Progressive Decentralization: a Legal Playbook for Web3 Builders

This article is part of a playbook series titled How to Approach Legal Strategy for Your Web3 Project. For further context, check out the previous article in this series: The “Decentralization Test” for Web3 Protocols.

The concept of progressive decentralization was first proposed in 2021 by several well-known Web3 VCs, including Variant Fund and a16z. The goal of progressive decentralization is to provide Web3 builders with a clear roadmap to guide their protocols toward a state of “sufficient decentralization”.

Why is achieving "sufficient decentralization" important for protocols? Several years before the first publications on progressive decentralization, a statement along with some case law materials and public comments from SEC officials appeared on the SEC website. They asserted that cryptocurrencies Ether and Bitcoin were recognized as outside the scope of securities laws, as they were issued as native tokens of blockchain networks that are sufficiently decentralized. In 2023, a similar approach was supported in the European Markets in Crypto-Assets Regulation (MiCA), which stated that fully decentralized protocols are outside the scope of CASP regulations. Since then, “sufficient decentralization” has become the market benchmark that most developers of decentralized protocols have begun to strive for.

However, building a fully decentralized or even “sufficiently decentralized” protocol from day one turned out to be nothing short of impossible. Instead, to achieve this, a gradual enhancement of the protocol’s state of decentralization is required. Enter “progressive decentralization". In this article, we will explore the concept to help Web3 builders understand exactly what each stage involves. We will also explore the legal works and requirements of each stage of a project’s gradual decentralization.

Stages of “decentralization” of the protocol

As previously discussed, Web3 builders strive for “sufficient decentralization” in their protocols for various reasons. These include addressing security concerns, making the protocol resistant to censorship, and notably, minimizing their own influence on the protocol. The latter is particularly crucial due to the legal risks it poses for protocol developers.

A basic rule of thumb for assessing the legal risks for Web3 builders is “The more influence on the protocol, the more responsibility for its operation”. A comprehensive risk analysis begins with evaluating the developers' position concerning protocol users, which is determined by their control over the protocol, namely:

1. Having significant control over the protocol positions developers as “insiders” and creates an informational asymmetry between them and users / the market.
2. This control fosters expectations among protocol users that the success of the protocol depends on the managerial efforts of a specific group of developers working on the protocol.

This situation creates legal consequences, wherein the group of developers may be recognized as a common enterprise. Additionally, the native protocol tokens might be deemed securities and the services that the protocol provides might be considered regulated activities. Therefore, builders who have chosen a strategy of centralization and control over the protocol may need to halt at this stage. For more information on the various legal strategies for Web3 projects, check out the first article in this series: How to Approach Legal Strategy for Your Web3 Project. Builders who are on the path to “centralization” will require a legal structuring roadmap that involves obtaining licenses, ensuring compliance, and establishing traditional financial compliance for their protocol.

The image below briefly outlines the three different stages of protocol decentralization.

For developers striving to achieve a state of “sufficient decentralization” for their own protocols and who would like to learn more about the progressive decentralization framework, we provide a detailed interpretation of this framework, explored in 3 stages.

Stage 1: protocol development

The development of each Web3 project begins centrally and involves building a team and securing initial investments to develop the technology. This stage provides a neat window of opportunity to build a comprehensive, long-term legal strategy for the Web3 project. Typically, during this stage, the team hasn't deployed the protocol on the mainnet, issued tokens, or engaged in other potentially legally consequential activities. Therefore, this stage offers an excellent opportunity to plan a legal roadmap to avoid any unwanted regulatory “surprises” in the future.

At this stage, the legal work is almost identical to the legal work for Web2 startups. They typically encompass company registration for project development and IP registration. There is one clear exception, however, and that concerns structuring fundraising. In a Web3 context, investors are offered a Token Warrant in addition to the traditional convertible equity documents like the SAFE in the USA or the ASA in the UK. The Token Warrant gives the investor a right to receive tokens at a substantially discounted price in the future, should the project decide to make the protocol with a native token.

Stage 2: protocol deployment

As soon as the initial version of the protocol has been developed and tested in the testnet, the team moves to the stage of preparing the protocol for deployment in the mainnet. At this stage, the first foundations for future decentralization are being laid. These can be conditionally divided into two blocks: technical and governance.

As soon as the technical foundations of the protocol's decentralization are laid and the ProtoDAO is launched, the following functions will rely on the ProtoDAO:

1. Deploying the protocol in the mainnet, the primary function of the ProtoDAO.
2. Launching and maintaining the first interface to the protocol, where theProtoDAO acts as the initial frontend operator.
3. Building a community of contributors and supporters of the protocol, including forming waitlists of community members interested in participating in future token airdrops and joining as DAO members. 
4. Fundraising through SAFT and other token pre-sale agreements.
5. Pre-minting tokens, either simultaneously with the deployment of the protocol or following the deployment of the protocol.

The majority of activities outlined for the ProtoDAO are one-time efforts focused on initiating the protocol's ecosystem, leading to the ultimate third stage of decentralization: a fully on-chain DAO. However, until arriving at this position, the ProtoDAO needs a corporate structure to have a legal personality and contractual enforceability. In particular, it will need to establish the corporate legal structure to sign SAFTs and use the legal entity in the terms and conditions interface and the frontend of the protocol.

Legal structuring of the ProtoDAO

Since the ProtoDAO is serving as an “intermediate” stage of decentralization and an early version of the decentralized governance body protocol, its participants include a wider range of stakeholders compared to that of a DevCo. These participants will include core contributors, advisors, early investors, genesis validators, among others. However, the governance body of the protocol is not decentralized enough to be considered “sufficiently decentralized”. Tokens haven't been distributed, a community of token holders hasn't formed, and there's no token-based incentive model to encourage community contributions and support the protocol's ecosystem operations.

Considering the temporary nature of the ProtoDAO stage, two approaches can be considered for establishing a corporate structure for ProtoDAO.

Approach 1: Creating special purpose vehicles (SPVs) for the legal structuring of various ProtoDAO activities. For example, a Token SPV can be created for minting and the initial distribution of tokens. A Frontend Operator SPV can be used for launching the interface to the protocol.

The choice of jurisdiction for structuring the ProtoDAO’s activities depends on the specific function or activity in question. For instance, island options, such as the British Virgin Islands, or other jurisdictions such as Panama, might be most suitable for setting up a Token SPV for the decentralized deployment and airdrop distribution of tokens. Conversely, jurisdictions offering regulatory authorization for the centralized deployment and public sale of tokens, such as Switzerland or Liechtenstein, may be more suitable options.

Approach 2: Creating a legal wrapper for the ProtoDAO with the potential for scaling it into a legal wrapper for a fully-fledged on-chain DAO after the token distribution is complete.

For these purposes, options such as the Marshall Islands DAO LLC, the memberless Cayman Foundation, or the ADGM DLT Foundation in the UAE, can be used as ownerless corporate structures for the legal wrapping of the DAO. These entities also offer the possibility of setting up programmable governance, and can be further considered for registering the legal wrapper for the ProtoDAO.

The main difference between the approaches described above is that in Approach 2 the legal wrapper will provide the ProtoDAO members with legal member status and also limited liability protection. Conversely, in Approach 1, the ProtoDAO exists virtually on-chain, and has created legal structures in the form of SPVs to handle various activities. It will also have delegated specific individuals to manage the SPVs.

Stage 3: Token distribution and the transformation of the ProtoDAO into a fully on-chain DAO

ProtoDAOs period of existence comes to a close with the initial token distribution. Typically at this stage, a part of the genesis token supply is distributed to the community to build a network of token holders, and another part remains in the ProtoDAO’s treasury as pre-minted tokens.

The tasks required during this stage include:

• Developing a DAO constitution, containing structured rules for token-based membership and voting processes.
• Enrolling token holders as DAO members. This only applies to token holders who meet the requirements of token-based membership, for example, token staking for governance rights or obtaining membership via a reputation-scoring process.
• Launching a members’ forum. This space is for the publication of proposals from DAO members and for a dashboard to display voting results.

Having completed the “constitutional” tasks, the DAO proceeds to make decisions about the legal structure required for future work. This can either involve reusing the legal wrapper of the ProtoDAO, which was the “predecessor” of the fully on-chain DAO, or creating new structures for the legal registration of various DAO functions.

Minimizing developer influence on the protocol at the full decentralization stage

In conclusion, let’s revisit the stages of progressive decentralization outlined earlier, this time focusing on how the control structure evolves at each stage. Let’s also examine how the level of control over the protocol gradually shifted away from the developers and transferred to the ecosystem’s community with each subsequent stage of progressive decentralization.

The culmination of the third stage of progressive decentralization signifies a pivotal shift. Once the community of token holders integrates as members of the DAO within the protocol ecosystem, all insider information dissipates. Transparency prevails as details regarding token allocations, the protocol's liquidity, and future development plans are fully accessible online. Decisions about the protocol's trajectory are now determined through token-based governance on the DAO forum. This marks the elimination of information asymmetry and the dissolution of concentrated control over the protocol by any specific entity or group. Success is contingent upon collective contributions and managerial efforts within the DAO community, where developers assume a role as one among many members.

Pin down your legal strategy for your protocol

Much of the excitement in the Web3 space lies in building, developing, exploring, and innovating within the community. In contrast, the legal aspect—the strategy, the structuring, the legal analysis, and opinions—tends to strike builders with fear, sometimes slowing and sometimes freezing the project’s process as attempts are made to resolve legal queries.

At Legal Nodes, we feel the excitement of the Web3 sphere, of founders and builders developing and launching their projects at all stages, including protocols that are fully decentralized, centralized, or somewhere in-between. 

We regularly assist Web3 teams with their legal conundrums, starting with the big question of “What even are our options right now?” before exploring the ever-changing water of worldwide regulation and assessing the risks and opportunities available to each team. We help pick out best-case examples and explore ways to proactively build a compliant structure that will dissuade regulators from issuing heavy fines in the future.

To receive legal support for your crypto project, protocol, token release, or any legal structuring matter surrounding your Web3 venture, speak with a team member today.