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Posted on Jan 03, 2022Read on Mirror.xyz

Making Sense of DAOs (2): Investment DAOs

Preface

None of what follows is legal advice; though I have a law degree, I am not a lawyer, which means I am certainly not your lawyer.

Fair warning: this article contains technical terminology. Where possible, I have tried to elucidate said terms, not least to ensure my own understanding of them (which may well be deficient – I’m also no computer scientist, as will become apparent). However, in the interests of brevity, if you are a blockchain neophyte, it may be worth reading up on distributed ledger technology (DLT), blockchain, public-key cryptography, Bitcoin, and Ethereum as a minimum. In addition to the links provided, I recommend delving into this canonical compilation on everything crypto from venture fund A16Z.

I refer to the first article in the “Making Sense of DAOs” series, so, if you haven’t already done so, I would recommend ploughing through it.

Introduction

The focus of this article is decentralised autonomous organisations (DAOs) that invest pooled funds to make a profit: investment DAOs. I shall analyse two such DAOs: Seed Club and The LAO, considering what legal status each might have under English law, though neither DAO purports to be domiciled in England, so this exercise is largely academic. This is by no means an exhaustive analysis. Many other DAOs invest pooled funds (e.g., MetaCartel’s Venture DAO or SquidDao), and DAOs come in all shapes and sizes, so the following analysis cannot be uniformly applied to all DAOs – nor is it investment advice, legal advice, or advice of any kind. It is simply the idle musings of an interested party. Enjoy.

Seed Club

Overview

Seed Club is a DAO that “builds, supports, and invests in tokenized communities”. It appears to work similarly to an early-stage venture capital firm (for example, the now-famous Y Combinator that supported companies such as Airbnb and Coinbase): providing financial, technical, and advisory assistance to the projects it incubates. In July 2021, Seed Club raised $2 million as part of an effort to fashion itself, in its own words, as the “Y Combinator of tokenized communities”. Members of the Seed Club hold CLUB tokens, ownership of which permits them to vote on how the DAO’s resources should be allocated, how its treasury is managed, and other proposals.

Throughs its accelerator program (a start-up incubator), Seed Club provides support to creators, communities, and brands that aim to launch and grow social tokens, and in return, Seed Club receives 3% of the project’s token supply, which is committed to the Seed Club treasury . Seed Club is, therefore, incentivised to add value to the different social token projects: any uplift in the value of their tokens would commensurately increase the value of the Seed Club treasury.

Membership

Information on The LAO’s website (an early supporter of Seed Club and the second DAO analysed in this article) suggests that members of Seed Club are either founding members of the DAO or “strategic collaborators” who have pledged capital to fund DAO operations of value between $2.5 thousand and $10 thousand (or both). In exchange for their contributions, these collaborators are granted non-transferable CLUB tokens, which enable them to partake in DAO governance. In addition, the first cohort of the Seed Club accelerator program received up to 1% of CLUB tokens in exchange for their own social tokens . Seed Club are now on their fourth cohort, and supported projects are asked to pledge 3% of their token supply to Seed Club in exchange for support .

Governance

In a recent interview, Jess Sloss, “Instigator” at Seed Club (one of its founding members), explained that voting is proportionally weighted based on the number of tokens held: one token equals one vote . Community governance consists of informal discussions on the Seed Club Discord server (an online group chatting platform), with weekly updates disseminated to DAO members. Proposals are first submitted as forum proposals, and if they receive more than 90% agreement, the proposal then goes to Snapshot (an off-chain voting platform) for a vote.

Where there is less than 90% agreement following the forum proposal, there is a governance call to discuss it further; if the proposal is approved of there, again it goes to a Snapshot vote. If the Snapshot vote passes, the relevant parties involved in the proposal enact it.

The DAO treasury is managed via a multi-sig wallet, which is like an on-chain bank account that requires a “core board” of DAO members to each sign it. Only once all members of the core board have signed the transaction will it be executed; this protects against errors and misappropriation of treasury funds by rogue board members.

DAO Analysis

As discussed in the first instalment of ‘Making Sense of Crypto’, Vitalik Buterin considered that the extent of automation in an organisation determines whether it is truly a decentralised autonomous organisation (DAO) or simply a decentralised organisation (DO): the latter is human at the edges and autonomous at the centre, and the former – human at the edges and human at the centre.

Figure 1. DAO Quadrants by Vitalik Buterin

Currently, Seed Club collaborators (DAO members and holders of the CLUB token) steer the future of Seed Club by voting on proposals by other members. According to a Seed Club investor proposal, votes require 50% plus one to pass and quorum is 15% after four days of voting. No information is provided regarding how evenly CLUB tokens are distributed among members. As one token equals one vote, an uneven distribution of CLUB tokens could theoretically result in a situation where one member with 15% of the CLUB token supply could vote in favour of a proposal and the outcome would be quorate and valid.

The voting protocol itself occurs off-chain on Snapshot. Snapshot is an off-chain voting platform that connects to users’ wallets, ensuring they hold the requisite tokens to partake in the vote and to determine their voting weight. The advantage of Snapshot being off-chain is users do not need to pay “gas” (a fee) when creating a proposal or voting . On the Ethereum network, each transaction requires computational resources, so gas is a measurement of the computational effort required to execute an operation on the network.

This is important as, when the Ethereum network is congested (due to lots of transactions), gas fees can be expensive. Research done by Tally (a voting dashboard that aggregates data from decentralised finance [DeFi] protocols’ governance), suggests that, unsurprisingly, transaction cost is negatively correlated with governance participation.

Following a vote, if consensus is reached, members of the DAO enact the proposal, including the distribution of any capital via the multi-sig wallet that is operated by the “core team”.

In its current form, Seed Club, therefore, appears to be more human than automation, with most aspects of its operations undertaken by human participants. In an interview, Jess Sloss acknowledged that while smart contracts are involved in the allocation of resources – presumably when smart contracts execute following the signing of a transaction from the multi-sig wallet – the rest of Seed Club’s operations are carried out by humans : voting, signing of the multi-sig and support meetings with members of the Seed Club accelerator cohorts.

Legal Status

Based on the above description, Seed Club appears to be an organisation consisting of more than two people (DAO members or “collaborators”) carrying on a business in common (building, supporting, and investing in tokenised communities) with a view to profit (increasing the value of the DAO treasury). Based on the available resources, Seed Club does not appear to be registered as a legal entity, so under English law, it would likely be considered a partnership (for more information about partnerships, see the first article in the ‘Making Sense of DAOs’ series). Were a court to view Seed Club thus, its members (the “collaborators”) would have unlimited legal liability, and due to a lack of legal personhood, the DAO itself would not be able to enter contracts, sue, or be sued.

Intriguingly, Seed Club recently voted on whether an entity called Seed Club Ventures (SCV) should be established. According to the voting proposal on Snapshot, 356 thousand CLUB tokens were committed to voting in favour of the proposal with 0 CLUB against . SCV is a “$20M+ early-stage fund structured as an investment club investing in companies & DAOs building the infrastructure and technology for DAOs and social token creators”. SCV will pledge 10% of its returns (50% of general partners carried interest [carry], which totals 20% of any overall profits realised by the fund’s investors) to the Seed Club treasury. The proposal outlines how SCV will operate as a Venture DAO with a limited and curated membership to “ensure the highest quality deal flow, deal due diligence, and support of portfolio projects”.

SCV stands to benefit Seed Club via this 10% of profit contribution to its treasury, and SCV “Core Contributors” will be compensated with USDC (a USD-pegged stablecoin) via a 2% operational fee, which will also be used to cover legal fees and other maintenance costs. The full-time Core Contributors will also receive CLUB token bonuses based on SCV returns. This incentive structure aims to ensure existing Seed Club investors will benefit alongside SCV contributors and members (investors).

Regarding the legal status of SCV, it is a Cayman Islands investment club/fund. This most likely means SCV will be structured as an exempted limited partnership, registered in the Cayman Islands. As the Cayman Islands legal system is predicated on legal concepts founded in English law, this Cayman Islands exempted limited partnership is very similar to the limited partnership under English law (described in the first instalment of ‘Making Sense of DAOs’ ): the partnership must act through its general partner (GP), and all agreements and contracts must be entered into by, or on behalf of, the GP; it has no separate legal personality, so the GP has unlimited liability for all debts and obligations incurred by the partnership, and; the liability of limited partners (LPs) is limited to the amount they invest (Cayman Islands Exempted Limited Partnership Law [2018 Revision]) .

The Snapshot proposal for SCV refers to the preferred shareholders of SCV, which suggests there may be an additional legal entity registered as an exempted company ¬– partnerships do not have shareholders. I suggest that an exempted company might be used because, section 163 of the Cayman Islands Companies Act (2021 Revision) states that companies can register as exempted where their objects (activities) are carried out mainly outside of the Cayman Islands, which is the case with SCV. In such entities, the liability of shareholders is limited to the amount unpaid on such shareholders’ shares (i.e., where shareholders have received shared but not paid the required nominal value [and premium] to the company).

In summary, the fund is likely to be structured as a limited partnership with the general partner (SCV) itself also being registered as a Cayman Islands exempted company to limit the liability of those operating it – this is standard practice in private equity funds. It is also possible that the core contributors will manage the SCV exempted company via a fund management limited liability partnership. To assist you in picturing how SCV might be structured (think layers of an onion), I created the diagram below. Note that this was made without any input from the SCV team, so it may well be inaccurate. Nevertheless, I think it is a useful visual aid in picturing how Seed Club Ventures could be structured, along with a (simplified) visual representation of how compensation might work.

Figure 1. Suggested structure of SCV (may be inaccurate)

The Cayman Islands is a popular jurisdiction for investment funds due to its English-law based legal system, respected judiciary, and lack of political or sovereign instability. Moreover, it is a tax neutral jurisdiction, meaning investors are not taxed more than once on any capital gains; in essence, such tax neutrality is ensured by a tax regime in which there is no income nor capital gains tax, as is the case in the Cayman Islands.

In short, SCV resembles other, more traditional, private equity (and venture capital – a subset of private equity) funds, where US sponsors structure a fund to accommodate US tax-exempt investors and non-US investors, which is domiciled in the Cayman Islands to enjoy tax neutrality. The Snapshot proposal makes no mention of any SCV tokenisation, so it is likely that the “Core Contributor Team” – a pair of experienced early-stage investors – will hierarchically lead the fund, as opposed to relying on token-based proposal votes in the manner of Seed Club. Now the SCV proposal vote has concluded, it is unclear to what extent Seed Club contributors will be involved in SCV decision making (aside from benefitting from 50% of the GP carry being allocated to the Seed Club treasury, which is nothing to be sniffed at).

Summary

To what extent is Seed Club a true decentralised autonomous organisation? Some aspects of Seed Club are decentralised, or partially decentralised – for example, blockchain-based democratic governance and the use of a multi-sig wallet to distribute digital funds secured by the Ethereum blockchain, which itself is a decentralised network. However, the multi-sig is controlled by a core group of Seed Club contributors, which inevitably entails a degree of centralisation, albeit tempered by the requirement for multiple signatures to confirm any given transaction.

Seed Club does not, however, appear to be particularly autonomous. Proposals are instigated via members of the DAO, voted on by members in the forum and subsequently Snapshot, and finally enacted by members or working groups within the DAO. The only element of Seed Club’s operations that seems to be partially automated is the use of multi-sig wallets, which are smart contracts that execute automatically when certain conditions are met, i.e., the requisite parties sign to confirm they wish the transaction to execute.

Seed Club might therefore be better characterised as a partially decentralised organisation in which two or more persons are engaged in a common enterprise to turn a profit, i.e., it might be viewed as a partnership. Partnerships do not have legal personhood and members are jointly and severally liable for all debts and obligations of the partnership.

Its spin-off organisation Seed Club Ventures is most likely an exempted limited partnership domiciled in the Cayman Islands with an exempted company as its general partner. If this were true, the SCV fund would not enjoy legal personhood, and its general partners would be jointly and severally liable for all its debts and obligations. However, the general partner may be an exempted company to limit the liability of any individual operator. In contrast to Seed Club, the liability of SCV’s investors (the limited partners of the exempted limited partnership) is limited to their investment amount, so long as they are not actively involved in the management and operation of SCV.

SCV thus looks very similar to a traditional venture capital fund, with a team of “Core Contributors” responsible for deal sourcing, due diligence, and the general operations of the fund. The only quirk of SCV is that 10% of its returns is to be committed to the Seed Club treasury. It is likely that SCV hopes to leverage Seed Club’s renown in the DAO and social token space to generate deal flow. It may also leverage the Seed Club community for deal sourcing and flow.

There is no doubt that Seed Club is innovative; it is experimenting with software and technologies that enable remote, trustless governance of the organisation, with ease of communication between parties who have never met, and many of whom do not live in the same country. The use of blockchain and digital assets also means these geographically and jurisdictionally disparate Seed Club members can easily pool capital without recourse to traditional financial institutions, thereby obviating the need for intermediaries and the associated fees.

The LAO

Overview

An interesting counterpoint to the legal ambiguity of Seed Club is The LAO, launched by OpenLaw: a protocol for stitching together traditional legal agreements with blockchain-based smart contracts. Like Seed Club, The LAO is a for-profit organisation that aims to streamline venture financing for Ethereum startups. The organisation aims to use its own “tools” (software) to help foster digitally native companies. Members of The LAO democratically vote on how to invest treasury funds, with investments ranging between $25 thousand and $250 thousand, denominated in Ether (ETH) – the native cryptocurrency of the Ethereum blockchain. At the time of writing, The LAO had contributed 15,199.82 ETH, or approximately 57 million USD (USD value subject to the vicissitudes of the volatile crypto market).

Legal Analysis

The LAO provides extensive information concerning its legal status, so instead of considering it in the context of English law, I shall instead explicate its structure under US law, where it is domiciled.

Unlike Seed Club, The LAO is a Delaware limited liability company (LLC) that is member-managed and uses smart contracts for governance by way of voting, as well as to pool and allocate funds. As such, members of The LAO will benefit from the limited liability of an LLC, thereby avoiding the unlimited liability of partnerships, for example. Instead, members of the LAO will be liable only for their initial investment, plus their share of any undistributed profits of The LAO, as well as those already distributed by The LAO.

OpenLaw fulfils The LAO’s administrative obligations (for a fee): for example, the preparation and submission of tax forms, maintenance of the DApp (decentralised app), validating information regarding prospective investments, and any other relevant duties. The LAO has an operating agreement, which details the ability of members to bind it (contractually) and the obligations that members of The LAO have to one another.

To comply with US law, The LAO membership is limited to accredited investors. To be an accredited investor as a natural person (i.e., not a legal entity like a company or trust) an individual must fit meet any of the following requirements: have an income of more than $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expect the same in the current year; or have a net worth of over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence) (Reg. D, Rule 501 Securities Act 1933).

Members invested Ether (ETH) – the native cryptocurrency of the Ethereum blockchain – in return for “LAO units”, which represent part-ownership of The LAO. The units were sold in blocks, with each block being worth 100,000 LAO units, and each member was permitted to purchase up to nine blocks, which constitutes 7.2% of the total supply. At the time of writing, these LAO Units had not been approved nor disapproved by the US Securities and Exchange Commission, or any other domestic securities or global regulatory authority . As the nature of LAO Units has not yet been determined, membership is capped at 99 members to ensure compliance with US law.

Any member contributing to The LAO is required to undertake accredited investor, anti-money laundering (AML), Know Your Customer (KYC), and US Office of Foreign Assets Control (OFAC) checks as per US law. Such checks require the disclosure of information to ensure prospective members comply with all relevant regulations. Foreign investors are permitted into The LAO so long as they verify their identity before.

A decision to wind down (disband) The LAO can be made via a majority vote. In the event of dissolution, members of The LAO are responsible for the expenses associated with the liquidation.

DAO Analysis

The LAO styles itself as a “new experiment in crowdfunding investment decisions”. Thus, unlike traditional venture funds, which have general partners or managing members, The LAO aims to offer tools to facilitate democratic decision-making by DAO members who are permitted to vote on prospective investments. In addition, where members do not wish to actively participate, The LAO offers software that enables members to delegate their votes to others. The decision-making, at least, is decentralised via blockchain-recorded votes, though the legal validity of The LAO is predicated on centralised entities: US law, its justice system, and other relevant enforcement bodies.

The LAO states that it uses the Ethereum blockchain as a generalised state to record and execute the decision of members when consensus is reached by way of voting . This is exactly what the Ethereum Virtual Machine (EVM) is: a finite-state machine – an abstract machine that can be in only one state at any given time based on its response to various inputs. The machine state of the EVM changes from block to block, not only due to changes transactions and changes in account balances (e.g., Matilda sends 1ETH to Will – the 1ETH is now in Will’s wallet only), but also other changes executed via the logic of smart contracts (e.g., members of the The LAO vote to invest in jmo.eth’s blog, triggering the release of the relevant funds from its treasury to jmo’s account on the Ethereum network).

The LAO’s documentation confirms that smart contracts are primarily used for the following: to collect initial contributions from DAO members; for voting; to delegate voting to third parties; for funding investments; for distributing proceeds; and for rage quitting. Therefore, it appears that many aspects of The LAO’s functioning will be automated via smart contracts, including the distribution of DAO funds. Contrast this with the manual dissemination of funds in Seed Club where a multi-sig wallet controlled by core members is used. Thus, with respect to the distribution of funds, The LAO appears to be more automated than Seed Club.

The LAO also permits members to “rage quit”. A rage quit might occur when a DAO member is unsatisfied with the performance or administration of The LAO. They would then quit The LAO, receiving back any unallocated funds they originally contributed to The LAO, and their LAO Units would be “burned” (retired). They also retain the rights to any proceeds that might accrue from previous investments while still a member, but they cannot subsequently participate in future investments. Thus, members are not locked in and can retain their funds, even where the majority vote in favour of a proposal.

Summary

Like Seed Club’s spin-off venture DAO, Seed Club Ventures, The LAO’s structure is designed to be legally compliant. It is member-managed and democratically governed; the decisions of voters appear to be final, with any funds automatically released via the logic of the underlying smart contracts. The key question is whether democratically governing a venture fund will prove an effective way of approaching early-stage investing.

In place of deal sourcing, talent discovery, and due diligence undertaken by a core team, The LAO will rely on the “wisdom of the crowd” for its decision-making. If they wish, members are permitted to conduct their own due diligence by directly contacting prospective startups. Presumably, such inquiries would then be fed back to DAO members via communications channels such as Discord. Aaron Wright – co-founder of OpenLaw, The LAO and Flamingo DAO – recently tweeted that “We’re moving from the wisdom of crowds to the wisdom of DAOs”; time will tell whether DAO governance transpires to be as sage as Wright hopes.

The LAO attempts to balance legal compliance with DAO-centric innovation. It provides a template for other DAOs, enabling them to follow its example. Legal uncertainties prevail, such as how the LAO Units will be viewed by securities regulators. Nevertheless, there is no doubt that as and when The LAO encounters legal difficulties, the outcomes of any such disputes will provide certainty for those that follow.

Indeed, The LAO community formulated and incubated Flamingo DAO: an NFT collective that aims to acquire NFTs, convert them into fractional works, commission works from prominent NFT creators, invest in digital artists, curate acquired works, and support investment in core NFT infrastructure and projects . It is structured in the same way as The LAO: a Delaware LLC with a similar membership allocation and use on-chain governance.

Conclusion

A profusion of DAOs exists for a variety of purposes. The DAOs discussed in this article are all investment DAOs, but this is but one of many guises a DAO may take. The legal status of a DAO will ultimately be determined by its constitution and purpose, so future articles will explore other forms of DAO including social DAOs, protocol DAOs, collectors DAOs and grants DAOs. Venture Partner at venture capital fund Variant, Cooper Turley, produced the following infographic that demonstrates the diversity of existing DAOs.

Figure 2. DAO Landscape, compiled by Cooper Turley

There exists no DAO-specific legislation or case law in England. Both DAOs explored in this article appear to be primarily populated by American members and thus they are focused primarily on complying with US law. The development of the law in England will likely occur contemporaneously with the emergence of more UK-based DAOs and the participation of UK citizens in such structures. Discussion is already underway as the publication of the UKJT and the FCA’s “Guidance on Cryptoassets” attests.

Though the business purpose of the DAOs mentioned in this article (to invest for profit) is not novel, the use of blockchain and smart contracts to pool and distribute capital, and to facilitate (relatively) decentralised trustless governance is. Seed Club and The LAO are both experimenting with new ways to raise funds and make investment decisions, as well as the legal frameworks that might enable them to do so in a legally compliant fashion. DAOs are generating new interest in the crypto and Web 3 space, as well as facilitating the pooling and investment of significant funds. It will be interesting to track how these nascent organisations fare as regulators turn their Eye-of-Sauron-like gaze towards them.

DAOs are a recent phenomenon. The first major DAO was formed in 2016 and known as “The DAO” and suffered an untimely demise after more than $50 million of ETH was drained from its treasury after a hacker spotted a flaw in its smart contracts . Both DAOs discussed in this article were formed in 2020, meaning we are still in the early days of this experiment. Whether democratic decision-making will prove an effective way to make investment decisions remains to be seen. Indeed, that Seed Club Ventures consists of an experienced small team of Core Contributors suggests the parent DAO (Seed Club) recognises the value of these qualities.

It is possible that in larger DAOs with a diverse membership, voting on every investment decision might slow down the operation of such an organisation, as well as introducing inexperienced investors to the decision-making process. VCs traditionally invest for 3 to 4 years then are locked in for between 5 to 10 years before they can liquidate their position – for example, when the company holds an initial public offering (IPO). The time horizon of the VCs and LPs must, therefore, align with this market reality. In some DAOs, because, in theory, all participants have a say in investment decisions, there may be a misalignment of time horizon, risk tolerance, and other factors key to the investment decision-making process. Such divergences could result in conflict within DAOs, which, again, is unlikely to be conducive to good governance and decision-making

On the other hand, where DAOs are investing in tokenised entities, the same 5-to-10-year lockup may well not apply, as is the case with existing VCs in the crypto space. A report on blockchain VC investing from Cointelegraph Consulting found that the lockup period for some crypto VCs is as short as quarterly, meaning they would receive tokens after three months, which may already be liquid (i.e., they can realise capital gains if those tokens have already increased in value).

The question for those seeking investment from DAOs (and other crypto VCs, for that matter) in exchange for tokens is – what is more valuable: an investor with a short time horizon who dumps their token holdings as soon as they vest (thereby possibly crashing the token price and community trust in the project), versus a supportive investor with a longer-term outlook. The latter is evidently the more attractive prospect. Whether one possesses a short-term or long-term bias is likely to be affected, in part, by one’s investing experience; experienced investors are more likely to appreciate the greater value accrual that comes from long-term support and growth, versus short-term payday investors.

Like any organisation, the outlook of a DAO will be determined by its culture and members. For example, DAOs need not consist of hundreds of members – one could just as easily be comprised of 10 people, a multi-sig wallet and smart contracts to preside over governance and capital allocation. Experiments such as Seed Club, SCV and The LAO may well help locate the sweet spot where the madness of crowds becomes the wisdom of DAOs.

Next instalment of ‘Making Sense of DAOs’: Collector DAOs