Using Sweat Equity to Motivate Talent & Align Incentives in For-Profit DAOs
By: Evan A. Santos
Decentralized Autonomous Organizations (DAOs) are shaping the future of work. With the rapid rise in freelance and remote work, startups face difficult decisions in determining a formation and governance structure and strategy. DAOs provide a way to solve a vexing problem faced by software developers and entrepreneurs today, namely, how to manage open-source technology that involves highly autonomous software such as smart contracts.
To build and ship a successful product, a startup must know what yields results, what to measure, how to measure it, and what to change. This type of data-driven scaling produces successful organizations in traditionally structured Web 2 startups and applies to for-profit DAOs that are shaping the Web 3 economy.
The beginning point for any startup — regardless of its legal entity status or industry vertical — is asking “what is the model? And what are the desired outcomes?” At its core, every startup in the form of a for-profit DAO project exists to solve a problem, scale, and maintain stability. The metrics a DAO measures largely depends on its circumstances and goals. One constant metric, however, is the measurement of value coming from its contributors.
This paper adds to the growing conversation around DAOs by discussing how DAO contributions are maximized through ownership incentives — also known as sweat equity distribution. In Section 1, the paper provides an overview of DAO fundamentals and what it means to be a for-profit DAO. Next, in Section 2, the paper discusses the shift from Web 2 management to Web 3 coordination in organizational governance. In Section 3, the paper addresses DAO contributor motivation and incentives. Finally, in Section 4, the paper concludes by explaining how Sporos DAO’s Sweat Equity Distribution System is solving the contribution challenges for early stage DAOs.
1. DAO Fundamentals and What it Means to Be a For-Profit DAO.
While there is no clear-cut definition of a DAO, blockchain lawyer Gabriel Shapiro succinctly defines a DAO as an unincorporated association of persons (an ‘organization’) utilizing blockchain technology to permissionlessly (‘autonomously’) engage in non-hierarchical, widely distributed (‘decentralized’) governance of shared resources and goals.
The Ethereum Foundation has encouraged those new to Web 3 to think of DAOs like an internet-native business that’s collectively owned and managed by its members. While a DAO is ideally structured with collective coordination, that is not typically the case as many DAOs have sacrificed decentralization. This results in DAO projects where true governance by the members does actually not exist. Distributing ownership through mechanisms such as a sweat equity token helps create DAOs that are truly owned and managed by its contributors.
Generally, DAOs have built-in treasuries that no one has the authority to access without the approval of the group and decisions are governed by proposals and voting to ensure everyone in the organization has a voice.
Traditional startup businesses exist to provide any number of products or services to generate a profit. Similarly, the products or services a DAO provides can be really anything, too. While we have seen DAOs with missions such as a charity, public good, and venture fund, startups launching as for-profit DAOs are increasingly grabbing the attention of developers and entrepreneurs.
For-profit DAO projects aim to decrease the technical costs related to the operation and management of an organization by relying on smart contracts and participatory governance, typically emphasizing making money for its most valuable contributors. Some notable for-profit DAOs include BitDAO, SuperDAO, Syndicate DAO, and Utopia DAO.
Profit oriented DAOs face significant challenges when a new venture is initiated. Like all startups, DAOs require financial capital. Generally, funds can be raised by selling DAO membership tokens with governance rights to new members, providing ownership rights to other sources of revenue — such as a DeFi protocol — that generates funds that flows to the DAO’s treasury for services rendered, or the DAO may be VC backed. Many of these, however, are not true governance tokens but an illusion, as governance remains largely siloed to centralized capital contributors. In essence, a typical contributor in these scenarios may have governance rights by name, but not nearly enough to make impactful decisions regarding the direction of the DAO.
Regardless of funding mechanism, early stage DAO projects are tasked with placing a precise and fair value on the work of their contributors when rewarding financial or ownership interests. When executed correctly, rewarding contributors with equity ownership can be a valuable incentive that recognizes past accomplishments and encourages contributor engagement and retention by allowing them to share in the success of the DAO.
2. Shifting From Web 2 Management to Web 3 Coordination.
The strength of Web3 lies in the ownership it gives to community members. DAOs, for example, shift business from a hierarchical and centralized management structure to a flat community coordinated organizational governance model. Because they are decentralized and implement new tools, DAOs allow anyone to contribute to and feel responsible for the project’s growth. This type of coordination has been called “decentralized governance” and contrasts with a centralized entity where shareholders and executives often hold too much power and manage from the top down.
For DAOs to comply with and exist within this distinctive decentralized governance model, they must focus on building a community where individual contributors grow collectively. Simply taking a Web 2 product and rebranding it for Web 3 doesn’t work because DAOs have an inherently different growth model than traditional startup companies. True decentralization is impossible to imitate in Web 2, but the benefits are apparent to those who have grown tired of traditional governance hierarchies and are seeking to build out Web 3 in a more equitable way. With the benefits of a DAO, however, also come challenges.
As discussed above, some DAOs incentivize their members to take part in a common mission by simply holding a governance token. The ease of inclusion in buying into a governance token can lead to “freeriding” — where a set of stakeholders unfairly profit from the work of others as Luis Cuende Aragon has explained. Without differentiating between capital contributions and labor contributions, the results of an average contributor’s time and effort can be quickly diluted by those with deeper pockets purchasing governance rights that otherwise may have taken a significant amount of time to accrue.
Without proper coordination and value attribution, for-profit DAO projects can suffer from this collective group dynamic, and as a result, sometimes depend on the work of a small subset of contributors who fail to reap their proportionate share of rewards. A DAO with too many freeriders is not a sustainable model and will inevitably lead to increased inefficiencies in DAOs as they scale, greatly reducing their ability to attract top-tier talent and outperform other businesses. Passive token holders in DAOs often negatively impact governance and can drown out a DAOs mission.
Providing contributors with equitable ownership is one way to motivate talent and drive DAO growth. While some DAOs are used for short-term endeavors like bidding for a copy of the U.S. Constitution, others for-profit DAOs are building products and companies meant to scale and endure. DAOs with a long term purpose must focus on foundational implementation of effective coordination in order to attract, reward, and incentivize their most valuable contributors.
3. DAO Contributor Motivation and Incentives.
Due to the meteoric rise of decentralized technology adoption, DAOs in the Web3 economy are already competing to attract the best talent. Attracting the top talent requires proper incentives. As previously discussed, one of the great powers of DAOs lies in the robustness and diversity of their communities. By leveraging thousands of contributors worldwide, they can work on exponentially more projects simultaneously than any Web 2 company ever could. Many DAOs, however, face growing pains when it comes to incentivizing contributors and measuring and scaling work. Whether it’s facilitating goals, determining how work gets done, or how funds are managed, early stage DAOs are faced with critical strategic decisions in building community.
DAOs benefit greatly from the flexibility they are able to offer their contributors. Unlike traditional companies, individuals can move fluidly between DAOs, and can contribute to multiple DAOs at the same time (if they are so inclined). While this flexibility is appealing to many contributors and is one of the factors that has enabled DAOs to attract top talent, contributors are often left with the challenge of navigating multiple compensation structures. To continue bringing in new contributors, DAOs will need to collectively develop compensation mechanisms and standards that work well with other DAOs.
As Spencer Graham of the Defiant has explained, DAOs must ensure that compensation is commensurate with value created, and their non-hierarchical nature presents a challenge for measuring that value, especially across time as contributors learn and grow. Some contributors flourish when they can flow between projects and contribute wherever they feel most inspired; others may flourish when they can dig into a single project without distraction. And still others want something in between.
In many traditional Web 2 professions — such as sales — variable compensation (or performance-related pay) is used as a way to align employee incentives with business incentives, designed to lead to positive outcomes for both parties. This model rewards outcomes instead of time worked, giving contributors a direct stake in the outcome of their efforts as well as autonomy over their work. Variable compensation is implemented in a variety of forms including sales commission, profit-sharing, bonuses, and stock options. These compensation models ultimately link performance to strategic goals and the recognition of different levels of achievement.
DAOs demonstrate strength over traditional companies in that they can support many contributors engagement models at once, allowing contributors to choose the one that’s right for them. Designing a Web 3 compensation program that promotes contributor choice while remaining fair, transparent, and simple to administer, however, remains a challenge. In DAOs it is critical to have clear, transparent compensation guidelines, while maintaining flexibility to adapt to the evolving nature of the organization. Such a governance mechanism has been successfully developed by distributing project ownership to motivate contributors with incentives and allows them to see and monitor their growth within the DAO. This is where sweat equity comes into play.
4. Sweat Equity Distribution in DAOs.
Fundamentally, sweat equity allows organizations to generate value without raising capital by offering ownership interest in exchange for the contribution of a service. The goal of sweat equity incentivization is to get contributors to think and act like owners. As explained above, one of the major pain points for early-stage projects is how to split equity among founders and contributors in a way that’s fair, transparent, and aligns incentives for long term goals. The ideal scenario is one where the more value you create for the DAO, the more upside you receive if the company is successful.
Web3 organizations like Sporos DAO are revolutionizing how DAO projects reach their goals by letting founders and contributors tokenize work on-chain to improve the quality of interactions and work by incentivizing good behaviors with equity.
Sporos DAO has developed a sweat equity distribution system on the basis that ownership and governance in a traditional company or DAO should be allocated to those who provide real value by contributing their talent, energy, and skills. The Sporos Sweat Equity Management System encourages flexibility by enabling contributors to earn on multiple projects simultaneously when contributing to projects that reward in sweat equity tokens.
As Sporos consultant Kyler Wandler recently explained, the distinction between capital contributions and labor contributions for DAOs can be mitigated by requiring a vesting period where liquidity or transferability of a token is restricted until the occurrence of certain consensus approved events — such as change of control or a liquidity event. Sporos enables projects to reward contributors with sweat equity tokens that represent ownership and governance rights in that DAO based on the value of their contribution prior to the DAOs approved consensus event. Importantly, this is all done in a way that complies with US securities and tax regulations.
If a DAO creates a legal structure, (and if so, in which jurisdiction) is a strategic decision. Although legal wrappers may seem inherently opposed to the premise of decentralization, DAOs who operate without a legal personhood often face difficulties when interacting with the traditional business world. This is why some DAOs incorporate an additional legal entity to interact with the traditional financial industry, to make payments in fiat currencies and to pay for developer tooling of engineers. Sporos Sweat Equity Management System is built on Kali DAO’s Ricardian LLC providing a solution that reduces legal risk for early stage for-profit DAOs projects while also improving organizational efficiency by rewarding contributors with proportional ownership interests and allowing for efficient on and off-chain interactions.
To realize their promise in the Web3 economy, for-profit DAOs must adopt and develop flexible contributor compensation programs such as the Sporos Sweat Equity Management System. A DAO without any governance actions is just a passive vehicle; and a DAO misplacing value on contributor’s work doesn’t scale. For-profit DAO projects looking to launch and scale must make a strategic decision to use tooling like a sweat equity management system to attract, incentivize, and retain valuable contributions through fair equity distribution.
After all, it takes a village to raise a child, but a community to raise a DAO.
*Special thanks to Kyler Wandler, Project Coordinator for DAO Research Collective & Consultant with Sporos DAO for edits.
