Is Sweat Equity Worth Anything? (Part 2 of 3)

© 2022 drllau | LexDAO (Guest Lvl 4 DAOsigner)

Avoid going from REC to Wreck

The first part [Lipman 2022] pointed out the need to measure inputs (ideas, labor, time) for a share of economic output of an enterprise. Historically these have been formalised into accounting standards (IAS-38 / FASB ASC 350), tax rules (barter arrangements) and investment term sheets. Legally speaking, shareholder equity is the residual claim on revenue-generating transactions after deducting debt. However, these conventions break down within amorphous organisations [Tan 2020] as is the case with many purpose-driven DAOs that (a) have no direct hires, (b) give away their intangible assets, or c) are not profit-maximising.

In this second part, we consider a basic framework to transform measurements (provisionally hourly) to a potential Legal Tender Digital Assets (LTDA) which can be a financial token as expounded in the last commentary.

Comparison of a D-Corp (conceptual successor to B- and C-corp) to a traditional company.

Relationship — Legal and Social

The first step is to clarify the relationship between the enterprise (often a separate legal entity at this point) and the members (both existing and external). Whilst the spectrum of DAOs is diverse, ranging from non-profit purpose-driven social enterprises to IPmaximalist investment fund-of-funds, we can triage members into at least three distinct legal relationships depending on their commitment and reciprocality.

1. Evangelist / buidler / fanatics [Kawasaki 1991] — the distinguishing trait being their exclusive participation or full-time commitment to the cause, expressed in traditional firms as non-compete clauses, equity lock-in and higher social status (e.g. job titles). The amorphous org doesn’t have a clear separation between employee and management but the legal obligation is an expectation of duty of loyalty in return for stronger governance input [Megginson 1990]. Social enterprises differ from the VC story [O’Mara 2020] in that founder egos are often submerged into the overarching purpose. The control/compensation conundrum can be difficult to navigate in a DAO as you can be too diffused to fire/retain someone, but centralised enough to still have fiduciary duties.
2. Independent contractors / contributor / consultants — where the relationship is more transactional, often assignment of IP in exchange for risk-adjusted compensation, work-for-hire arrangements, or in-kind contributions. This is the traditional sweat equity with the exchange of time, talent and treasure on an often deferred compensation basis. We note here that public policy dislikes paid-if-paid labor contracts so a more equitable basis is the contingent assignment of IP where the contractor/consultant retains ownership/control of their contribution/services until a liquidity/finalisation step.
3. Speculator / lurker / volunteer — the fundamental mistake that for-profit DAOs make is conflating the customer with the community. Token hodlers interacting with the smart contracts may contribute in many ways [Anderson 2004] beyond a pure economic punt. A more accurate description would be the early adopters [Moore 2014] who believe in the why and are willing to tolerate imperfect alpha/beta stage products. In an amorphous org, this would cover potential distribution partners, value-add side-projects, and invaluable feedback. Traditionally this has been impractical to measure but new web3 tools allow for targeted airdrops based on some (semi)objective measure of activity, if not productivity. Care should be taken to treat airdrops as unilateral gifts rather than “investment” which can attract the negative attention of regulators.

Is starting a DAO like jumping into unknown? In KaliDAO and Sporos DAO, you’d have company as we freefall.

Equivalence — Mechanism of Exchange

Once a satisfactory performance measure has been accepted by the community, the next challenge is to derive the equivalence in either governance, economic or ceremonial tokens (e.g. NFT badges). Ceremonial tokens are a subtle way of acknowledging skill, standing or social status. Deferred monetary compensation however, run into contentious issues as to the:

• relative value of different skill sets in different disciplines;
• location specific cost differential between OECD and developing country [O’Grady 2013];
• market supply-demand of scarce talent, especially at early stage;
• trilemma of talent, treasure & time [Drucker 1989]] in weighing relative contributions;
• risk-premium of being pre-revenue early hire compared with band-wagon later-comers;
• tension between invisible benefits to community vs tangible distributions to individuals.

There is no universal solution, but market accepted practices have emerged such as:

• community governance token airdrops;
• mix of cash (living wage) and tokens plus milestone-based bonuses;
• staking mechanisms to surface revealed rather than expressed preferences [Yalor 2022];
• monotonic decreasing cash multiplier over the investment cycle [Moyer 2022],

These equivalence artifacts need to be carefully considered as they may have tax, securities, or liability implications. For example, using unpaid interns with bad-faith illusion of an eventual job is considered labor market abuse in some countries.

The overall objective at this stage is to convert the internal sweat equity into a means of exchange which may be another token or formulae to a more liquid algocoin with the community deciding on a fair, reasonable, iterative (over the DAO life-cycle), equitable (including external investors), and non-discriminatory compensation / benefits scheme.

This can be as simple as listing the governance token on a decentralised exchange (DEX), or as sophisticated as a self-managed retirement plan linked to a ROTH-style savings account with optional income-protection insurance. Given that programmable share classes can be implemented via smart contracts with provisional taxes withheld in escrow, it should be feasible to craft deferred compensation patterns which are compliant with pluri-national labor laws.

Conversion — Value Interchange

The last step is to convert the result into either discounted/purchased services (business expenses), salary (drawings) or retirement (long-term savings). This is where the documented legal relationship is essential to determining fiat accounting, tax obligations, and securities safe-harbor exemptions. Whilst every country is different, conversion/sale of tokens into fiat may trigger reporting requirements with the general tax categories being GST/use, personal/corporate income, and capital gains.

A non-exhaustive list of conversion options might be:

• convert sweat equity tokens into legal tender to settle fiat off-ramp tax obligations;
• airdropped utility tokens which can be discounts to future services;
• alternatively exchangeable for swag (a la Kick-starter) or limited edition memorabilia;
• augmented bonding curve for continuous offering and buy-back [Fairmint];
• consultants can build up a position by buying out contractors to become stakeholders;
• investment firms might enter the secondary market to bulk up their initial portfolio;
• ROTH account(s) operated as a blind trust for long-term savings (and diversification);
• auction of memorabilia to museum or fan-clubs (cf post-ConstitutionDAO);
• partners accumulating utility tokens to handle demand surges or reducing inventory;
• fair of proceeds in acquihire by a traditional C-corp whether cash or equity [Skelly 2022]
• conviction weighted voting in accepting external investment and traditional path to ICO
• relative contribution when merging multiple DAOs into a more resilient organisation

Complex market transactions require interfacing to a liquid exchange denominated in a functional accounting unit of choice (e.g. a mix of USD, EUR, etc). The choice of convertible virtual currency (CVC) or legal tender digital asset (LTDA) will be dictated by market demand and requires specialist services compliant with competent authority.

Wrecking the Gravy Train

The design of any D-corp needs to mitigate a number of risk factors. Look at examples of what went wrong in previous DAOs:

• Purple-pill putsch for-profit MakerDAO — a key friction point is when the cost-splitting arrangements and gentleperson agreement meets outside funding, whether paid SaaS service or 3rd party investor [Milenius 2019]. Economic misalignment occurs when investors want to deprecate the prior (unpaid) work or volunteers want to divert early cashflow to reimbursement. There may also be culture clashes or resentment of side-projects being “misappropriated” for commercial purposes. Examples can be seen in the early days of MakerDAO when creative developers were marginalised in favor of more time-definite project “management” and product-release death-marches.
• SourceCred fork in coop / collective — another friction arises when the initial monies are exhausted, financial support dries up, or the optimistic market forecasts meet black-swan events. Paid contributors rationally evaluate the up/down-side and if they decide to jump, can zombify the original enterprise. Traditional VCs use vesting schedules and non-compete but if the token is zero and the treasury is bare, then the incentive for contributors disappears;
• Secession event in the initial capTable phase where a prominent founder was upset at the allocation process and ragequit to the detriment of the non-profit. Given that purpose-driven DAOs are heavily reliant on volunteers, any perception of ill-treatment or perceived unjust enrichment can poison the culture if grievances are not addressed.

In conclusion, starting a DAO is hard, growing a for-profit D-corp is harder, and trying to balance the interest of members through the investment life-cycle is a Sysphean task. This framework provides a high-level overview of the possible options for amorphous orgs. Sporos is currently building out web3 tools to simplify a subset of above legal artifacts using the power of KaliDAO.

For more, join our waitlist if you’re interested in using sweat equity for your project. We’d be happy to chat with you and help you even if you don’t use our product.

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Disclaimer: This framework should not be construed as legal advice for any particular facts or circumstances and is not meant to replace competent counsel. None of the opinions or positions provided hereby are intended to be treated as legal advice or to create an attorney-client relationship. This analysis might not reflect all current updates to applicable laws or interpretive guidance and the authors disclaim any obligation to update this post. It is strongly advised for you to contact a reputable attorney in your jurisdiction for any questions or concerns.