Xiao Za: PE, VC, or investment banks, which "rice bowl" will DAO take away in the future?

Source: Xiao Za Team, Xiao Za Lawyer

The digital information age has a multifaceted impact on social governance and the daily lives of residents, with one significant change being the "decentralization of influence." For example, ordinary people can use social media and information technology to disseminate their knowledge and viewpoints, allowing the world to "see," "hear," and "perceive" their perspectives that differ from the mainstream; this is the decentralization of "discursive influence." Similarly, artists can create outstanding new artworks and lead contemporary art trends through social media and information technology, representing the decentralization of "aesthetic influence"…

In today's era of rapid development and convergence of information technology, artificial intelligence, and hardware devices, the Xiao Za team observes that the financial industry is also undergoing a silent yet significant transformation. With the promotion of blockchain technology, crypto assets, and DAOs, the process of financial democratization and the related decentralization of influence seem to be happening more swiftly than in any previous era. Today, the Xiao Za team will discuss, from a compliance and practical perspective, the potential impact of investing in DAOs on the traditional investment market in the foreseeable future.

1. Investing in DAOs: A New Paradigm of Future Venture Capital

The process of financial democratization is not an overnight phenomenon; every development has its own timeline. In 1958, the formal passage of the U.S. Small Business Investment Companies Act marked the beginning of a new investment model where the government guided funds to invest in innovative and entrepreneurial small and micro enterprises. The initial purpose of this investment model was to use government funding to promote the development of technology and productivity in a direction conducive to achieving macroeconomic plans and overall governance goals. This act officially allowed financing and management for small entrepreneurial enterprises in the U.S., leading to the emergence and development of early private equity organizations and diversified small and medium-sized investment organizations, which later generations regarded as one of the milestones of financial democratization.

The Xiao Za team believes that today's investment DAOs also have the potential to become a milestone in the development of the financial industry. What is a DAO? A simple understanding of a DAO (Decentralized Autonomous Organization) is that it is a multi-centered organization driven by smart contracts based on blockchain technology, where all member actions are guided by the smart contract, with equal status among members, shared risks, and shared returns. In a sense, DAOs realize the "toolization" of humanity.

Generally, DAO organizations have a clear organizational structure, a defined organizational vision, equal pathways for exercising rights, and an automated and transparent decision-making process. Organizational members contribute, exercise rights, and enjoy benefits by holding certificates issued by the DAO based on blockchain technology (usually special crypto assets like NFTs).

Typically, the establishment process of an investment DAO is very similar to that of ordinary private equity (PE) and venture capital (VC), but it lacks many regulatory "shackles": (1) A charismatic initiator publicly declares the establishment of an investment-focused DAO and builds the underlying technical architecture of the DAO organization; (2) A small number of "shareholders" with ample funds and a shared investment intention agree to inject capital into the DAO and jointly formulate a proper "charter" with the initiator, externalizing this "charter" into a smart contract under the principle of "code is law"; (3) The investment DAO goes live and continuously attracts new investors.

From the perspective of the establishment of investment DAOs and the rules for investor participation, investment DAOs resemble private equity funds that do not set thresholds for investors. However, unlike traditional private equity funds, the operation and post-investment management of investment DAOs can theoretically be conducted without information disclosure or the involvement of a general partner (GP). In all aspects, including investment decision-making, post-investment management, and project liquidation, processes are carried out through "proposals-voting-decisions," executed via smart contracts, with all processes recorded and publicly available on the blockchain.

Thanks to the theoretical "transparency," "fairness," and "de-GP management" that DAO organizations can achieve, a large number of venture capital DAOs investing in crypto assets or the Web3 industry are emerging rapidly, even traditional investment institutions like Sequoia and Bessemer Venture Partners are hastily testing the waters by launching their own investment DAOs.

So, with numerous entrants, has this new paradigm of future venture capital in DAOs made everyone money? Does DAO conceal unknown risks?

2. Legal Risk Analysis of DAO Investments

The Xiao Za team believes that the biggest risk points in investing in DAOs currently are twofold: (1) The high uncertainty of legal systems and regulations leads to weak practicality; (2) The fundraising and operation of DAOs can easily be exploited by criminals as tools for fraud.

(1) Uncertainty in Law and Regulation Leads to High Risks and Weak Practicality in Investment DAOs

Looking at the investment DAO projects still alive in the market, most choose to operate in one of three ways:

(1) Pure DAO model, not registering any legal entity;

(2) Based on DAO, but superficially registered as a traditional legal entity, such as a non-profit foundation or limited company;

(3) Registered as a legal entity DAO in special jurisdictions.

The Xiao Za team has previously introduced that the current development status of DAOs can be described as: "Entering mainstream visibility but not yet successfully integrated into the mainstream," primarily reflected in the fact that this organizational form has been "recognized" by legislation in some countries and jurisdictions, such as the Republic of the Marshall Islands and the states of Wyoming, Tennessee, and Vermont in the U.S.

However, the Xiao Za team wants to remind everyone that the legislation in these countries and jurisdictions is still in its early stages and somewhat rudimentary. Relevant legislation either draws analogies and references from the regulation of traditional legal entities while ignoring the uniqueness of DAOs or is overly abstract, lacking practical operability.

As a result, investing in DAOs faces significant challenges in practical execution: frequent investment disputes arise, yet there are no effective dispute resolution channels (in some regions, there have even been extreme cases where certain judicial authorities have ignored DAO-related disputes, violating the principle that "judges must not refuse to adjudicate"), leading to many investment DAOs facing the dilemma of "easy to initiate but hard to profit."

(2) Fundraising and Operation of DAOs Can Easily Be Exploited by Criminals as Tools for Fraud

The Xiao Za team has found that many Web3 builders and investors believe that investing in DAOs benefits from the "trustless" mechanism inherent in blockchain technology, where all decisions are transparent, and investment information is fully disclosed, making their money seem almost secure. But is reality truly so? If you now open a search engine and search for keywords like "DAO" and "fraud," you will find numerous cases of fraud under the guise of DAOs, with many criminals already subjected to criminal coercive measures.

The Xiao Za team believes this is mainly because participating in a DAO, as a product of blockchain technology, requires sufficient understanding and knowledge of new technologies; the threshold for participating in a DAO is actually not low, making it easy to fall victim to scams. For investors participating in investment DAOs, they need to have a technical background, be knowledgeable about relevant financial and investment knowledge, and have a basic understanding of their country's legal regulations.

For ordinary investors, they generally need to pay fees to purchase the crypto assets issued by the DAO (the purchased assets can be NFTs or other DAO tokens), and some DAOs even require a fee + contribution model to join, where the more one invests, the greater their voice. The Xiao Za team believes that depending on the amount of investment and the different operational models, if an investment DAO operates in our country, it generally carries risks of suspected illegal business operations (without holding financial licenses), illegal fundraising, and organizing and leading pyramid schemes.

3. In Conclusion

Risk and reward coexist; this is not an empty phrase. Investing in DAOs is still in its early development stage and represents a highly risky investment method, with risks primarily stemming from legal and regulatory uncertainties and the immaturity of the crypto market. However, it is also a highly attractive investment tool that, under ideal conditions, can reduce investment costs, increase investment returns, and make investment activities more free, significantly lowering the investment threshold.

The Xiao Za team does not believe that investment DAOs will replace traditional PE and VC in the short term, but in the foreseeable future, we believe that investment DAOs are likely to penetrate the traditional investment market as a "technical support" optimizing traditional investment methods, gradually revealing their true value.