Illegible Enterprises: DAOs, Unwrapped

This is the second in a series on legal entity structuring for DAOs. Part I, on the problem of illegibility in entity formation, can be found here. Part II, below, addresses the role of entity formation in risk management for DAOs, and Part III addresses risk management for DAO contributors (and will be linked here when published).

DISCLAIMER: As my ENS address clearly states, I am not your lawyer. Nothing herein should be construed as legal advice. The material published below is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material below to your individual facts or circumstances without speaking to an attorney.

You, me, and corporations are legal persons. We are legible to the state. They can see us, they know which rules to apply, they know whose throat to choke if things go wrong.

In contrast, most DAOs today are unable or unwilling to pursue legal personhood by incorporating or “wrapping” their DAO in one or more corporate entities, either because they see no reason or they never even think about it.

DAOs may choose to remain illegible to the state, but they are not invisible. The state can see them, but they have no idea how to interact with them. They can't impose their rules efficiently or effectively, and there's no obvious throat to choke when things go wrong. Bureaucracies cannot do their jobs if they don’t know which rulebook to apply, so when faced with the illegible they reach for as many books as they can find—and, when threatened, throw all of them.

Illegibility is risky, but so is legibility. Navigating that tradeoff is at the heart of risk management for illegible enterprises. How to strategically use legal entities is a critical threshold issue for every DAO.

Most corporate lawyers can help you figure out the right structure for you, and I recommend all founders work closely with counsel early in the DAO structuring process. Many guides have been written explaining the different utility of Delaware Corporations, Wyoming DAO LLCs, Cayman Foundation, Guernsey Purpose Trusts, Unincorporated Nonprofit Associations, and so on.

But in order to understand what structure is appropriate for their DAO, founders must first figure out how “decentralized” and “autonomous” the organization is today and wants to be in the future. Based on the vision, values, and purpose of the DAO, one of three structural archetypes will be appropriate:

  1. Wrapper. A DAO is fully wrapped in a corporate entity where every DAO member is a shareholder or member of, or in privity of contract with, at least one corporation holding DAO assets.
  2. Ecosystem. A DAO can maintain an ecosystem of corporate entities that fall into two broad categories: what I call D-Corps, which function as any other DAO member; and Bridge-Corps, which are deployed to solve a narrow and defined legal, financial, or political issue.
  3. No Corporate Structure. A DAO can unplug entirely from the legacy legal-financial protocol, living the dream of true decentralization and autonomy.

DAOs can move between some or all of these archetypes throughout their lifecycles.

“Fully Wrapped” DAOs, aka Automated Companies

DAOs that can be fully wrapped are neither decentralized nor autonomous.

Any DAO that can be fully “wrapped” by one or more legal entities is, from the state’s perspective, indistinguishable from a traditional enterprise. By defining a comprehensive corporate structure, the DAO subordinates itself to states which can, in their sole discretion, “unwrap” the DAO by ignoring (or revoking) legal personhood and piercing the corporate veil to hold DAO contributors liable.

This is why every single well-intentioned DAO LLC law, from Wyoming to the Marshall Islands, is ultimately doomed to fail. DAOs are exposed to legal risk because they are incompatible with the state-run protocol underlying today’s legal and financial systems. DAOs are not backwards-compatible. Legislative patches might fix certain discrete problems, but any solution that relies on a centralized state-actor necessarily sacrifices the definitional values of decentralization and autonomy.

To be clear: there is nothing wrong with traditional enterprises, and nothing wrong with building your business on the traditional legal-financial protocol! Not all organizations should be DAOs. Hierarchical command structures can be far more effective than democratic communities at executing on a vision, bringing a product to market, and coordinating complex behavior across time and space. Delaware corporate law has been honed for decades into the world’s best corporate regulatory regime, powering the most successful economy in history to date. No shame in playing that game.

Some of traditional enterprises call themselves DAOs because they use tokenization and smart contracts to automate their administrative and governance functions. When a manufacturing company automates its assembly line by replacing workers with robots, that fact alone provides no reason to modify the corporate structure; a similar logic applies to software companies that automate back office work by replacing lawyers and accountants with smart contracts. Because these organizations are neither decentralized nor autonomous, I prefer to call them Automated Companies (these align to what Vitalik once described as Decentralized Organizations or, in most cases, traditional enterprises running Decentralized Applications), but whatever you call them, they raise no fundamentally new legal questions; existing corporate law can cover it all.

Therefore, fully wrapping a “DAO” in one or more corporate entities is likely the best approach of organizations where key contributors, such as founder-CEOs or high-profile lead developers, maintain effective control over the protocol or treasury, or interact on behalf of the DAO in the outside world by acquiring assets or hiring employees. Tried-and-true corporate entity structures offer the best protection against attempts to hold those key contributors personally liable for the actions of the DAO.

Ecosystems — Corporations as DAO Members

Decentralized autonomous organizations can welcome corporations into their membership without sacrificing decentralization or autonomy if those members do not enjoy any additional powers or rights as compared to other DAO members. From the perspective of governance contracts of the DAO, corporate members could be members like any other. As a play on C-Corps, I call these entities D-Corps (and I welcome better names).

The most common D-Corp is a “DevCo”, the development company that employs the core development team. In fact, most DAOs that require professional developers to bring them into existence don’t start as DAOs, they start as regular old technology companies, and most tech companies are Delaware C-Corps or LLCs.

Once the DAO architecture is built and the DAO comes into existence, a critical choice must be made: does the DevCo become the corporate wrapper for the DAO?

If so, then you likely have an Automated Company or a traditional enterprise as described above.

If not, then the DevCo should technically and legally transfer governance responsibility to the DAO. The most important steps here are (1) the separation of the DevCo’s assets from the DAO treasury and (2) clear transfer of control over the DAO’s governance contracts from the DevCo and its employees to the DAO and its members.

After those steps, the DevCo can (and often does) continue providing services to the DAO as a sort of Master Service Provider, paid out of the DAO treasury according to a contract approved by the DAO. Similarly, the DAO can welcome other corporations as members; we see this where certain critical services, such as legal structuring, are requested by the DAO and members operating individually cannot provide the service on their own, so they either rope in the entity that employs them or form a D-Corp with a subset of DAO members. In this way, an organic ecosystem of D-Corps can come and go as members without sacrificing decentralization or autonomy.

The end goal is that each D-Corp is a replaceable service provider to the DAO; thoughtful architecture and governance structures are critical here to avoid centralization risks. If the DevCo continues to enjoy constructive control over the DAO treasury and de facto veto power over governance votes, then you don’t really have a DAO (which, again, is fine, but it is a choice that should be made with eyes wide open).

Bridge-Corps are the other type of corporate DAO member, so-called because they allow the DAO to “bridge” into the legacy legal-financial protocol so they can take advantage of a legacy applications unavailable on-chain. They serve very narrow, limited purposes, and can be dissolved when they are no longer needed—unlike corporate DAO members, these entities are legally independent, though in practice are constrained by a combination of their narrow mandate and their obligation to follow binding DAO votes.

Very few DAOs begin as decentralized organizations, and even fewer begin as truly autonomous. It is often easier to start centralized and go through a process of decentralization, and Bridge-Corps are critical to effective decentralization as stopgap solutions for enterprises that need to do things like open bank accounts, sign contracts, hire employees, pay taxes, and appear in court (among many other functions). Early on, a single entity might run all of these applications, but decentralization requires that be a temporary solution. A series of Bridge-Corps distribute assets and risk across multiple entities and ensures that malicious actors have no one throat to choke. As on-chain solutions emerge and are adopted by the DAO to solve the same problems, Bridge-Corps can be decommissioned.

The Foundation Company is the most common vehicle for a Bridge-Corp, a barebones general legal entity that a DAO can use to open a bank account or sign services contracts. Other entities are gaining in popularity as well, such as Guernsey Purpose Trusts to hold assets like intellectual property and British Virgin Islands limited companies to issue tokens.

No Corporate Form — “Real” DAOs?

The purest, and most legally risky, entity structure for decentralized autonomous organizations is no corporate structure at all.

“DAO” is an inherently anarchist concept. The “autonomous” in the term DAO is not meant to mean “automated” but exactly what it says—“autonomous”. Autonomous is an anarchist term and concept, as seen by the “autonomous zones” set up by anarchists in the Pacific Northwest in the summer of 2020, Hakim Bey’s “temporary autonomous zones,” and similar uses of the concept. True DAOs are not meant to be existentially dependent on a state charter or limited to compliance with a particular parochial set of laws. True DAOs should not be dissolvable because the Secretary of State of Wyoming deems that they should be dissolved.

—Gabe Shapiro, Wyoming’s Legal DAO-saster

Formless DAOs are the ultimate ideal in permissionless order, a distributed opt-in enterprise coordinated entirely through incentives. At scale, DAOs of DAOs provide stability through composability without risk of sclerosis, contributors and organizations seamlessly shifting resources and talent to wherever its wanted.

That’s the promise of DAOs, at maturity: a stable legal order of enterprises without the need for coercive intermediaries.

Very, very few DAOs meet this ideal today. Almost all formless DAOs would benefit from a Wrapper or Ecosystem approach as temporary protection against legal risk. Formless DAOs have very little legal precedent. Truly decentralized, truly autonomous organizations have no throat to choke, no person or entity that can be coerced, no obvious way for outsiders to command and control the resources of the DAO—in other words, centralization and governance themselves are the key source of legal risk for DAOs, giving a clear attack surface to litigators, regulators, and coercive market actors like banks.

If governance is the source of the risk, then removing governance can reduce the risk. Several projects are taking this approach, such as Reflexer (see their “ungovernance” process) and Liquity (which has been “governance-free” from launch). Experimentation by projects like these is being closely watched by lawyers who hope to generalize the lessons learned.

Whereas corporate law can almost completely address the legal problems of fully wrapped DAOs, the opposite is true for formless DAOs. We still have much to learn, but what’s increasingly clear is that distributing power over DAO resources and automating away human discretion is one of the best way for DAOs to achieve autonomy. Consensus is building around “legal decentralization” as an emerging legal practice for helping DAOs reduce legal risk and achieve these goals.

Risks still remain, even after decentralization or autonomy or “degovernance” is achieved. After all, the tax man must get his cut. Because true DAOs have a natural immunity, as it were, the target will likely shift from DAOs to the DAO contributors themselves—returning us to the problem of limited liability discussed in Part I.

Fortunately, our community is rapidly iterating on solutions to protect contributors where wrappers, D-Corps, and Bridges aren’t an option. Some of those solutions are discussed in Part III (coming soon).

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