In the ever-evolving world of decentralized finance, it can be hard to keep track of all of the technical terms. New acronyms pop up all the time, and one you may have seen popping up lately is DAO, or Decentralized Autonomous Organization. That sounds like a vague concept for some, so let’s break it down.

What is a DAO?

A DAO is a type of organization or company made up of like-minded investors, large or small, who come together to form a group and then pool their capital, then collectively decide how to fund their DAO’s mission. A DAO runs on blockchain technology, usually propped up using smart contracts. DAOs are not particularly new - the first one debuted in April 2016 and quickly became one of the largest crowdfunding campaigns in history. When they first came on the scene, DAOs were lauded by TechCrunch as “a paradigm shift in the very idea of economic organization…” offering “complete transparency, total shareholder control, unprecedented flexibility, and autonomous governance."

There is a spark of utopian idealism made real in DAOs: pure shareholder governance without managers or boards of directors. What may begin as an informal chat group can later blossom into an investor-directed venture capital fund, opening up seemingly infinite opportunities for global coordination and collaboration between investors.

Many DAOs pool their crypto funds using an Ethereum wallet. Anyone who purchases and holds tokens native to the DAO becomes a voting shareholder in the organization. Any changes made to the DAO are done so by consensus of voting members.

Starting a company or organization with people you’ve only met on the internet may sound risky, but DAOs are designed to mitigate some of those risks. The DAO’s code is the only element one needs to trust, and because the code is stored on the blockchain, it’s completely transparent and verifiable. Smart contracts, the backbone of any DAO, are largely tamper-proof and easily used in place of traditional corporate structures to coordinate and execute common goals.

Types of DAOs

As a general rule, many DAOs fall into one of two categories: Those that collectively manage open source, blockchain-based projects, and those that make investments. A DAO can serve the same function as an LLC, investment company, or a venture capital firm; the way each DAO is structured and governed depends on the collective vision and goals of the group who formed it.

With this kind of structure, it’s easy to see that a DAO might lend itself to a charity, without the need for the typical middlemen to administer all the fundraising efforts. Using a DAO to run a charity would be similar to the way a service like GoFundMe operates. A DAO could also be used to pool investment capital from VCs where members would democratically vote on which projects to fund. Any profits made as return-on-investment would automatically be split amongst the group, thanks to the self-executing nature of smart contracts.

Risks and benefits of DAOs

As outlined above, the foundation of any DAO is its smart contract. Smart contracts are renowned for their supreme security, but they are not impenetrable. Although quite rare, it is possible that a smart contract could be compromised as the result of a coding error that a hacker could exploit. This is exactly what happened in June of 2016.

The first Ethereum-based DAO, which had raised over $150 million at the time, was hacked by an unknown operator (or group of operators) who made off with over $50 million in ether. Bloomberg News technology reporter Matthew Leising wrote a book about the historic breach titled Out of the Ether: The Amazing Story of Ethereum and the $55 Million Heist That Almost Destroyed It All. But that was almost 6 years ago. Great strides have been made in DAOs since the first one made its debut. In those intervening years, smart contracts have largely proved themselves to be tamper-proof.

Smart contracts are stored on the blockchain in full view of all members, therefore they cannot be changed covertly. In the case of a DAO, any changes made to the “rules” (the smart contract) would have to be made by a majority of stakeholders voting ‘yes’. Anyone trying to operate outside the rules of the smart contract will be automatically prohibited from doing so. No money from the DAO can be spent without majority approval, either. When a majority approval is reached, payouts self-execute.

Final thoughts

Of all the products offered in the decentralized finance space over the past decade, DAOs seem to be particularly exciting to many in the traditional corporate world. It strikes as a natural progression from the conventional LLC or organization, and cutting out the middleman of a central authority structure is an attractive proposition. Years from now, we could find ourselves wondering how we ever conducted business without them.