Three Key Functions of a DAO Foundation

September 29, 2022
TABLE OF CONTENTS

Three Key Functions of a DAO Foundation

September 29, 2022

A DAO is a decentralized autonomous organization and a creation of the world of Web3. DAO’s often need a legal wrapper to enable them to operate within the Web2 business world. These legal wrappers hold the DAO treasury, protect DAO members from unlimited liability, and permit DAO members to vote. A DAO that has been ‘legally wrapped’ is often more attractive to investors as a DAO with a strong legal framework is less likely to face difficulties with issues of liability, non-compliance with regulation, and ineffective treasury management. 

There are several options for creating a legal entity to ‘wrap’ a DAO in, including foundations, associations, and non-profit LLCs. This article focuses on foundations and gives an analysis on three key functions of a DAO foundation.

When does the need for the right legal entity emerge?

One of the most important stages in the development of almost every Web3 project is when the project transforms into a DAO. Usually, this happens after Web3 founders have grown a somewhat substantial community of token holders and motivated them to contribute to the ecosystem by implementing well-thought-out tokenomics. Additionally, Web3 founders should have also developed a sustainable decentralized governance strategy and a treasury management plan.

At this point in the development of the Web3 project, the founders begin to think about what the legal structure for their DAO should look like. The complexity of this issue comes from the fact that the legal structure in question, which is a type of legal entity, can not be a classic joint-stock company. These types of companies have a hierarchical vertical governance structure comprising a board of directors, shareholders, chief officers of the company, and shareholder meetings, all of which operate on the premise of centralized ownership. Instead, Web3 founders must choose a type of legal entity that is suitable for Web3 projects which are inherently decentralized in nature. The legal entity must allow for the implementation of decentralized governance (horizontal governance, compared to hierarchical governance in typical companies) and decentralized ownership of DAO assets via a DAO Treasury.

📚 Read more: Does my DAO need legal structuring? 8 common legal questions DAO founders ask.

A foundation as a form of a DAO Legal Wrapper

Considering the fact that traditional joint-stock companies are not the best-fit solutions for legally structuring DAOs, the Web3 industry started to look at using trust structures for DAO registration. These trust structures do NOT involve centralized company shareholders and managers. Instead, they are often used as a “legal wrapper” for a community of people in whose interests the “legal wrapper” carries out certain functions. These DAO legal wrappers take care of the decentralized management and the DAO Treasury.

Taking that into consideration, most legal wrappers for DAOs are usually structured in the form of foundations, associations, and non-profit LLCs. Their role in the DAO structure is usually very limited, and focus on three core goals:

  1. a liability wrapper for DAO members;
  2. a governance wrapper for decentralized voting and DAO management;
  3. a guarantor of compliant disposal of the DAO Treasury.

Function 1: a liability wrapper for DAO members

In the Web3 industry, some DAO founders might think that if the DAO Treasury is on-chain and its management is carried out by on-chain voting, the DAO won’t need any legal structure. However, in an unregistered DAO, the community of members can sometimes be recognized by regulators or judicial bodies as an unregistered general partnership.

The recognition of a DAO as an unregistered general partnership in turn implies unlimited legal liability of each member (partner). Thus, if regulators, tax authorities, or financial supervision authorities have doubts about the legality of certain activities committed by the DAO and establish liability of at least one member of the DAO, liability can extend to all their property and other assets and the DAO member may be recognized as responsible for all actions of the DAO as a whole.

To protect the DAO members from unlimited liability, Web3 founders often consider the registration of the foundation as a “legal shield” for DAO members. In cases of regulatory investigations, it will act as a “legal representative” for the community of the DAO members and protect them from the risks of unlimited liability.

Function 2: a governance wrapper for the DAO

After the Web3 founders have decided to launch a DAO, the first step is to identify the “founding fathers” of the organization and prepare the DAO Constitution, which will be approved at the first meeting of the DAO. The DAO Constitution usually provides the criteria for membership in the DAO, the structure of the DAO’s governing bodies, as well as the process of publishing proposals and on-chain voting for decision-making.

Most of the DAO governance conditions prescribed in the DAO Constitution are “automated” with the help of smart contracts, and are performed "on-chain". However, this process of "automating" governance is often gradual, as many concepts of decentralized governance may require testing and modification when they begin to be implemented. Therefore, the key provisions of the DAO Constitution are often reflected in the statutory documents of the foundation, which is registered for the DAO.

Reflecting the terms of the DAO Constitution in documents such as Articles of Association and other Bylaws, for example, gives the terms of the DAO Constitution a legally binding status, and, as a result, gives Web3 founders more flexibility while they test the decentralized governance model before fully transferring it to a blockchain. This, in turn, allows us to call the foundation a governance wrapper for a DAO.

📚 Read more: Intro to DAO governance: a guide for Web3 founders.

Function 3: a compliance supervisor for the disposal of the DAO Treasury

Each DAO has its own Treasury, which is the DAO fund, filled with tokens or virtual assets depending on the DAO’s business model and spent in line with the decisions of the DAO members. It can, therefore, be said that the DAO Treasury is managed in a decentralized manner. However, because all the receipts and expenses from the DAO Treasury take place completely on-chain, at a certain stage, it becomes difficult for the DAO members to control the process in terms of AML (Anti-money Laundering) compliance. For example, it becomes difficult to control and prevent any virtual assets with a dubious source of origin from “polluting” the DAO Treasury.

That is why, at some stage of the DAO’s development, important decisions put to vote will include:

  • the implementation of an on-chain analytical system for the analysis and tracking of incoming transactions that have a dubious source of origin (such systems include Chainanalysis, Elliptic, Crystal); and
  • the appointment of the foundation’s compliance officer, who will conduct KYC (Know Your Customer) procedures for the DAO counterparties receiving grants/service fees from the DAO Treasury.

Putting in place these compliance procedures will help the DAO to avoid the risks of being associated with money laundering and other financial crimes. The foundation, in turn, acquires the “guarantor” function for the decentralized Treasury management in accordance with the regulators’ AML recommendations.

💡 Worth checking: Swiss foundation as a DAO legal wrapper: what you need to know.

Three key functions of foundations in the DAOs’ structure

 All in all, in the DAO structure, a foundation performs three main functions, acting as:

  1. a liability wrapper to protect the DAO members from unlimited liability for the DAO’s activities;
  2. a governance wrapper to give the provisions of the DAO Constitution a legally binding status and legitimize them; and
  3. a compliance manager for the DAO Treasury to implement the AML measures and supervise their realization in the process of disposing of the DAO Treasury.

Getting started with setting up a legal entity for a DAO

Choosing the right legal structure and entity for a DAO project can be a complicated process. Here, at Legal Nodes, we work with qualified lawyers from different jurisdictions that are suitable options for DAOs to potentially incorporate. Our Web3 legal team and network of Web3 legal service providers have accumulated many best practices on which entity and which country to choose when creating a legal wrapper for a DAO. 

If you’d like to start an incorporation process for your DAO, consider booking a Legal Discovery Session with us. During the session, our Head of Web3 Legal will help you better understand the options available for your project and clarify all the regulatory requirements that might apply in your case. 

Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice. Mentioning any of the assets in this article is not an endorsement to purchase them.

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Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.

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