems over the past seven years.
A predicate to the generalized notion of a DAO, was proposed by Dan Larimer in 2013, when he began to describe Decentralized Autonomous Corporations (DACs), that relied on blockchains and smart contracts to organize commercial affairs. The Ethereum Whitepaper extensively referenced Larimer’s work, when it was released in early 2014, presenting a more formalized and generalized version of the DAC with the more generalized concept of a Decentralized Autonomous Organization.
Despite the long lineage of blockchain developers, who have described and explored DAO-structures, commentators on The LAO have suggested that these structures have already been built. One criticism is that the first time a LAO was built was in “in 2014 [sic], when [Monax employees]proposed linking a DAO — properly, just some software that automated organizational governance using a permissioned Ethereum template — to a private organization, specifically a 501(c)(6) non-profit trade association.”
We scratched our heads a bit at this criticism, because the referenced entity was never launched from what we can gather.
In any event, the novelness of The LAO does not rest on linking smart contracts to legal agreements for purposes of developing a not-for-profit. It rests on the fact that The LAO will be engaged in for-profit endeavors in ways that limit the legal risk of members and aims to comply with US law. The LAO will modify well established organizational documents to accommodate smart contract-based corporate governance mechanisms, while working within the current confines of the law.
For what it’s worth, the idea of legally-recognized digital organizations, with presumed legal agreements standing behind them, stretches far back well before 2014 and the fantastic Monax team. Take for example the sci-fi imaginings of Charles Stross in Accelerando (2005):
“The divested Microsoft divisions have automated their legal processes and are spawning subsidiaries, IPOing them, and exchanging title in a bizarre parody of bacterial plasmid exchange, so fast that, by the time the windfall tax demands are served, the targets don’t exist anymore, even though the same staff are working on the same software in the same Mumbai cubicle farms. Welcome to the twenty-first century . . . . Today’s increasingly automated corporations don’t understand mortality.”
The LAO Will Streamline Venture Financing for Ethereum Startups.
A second exciting aspect of The LAO is that it’ll handle many of the operational issues related to entering into and financing a startup. As part of that process, The LAO will require that young Ethereum startups begin their journey “digitally native,” relying on organizational documents that are largely standardized in Silicon Valley but also modified to permit — and provide legal effect — to tokenized stock.
The use of tokenized stock in these companies will hopefully, over time, create fertile ground to explore concepts currently swirling around the blockchain ecosystem in relation to tokenized securities (STOs), including real-time dividend and royalty payments. With companies starting with their life with tokenized stock — on open and permissionless blockchains — the Ethereum ecosystem will finally have a reason to build more advanced market infrastructure to handle the custody and trading of these important financial assets in a more standardized fashion. In our view, digital assets will likely be adopted in a bottom-up, as opposed to a top-down, manner. And as Ethereum-based startups grow in size and importance, it will force Wall Street and more established financial actors to accommodate and adopt blockchain technology.
The LAO, despite strongly-worded assessments, is not a rediscovery that “a Delaware corporation’s back office can be run with software.” The LAO will ideally serve as an important piece of infrastructure for the Ethereum ecosystem — one that isn’t based on a proprietary database or company, like Carta. The LAO will create a generation of digitally native companies, many of whom are hopefully successful. Data related to these companies shouldn’t be owned by one centralized entity, but should exist on open, secure, and permissionless financial infrastructure.
Likewise OpenLaw, as the administrator of The LAO, will not “serve as a law firm,” rather it will provide projects (and their independent counsel) easy to use tools to build digitally native companies. Unfortunately, starting a business today is still hard and expensive. We want to make starting a digitally native business exceptionally easy.
The LAO Will Be Member-Managed, Because US-Based LLCs Do Not Need a Manager, and Members Will Enjoy Limited Liability.
The LAO is a new experiment in crowdfunding investment decisions — an express homage to The DAO. With the first version of The LAO, the wisdom of the crowd will be tested and members will manage investment decisions and the entire proposal process. Unlike other for-profit venture funds, there will be no general partner or managing members and we’re building tools to enable members to delegate their votes to other members.
The LAO can be legally formed in the US (without a managing-member) and will not require that OpenLaw manage the affairs of the enterprise. Instead, OpenLaw will simply provide the software and additional tooling necessary to operate the fund, while all substantive decisions are democratically managed.
As many corporate lawyers know, this is the default way that LLCs and other limited liability pass-through entities work in many states in the US. In Delaware, for example, under Section 18–402, of the Delaware Limited Liability Company Act, “the management of a limited liability company [is] vested in its members . . . . Unless otherwise provided in a limited liability company agreement, each member and manager has the authority to bind the limited liability company.” Questions related to what liability members owe to one another (fiduciary or otherwise) can be varied via the entity’s operational agreements and will be enforced by Delaware law. See, e.g., Miller v. HCP & Co., 2018 WL 656378 (Del. Ct. Ch. Feb. 1, 2018) (noting the axiomatic principle under Delaware Law that LLC or LLP agreements can “eliminate fiduciary duties that members or managers would otherwise owe to one another,” because Delaware Law gives “maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”)
Accordingly, criticisms that The LAO “can really only work if there is one LLC manager — OpenLaw or a delegate — or if all the LLC members are managing members” isn’t supported by the default rules of Delaware corporate law and certainly won’t be the case here.
Likewise, critiques that The LAO will not address any lingering questions related to who is “liable for discharging certain duties, both to the [The LAO] members and third parties with which it deals on their behalf” is simply false. The operating agreement for The LAO will articulate the ability of members to bind the entity and deal with obligations that members have to one another.
These questions, while important, obscure the importance of what The LAO is hoping to accomplish. With The LAO, members are using Ethereum for what it’s good for — serving as a generalized state to record and execute their decisions and transfer funds when consensus is reached.
If members don’t want to participate in the decision-making process, that’s completely fine. They will have the right to delegate their voting power to other members and will be expressly permitted to do so under The LAO’s organizational documents. As a result, members will be able to actively participate in funding decisions or give other members the authority to do so (without deputizing any one member a manager).
Equally important, if a member is not happy with the performance of The LAO, members will have the right to “rage quit” or redeem — at any time — any unallocated capital contributed to The LAO. Once a member exercises this right, the member’s pro-rata portion of any securities in LAO-funded startups that they are entitled to (based on their capital contribution) will be held in an escrow-like smart contract until they are permitted to be traded. The right to walk away provides strong protection for members and should further limit the risk of liability between members.
The LAO Will Receive Tokenized Stock in Exchange for Investment, Clarifying Tax Issues.
By providing funding, in exchange for tokenized stock, The LAO will hold in its shared account tokenized securities backed by binding legal documents. If all goes as planned, the value of those securities will go up in value and The LAO will be the go-to source of funding for generations of companies seeking to build on Ethereum. Like today’s venture capital funds, any proceeds from the sale of those securities will be distributed in accordance with The LAO’s underlying legal agreements (and OpenLaw will help administer the distribution of funds if they are not in crypto).
The criticism “that LAO members would insist on ‘continuously claiming their fair share of profits’” doesn’t make much sense, considering that The LAO will hold private company stock (which is subject to transfer restrictions). And because The LAO will be dealing with tokenized securities (backed by valid legally binding agreements), the tax consequences will be predictable.
It is true that, in the future, The LAO members may choose to accept other forms of securities, which permit real time dividend payments or other streams of payment (a fantastic blockchain-based use cases). But, if that eventuality occurs, members can decide whether they want to amend their organizational documents to accept these novel types of securities. Alternatively, a new LAO could be organized to expressly experiment with these new securities.
The Status of LAO Member Interests Is Far From Certain.
One of the beautiful things about The LAO is that it will be member managed and democratically governed. For many that’s a scary proposition because it’s new and untested. But, to us, it’s a logical reflection of the underlying architecture of blockchain-based networks and their supporting communities.
Some question whether this will be effective and those criticisms are fair — we are venturing into uncharted territory, but we believe the hypothesis is sound, especially when softened by delegated voting rights (noted above).
Legally, however, it also brings the status of The LAO membership interests into a gray area. Because The LAO is member-managed, there are open questions as to whether interests in The LAO will be classified as securities. Under US law, interests in limited liability entities that are member-managed often are not considered securities, unless there is a majority holder of the entity or a party that dominates decision making.
The reason for this is plain. Securities law fundamentally addresses informational asymmetries between managers and issuers, on the one hand, and members and shareholders, on the other. With members actively participating in the governance of a limited liability entity, the membership interests are generally not considered securities. See, e.g., Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003); Ave. Capital Mgmt. II, L.P. v. Schaden, 843 F.3d 876 (10th Cir. 2016).
The logic undergirding these decisions is even more applicable here because The LAO is entirely member managed (no one member will be able to hold more than 10% of the underlying voting power by default) and the entire operations of The LAO will be readily available to every member. That means that interests in The LAO very well may not be securities, depending on how actively members participate in these structures.
Nevertheless, in the abundance of caution, The LAO will limit its sale of interests to accredited investors to a limited number of members to get the ball rolling. There are enough challenges to tackle first before making a fulsome case for excluding memberships interests in LAOs from being classified as securities. We hope to make those arguments, once these structures are validated and launched. At that point, we can show actual successes and a meaningful impact.
It’s worth noting that when The LAO makes accredited investor checks it will aim to experiment with new ways to validate this information, checking to see if a potential member’s Ethereum address contains sufficient ether to meet the definition of an accredited investor in the US (using real-time pricing information provided by decentralized oracle services, like ChainLink, to convert the value of the ether at time into US dollars).
Accredited investor requirements in the US can be satisfied, inter alia, if the: (a) member has a net worth, or joint net worth with that person’s spouse, which exceeds $1,000,000; or (b) is a non-excluded organization with assets over $5 million.
There is nothing under US law that precludes the use of digital assets to assess whether a potential member qualifies to join. Criticisms that “[t]his is not how accredited investor verification works” are not grounded in US law.
The LAO Will Provided Startups With Predictable Investment on Fixed Terms to Make it Easier for Members to Manage Their Pooled Assets.
As noted in our announcement, projects that seek funding from the LAO will be provided with investment on a take it or leave it basis. The investment terms will be standardized and there will be no negotiation on the part of The LAO members and projects. The reason for this is practical — group decision making is difficult — and we want to provide projects and members with a degree of predictability as to ongoing investments.
At any point in time, members will know how much capital (ether or dai) is being held by The LAO and thus criticisms that there will “Ethernomics” at play are a bit puzzling. If The LAO does not have sufficient assets to complete a funding, OpenLaw as the administer of The LAO can be deputized by members to wind down the entity and bring the experiment to a close.
The LAO is a Grand Experiment That The Ethereum Ecosystem Needs.
The Ethereum ecosystem has an astounding mix of ideas and talented developers — the likes of which we only saw during the first wave of the Internet. We’re committed to providing software to help create new, more democratic vehicles to better enable developers to build incredible companies and tools.
The LAO’s structure will be disclosed in more detail over the upcoming weeks, as we work with counsel to finalize the nitty-gritty details and do our best to ensure that The LAO complies with the intricacies of US law. Some may argue that The LAO is one or more limited liability entities “with some weird corporate governance arrangements that probably don’t work, and funky tax consequences.”
However, in reality, it will streamline a fairly cumbersome process today for early-stage Ethereum process and give members of The LAO greater control and access to companies that members collectively agree to invest in. The LAO is not “add[ing] another layer of complexity” or “cargo cult finance” but rather reducing complexity both for members and startups. The tax treatment should be predictable because The LAO will only hold securities and will be a structure that is not available on other “normal equity crowdfunding platform[s].”
The LAO aims to build an Internet native Silicon Valley — one that can serve projects and developers regardless of background or location. If you’re interested in this vision, we’d love to hear from you. Shoot us a note at email@example.com.