The world of finance and investment is rapidly evolving, with new and transformative methods of funding new projects. One of the latest methods is the use of Decentralized Autonomous Organizations (DAOs).
Similar to traditional venture capitalists, DAOs pool and allocate resources towards projects, but in a different way. They present a systematic shift in how businesses raise capital for their operations.
In this article, we will explore DAOs and their potential to transform venture capital in the DeFi space. Read on!
What are DAOs, and How Do They Work in Venture Capital?
In general terms, Decentralized Autonomous Organizations are autonomous, member-owned, token governance organizations without centralized leadership. They also distribute entity ownership, management, and decision-making among members, aiding complete transparency.
In this context, DAOs are token-based organizations that pool their assets together to raise and allocate resources for business funding.
They typically utilize blockchain and Web3 to coordinate individuals, as well as facilitate resource pooling and allocation, thereby eliminating centralized authorities.
DAOs operate via a token-based governance model, where voting rights and decision-making are determined based on the number of tokens held by each member in the DAO. Enforcement of community rules is also carried out via smart contracts.
So, how do DAOs compare to traditional venture capital (VC) firms?
Both of them yield similar results, but the major difference between them is democratization. Unlike traditional VCs, investment DAOs democratize the funding procedures via smart contract automation.
VCs are selected groups of investors (limited partners) that provide funds to new ventures through centralized decision-making.
Decentralized Autonomous Organizations, on the other hand, operate with a decentralized structure, allowing a larger number of investors to collaborate and fund new ventures or projects through governance tokens.
Why Venture Capital Needs a DAO Makeover
While VC has proven to be impactful and useful for startups over time, it is not without some pain points. Some notable drawbacks with traditional VC include:
- Inclusivity: Traditional VC requires a large initial investment, which makes it suitable for only a few sophisticated investors.
- Gatekeeping: Pooling and allocation of resources are controlled by a relatively small group.
- Centralized power: A highly centralized structure with decision-making in the hands of a few people.
- Limited access for early-stage builders: Due to issues such as limited investor pools, financial management gaps, and underdeveloped exit markets, early-stage investors may struggle to access VCs.
- Slow speed of capital deployment: Due to factors such as increasing selectivity, declining valuations, and economic uncertainty, the speed of capital deployment is gradually slowing. This slow speed affects early-stage startups seeking funds.
- Geographic inclusion: To reduce costs associated with information and oversight, VC industries prefer to invest in startups geographically closer to them. This is a problem for ventures located far from the VCs.
Luckily, the integration of DAOs into the VC landscape has the potential to eliminate or alleviate these drawbacks significantly.
Investment Decentralized Autonomous Organizations in Action
As mentioned above, Decentralized Autonomous Organizations have the potential to transform VCs for innovative and improved business funding. Here are some real projects showcasing the transformative potential of investment DAOs in VC.
The LAO
The LAO is a blockchain-based investment firm founded in 2019. The LAO invested in seed in over 70 disruptive early-stage firms and projects based in the US and Singapore. These include blockchain infrastructure projects, cryptocurrency and financial services, decentralized social networks, NFT platforms, etc.
The LAO, which started with a $2.5 million experimental venture fund, now has an average round size of $3 million to $10 million.
VC3 DAO
VC3 DAO started in 2021 but started issuing its governance token to members in 2022. This investment DAO started with a $25 million fund to invest in Web3 startups at the seed stage. VC3 DAO has more than 200 voting members in 28 countries, and has only professional venture capitalists.
Flamingo DAO
Flamingo DAO, founded in 2020, focuses on NFT projects and aims to invest in ownable, blockchain-based projects and assets.
Flamingo DAO has invested in about 30 early-stage projects, focusing mainly on Chicago, San Francisco, and New York.
MetaCartel Ventures
Founded in 2019, MetaCartel Ventures (formerly Rarible) aims to invest in the Ethereum ecosystem. This investment DAO is located in Waterloo, Canada, and has invested in over 30 blockchain early-stage projects and startups.
The firm prefers to invest in the software, infotech, and financial technology sectors.
Syndicate
Syndicate DAO is known for social networking and decentralized finance investments.
The platform enables community members to create Web3-based investment DAOs. There are also tools and infrastructure for members of the investment DAOs to network socially and stay compliant. Also, fund pooling is easy via a multisig transaction.
Advantages of Decentralized Autonomous Organizations for Startups and Investors
In today's rapidly evolving financial and investment landscape, DAOs have proven to be a game-changing force. Let's see how DAOs provide value to both the startups and investors:
For startups:
- Fairer access to funding: Investment DAOs offer innovative ways for startups, especially those in the Web3, blockchain, NFT, Decentralized Finance (DeFi), and FinTech space, to access funds. DAOs have a wider pool of investors and can also connect with more potential investors. This makes funding fairer and more accessible to a wider range of startups and projects.
- Community-aligned investors: Decentralized Autonomous Organizations can strategically allocate funds to benefit local startups or/and specific communities. For instance, DAO members can make a unanimous decision to favor a project that aligns more with community values.
- No equity dilution unless chosen: Traditional VCs often offer funds to startups in exchange for a percentage of shareholders' equity. This usually leads to dilution, which reduces stakeholders’ stake. However, there is no equity dilution with Decentralized Autonomous Organizations due to the tokenization of contributions and community-based governance.
For investors:
- Lower entry barriers: Traditional VCs usually demand high fees and require members with significant capital. These requirements often create entry barriers and limit access for potential investors. On the other hand, DAOs remove, at least, lower entry barriers in terms of capital requirements. Potential investors with as little as $2 can participate in the investment opportunity, which is not possible with traditional VCs.
- Real-time participation: DAOs are blockchain platforms that allow real-time participation. For instance, the decentralized governance structures enable investors to actively participate in any community activity, like decision-making, voting, etc.
- Diverse deal flow from peers: Finally, DAOs leverage a decentralized approach and peer-to-peer (P2P) system to facilitate diverse deal flow from peers. Other advantages of DAOs include enhanced transparency, cost efficiency, enhanced security, global collaboration, innovation, etc.
Risks of Investment Decentralized Autonomous Organizations
While the integration of DAOs into VC presents unique opportunities, it also comes with some specific risks, like:
- Security vulnerabilities: A functional element in Decentralized Autonomous Organizations is smart contracts. As with any other network system, smart contracts are prone to hacks and bugs. If the smart contract is exploited, then investors risk losing their investments.
- Regulatory uncertainties: Currently, there is no global consensus on DAOs’ evolving legal status. Hence, the regulatory landscape of DAOs is uncertain, which is challenging for regulatory compliance, governance, and wider adoption.
- Poor operational transparency: The lack of a central authority in investment DAOs poses a risk to operational transparency and consumer protection. This necessitates the development of a robust governance system to ensure adequate operational transparency and investor protection.
- No exit strategies: DAOs lack exit strategies, unlike traditional VCs. Hence, startups would have to look for alternative ways to realize returns.
- Consensus issues: Due to the large number of members in DAOs, reaching consensus can be challenging. This can subsequently lead to unnecessary delays in investment or decision-making.
- Scalability issues: As the network or community expands, scalability concerns may arise.
- Issues with free riders: Some pesky members (free riders) may intentionally choose to undermine the efforts of other serious members. Free riders don't make any meaningful contribution to the community.
Final Thoughts
DAOs are transforming VCs and opening up new possibilities for them in the DeFi space. Likewise, Decentralized Autonomous Organizations are transforming how startups raise capital and run their operations.
These and other benefits are triggering growing institutional interest in DAOs. We may likely witness an increase in their adoption shortly.
However, integrating Decentralized Autonomous Organizations fully into VCs will require growing DAO infrastructure tools and considering regulatory compliance and governance. Solving these challenges would lead to a more democratic and decentralized approach to pooling and allocating resources for startups.