Background on DAOs

Decentralized Autonomous Organizations (DAOs) are a novel form of governance for blockchain-based protocols. Unlike traditional companies or non-profits, DAOs are member-controlled organizations that operate without a central authority or hierarchical management. Instead, DAOS use smart contracts, often on the Ethereum blockchain. DAOs often use governance tokens to enable members to vote on proposals, make collective decisions about the organization’s operations, treasury, and future development. 

DAOs are different from traditional companies and non-profits in that they aim to be transparent, autonomous, and decentralized in their governance and decision-making process. Combined with the network effects and the decentralized nature of the blockchains that DAOs are built on, DAOs provide a unique opportunity for the creation of new types of organizations. However, this also presents a challenge to regulators seeking to establish appropriate legal frameworks for these types of organizations.

DAOs represent a fusion of organizational theory, coordination mechanisms, network effects, blockchain, and smart contract technology. DAOs enable a group to organize around a shared mission or goal, coordinate their efforts through smart contracts that are enforced immutably and autonomously on distributed ledgers. This structure helps DAOs eliminate or minimize the roles of executives and managers in the organization, relying instead on transparent rules that apply to all members and participants. The rules are set out in the governing principles of the DAO, that cover issues such as the purpose of the DAO, how it is governed, how proposals are brought to a vote, how the treasury is managed and funds are added and distributed, the form of voting, the smart contracts that are at the heart of the organization, and similar internal administrative issues.

DAOs are rapidly expanding in the Ethereum blockchain ecosystem, and this emerging technology is being experimented with, used, built, and iterated on in real time. There are many unsolved problems with DAOs, particularly around issues involving legal compliance, benefits, recruiting, talent retainment, income volatility, and governance. Regardless of the current problems, DAOs have the potential to empower groups to solve problems, coordinate, and execute ideas in a way that may be increasingly necessary to solve entrenched 21^st century problems. Before getting into the technical aspects and legal requirements, we will discuss how DAOs represent a new type of organization.

DAOs as Organizations

The unique structure of DAOs has led to challenges in defining clear regulatory and legal structures for their existence. One of the problems is that the membership is not necessarily located in any single jurisdiction, nor are the members disclosed in the form that is normal for banking and financial organizations, making regulation in traditional ways more difficult.  The automaticity of smart contracts and the lack of a formal management structure contribute to the difficulty in regulating their activities.  The lack of clear legal guidelines tailored to DAOs has hindered their potential. This uncertainty often forces DAOs to choose between two suboptimal paths: Abandoning decentralization to fit within existing legal structures or operating in a legal gray area that fails to adequately protect members or serve the DAO’ objectives. 

Wyoming’s recently passed Decentralized Unincorporated Nonprofit Association (DUNA) law aims to provide non-profit  DAOs with legal recognition, enabling “blockchain networks to operate within the bounds of applicable laws without compromising their decentralization.” Before analyzing some of the legal benefits DUNAs could potentially provide DAOs, we will explore the technical aspects of DAOs that make them unique entities, while also showing the challenges nascent in regulating them.

Blockchain technology forms the foundation for DAOs, providing a decentralized, transparent and immutable ledger for recording transactions across a network of computers. Key features of blockchains include:

1. Decentralization – No single entity controls the network;
2. Transparency – All transactions are visible to network participants;
3. Immutability – Once recorded, transactions cannot be altered or reversed; and 
4. Security – Cryptographic techniques ensure data integrity and prevent manipulation of the data once recorded.

Smart contracts are self-executing programs deployed on blockchain networks like Ethereum and Solana. They are a key feature that enable the autonomous and transparent operation of DAOs. Smart contracts help define the rules, decision-making processes, and treasury management features of the organization. Critically, the organizational rules can be customized and defined by the members and are transparent for all members to see and understand. The rules are often spelled out in governing principles, operating agreements or other standard forms. DAOs leverage smart contracts and blockchain technology to create organizations that are autonomous from third party control using token-based voting systems. These voting systems can take on many different forms, from simple majority delegative voting, quadratic voting and more. All smart contracts will execute, and are all available openly to be viewed on the blockchain. This powerful transparency means that  you simply cannot structure a DAO that has perverse incentives going against the best interests of the members, as they can simply view it in real time, and due to low switching costs, leave the DAO for more appealing opportunities. 

A typical DAO consists of several key components:

1. Governance tokens: These digital assets represent voting power within the DAO. Members use these tokens to participate in decision-making processes.
2. Treasury: DAOs can control substantial assets, that are used to fund the DAO’s operations and initiatives and pay members. These funds are typically held in cryptocurrencies, in a wallet that requires multiple signatures from different members to use.
3. Proposal Mechanism: Members can submit proposals for use of treasury funds, changes to the DAO’s operations, or protocol upgrades.
4. Voting System: Governance token holders vote on proposals. The voting system can take on a variety of forms, as determined by DAO members.
5. Execution Layer: Approved proposals are implemented, often automatically and autonomously through smart contracts.

DAO Network Effects

The unique components of DAOs, outlined above, enable novel use cases that traditional corporate structures struggle to accommodate. These distinctive features have been pivotal in the challenges faced by both regulators and DAOs in developing a comprehensive legal framework. The goal is to provide DAOs with legal recognition while preserving the innovative elements that set DAOs apart. A key aspect of this challenge, and indeed a significant opportunity, lies in the ability of DAOs to harness powerful network effects within organizational structures.

Network effects in DAOs manifest in several ways, each amplifying the organization’s value and capabilities. As more members join a DAO, the collective intelligence and resource pool grows exponentially, enabling more complex and impactful interactions and initiatives. These interactions and initiatives are interoperable with one another, and the broader blockchain ecosystem in which they exist. This creates an ecosystem of interconnected organizations that can leverage each other’s strengths. 

The open-source nature of DAOs allows for quick iteration on ideas and rapidly deployed improvements, allowing successful features to be replicated with open-source code within the DAO and within aligned organizations. DAOs can also take advantage of a global talent pool, drawing from members across the globe that geographically constrained organizations struggle to match. Providing incentives to developers, aligned organizations and to members through token-based governance aligned interests of all participants, allowing casual participants and core contributors to focus on growing the value of the central DAO mission, in whatever way their participation form takes.

DAO Use Cases

DAOs serve a unique role in governing decentralized finance (DeFi) protocols. Many decentralized exchanges and lending platforms, often worth billions of dollars, use a DAO governance structure to ensure that control of the protocol remains decentralized, and any changes must be able to be voted on transparently by members. Investment DAOs are groups that pool capital for investment in cryptocurrency, NFTs, or even traditional assets, lending a governance structure akin to a cooperative for the growth of shared capital and assets. 

Beyond capital markets, there are also Social DAOs, which are communities focused on social interactions, often with exclusive membership. While social DAOs often have a shared treasury for expenses and proposals, the explicit purpose of the DAO isn’t for increasing the value of capital assets, but furthering member chosen goals or maintaining shared resources for the community. DAOs can also serve as decentralized platforms for content creators, allowing creators to share resources and split profits and royalties more easily on shared creative works.

We can see from some of the DAO use cases outlined above that while DAOs can reflect traditional companies’ structures in some ways, the decentralized nature of how DAOs operate also leads to different use cases and purposes beyond increasing shareholder value. DAOs can also serve as a structure or platform for traditional companies to launch on blockchain enabled networks. 

This is one of the key facets that Wyoming’s DUNA law attempts to address, in making the DAO form of governance available to non-profits and attempting to classify their activities in a unique way.

Wyoming efforts to be crypto friendly and DAO Supplement for LLCs

To understand how the DUNA framework arose, it is helpful to look at Wyoming’s continual efforts to provide legal frameworks in the crypto space. The State of Wyoming has been a leader in developing legislation to guide the formation and management of organizations utilizing blockchain technology.  In July 2021, Wyoming became the first state to promulgate legislation to specifically permit the formation of DAOs (DAO Supplement). The law is a supplement to the existing Wyoming law permitting the formation of limited liability companies (LLC), which was notably the first in the nation. The law allows the creation of DAOs as limited liability companies, conferring legal status and identity on such entities for the first time in the United States. 

As a supplement to the LLC Law, the DAO Supplement is viewed as providing specific legal provisions that apply to DAOs, but its specific set of rules is governed by the rest of the LLC Law, where not specifically carved out. The technical requirements include using DAO, LAO, or DAO LLC in the name of the organization to distinguish it from current LLC usages.  The Articles of Organization must include a specific notice to alert all potential members that the DAO may eliminate fiduciary duties and restrict transfers of ownership interests, withdrawal or resignation from the DAO, return of capital contributions and dissolution of the DAO. There are some additional requirements, such as providing an identifier to the state for the smart contract in order to form the DAO LLC.

DUNA legal analysis

On July 1, 2024, the Wyoming Decentralized Unincorporated Nonprofit Association (DUNA) Act, entered into effect. The new law took the same approach as the DAO Supplement, in that it drew from the existing Wyoming Unincorporated Nonprofit Association Act and adapted it to the use of distributed ledger technology and autonomous organizations. These new types of DAOs are intended to permit the formation of non-profit charitable organizations on blockchain-enabled public, open-source networks, rather than the proprietary networks dominated and controlled by a few giant tech corporations.  Most of these tech giants benefitted from the original open-source structure of the world wide web that evolved into the existing internet. 

The new nonprofit version of DAOs provides the organization with legal existence, a critical necessity for the organization to participate in contracts, appear in court, file taxes and comply with government regulations, where those exist.  The members also have limited liability for the actions of the organization, just as corporations and other organizations have under U.S. laws.  The DUNA law also helps ensure that the members can govern the organization through governing principles that outline the non-profit purpose of the DAO, guide the distribution and use of funds, keep the network open source, ensures that it does not show discrimination, and that it is not used to extract unduly high fees as profits for the owner of the network, unlike Microsoft, Google, Apple or the other tech megafirms.

Despite the prohibition of taking profits for the management of the network under the DUNA Act, profit-making enterprises could potentially build public-facing applications on top of these non-profit blockchain networks.  Because corporations cannot own the network, they cannot set up the hyper-extractive, high-fee proprietary networks that have turned the internet into such an ad-based and unduly expensive system.

DUNA Requirements and Coverage

A DUNA must be established for a charitable purpose as described in Internal Revenue Code Section 501(c)(3).  This provision covers organizations that have purposes that are religious, educational, charitable, literary, testing for public safety, fostering national or international amateur sports competition, or prevention of cruelty to children or animals in nature.  This may be somewhat problematic for a DUNA intended to serve as an open-source platform for profit-making enterprises to use.  However, the provision of free software may be  the basis for a charitable designation.   

A DUNA must also have at least 100 members to qualify.  It is up to the DUNA as to whether each member has a wallet and voting rights or uses another approach to membership set out in its governing principles.  For an existing charity, a careful analysis of the benefits of conferring membership on donors or users of the DUNA’s smart contracts will be important to ensure that the value of its tokens is not to make a profit, but rather to incentivize the creators of open-source networks to provide the software that will permit use of the blockchain network for all users and fulfill the charitable purpose of the DUNA without a profit making motive or effect.  It will also support the charitable work on the DAO in that a growing treasury can fund more programs.

When forming a DUNA, consideration should be given to establishing “Governing principles” as defined in the statute as, “all agreements and any amendments including any decentralized unincorporated  nonprofit association agreements, consensus formation algorithms, smart contracts or enacted governance proposals, that govern the purpose or operation of a decentralized unincorporated nonprofit association and the rights and obligations of the nonprofit association’s members and administrators,”  Where an LLC DAO would have an operating agreement to spell out how the organization will be governed, a DUNA must use governing principles for the charitable or other non-profit activities of the organization.

The DUNA law provides that the DUNA may engage in profit-making activities only if the profits are used in furtherance of the common nonprofit purpose.  For a DUNA developing an open-source blockchain network, any funds generated by entities using the platform should go into the treasury and be used to support creators of open-source code, smart contracts and similar activities that further the network’s availability freely and openly to all developers and users, as part of the charitable purposes of the DUNA. The law also provides for the normal requirements for an organization to be established, operate, deal with claims, membership duties, use of distributed ledger technology, administrators, based on the DUNA’s legal basis for its activities.  

Under Wyoming law, DUNAs can engage in for-profit activities. Wyoming’s DUNA statute also specifically permits the payment of reasonable compensation for any services provided to a DUNA’s ecosystem.  This is likely to include the operation of a decentralized exchange protocol, or other open-source network.  The profits must be used for the purposes of the DUNA, but that should enhance the ability of developers to create apps that use the network freely, while conducting separate for-profit activities built on the network.  That should prevent the formation of corporate networks to extract value because the blockchain can be forked should apps become too extractive.

Using this feature, a DAO conceivably could pay compensation to its members in exchange for participation in governance. In that case, the justification for the DUNA rewarding people for voting or delegating might be that by statute the DUNA has no centralized management and is therefore reliant on its members to govern all of its affairs. As a result, significant member participation is necessary to ensure proper administration of the DUNA, and the DUNA can compensate members to achieve that end.

Tax exempt organizations under IRC 501(c)(3)

The IRS states that a charitable organization or trust must be set up for the benefit of an indefinite class of individuals. It may not be set up for specific persons.  That test is met if membership in the DUNA does not confer a right to distribution of the treasury of the DUNA.  An organization may have a purpose to benefit a comparatively small class of beneficiaries provided the class is open and the identities of the individuals to be benefited remain indefinite. 

Charitable purposes include erecting or maintaining public buildings, monuments, or work, among other things.  One could argue that a DUNA blockchain network providing free or nearly free network protocols is a digital form of public works and therefore is covered by the definition of “charitable.”  This will have to be discussed with the appropriate regulators to confirm. The public facing benefit that will be conferred by a blockchain network that continues to upgrade its coding through developer incentives paid for by donors, is likely to be a charitable purpose not conferred on a specific set of members or a class of individuals, thus supporting the designation of a DUNA as a nonprofit association.

Case Study: Exploration of the DUNA Framework by Nouns DAO

Nouns DAO, a prominent community owned DAO governing the Nouns Protocol, has recently begun exploring the adoption of the Wyoming DUNA structure. Launched in August 2021, Nouns DAO is known for its unique approach to NFTs and community governance. The project auctions one Noun NFT daily, with all proceeds going to the DAO treasury. Each Noun grants its owner voting rights in the DAO, allowing them to participate in decisions about treasury fund allocation and project direction. This model has led to the creation of a vibrant community and a substantial treasury, making Nouns DAO a significant player in the broader web3 ecosystem.

The case of Nouns DAO exploring the Wyoming DUNA structure offers valuable insights into how established DAOs are navigating the evolving legal and regulatory landscape. Three years after its inception, Nouns DAO finds itself at a crossroads, reassessing its legal framework in light of clearer operational patterns and an increasingly complex regulatory environment. The DAO is considering adopting the DUNA structure, which offers several potential advantages including limited liability protection for members, reduced global tax uncertainty, and the legitimacy associated with U.S. jurisdiction. Importantly, the DUNA framework allows for the incorporation of decentralized governance and on-chain voting, aligning well with the DAO’s existing practices.

However, the transition to a DUNA is not without challenges. Nouns DAO would need to implement significant changes, such as replacing its fork mechanism with a refund system, conducting KYC for grant recipients, and performing sanctions checks on auction bidders. These requirements, while potentially onerous, are seen as necessary steps to ensure compliance with tax and AML/OFAC regulations. The Nouns Foundation, working closely with advisors, is carefully weighing these factors against the increasing vulnerability of the DAO’s current unincorporated structure to regulatory uncertainties.

This real-world example illustrates the complex decisions DAOs face as they mature and seek to operate within existing legal frameworks. It highlights the potential of structures like DUNA to bridge the gap between decentralized governance and regulatory compliance, while also underscoring the practical challenges of such a transition. As Nouns DAO continues to explore this option and seek community feedback, its journey provides valuable lessons for other DAOs considering similar legal structuring options.

Conclusions and Recommendations 

DAOs allow members to decentralize and form smaller, autonomous groups within a larger organization, while still supporting the DAO’s primary goals. This creates powerful network effects, as, the DAO becomes a collection of interconnected groups.  In a DAO, members don’t just participate, they actively shape the organization by voting on and creating rules that are maximally beneficially to all participants. The DAO itself becomes a emergent, evolving entity guided by its members. 

DAOs represent a significant evolution in human organization and coordination, built on a foundation of web3 and blockchain technologies. At their core, DAOs leverage digital assets, which allow ownership of fungible and non-fungible goods to be tokenized. We have seen many cryptocurrencies rise over the past decade, and recently there has been an explosion in Non-Fungible Tokens (NFT)s, each representing a unique digital asset. This innovation allows participation in a DAO to be tokenized, with members granted voting rights and incentives based on what tokens they hold. As tokens are all smart contracts, the way DAOs are governed can be programmed and voted on by their participants. Smart contracts run immutably on the blockchain and are censorship resistant. This means that 3^rd parties can’t arbitrarily change the rules to their benefit, and members can know that voting proposals within a DAO will execute autonomously of human intervention.  

The Wyoming DUNA structure is a potential route to a legal framework that provides clarity for DAOs forming in the US. Although based around an existing non-profit law, the DUNA law is structured to give DAOs flexibility to exist as decentralized governance base-layers to govern new types of organizations. As DAOs continue to grow, iterate, and experiment, a custom legal framework is needed to ensure they have the proper structure to reach their full potential and allow significant potential benefits to be realized. As DAOs represent a new and emergent way of coordinating, funding public goods, and founding transparent, member run organizations, the DUNA law represents a significant step forward in ensuring DAOs can become a key piece of the United States and global economy.