What is 'The DAO'? Should you invest?

Author: Meher Roy, co-founder Validity Labs

Interest in ‘The DAO’, an automated investment fund powered by Ethereum, has skyrocketed in recent weeks and brought media attention to smart contract technology. Friends and patrons of Validity have sought our opinion on whether they should invest money in this successful crowd-fund so I shall summarise my perspective about ‘The DAO’.

Disclaimer: All that follows is my personal analysis and must not be construed as financial advice.

What is ‘The DAO’?

‘The DAO’ is a set of interacting smart contracts on Ethereum that collectively enable a group of people, mutually unknown to each other, to pool their funds and invest in technology projects executed by external contractors. These investments are expected to produce financial returns for ‘The DAO’.

Investors in ‘The DAO’ receive a crypto-token, called XDT, that represents a fractional claim over the funds held in the smart contracts of ‘The DAO’ and dividends received from funded projects. XDT holders exert influence over the utilisation of pooled funds by voting on funding decisions.

Figure 1 shows the major players and their interactions. The set of relationships making up ‘The DAO’ might remind the reader of Venture Capital firms. Just replace contractors with startups and XDT holders by Limited Partners.

Parties, relationships and funds flow in 'The DAO'

Differences with Venture Capital

The superficial similarity between Venture Capital and ‘The DAO’ has led many people to christen it a “decentralised VC firm”. Some key differences between them are:

1. Lack of a central fund manager: ‘The DAO’ frames every investment decision as a Yes / No vote and lets XDT holders vote on it. There are a set of rules determining the number of total votes and ‘Yes’ votes needed for the fund transfer to be approved. These rules are implemented as smart contracts on Ethereum.
2. Inability to purchase shares in incorporated firms: Traditional VC firms take an ownership stake in investee companies. This stake entitles them to influence capital allocation and management decisions of the company. In the United States, most VC investee companies are registered as Delaware Type C corporations. As of today, ‘The DAO’ cannot own shares in corporations, GmbHs, AGs or other traditional entities due to its uncertain legal status. Finally, it can acquire a stake in other DAOs.
3. Open data: Funding proposals to ‘The DAO’ are open for perusal by anyone with an internet connection. This is in stark contrast to deal secrecy maintained by traditional VC firms. The flip-side of this property is that ‘The DAO’ is unable to fund projects operating in stealth mode.
4. Low barriers to entry for technology analysts: One consequence of open data is that ‘The DAO’ can tap into a pool of non-traditional analysts that study various offers and evaluate them in order to make a name for themselves in the community. A fundamental business assumption is that this feature shall enable it to make good investment decisions.
5. Need to receive dividends / revenue on Ethereum blockchain: Interfaces to ‘The DAO’ are other smart contracts on the Ethereum blockchain. Hence, dividends must be sent as Ethereum based crypto-tokens. Fiat payments cannot be directly processed by ‘The DAO’.

Differences with traditional crowdfunding

Crowdfunding, done through platforms such as Kickstarter, enable participants to back product development in exchange for equity or in-kind rewards (early copies of products, T-shirts etc.). This enables product developers to solicit feedback from a large group of people and receive revenue / investments.

The participation of a large number of people in ‘The DAO’ funding cycle propelled commentators to give it names such as “decentralised crowdfunding”, “crowdfunding 2.0” etc. Just like the previous analogy there are multiple differences:

1. Persistence as a structure across investments: Consider of the set of people that funded the Oculus Riftduring their crowd-fund. This group of people dispersed and did not go on to make a follow on investment in a different Virtual Reality product as a group. With ‘The DAO’, crowd investing in one contractor persists as a permanent structure that can fund synergistic follow-on projects.
2. Can possess agency to drive a particular long term agenda: By funding a series of synergistic projects in one technological niche, such as the Internet of Things, ‘The DAO’ can propel an agenda of bringing a particular technology to the mainstream. Crowdfunding aggregations do not have the possibility of similar long term co-ordination. Currently, ‘The DAO’ currently does not subscribe to any long-term goal.
3. Enables passive investors to participate in XDT value-gains: Traditional crowd-funding requires active management from every fund contributor to locate good projects . In contrast, ‘The DAO’ theoretically allows synergy between active investors that participate in due diligence and passive investors that don’t. However, this functionality of ‘The DAO’ has not been designed well, so this point is reflective of future possibilities rather than the current state.

Horseless carriages

In the early life-cycle of automobile technology, it was fashionable to call cars ‘horseless carriages’. This reflects a societal need to frame the genuinely new in the language of the familiar. Explanatory phrases for ‘The DAO’ such as ‘decentralised VC’ and ‘crowdfunding 2.0’ reflect of the same tendency. It is good mental practice to avoid these terms and analyse ‘The DAO’ as its own unique thing.

After all, this is one of the first times a group of people are using an immortal program as a governance mechanism!

Should you invest?

Investment decisions depend on the risk appetite, ticket size, financial condition and time-horizon of the investor. Usually, there cannot be a correct-for-all answer unless the instrument in question is an obvious scam. What is achievable, however, are concrete answers to fundamental questions that drive investment decisions:

1. How should the performance of ‘The DAO’ be measured?: We measure corporations by their annual profit, quarterly earnings growth, returns on invested capital and other metrics. These metrics might in turn depend on unit costs, product quality and competitive advantages. What are the correct metrics to measure ‘The DAO’? How is ‘The DAO’ performing on these metrics?
2. Unique strengths and weaknesses: Success of organisations rests on early identification of strengths and sharp focus on leveraging those. What unique strengths does ‘The DAO’ possess? Is it positioned to leverage these well?
3. Opportunities and threats: Which features of the current landscape create upsides and risks for the XDT investor?
4. Key landmark developments to watch out for: Just as a savvy investor into pharmaceutical companies pays close attention to product clinical trial results and patent life-cycles, are there similar guiding beacons for XDT investors?

How does that sound? Drop us a comment if you would like us to cover these issues in later blogs.