When to Choose Decentralized Governance

By Chris Ahn

Startups obsess over how to achieve product-market fit and business model fit, but they rarely discuss business-governance fit. Web3 has brought renewed attention to this formerly overlooked concept that certain governance models are better suited for specific projects.

Choosing the right governance model is relatively straightforward for non-crypto-native projects because the tradeoffs are well known. Even a non expert can answer whether a project would benefit from being public or private, or for-profit or non-profit. For crypto-native projects, the decision is more complex because they must consider a new axis: decentralization.

Decentralized governance allows anyone to contribute without securing permission from a central authority. Like historical governance parameters, decentralization has distinct tradeoffs. Contrary to common belief, it’s a tool that can benefit some–but not all–web3 projects. Web3 founders should weigh whether their project might benefit from decentralized governance.

Historical governance models

Historically, governance decisions were based on two considerations: for-profit vs. non-profit and public vs. private.

• Public for-profit companies like Apple have a distributed shareholder base that elects a board of directors by which it is governed.

• Private for-profit companies like Fidelity have a concentrated shareholder base and are historically family owned.

• Public non-profit entities like public universities and hospitals are governed by a board in which more than 50% of its directors must be unaffiliated with the organization. In addition, profits cannot be distributed outside of the organization.

• Private non-profit entities like the Gates Foundation usually have a limited number of donors and need not have outside board directors.

The most notable feature of these historical governance models is that people can only contribute with the proper permissions, typically via employment. Apart from open source projects (which generally do not operate as formal organizations), it’s not possible for someone to simply contribute to a project. To contribute to (aka work for) Apple, Fidelity, a university, or the Gates Foundation, you must first make a serious effort to be trusted by becoming an employee.

When MakerDAO decided to hold its first ever public MKR vote in 2018, it kicked off an experiment in decentralized governance. Since then, some of the most prominent projects in web3 have adopted decentralized governance, including Uniswap ($7.4 billion), Compound ($521 million), Aave ($1.4 billion), Curve ($4.1 billion), and dYdX ($2.0 billion). These five projects alone account for over $15 billion in fully diluted market cap (as of July 25, 2022), and many more valuable decentralized projects will emerge.

The significance of business-governance fit

Choosing the right governance model is a critical decision for founders because the proper fit can act as a strategic advantage. Governance communicates two key signals about an organization:

• Commitment. When a business chooses a governance model, it conveys the objective of the organization. Consider the difference between Facebook Messenger and Signal. Signal’s status as a non-profit strengthens its value proposition as a user-first, privacy-preserving service because it’s clear that it serves no ulterior motive. Many users trust and are loyal to Signal for this reason. Even with feature parity and strong network effects, one dimension on which Facebook Messenger can’t compete with Signal is mission.

• Decision-making. Each governance model comes with its own decision-making framework that determines who makes decisions at every level. For example, public organizations ultimately answer to a board of directors that represent a broader shareholder base, while private ones answer to its majority owners. The decisions made at board meetings tend to be high level, and strategic and tactical decisions to execute on high-level direction set by the board are left to employees.

Why decentralize?

Decentralization is a unique governance mechanism because it invites anyone to contribute without permission. So why would an organization want more proverbial cooks in the kitchen when that can slow down and sometimes paralyze it from moving forward? Using the same framework as above, decentralization communicates the following:

• Commitment. It signals the desire for maximum alignment with an organization’s community of users. In historical governance structures, the maximum a user can contribute to a project without becoming an employee is by providing product feedback in designated channels or by voting on specific shareholder resolutions. Because decentralized governance invites anyone to contribute, decentralized projects make a concerted effort to directly involve their communities in what and how they develop.

• Decision-making. Decentralized governance hands over decision-making and execution powers to its community at every level. The community decides on which changes to implement by voting on proposals. It can also propose and execute improvements, including detailed product enhancements that would otherwise lie in the hands of employees.

In many ways, the case for decentralized governance is similar to the case for a public permissionless database (e.g., the blockchain). Although the latter is slower and more costly than its centralized counterpart, there is one aspect—permissionless participation—that is uniquely different, and that unlocks a net new value proposition that wasn’t previously possible.

The most common criticism of decentralized governance is that more participants mean a less efficient organization. This criticism is undoubtedly true. An organization with five decision makers has 10 possible communication channels, while an organization with 100 decision makers (20x increase) has 4,950 (495x increase). Getting people aligned becomes exponentially more burdensome with more people––hence why in politics, dictatorships make decisions more quickly than democracies, and in business, private companies are more nimble than public ones.

One way to justify decentralized governance is to answer the question: do organizations that optimize for a diversity of perspectives deserve to compete alongside organizations that optimize for fast decision-making? For those fortunate to live in democracies, the analogy should resonate. Sometimes the axis to optimize for is not speed or cost, but broad representation. Doing so can produce results that are far more durable and valuable than projects built for speed alone.

Choosing decentralized governance

Just as not every for-profit organization aspires to be public, not every web3 project needs to be decentralized. The organizations for which this governance mechanism would represent a strategic advantage are protocols. Protocols are credibly neutral projects that aspire to solve the same needs for its users for as long as possible. Three characteristics about protocols stand out:

1. Dependability. When products look to leverage protocols, the most important consideration is dependability. Will the protocol credibly serve the purpose I need it to 100 years from now as it does today? Will I have any input into potential changes? For a protocol, choosing decentralized governance shows it intends to be maximally aligned with those who are looking to build products on top of them and provides a direct path for these builders to have a say in the protocol’s development.

2. Small product surface area. Protocols are designed to be lowest-common-denominator abstractions that other products can leverage. As a result, they tend to have small product surface areas. This is desirable for decentralized governance because such decision-making is already complex with only a single product feature; additional product surface area makes decision-making exponentially more complicated.

3. Standardization. A successful state for a protocol is to become a standard with network effects. Every incremental product that builds on a protocol makes the value of doing so more compelling for the next one. Decentralized governance helps protocols become standards by providing products with skin in the game to convince others to join.

In addition, decentralization is not a binary choice, but rather, a sliding scale. Protocols should choose how much decentralization is strategically the right amount for them since it comes with clear trade-offs in execution complexity. This can be done by deciding what level of decision making will live with the community versus a pre-defined (sometimes elected) team.

It may be controversial, but non-protocol web3 projects may find decentralized governance unhelpful. As a non-protocol, the project’s objective is growth. Growth occurs by servicing more users and different use cases with additional product functionality. As a result, the product surface area will become larger and eventually unreasonable to govern across many decision makers.

Towards a Lego block future

Choosing the right governance mechanism is a strategic advantage for any organization, and deciding to decentralize is no different. Today, protocols represent the best type of project to take advantage of the strengths of decentralized governance.

It’s possible to imagine a world where modular Lego blocks of decentralized protocols built on one another will exist alongside monolithic apps. This alternative universe will be difficult to create and riddled with failed prototypes . But, it’s an exciting experiment in which to participate – an alternative built for the community, by the community, and maximally aligned with the interests of users.

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