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DAO Governance Token

A Beginner’s Guide to DAOs & Governance Tokens

Learn how DAOs work, the role of governance tokens, and what’s in store for the future.

Decentralization is at the heart of the crypto movement. Following in the footsteps of currencies (cryptocurrencies) and financial services (decentralized finance), decentralized autonomous organizations (DAOs) could revolutionize corporate governance. As a result, it’s worth taking the time to understand how they operate and what’s next.

Let’s look at decentralized autonomous organizations, governance tokens, and what’s in store for the future.

What Is a DAO?

A Decentralized Autonomous Organization (DAO) is an entity that delegates control to its participants rather than relying on a conventional top-down corporate hierarchy. For example, a DAO may manage a decentralized finance (DeFi) protocol, and participants might vote on matters like setting the interest rate or allocating profits.

DAO Governance Token
How a DAO Works Under the Surface. Source: Yield App

Advocates hope DAOs will democratize organizations by giving everyone a vote while benefiting from the wisdom of the crowds. In addition, DAOs offer more transparency than conventional organizational structures since all votes and decisions are public. The hope is that DAOs will become a hallmark of Web3 organizations and eventually transcend crypto.

However, the lack of an authority figure also means that DAOs are slower to make decisions. In fact, it can become nearly impossible to make decisions when strong disagreements result in two prominent factions. Moreover, since DAOs rely on token economics, those with the most tokens also have the greatest say, creating a plutocracy.

DAOs & Governance Tokens

Decentralized autonomous organizations are little more than smart contracts under the surface. When forming a DAO, a group of founders codifies rules into a smart contract and commits them to a blockchain. Then, the DAO typically raises capital by selling governance tokens, which also serve as their decision-making mechanism.

The rights and value of these tokens depend on the project:

  • Uniswap token holders can vote to distribute a portion of the fees the protocol collects to themselves.
  • Compound token holders can vote to distribute protocol fees toward system upgrades and bug fixes.
  • SharkDAO token holders vote on acquiring expensive non-fungible tokens (NFTs) to add to the collective collection.

In addition to voting on matters, token holders can typically propose changes through a formal proposal process. The exact process and capabilities depend on the smart contract details. But generally, individuals must have a certain number of tokens to present a proposal that then moves on to a vote among the community.

Regulatory & Tax Concerns 

Decentralized autonomous organizations are a radical departure from conventional organization types. As a result, policymakers and regulators still need to understand how existing rules affect these organizations. Moreover, they must determine what responsibilities founders and members might have concerning legal and tax matters.

For example, DAOs don’t fall under any existing corporate entities throughout much of the United States. Therefore, DAO members don’t enjoy the same legal protections as a limited liability company (LLC), and its members could face personal liability. That said, Vermont, Wyoming, and Tennessee have introduced some protections on paper.

Aside from legal liability, the SEC has taken an interest in the line between governance tokens and securities requiring formal registration. The agency issued guidance saying that the greater a project’s decentralization, the less likely the underlying tokens would be considered securities. However, the line remains very blurry.

And finally, the IRS’ treatment of governance tokens continues to evolve. Most accountants agree that you recognize ordinary income when receiving governance and incentive tokens at their market value. And when you sell them, you must pay taxes on any capital gains – or the increase in value since you originally received it. 

What’s Next for DAOs?

Decentralized autonomous organizations hold more than $10 billion in their treasuries, with about 1.7 million token holders in 2022. While that’s just a fraction of the ~$800 billion crypto ecosystem, DAOs have seen tremendous growth over the past two years. And they will likely continue to play a significant role in the industry’s future.

There are several trends to watch in 2023 and beyond:

  • Regulatory Clarity – Several states have introduced regulations providing protections to DAOs, while the federal government continues to work toward more precise rules. For instance, Wyoming makes it easy to set up a DAO under their definition of an LLC, providing owners and participants with legal protections.
  • Mainstream Awareness – DAOs have moved beyond DeFi protocols to become more mainstream. For instance, the UkraineDAO has already raised more than $1.7 million to support humanitarian aid efforts in Ukraine. And, FriesDAO is buying up physical fast-food franchises with the help of former industry execs.
  • Easier Workflows – DAODAO and other tools are making it easier for anyone to participate in DAOs without needing crypto knowledge and experience. That way, anyone can set up a DAO to raise capital and manage their organizations while casting votes and other activities could become a lot easier for participants.

Ultimately, DAOs could become a new governance structure alongside LLCs or corporations, enabling more democratized access to voting rights and shareholder benefits. In particular, these structures could become de facto standards for the Web3 ecosystem, replacing today’s social media giants with democratic organizations in the future.

The Bottom Line

Decentralized autonomous organizations are little more than smart contracts managing governance tokens – but the concept is introducing some big changes to the corporate and legal landscape. By democratizing organizations and providing unparalleled transparency, they could revolutionize tomorrow’s corporate environments.

That said, there are plenty of legal and technical hurdles that remain before widespread adoption. For instance, DAOs don’t enjoy the same legal protections as LLCs in most jurisdictions and the SEC may regulate token sales as securities. Most DAOs also remain difficult to create and manage for non-technical users.

If you trade governance tokens or other crypto assets, ZenLedger can help aggregate all of your tokens into one account, compute your capital gain or loss every year, and generate the paperwork you need to file. You can also use the platform to identify tax loss harvesting opportunities throughout the year and ensure you don’t overpay your taxes.

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Justin Kuepper