In part 1, we provided a primer on DAOs. Part 2 walked readers through the evolution of DAOs. This article will discuss why we believe the best investable opportunities in this space are legally wrapped DAOs.
DAOs have come a long way in a short time but still leave much to be desired, as described in our first article. At ID Theory, we have invested in many DAOs, both entity-less and legally wrapped. This has given us domain expertise and insight into what does and doesn’t work. We believe that the best investable opportunities in this space are legally wrapped DAOs outlined in our second article. Consequently, we have concentrated our capital, time and efforts on them.
This article will summarise what has given us the confidence to commit so much to legally wrapped DAOs and point to how a utopian vision for investment DAOs may look.
Our experience of what works now
Having spent most of the last two years investing and working in DAOs, we have learnt what works and what doesn’t, as summarised below. These notions, although segregated in this article, are all highly interlinked and interdependent:
Structure
Investment DAOs should be legally wrapped. As highlighted earlier, the legal and tax challenges to DAOs are just beginning to materialise with significant direct impacts on members of non-legally wrapped DAOs. The regulatory opacity, especially in the US, means that operating without a legal wrapper, especially when considerable capital is at stake, is not worth the risk.
In our experience, legally wrapped DAOs are highly performant. This is partly due to the 99-member cap, as specified by the LLC legislation, which results in highly curated membership, drastically reducing noise and streamlining decision-making processes.
Exclusivity is another consequence of the member cap scarcity as DAOs become very hard to join once established and with an ecosystem-wide reputation. Regarding Tribute Labs DAOs, many tier 1 funds have come knocking, trying to get a seat at the table, and are either forced to pay high premiums to join or are flat out refused entry.
Membership Curation
DAOs can start off on the wrong foot by allowing anyone to join upon launch. This is fine for community DAOs and aligns with the permissionless nature of blockchains, but not for investment DAOs. Careful outreach to sector experts, project founders, angels/funds that have specific domain knowledge of the investment vertical is important; a process that can take months but is pivotal to the long-term success of the DAO.
All DAOs are essentially little “tribes”. They each have their own culture, and it is important that all members feel at home. They don’t necessarily have to all get along, but there should be an environment of respect for differing views and opinions and member alignment — this results in vibrant social communities. As mentioned in Practice Upwards by Nathan Fielder, friendship groups are the original DAOs — ‘friends’ encourage debate, share “deal flow”, and network. Aristotle wrote that the extent of one’s friendship could be measured by the extent to which justice exists between them. Smart-contract assured justice means members can interact in a trustless manner, and ‘friendships’ can form. DAOs are only as valuable as the members’ relationships within them.
Curation creates an exciting dynamic; the optimised hive mind. We are seeing the emergence of cerebral structures that transcend any one individual. The DAOs diverse constituents include experts, investors, founders and developers. DAOs are only as valuable as the demographic of their membership.
The results of the hive mind are diverse, with a couple of prominent examples. Firstly, a lack of ‘formal’ due diligence to parse deals. DAOs can make snap decisions with “gut instinct” that have much higher success rates. Secondly, DAOs are incredibly forward-thinking. They can spot trends in advance and can position themselves accordingly.
Participation
Firstly, everyone doesn’t have to participate all the time. If you optimise for this outcome, a very noisy DAO emerges where it becomes hard to evaluate opportunities and decipher who actually has a credible view. Too much noise means the actual experts get drowned out and gradually lose interest over time.
In most cases, even members who contribute extremely infrequently are still valuable. Could the DAO kick out those that never contribute? They can via the “Rage Kick” function, but that creates a bad ethos. In our experience, we typically see:
- 10–15% — membership core that contribute all the time and is passionate and knowledgeable.
- 20% — either join most of the calls and/or contribute periodically in the Discord.
- 30% — occasionally join calls and occasionally contribute in Discord.
- 30% — very rarely contribute, but when they do, it is valuable
- 5–10% — never contribute
Rewarding participation and contribution is complicated and is well covered in this review which describes level-based systems, time-locked emissions, and liquid voting for unvested tokens. However, paradoxically, we have found that compensation of individual members leads to a decline in participation, leading to worse outcomes. As soon as someone is paid to do something, other members feel it is no longer their responsibility. New incentive mechanisms need to be designed that are output orientated instead of input orientated.
Timing
Being early to a vertical is important. Forming a community of experts and investors to explore emerging uses case of this technology has several advantages:
- Coalescing the best experts in that vertical due to a lack of competing investment vehicles/funds and potential conflicts of interest.
- Highly motivated members, as opportunities discovered will have asymmetric returns as the investment area matures.
- The DAO can become a thought leader and pioneer within the emerging ecosystem and cement a strong reputation.
- Reputation = deal flow = high participation
A great example of the above is Flamingo DAO. It was formed in the summer of 2020 before NFTs hit the mainstream. The DAO assembled some of the most prominent collectors and founders in the space and made high conviction bets into Cryptopunks and Art Blocks before the broader market understood their significance.
Making big moves in an early sector can often make a market. These early investments can result in feedforward loops that create a flywheel of attention from the broader market.
Similar trends are emerging now in De-Sci and Re-Fi, and the newly formed Beaker DAO members are in a great position to take advantage as pioneers.
Investment Horizons
The expected duration until investments are realised can impact participation and morale within the DAO. Human nature thrives on rewards, so realised returns provide a positive feedback loop for members. This, in turn, drives higher participation and interest in the DAO.
Conversely, when a DAO invests in early-stage opportunities that have a 3–5 year time horizon before validating a hypothesis, this can drag on participation and conviction within the DAO.
This is evidenced across these DAOs; for example, Flamingo, despite launching after the LAO, has higher participation as members can see the live performance of investments within a secondary market. Again, this highlights the importance of membership curation and attracting those who appreciate these time horizons.
Aligned Interests
Recognising the impact of members being able to invest alongside the DAO is important. Members can compound their exposure to an opportunity by backing it personally and ‘dialling it up’ should they find it attractive. These activities have positive and negative knock-on effects depending on the investment area.
Firstly, it must be broadly understood and formalised within the DAO that DAOs eat first. Therefore, any front running of deals by a member should be forbidden and result in “rage kicking”.
The positive knock-on effects see an increase in demand and, therefore, the value of the investment. This is particularly relevant regarding publicly available assets such as NFTs or liquid crypto, as seen in early 2021 with Flamingo DAO and its acquisition of Cryptopunks and then Art Blocks.
Negative effects occur when an investment is zero-sum — for example, in DeFi yield farming strategies where participants share a fixed yield: (1) members are disincentivised to share new strategies they discover and (2) when the DAO operationalises a strategy, its members usually follow, therefore reducing the DAOs yield. Unfortunately, this happened with Neptune DAO.
Facilitation
Having a group responsible for the administration of the DAO is vital. Such responsibilities can include; onboarding new members, tax reporting, regulatory filing, coordinating members and investment calls, checking legal documents and facilitating trades.
Whilst these roles could be designated internally by a founding team, employing specialist service providers to perform these tasks allows them to draw on experience across multiple DAOs and establish the best practices. In addition, not being members of the DAO removes a potential “layer of management” that could create regulatory issues in the future.
We have had the good fortune to work closely with Tribute Labs in most of their legally wrapped DAOs. They have built exceptional teams and a technical layer to enable smooth onboarding, fast off-chain rough consensus, and automatic buy bots.
ID Theory DAO Journey
The founding partners have been passionate DAO advocates since their 2016 investment in The DAO and their 2017 investment in the Aragon ICO. However, having experienced the problems with The DAO first-hand, it was abundantly clear that two things needed to change before we could make material commitments to DAOs from the Fund.
- Firstly the technology and infrastructure needed to improve, as described in article 2, reducing the risk of exploits that result in loss of funds. This was achieved with the rollout and subsequent battle testing of robust frameworks such as Moloch V2. It provided the functionality, extensibility and security to be able to run DAOs at scale.
- Secondly, the legal risk and lack of indemnity provided by DAOs with no jurisdiction or legal recognition conferred too much risk to allocate meaningfully with the Funds capital. We became very excited with the announcement from Tribute Labs (then Openlaw) that they were using a Moloch DAO wrapped in a Delaware LLC to create the LAO. Since then, we have seen the emergence of other frameworks, including Syndicate and MiDAO.
ID Theory contributed the first external capital into the LAO. After a few months, it was clear that the LAO was exceeding our expectations. The hive mind of members proved to be highly efficient and effective. Deals would come into the LAO, and within 48 hours, thanks to members’ rapid review, a fairly clear picture as to the attractiveness of investments would emerge. Our fears around slow DAO decision-making processes were replaced by confidence in their ability to execute.
As time passed, the deal flow increased. Crypto-native projects and protocols saw value in having the most crypto-native investor, a DAO, on their cap table. Most notably, the benefit of having 60+ members with a single investor.
Clearly, the Tribute Labs team were adding immense value from a legal and operational perspective, covering onboarding, tax filings, discord and call organisations. The participation in the day-to-day decision-making and discussion from Aaron Wright and Priyanka Desai was unexpected and immensely valuable. Their passion, knowledge and experience were a vital driving factor in the early days and helped the DAOs gain the traction they now have.
The hive mind was then identifying opportunities outside the LAOs mandate, so sister DAOs were summoned. We then had the comfort to commit significant capital and time to each of these emerging DAOs in the Tribute framework (as pictured below). This was an opportunity to build out meaningful positions and establish our reputation when most funds were either (1) unaware of what had been created or (2) concerned about how value would be realised in the future.
As broader recognition of the value of legally wrapped DAOs has materialised, this dynamic is changing. However, our contribution and value brought to the existing DAOs provide us with a front-row seat for each new DAO launched from the Tribute network. We believe them to be highly attractive long-term opportunities for capital growth, despite the lack of liquidity in the medium term.
Beyond mere participation in these entities, we have now begun summoning DAOs ourselves using the Tribute framework. A recent example is De-Sci DAO called Beaker, created by ID Theory co-founder James Brodie. We are also exploring the possibility of creating a Climate focused DAO in the near future.
ID Theory DAO Commitment
DAOs now make up the majority of the workflows for our team. So why have we done this?
- Reach far beyond our numbers — exposing us to emerging verticals and developing our knowledge in each, assists in recognising opportunities by leveraging our wider networks.
- Act as an information filtering system resulting in fewer time sinks and high signal-to-noise ratios.
- Entrench powerful reputational signals.
- Allowed us to compound our investments in high conviction areas directly by joining venture rounds through the Fund or buying assets on the secondary market.
- Provide the Fund, and their investors, indirect broad exposure to investments in every vertical that would be impossible to a) manage effectively and b) have enough capital — to achieve without DAOs.
- A unique and value-generative network emerges from all of the above.
Four members of ID Theory are now spending significant portions of their time contributing to the DAOs and feeding back internally to progress and opportunities. Participating in investment DAOs is a highly active process and not a job suited for everyone.
Passive investors cannot extract the same level of value from DAOs — it is a two-way street; participation is rewarded by a backflow of wisdom from the DAOs into the Fund. Furthermore, inactive investors are unlikely to be invited to the summoning of new DAOs.
Flamingo is a prime example of ID Theory capitalising on their engagement in the DAOs — when half the team were skeptical in the summer of 2020 about the utility of NFTs, observing the discourse within the DAO informed how the landscape was evolving and how the space would play out. This wisdom backflow convinced the team to allocate capital to NFTs directly.
The relationship has also allowed the Fund to dial up and down investments in this area independent of the activities of Flamingo. By the end of the year, it was purchasing CryptoPunks for 3–4 ETH, and in early 2021 it was minting Art Blocks season one.
Liquidity and The Future
So, how does the future of legally wrapped DAOs look?
Realising liquidity within DAOs was one of the leading reasons why some larger investors and funds did not allocate during the early days of legally wrapped DAOs. Now, there is a marked increase in interest from Tier 1 Funds trying to join these existing DAOs. However, due to the 99-membership cap, obtaining a seat is becoming increasingly difficult. Both the LAO and Flamingo have recently raised capital at 4x NAV in recognition of this dynamic, and we will see multiples increasing as the number of available seats decreases.
Furthermore, we still believe there is a distinct lack of appreciation for how game-changing these vehicles are. Over time, we believe that leading legally wrapped DAOs will significantly outperform most traditional crypto funds.
There remains the outstanding question of liquidity — how do members of each DAO capture returns on their investment? Again, several routes are available; some exist now, whilst realising others will take time.
Internal Sales
Currently, any member can buy shares from another without a governance vote. This allows members in need of liquidity to access it. However, the price remains a negotiation between the two parties and often is not reflective of the actual value of the shares. There is also no guarantee of being able to sell through this mechanism.
External Sales
Periodically, the DAOs have chosen to add new members and raise capital for the DAO. The membership votes on who can join and the price of entry. Sometimes, the shares have been issued from the DAO treasury; sometimes, they have been bought from members. Therefore, external sales represent a better opportunity to achieve a higher price due to the new entrant gaining a seat in the DAO and shares. It is the seat/access that commands a premium.
NFT Sets
Many DAOs have communities that extend beyond the DAO itself. These communities are often highly participatory and willing to contribute to the success of the DAO despite not being a member. Several DAOs are exploring using NFT sets to broaden and reward non-member contributions and generate revenue for the DAO in the form of royalty sales. The idea is that a DAO could launch an NFT to either sell or issue to community participants. This NFT could grant varying degrees of access and benefits and, from a price perspective, could track the NAV of the DAO if well calibrated.
Public Markets:
In the future, DAOs could access public markets to create liquidity; for example, it may be possible to back a DAO into a public shell company or to create a SPAC. Within the DAOs, this appears to be the least favourite route to liquidity, preferring to strive for a crypto-native solution.
Tokenisation
Should there be more regulatory clarity in the future, it may be possible for the DAO to tokenise itself and have non-voting shares issued in crypto’s secondary markets. We believe this to be the optimal route for liquidity as the most crypto-native solution and one that enables broad exposure to the performance of the DAO. Conceivably if it was possible to tokenise, one could imagine the multiple to the NAV of the DAO could be considerable.
Revenue Streams and Liquidating Assets
Some investment DAOs are not focused on asset accumulation but on generating revenue streams. When profit is generated, this profit can be remitted to members. In the same way, any investment DAO focused on asset accumulation has the ability, based on membership agreement, to sell assets at any time and remit them to members.
What does DAO Utopia look like?
Contribution and participation will be appropriately incentivised and compensated in ways that do not diminish participation from others. Reputation will be earned through provably good decision-making; this will be relied upon for other members to delegate voting power. These changes will make DAOs highly efficient, organically active and with a low noise-to-signal ratio. This will improve the decentralisation of the entities as loud minorities will not rule them.
Winners will emerge from the infrastructure projects and protocols discussed in article 2, allowing for a well-coordinated and smooth technical layer to how these entities run. They will be as autonomous as possible. Humans will still be making critical decisions, and operationalisation will still have to be facilitated by an efficient team. A services industry will emerge in the form of serviceDAOs — as explained in article 1 — becoming pseudo-ETFs.
From an organisational perspective, these entities should be recognised in the same way that corporations are; a legally separate and distinct entity from its “owners”. Currently, we are at a halfway house where existing structures are used to “wrap” these entities to meet those ends. These are stepping stones; with time, governments and regulators will pass legislation to enact this recognition.
If like corporations, DAOs are considered a “person”, they can sue and be sued or held liable under civil and criminal law. Individual members are not legally responsible for the DAOs debts and damages beyond their stakeholding in said DAO. Furthermore, they needn’t be formed in any particular jurisdiction, merely registered (akin to a passport) where they are conducting operations. In the same way, a person visiting a country can be held to account for breaking the law, and so should a DAO.
Closing Thoughts:
It takes a lot to make DAOs operate successfully, and every aspect of the structural, technological and behavioural factors are always evolving. That said, we believe we have found a sweet spot in this stage of the evolution where based on the factors outlined in this article, DAOs can be highly effective and performant.
Performance tracking of DAOs, however, is an area that is underdeveloped right now. DeepDAO is leading the way here but is only as good as the data submitted to them (due to complexities around wallets used by DAOs). As such, we believe that in a few years, as the data improves, there will be a broader realisation that the leading legally wrapped DAOs are amongst the highest-performing entities in the space. Indeed, that is what we are seeing from inside these DAOs.
Objectively, ID Theory took a considerable risk in committing the amount of capital, time, and energy to legally wrapped DAOs we have. However, sometimes as investors, several factors line up at the right time to provide an opportunity for high conviction, concentrated bets. We saw this with legally wrapped DAOs, and whilst we started investing relatively conservatively, our experiences within the early Tribute DAOs increased our conviction significantly, becoming core to the Fund.
Liquidity within DAOs is a leading factor as to why larger institutional investors and funds did not allocate to the early iterations of legally wrapped DAOs. Whilst the road to value capture and liquidity remains unclear, viable routes already exist. As the regulatory landscape matures, a cryptonative solution will emerge to yield the highest multiples for existing members.
The final evolution will take many years and relies on a far broader understanding and recognition of the importance of DAOs. However, until we reach this point, the hybrid structures utilising existing legal frameworks are the optimal way for investment and collector DAOs to thrive.
Special thanks to Aaron Wright, Priyanka Desai and Harry Ephremsen for reviewing and providing critical feedback.
ID Theory may hold positions in some of the assets discussed in this post. This post is strictly for informational and educational purposes only. It does not in any way constitute an offer or solicitation of an offer to buy or sell any investment or cryptoassets discussed herein. Always perform your own research and conduct independent due diligence prior to making any investment decisions.
Interested in partnering with ID Theory or building something special? Get in touch through our website or at info@idtheory.io.
