Stake-based governance is a terrible idea.

This should be a no-brainer. Nevertheless, it is offensively common with DAOs. In our opinion this is related to the industry’s relative immaturity and consequent “myopathy,” as well as to general laziness. Most DAOs start as dictatorships or very close to it. It’s not a sign of pathology. It’s natural. Most DAOs, like any other group, start with one person or a small group sharing a vision. As long as the DAO community is small, it makes sense that the design and setup be handled by a small group of leaders or even a single dictator. In such a setting, the question of governance in such a setting is not urgent. Thus, inexperienced founders tend to discount the need for a well-thought out and rigorous governance system. Given that a stake-based governance is easy to code and deploy, and that it perpetuates their political power (which as mentioned, is to be expected at the early stage), it seems that there is little reason to invest resources into something that is over the horizon. Moreover, most of them are familiar with the share-based corporate governance model, and replicating it seems natural. Lastly, the fact that there is a healthy mix of libertarians and neo-/capitalists in the general cohort of WEB3 founders, provides an ideological justification for this choice.  

And yet, it’s a bad idea. Here’s why. Say that you have an idea or a vision for a new venture. If the goal is to make money, regardless of the real value your venture may produce, an LLC or similar is probably the best way to go. Corporations are very effective in maximizing shareholders’ value. However, if the fulcrum of your venture is collaboration, i.e., a group of people working together towards a common goal, perhaps a plutocracy may be a sub-optimal path for maximizing value. Countries are a good example of a community-centric collaborative venture. And it is not surprising that most countries decided not to copy the corporate model. Some have. Dictatorship as a form of governance is comparable to corporate, and stake-based governance. At least as far as political power is concerned. All three tend to concentrate decision power in the hands of a select few. To be clear, not all dictatorships are North Korea-esque dystopias. Singapore is a defendable example of a successful dictatorship (not without its faults). 

In the case of stake-governed DAOs, the founders issue the governance tokens, and they almost always have the lion-share. It is possible to claim that stake-governance is a temporary measure for the early stages of the DAO, and that once the community grows enough, a new governance system, which is more inclusive and provides better protections for the minority stake holders, will replace the stake-governance. That would be a valid argument if the alternative governance system and the criteria for initiating the replacement were well defined, as well as coded into smart contracts. Power is seductive and leaders, even benevolent leaders, rarely give it up voluntarily. The unfortunate, and common, result are DAOs that are de facto business dictatorships. 

The issue of potential majority-based tyranny is not new to the corporate ecosystem. Indeed, most investment contracts have clauses designed to protect the minority shareholders. For example, the Tag-along clause. In case the majority decides to sell their holdings, the minority has the option to tag-along. These protections came about because of the pure stake-based plutocracy falls short. 

Another way to mitigate the risk of a plutocracy is to tie stake governance to an S-curve (or a Z-curve). This means that over a certain cap the governance “return” for more governance tokens diminishes exponentially. For example, a DAO can set the cap at 10% and diminish the return by a factor of 2. In a simplified, linear model, that would mean that while a 10% stake gives you twice the voting power of a 5% stake, a 20% stake only gives you the equivalent of 15% (in an uncapped system). 

Below is an illustration of such a model with different parameters.

This type of improved stake-based model prevents the abuse of the minority. Moreover, it disincentivizes any single party from accruing excess power.

And yet, even if we employ these adaptations, the problem remains. A community of people lends itself to complexity that transcends maximization of profit. In the next piece we will discuss the different types of decisions these types of organizations are faced with, and demonstrate why any dogmatic governance framework, stake-based or other, remains deficient in facilitating, effective and efficient decision making. 

Bye.