“I have a fantastic idea for a startup, but I need to form an entity. I’m thinking about using a DAO.”
One application of blockchain’s distributed ledger technology that has taken hold recently is the “distributed autonomous organization” or “DAO.” These blockchain-based organizations are very attractive to startup founders. Between allowing for true democracy in an organization and having the potential to operate autonomously, they embody the ideals of the blockchain community and Web3 (not to mention the opportunity to be a first adopter).
Until last year, operating a DAO was exceedingly risky from a legal and regulatory standpoint (and nearly impossible to obtain a bank account). But in 2021, the State of Wyoming enacted legislation recognizing DAOs as a type of LLC, becoming the first state to recognize DAOs as legal entities. Under the Wyoming statutory framework, DAOs are classified as LLCs, providing the limited liability and reliability of a typical business structure, while allowing management by a combination of humans and smart contracts. In a sign that DAO legislation is gaining traction around the country, Tennessee passed its own DAO LLC statute in April 2022, incorporating many of the same principles from the Wyoming law. DAOs are catching on, but is a DAO right for your startup?
Outside of Wyoming and Tennessee, forming and operating a DAO remains fraught with uncertainty. A key consideration for anyone participating the governance of a DAO should be the issue of potential personal liability. Unlike typical corporate structures and DAOs organized in Wyoming and Tennessee, DAOs operating without a statutorily recognized legal structure may be treated as general partnerships, meaning members will have unlimited personal liability for the acts of the DAO and the other members.
In a case that appears to be the first of its kind in the United States, Sarcuni et al. v. bZx DAO et al., Case No. 3:22-cv-00618 (S.D. Cal., May 2, 2022), a group of class action plaintiffs have alleged that a DAO and its members are jointly and severally liable for negligence resulting in the theft of approximately $55 million. Though it remains to be seen how the court will rule in the bZx case, the plaintiffs’ complaint underscores the need for careful consideration before forming or holding governance tokens in a DAO and the importance of formally-recognized DAOs.
In addition to the risk profile, founders should consider other factors as well, such as the additional costs of forming a DAO LLC, developing smart contracts, etc. Fundamentally, founders should evaluate whether a DAO would actually bring real value to their startup or simply be a distraction and drain on limited resources.
It is easy to imagine the immense potential for DAOs in startup funding, real estate investing, and other ventures. The recent passage of DAO-specific legislation in Wyoming and Tennessee legitimizes decentralized governance while providing those participating in state-recognized DAOs with limited liability. Though many questions remain about how DAOs will be defined and regulated at the state and federal level, the future appears bright for investors and entrepreneurs to take part in Web3.