Many people learned about DAOs for the first time when one of them tried to raise $50 million to buy a copy of the Constitution.
While that initiative failed, it did raise awareness of a sort of blockchain-based communal governance that has spread like wildfire in the last year or so, infecting everything from charitable fundraising and political lobbying to sports investment and art collecting.
More recently, the UkraineDAO, which was just a few days old, raised over $3.3 million for the Ukrainian war effort by auctioning off a Non-Fungible Token (NFT) of the country’s flag. However, this is only a portion of the $53 million raised by AssangeDAO in the past months to finance legal attempts to liberate Wikileaks founder Julian Assange from a UK prison. Big Green DAO, a food-and-nutrition-focused nonprofit owned by Elon Musk’s brother, is also decentralizing how donations are allocated.
Meanwhile, PleasrDAO, a Chinese art investment firm, recently paid $4 million for the single copy of Wu-Tang Clan’s record “Once Upon a Time in Shaolin.” FriesDAO just hired a former Domino’s Pizza executive to help build a community-run fast-food franchise empire.
The DAO is at the epicenter of the decentralized finance (DeFi) revolution.
Almost all DeFi initiatives are or will be run by DAOs. The fundamentals of a DAO are simple and clear: Sell cryptocurrency tokens that include a vote on how the funds raised are used by the entity in charge. Because voting is governed by self-executing smart contracts, there is no need for centralized administration to guide the organization.
But that’s not the end of the story. DAOs have also ventured into the market of investing with a new name – Investment DAOs. Investment DAOs are groups of crypto-wealthy investors that pool their resources to fund companies or to make investments, with the group’s governance rights being enforced through smart contracts.
Let’s take a close look.
What is an Investment DAO?
Investment DAOs use the potential of Web3 to democratize and expand the investment process.
DAOs can issue tokens that are listed on a cryptocurrency market. Governance is enforced using smart contracts. Voting rights can be divided up based on how much a person owns in the DAO.
Traditional investment vehicles work in different ways than decentralized organizations that invest in cryptocurrencies, real estate, Non – Fungible Tokens (NFTs), or any other asset class. This is especially true when the underlying investment opportunity is a cryptocurrency firm.
However, how does this differ from typical venture capital (VC)?
Before delving into the distinctions between regular venture capital and investment DAOs, let us first examine how traditional venture capital works.
Venture Capital Fund – Centralized Fundraising
Venture capital funds are created and managed by general partners (GPs). GPs research investment opportunities, undertake due diligence, and close portfolio investments.
Venture capital is part of the capital pyramid that invests cash from pension funds and endowments into portfolio enterprises. Limited partners (LPs) are major institutions, family offices, and certain individuals who invest in VC funds.
GPs must obtain funds from LPs, discover high-quality firms, do detailed and proper research, and deploy capital profitably. As startups grow and give returns to VCs, the VCs pass those rewards on to LPs.
Traditional venture funding has fueled the growth of the internet, social media, and Web2 titans for three decades. However, it is not without its flaws, which the Web3 model aims to resolve.
Even if participation as an LP is exclusive, investment choices are often determined by a limited number of persons who sit on the VC fund’s investment committee. As a result, the majority of investment choices are extremely centralized.
This can be a barrier not just to global investment but also to identifying hyperlocal possibilities in the world’s final mile. A centralized team can only do so much in terms of sourcing (of investment deals) and global deployment capabilities.
Another major difficulty with traditional venture capital is that it is an illiquid asset type. Capital invested in these vehicles is frequently locked in for years. Only when the VC fund makes an exit, such as when a portfolio firm is purchased or goes public, do the LPs get part of their money returned.
LPs continue to engage in venture capital because the returns are often higher than those of more liquid assets such as bonds and publicly traded stocks.
The venture capital model is not as broad as it could be. Because of the amount of capital needed and the asset class’s risk profile, it is frequently only sustainable for skilled investors.
It is essential that investors understand the risk-reward profile of their assets. As a result, venture capital may not be suitable for all retail investors. However, some segments of the retail investor population are smart enough to participate in this asset class. However, even skilled retail investors find it challenging to become limited partners in venture capital funds.
This is due to the fact that experienced GPs are sometimes difficult to approach for regular investors or because the minimum investment into these funds is several million dollars.
This is where investment DAOs step in.
DAOs combine the Web3 ethos with the operational scalability of smart contracts. Investors that agree on a specific investing thesis might band together to create a fund. Investors can contribute to the DAO in differing proportions based on their risk tolerance, and their governance (voting) rights are allocated based on their contributions.
So how are Investment DAOs changing the game?
Accredited investors can invest any amount through Investment DAOs. These investors have the ability to vote on crucial investment choices as a result of their contributions. Therefore, both the procedures of investing in the DAO and selecting portfolio assets are more inclusive.
Like governance, deal sourcing may be decentralized. Just imagine you’re in charge of a global fund that invests in technological solutions for coffee producers. Having members from Nicaragua to Indonesia in the group undoubtedly helps in locating the finest last-mile investment possibilities. This enables investment vehicles to be more specialized and globalized while being relatively local.
Because these DAOs may be tokenized, investors can make smaller contributions. This allows them to diversify their risks by selecting from a basket of funds in which they can invest. Furthermore, with a few exceptions, DAOs are more open to taking investments from all across the world than traditional venture capital.
Consider a $100,000 accredited retail investor seeking exposure to subclusters of Web3 and crypto companies. To distribute their investment over all these different DAOs, the investor can select an investment DAO specialized in NFTs, decentralized finance, layer-1 cryptocurrencies, and so on.
Investments are Liquid
LPs in traditional venture capital cannot liquidate their stakes in the fund before the fund offers an exit. DAOs with tokenized investments address this issue. Investment DAOs may have a token whose value is derived from the underlying portfolio. Investors who possess these tokens can sell them on a cryptocurrency exchange at any moment.
By providing this feature, investment DAOs provide comparable returns to traditional VCs, although with lower liquidity risk. Based on the risk-return profile, this makes DAOs a superior investment vehicle.
However, despite all the added perks that stem from Investment DAOs, there are some risks.
Risks with DAOs
For example, because crypto investments are anonymous, it is sometimes hard to ascertain the investor’s intellect. This makes it more difficult to shield investors from taking high risks with a volatile asset. Regulators are attempting to solve this issue by regulating how a DAO promotes itself in order to attract investors.
There are other challenges in establishing a DAO in which the legal language is programmatically placed into smart contracts. These investment structures are frequently handcrafted by massive legal teams in traditional markets. Using smart contracts to accomplish this efficiently involves both a legal and technological risk.
However, there are some projects that are working on bridging this legal gap between Web3 and the real world.
The development of investment DAOs is still in its early stages. Despite this, there is potential in the model. Investment DAOs have the potential to become the paradigm that typical venture capitalists adopt once the legal and regulatory problems have been overcome.