Will the Next Unicorn be a Distributed Autonomous Organization?
With the recent talk of reddit being cannibalized by bitcoin technology, I thought it a good time to post something I’ve been thinking about for a while. Could a completely decentralized startup one day rival the likes of Google, Facebook and Amazon?
Within the bitcoin world there’s a common understanding that the most valuable thing about bitcoin is not the monetary currency but the underlying “blockchain” technology that the bitcoin currency runs on. For those unfamiliar, you can check out three heavily-funded ventures creating infrastructure that would enable anyone to program applications on the blockchain that go way beyond monetary currencies: Ethereum,Swarm and Blockstream.
One such application is what’s known as a “Distributed Autonomous Organization,” which is an organization like a corporation, government or NGO, but which has no central leadership and uses internet technologies to organize and function. Examples of DAOs that you are familiar with include open-source software systems like Linux; terrorist organizations like Al Qaeda; communities like Anonymous; and of course, the Internet itself.
The logical question it seems to me is what will it take for the first Silicon Valley style startup to appear that provides a truly useful product or service to the marketplace, and makes its founders and investors gobs of money, but which is truly distributed.
What follows here is an analysis and thought experiment on how the next unicorn could be a DAO.
The Central Hurdle
In the U.S. today, the main hurdle for any startup is access to capital. Even the great Mark Zuckerberg took several years and significant effort to raise enough venture capital to expand beyond the tipping point and crush Fox/MySpace. Imagine if Zuck, instead of pitching a handful of gatekeepers in Silicon Valley, could have sold just $100 worth of stock to each of the first 100,000 Facebook users? Facebook would have been able to bypass the VCs and have $10 Million in working capital. Not to mention 100,000 new evangelists to expand the network — each of which would go on to become a college-educated millionaire today, ready to revitalize the economy and invest in the next Facebook.
If this seems far-fetched, consider that Kickstarter and IndieGogo have crowdfunded several $10+ Million campaigns to launch startups. The most successfully crowdfunded startup to date is a video game company called Star Citizen, which has raised $85 Million from almost a million financial backers as of today. And all of these campaigns were done simply by offering products and other rewards, no financial upside for backers.
While donation and rewards crowdfunding sites have proven that the public appetite for funding great ideas is latent and massive, there is the beginnings of a backlash towards for-profit endeavors that make founders rich while leave backers holding the bag full of product (see Oculus and Spike Lee for two high-profile examples).
So why don’t startups like Oculus offer stock as a reward for its early backers? The short answer is that it’s illegal to make such an offer in the U.S. unless the backer is an Accredited Investor — someone worth over $1,000,000 not including their home.
While non-accredited investment crowdfunding is in the process of becoming legal and regulated by the Securities Exchange Commission (SEC), that process has been stalled for over 3 years. And it’s likely to take several more years before this is the default way startups attract investment.
In the meantime, many startups are turning to platforms like Crowdfunder* where they can crowdfund invesetment from Accredited Investors. A poignant example is Neil Young’s startup, PonoMusic, which attracted over $6 Million in investment interest in the first 48 hours of their campaign on Crowdfunder.
But this is just the tip of the iceberg in terms of unmet demand, and it doesn’t address the $20 Trillion of investment capital in the U.S. public stock markets. The vast majority of U.S. investors — a full 93% — are not accredited and never will be.
On the flip side, there are 540,000 new businesses started each month in the U.S. alone. Venture capitalists and angel investors combined invest under $100 Billion per year. And while that may seem like a lot, it’s just 0.3% of U.S. long-term investment capital and 0.02% of worldwide long-term investment capital. Once you compare the 9% historical returns in public stocks to the 28% historical returns in startup stocks, you begin to see the magnitude of the problem — and the opportunity for non-accredited investment crowdfunding.
Threading the Needle
One of the more fascinating aspects of Swarm and Ethereum is that they capitalized their idea by running a crowdfunding campaign to non-accredited investors. Each of these crowdfunders received a “reward” of virtual currency that has a lot of the same properties as stock, including voting rights and the potential for financial upside. And because of this, the SEC is taking a very close look at whether they have violated securities laws.
The founders of these two groups will argue that they have “threaded the needle” and successfully constructed an offering that has the desired properties of equity ownership while staying clear of selling unregistered securites. And while they may have a valid technical point, the SEC takes a practical stance rather than a technical one: if it looks like a duck, quacks like a duck and waddles like a duck….
The main litmus test the SEC employs in such cases is called the Howey Test, which asks whether there is “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others” (for more details read here and here).
As a serial startup founder and prolific angel investor, I believe the Howey Test is not only simple and elegant, but also a good thing. Over the course of the last 80 years, corporate structures and financial engineering of securities have served to limit the liability of investors and distance them from the source of their profits. This has been essential for the public markets to flourish, but in the startup world, it’s counterproductive.
As a founder, I’d much rather have an investor who provides value beyond their money; I want someone who is passionate about the business and will use their network, their expertise and their time to help the company grow. And as a startup investor, I desire to have more visibility into and influence over the performance of my investment than typical equities contracts guarantee or anticipate. Again, think back to what would happen if the next Facebook or Uber could offer equity to their most ardent users and customers?
Threading the needle on securities regulations, especially for an undercapitalized startup, is fraught with unacceptable risk, in my opinion. Not only is the SEC hyper-sensitive to this sort of activity, it has nearly unlimited resources it can (and does) use to enforces its regulations. Each state also has an SEC-like agency with nuanced state-specific regulations that apply if anyone involved in a securities transaction happens to be in that state. I found this out first hand as an investor in an early equity crowdfunding site, which was forced to close because the State of California made a unilateral determination that what the company was doing wasn’t kosher. While company lawyers and investors disagreed, nobody was wiling to re-invest to fight the state’s decision, and we ran out of money quickly thereafter and had to shut down.
Rather than threading the needle, I believe there is a way for startups to raise investment from non-accredited investors today, and be fully compliant with all current securities laws and regulations. But until recent advances in both blockchain and crowdfunding technology, it hasn’t been practical.
My purpose in publishing the following is twofold:
- Provide a roadmap for pioneering entrepreneurs and their lawyers to unlock the buried treasure
- Alert regulators so they can be prepared to work with the pioneers
Here’s my warning for the pioneers: do not go off half-cocked; talk to several securities and corporate attorneys before you go down this path. And make sure they are confident that you are in the clear, and they are willing to defend you (without bankrupting you) in case there’s a fight with regulators.
And here’s my warning to regulators: trying to stop DAO activity is as foolish as banning the internet itself; given the financial incentives for both entrepreneurs and investors outlined above, DAOs that sell profit interest are inevitable, and will simply go offshore and underground if the climate is too restrictive. Given recent advances in blockchain anonymity and cryptography, there will be no way to identify who the principals are, let alone seize their virtual currency assets.
The Roadmap to Unstoppable DAOs
From here on out, I’m going to assume a layman’s working knowledge of blockchain technology, equity crowdfunding, and basic securities and corporate law. You should also go to Ethereum.org, read what’s on the home page, watch the 10 minute video, and read the white paper. Note, that even if Ethereum is stillborn, or shut down somehow, these same advancements are being added to the Bitcoin blockchain (see Sidechains), which means the necessary technical infrastructure for DAOs is already unstoppable.
In order to function and thrive, a DAO must be “invisible” to government bodies which would seek to threaten its existence. Since the main hurdle is securities law, and since the SEC has pre-emption over the states, the key to DAOs is staying out of the crosshairs of the SEC. The SEC’s mission is in regulating the sale of securities, and protecting investors from securities fraud. But the SEC has no jurisdiction over entities or individuals that do not deal in securities. If you’re selling hotcakes out of a food truck, you’re going to fall under many regulatory agencies’ purview, including FTC, FDA, DMV, various health departments and business administrations. But unless your hotcakes are laced with company stock, you are a non-entity as far as the SEC is concerned.
While most startups are structured as C-Corps, S-Corps or LLCs, these are not the only options. In fact there are much older corporate structures better suited for startups, namely General Partnerships and Workers Cooperatives. Rather than limiting investor control and liability like their newer counterparts, GPs and Co-ops blur the distinction between investor and founder. And in so doing the presumption under law is that membership in a General Partnership or a Co-op is not a security. Unless of course it fails the Howey Test.
So let’s talk about how to pass the Howey Test while allowing startups to raise capital from investors. Since the Howey Test is to determine whether something is a security, we must reverse the logic of the test to “pass”. For instance, if there’s no “reasonable expectation of profit”, there’s no security. Similarly, if there is reasonable expectation of profit, but that profit is based on the investor’s own efforts, then it’s not a security either.
As a thought experiment, let’s imagine that you tell me you are starting a gold mining club and that for $100 you will sell me a membership that entitles me to mine for gold on your land and keep whatever I find. You warn me that only one in a thousand people who do this full time for a year have found enough gold to make a profit, but the ones who do strike it rich. Here’s a situation where there’s no reasonable expectation of profit. And, any profit that I might make is derived only through my own entrepreneurial and managerial efforts. Clearly, membership in your mining club is not a security.
However, we don’t have to be so strict. For instance, you could say that I have a 90% chance of making a profit, and as long as I’m doing my own mining, it’s not a security if you sell me the right to do so. Or you could say profits are one-in-a-thousand, but that you have a mining rig that does all the work and randomly assigns any proceeds to members based on how much they paid for their membership (i.e. a $200 membership is twice as likely to get gold as a $100 membership). It should be noted that this probably would be considered an “illegal lottery” in most states, but the point here is that it’s not a security.
Since the exercise here is to solve for allowing anyone to invest in a startup, there’s always an expectation of profits. Thus, we need to focus on whether this expectation comes “from the entrepreneurial or managerial efforts of others.” Before I dive in though, it’s worth remembering that the whole reason we are even having this discussion is that prior to the the Securities Acts of 1933 & 1934 (and the formation of the SEC), stock market fraud was rampant. Grandmothers in Kansas would regularly get fleeced out of their retirement nest egg by stock brokers in New York. So the main thing you need to remember is that the SEC’s raison d’être is to protect investors from getting hurt.
Which means that to stay out of the SEC’s crosshairs, we need to prevent investors from getting hurt whenever they are expecting profits from the entrepreneurial or managerial efforts of others. Let’s look at these elements in a bit more detail:
- Financial Risk & Liability – By definition, if your paycheck is not at risk, it’s not entrepreneurial activity, it’s a salaried job. Thus to remain clear, there must be financial risk for both investor and the people doing the work at the startup. And they must both bear the financial liability if there’s a loss.
- Corporate Governance & Control – When the SEC takes action against a company for securities violations, they look for who’s making the decisions (governance) and who’s ultimately in control of the company. If everyone is a decision maker— investors and employees alike — and no individual person can be identified as having more control than others, then there’s no security, regardless of the financial risk and liability.
Thus, we are looking for a way to organize and run a startup that distributes risk, liability, governance and control amongst its stakeholders such that, when the SEC comes looking, it only sees a group of individuals who have pooled their resources for mutual benefit, and who are not offering investment to anyone outside the group.
Programming Your First DAO
At this point you may be wondering if we are about to throw the baby out with the bathwater. In particular, how many people would want to invest significant sums of money into a startup and have to do a lot of work? Wouldn’t this be antithetical to the first rule of investing, which is to diversify (and thus not put too many resources into one basket)?
In the past, having distributed governance and control would indeed have required each investor to do significant amounts of “work”. But with the ability to automate and coordinate activity virtually, a Distributed Autonomous Organization need not require more labor from its investors than overseeing a startup investment does today. In fact, investing in DAOs has the potential to streamline investor engagement and allow investors to spend less actual time on more startups, leading to greater diversification and thus reduced financial risk.
What follows is a description of one possible DAO structure that accomplishes these goals and remains clear of securities violations (check with your lawyer first, I’m not one :-) There are many possible alternative structures that will work, some no doubt better and more efficient than the one I am proposing. This is simply to illustrate that it’s possible. The structure I will begin with is that of a General Partnership, and for clarity I will refer to the partnership as the Company, regardless of whether it is registered as such in any legal jurisdiction.
The structure proposed here is to be run on a system like Ethereum, where smart contracts, currency and financial flows are enforced in a distributed and autonomous fashion.
General Partners (GPs) – Any individual who has a financial stake in the Company (not including Charitable Beneficiaries) must be a General Partner. GPs — and only GPs — may also be Directors, Managers, Workers or Investors (see below). GPs must be individual human beings (not corporations, organizations, animals or technological agents such as software programs). GPs have the following rights and obligations:
- Right to an equal portion of Dividends (see below)
- Right to an equal vote on all voting matters
- Eligibility to work for the Company for cash and/or equity (see Working Partners)
- Equal responsibility and liability under the law for the Company’s decisions and actions in all jurisdictions it operates in plus all jurisdictions the GPs reside in
- An obligation to indemnify all other GPs from legal actions and government sanctions arising from their role as a GP
- All GPs are granted a single Share of Company equity upon becoming a GP, and may acquire more Shares via investing or working
- Upon voluntary or forced removal as a GP, all Shares are relinquished back to the Company
Directing Partners (Directors) – Directors serve the sole function of hiring/firing and compensating the Managers. Directors may not contemporaneously be Managers or Workers. Directors are elected by a majority vote of GPs once per quarter. Directors may not receive compensation of any form (except Dividends) while they are Directors. Think of them as jurors; they serve temporarily for the greater good, and they sacrifice accordingly.
Managing Partners (Managers) – While their main function is management of the Company and Workers, the Managers also set the strategic direction of the Company (relative to the Mission), and they hire, fire, and set compensation of the Workers (other than themselves, which is handled by Directors).
Working Partners (Workers) – A Workers is anyone who does work for the Company in exchange for compensation. In the eyes of many legal jurisdictions, there is a distinction between officers, employees, contractors, and advisors, but for the DAO these are all considered Workers.
Investing Partners (Investors) – An Investor is anyone who purchases Shares in the Company from the Company itself. Being an Investor does not affect one’s status as a GP, Director or Manager.
Charitable Beneficiaries (CBs) – Any organization or individual who receives cash donation from the Company without obligation in return. CBs may not be GPs.
Shares – The Company’s currency, which entitles holders to Royalties and Liquidity. Shares may only be held by GPs (who are referred to as Shareholders in such capacity).
Royalties – A percentage of revenues which is allotted for distribution to Shareholders on a pro-rata basis.
Liquidity – Shareholders may sell all but one share to the Company or other GPs through a transparent/fair marketplace at any time. Upon dissolution of the Company via acquisition, merger or IPO, all assets of the Company will be distributed to Shareholders pro-rata.
Revenue Waterfall – All revenues to the Company — including from sales, contracts, grants, prizes and investment returns — will be distributed in the following manner:
- Taxes: all accrued and potential estimated taxes are paid first
- Royalties to Shareholders: distributed pro-rata based on % of Shares held
- Salaries to Workers: as set by Managers (or Directors in case of Managers)
- Accounts Payable: as standard for any corporation
- Capital Investment: the Company may invest in assets to grow capital or hedge operational risk, as determined by the Managers
- Charitable Contributions to CBs: the Company may make charitable contributions as determined by vote of GPs
- Bonus Pool to GPs: all GPs except acting Directors participate
- Dividends to GPs: all GPs get an equal share
Company Formation – The Company is formed by a Genesis Raise that ratifies the Charter, which can only be changed later via supermajority vote of all GPs.
- The Mission: why the Company is being formed and what its ultimate goal is
- Royalty Rate: % of undistributed revenues distributed to Shareholders
- Charitable Contribution Range: minimum and maximum % of undistributed revenues to be donated
- Bonus Pool Size: % of undistributed revenue distributed to GPs
- Initial Directors: an odd number of Directors, along with names of individuals willing to serve the first quarter
- Initial Managers: one or more individuals who will serve at the pleasure of the Directors
- The Genesis Raise: the number of Shares to be sold (in BTC) during an initial capital raise and a timeframe during which it will take place. Note that:
• The first share purchased by any individual comes with GP Membership
• Proceeds from the Genesis Raise are not included as Revenue
Becoming a GP – After the Genesis Raise, if there are Shares left over, or new Shares issued, then anyone who is eligible (see above) can purchase their first Share, thereby becoming a GP.
Voting – Voting matters will be programmed into the DAO and automatically administered. In addition a majority of Shares may call a referendum at anytime for any reason. Here is a non-exhaustive list of voting matters and their requirements to carry:
- Referendum: simple majority
- Issuance of New Shares: simple majority
- Quarterly Election of Directors: simple majority
- Modification of Company Charter: supermajority
- Removing GPs: supermajority
- Acquisition / Dissolution / Change of Control / IPO: unanimity
While the above is not meant to be complete, it should give anyone a good headstart. Note that the standard way a company’s operating agreement or articles of incorporation is enforced is through legal contracts as interpreted by officers of the company and attorneys. With DAOs, the vast majority is programmed into the blockchain and thus immune from interpretation, tampering or influence. Still there will always be elements that require human oversight and discretion. The exercise above is designed to minimize human involvement, and where necessary to distribute both the effort and control in a way that is both mission-aligned and free from securities violations.
- CNBC blockchain tech summary
- Building a stock market with blockchain technology
- Programming legal contracts
* full disclosure, I’m a principal Crowdfunder.