How DAOs Work

Remember how DAOs operate without a central authority? That’s exactly why governance is so critical. When decisions need to be made, each DAO relies on its chosen governance model to ensure things don’t haywire. 

We’ve tackled some governance models in the previous module but now let’s go more in-depth with the different types!

1. Token-Based Governance

In a token-based DAO, governance power is directly tied to token ownership. The more tokens a member holds, the greater their voting power. The idea is that having more tokens reflects a stronger stake in the community and that the ones making the decisions are literally putting their money where their mouth is! 

Example:

• Uniswap DAO: Uniswap, a leadingDEX on Ethereum, uses the UNI token for governance. UNI holders vote on proposals to change Uniswap’s protocol fees, system upgrades, and treasury allocations.

Pros:

• Encourages participation by rewarding token holders with governance power.
• Offers a clear structure for decision-making (more tokens = more power). 

Cons:

• This model can lead to wealth concentration, where large token holders (whales) exert the most control in the system, limiting the voice of smaller participants.

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2. Reputation-Based Governance

Instead of relying on tokens, reputation-based DAOs assign voting power based on contributions, expertise, or past involvement in the community. This system prioritizes time and effort spent within the ecosystem over financial investment. Active community members get to have a greater say in the DAO’s direction since they’re the ones who consistently contribute.  

Example:

• Colony: Colony is a platform that supports the creation and management of reputation-based DAOs. Members earn reputation points through their contributions, which determine their voting power. It also features a reputation decay mechanism, requiring ongoing participation to maintain influence.

Pros:

• Rewards meaningful participation rather than financial investment.
• Helps reduce the risk of governance centralization.

Cons:

• Fairly measuring contribution can be complex and subjective. 
• Newcomers may struggle to gain influence compared to older members. 

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3. Liquid Democracy (Delegated Governance)

Liquid democracy is a flexible governance model that combines elements of direct democracy (voting on policies yourself) and representative democracy (electing individual/s to vote on policies for you).

In this system, DAO members can either vote directly on proposals or delegate their voting power to a trusted representative (delegate) who votes for them. For example, a proposal to increase the number of transactions per block in a blockchain could be voted on by users themselves (if they feel like they understand the implications of this) or delegated to someone more experienced in the ecosystem. Delegative voting is especially useful for technical topics for the casual DAO user or when they simply do not have the time to vote on every issue. 

One of the strengths of this system is that delegation isn’t permanent. Members can reclaim their vote or switch delegates at any time based on performance. Imagine impeaching an underperforming politician instantly! 

Example:

• MakerDAO: MakerDAO, the governance body behind the DAI stablecoin, allows MKR token holders to delegate their voting power to active community members. This ensures that highly informed participants guide key decisions, while regular users still have the ability to participate whenever they choose.

Pros:

• Offers flexibility, members can vote directly or delegate their vote.
• Members who lack time or technical expertise can delegate their votes to more suitable and informed candidates. 
• Delegated votes can be revoked or reassigned at any time.
• Prevents whale dominance in decision-making, since votes are reliant on community support. 

Cons:

• Requires members to stay informed in order to choose responsible delegates or actively vote when necessary.
• If too many votes are delegated to a few representatives, governance power may become overly centralized.
• Delegates may be influenced by external incentives, potentially leading to biased decisions.

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4. Quadratic Voting 

Quadratic voting is a governance mechanism designed to promote fairness and reduce wealth concentration. Unlike the standard "1 token = 1 vote" system, this system allows members to allocate multiple votes to issues they care deeply about. However, the cost of each additional vote increases quadratically, meaning that casting more votes on a single proposal becomes progressively more expensive. 

For example, the first vote might cost 10 ABC tokens, the next vote would cost 100, then 1,000, and so on. This discourages whales from  overpowering governance decisions and ensures that the community is better heard. 

Example:

• Gitcoin DAO: Gitcoin is a platform focused on funding open-source software. It uses a variation called quadratic funding. This method invites community members to make donations that essentially act as votes on fund allocation. However, instead of a simple majority vote, community contributions are weighted using a quadratic formula. This ensures that projects with broad community support receive more funding, even if individual contributions are small.

Pros:

• Reduces influence of large token holders. 
• Better represents the overall community sentiment.
• Encourages more thoughtful participation, as votes become increasingly costly. 

Cons:

• More complex than traditional voting methods.  
• Susceptible to creation of multiple wallets to bypass the quadratic cost mechanism.
• Challenging to implement on-chain voting infrastructure that properly enforces quadratic calculations. 

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Interestingly, some DAOs adopt hybrid governance models that combine different methods. For instance, DxDAO uses a reputation-weighted voting system where both governance tokens and earned reputation influence decision-making. It’s like the best of both worlds! 

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As with any cryptocurrency project, tokenomics is a crucial aspect of DAO’s design. Token economics (tokenomics) is the study of how a blockchain project's digital tokens function economically. It focuses on the design and distribution of tokens, as well as their impact on the project's value. Specifically for DAOs, how tokens are issued are extremely relevant because an unfair distribution could concentrate too much power in a whale’s hands. 

A well-designed token economy aligns incentives among all stakeholders, ensuring that the DAO can function efficiently while minimizing the risk of centralization. 

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Utility and Governance Tokens

DAOs typically issue two types of tokens:

Utility Tokens – These provide access to specific features or services within the DAO ecosystem. For example, a DAO managing a decentralized exchange might require its token to unlock reduced trading fees or staking rewards. Examples of these include Golem (GLM) and The Graph DAO (GRT). 

Governance Tokens – These give holders the right to vote on proposals, treasury management, and protocol upgrades. In token-based voting models, the more tokens a member holds (or stakes), the greater their influence in decision-making. Examples of these include UNI (Uniswap), MKR (MakerDAO), AAVE (Aave).

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Incentivizing Participation and Contributions

A well-designed tokenomics model should encourage members to actively participate in governance and contribute to community initiatives. DAOs commonly use:

• Contributor Rewards – Members earn tokens for their work, proposals, or project contributions.
• Voting Incentives – Some DAOs offer staking rewards or bonus tokens to members who consistently participate in governance.
• Bounties and Grants – DAOs provide funding to developers, researchers, and content creators to build useful tools or raise awareness.

Example: Bankless DAO rewards contributors in BANK tokens for writing articles, hosting podcasts, and developing Web3 education resources.

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Sustainability and Long-Term Economic Models

To remain viable, DAOs must balance inflation, treasury management, and token utility to prevent economic instability. Sustainable models include:

• Capped Token Supply – Some DAOs set a maximum supply to control inflation (e.g., Bitcoin’s hard cap of 21M).
• Deflationary Mechanics – Token buybacks, burns, or fee redistribution mechanisms help reduce supply and increase token value over time.
• Diversified Treasury Assets – Holding multiple assets (ETH, stablecoins, NFTs) helps DAO hedge against market volatility.

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Token Distribution Models

A key aspect of tokenomics is how DAOs distribute tokens to ensure fair governance and prevent centralization. Common distribution models include:

• Airdrops – Tokens are given for free to early adopters, users, or community members to encourage initial participation.
• Vesting Schedules – Founders and core team members receive tokens gradually over time, aligning their interests with  the project’s long-term success.
• Staking Mechanisms – Members stake tokens to earn rewards, locking up tokens from circulation and reducing speculative selling.

Regardless of the method of distribution, a well-balanced allocation is crucial for fair decision-making. If too few holders control the majority of governance tokens, it risks becoming just like a traditional centralized company! DAOs need proper token allocation to help distribute power fairly and protects against governance attacks. 

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Ensuring Decentralization Through Proper Token Allocation

Key Strategies:

1. Balanced Distribution – Tokens should be fairly allocated among core contributors, early investors, and the wider community. Tokens reserved for core contributors and early investors can be locked in vesting schedules (gradually unlocking over time) to prevent large sell-offs. Meanwhile, the wider DAO community should receive  sufficient share of the tokens to ensure that everyone has a voice. 
2. Fair Launch - Another strategy to ensure decentralization is to avoidpre-allocated tokens entirely. A fair launch gives all DAO users equal access to tokens at the same time. No head starts for those sneaky insiders! 
3. Pre-Minted Allocation – Some DAOs adopt pre-minted models. This essentially allows pre-allocation of tokens but enforces strict rules to limit concentration. For example, Gitcoin DAO airdropped governance token  only to active users and contributors. 
4. Ongoing Airdrops – Periodic token distribution to new and active participants help reduce intense selling pressure. These retroactive rewards incentivize sustained contributions based on actual impact to project over time rather than rewarding early buyers only. 
5. Capped Voting – Some DAOs limit the maximum voting power any single member can hold, regardless of token balance. This prevents whales from dominating decision-making and ensures fairer participation. 

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While there are ways to prevent abuse of power such as through efficient token allocation, what happens when someone still finds a way to do it? 

DAOs undoubtedly provide a more decentralized approach to operate organizations. However, they still exist in a legal gray area in many countries.

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Are DAOs Legally Recognized?

Are DAOs recognized everywhere? Not quite. Some jurisdictions, like Wyoming (USA), the Marshall Islands, and Switzerland, have introduced legal frameworks to formally recognize DAOs. The growing acceptance of cryptocurrency ETFs worldwide is also helping push forward legislation towards DAOs. 

Still, many DAOs still operate without legal basis. In most jurisdictions, DAOs are not considered legal entities. This means they cannot enter contracts, own assets, or be held liable in the same way traditional organizations can. 

Without legal recognition, individual members could potentially face personal liability for actions taken by the DAO, as it creates potential risks to users. To avoid regulatory uncertainty, some DAOs choose to incorporate under existing legal structures, such as Limited Liability Companies (LLCs), cooperative associations, foundations, or non-profit organizations. 

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Compliance Challenges 

DAOs operating in financial sectors often face significant compliance challenges, particularly around Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations. Governments require identity verification for financial transactions to prevent fraud and illicit activities, directly  conflicting with the pseudonymous nature of most DAOs. 

Additionally, many governance tokens resemble securities, potentially subjecting them to strict investor protection laws. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) have already taken enforcement actions against projects issuing tokens classified as unregistered securities. 

Another major hurdle is taxation and liability. DAOs that generate revenue ay be subject to corporate or capital gains taxes, yet their decentralized structure makes enforcement difficult. After all, how do you tax an organization with no headquarters and members  distributed throughout the globe? 

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Jurisdictional Differences in DAO Regulation

DAO regulations vary widely across jurisdictions, creating a complex legal landscape. Some countries have begun recognizing DAOs as legal entities, while others maintain unclear or restrictive policies. For instance: 

• United States – In the U.S., DAO regulation is still evolving. Wyoming was the first state to establish a legal framework allowing DAO to register as Limited Liability Companies (LLCs). This provides DAOs legal personhood, liability protection, and a structured way to interact with traditional financial and legal systems. However, federal agencies like the SEC continue to scrutinize DAOs, particularly regarding securities laws and financial compliance. 
• Europe – The European Union has yet to introduce specific DAO legislation, but existing financial regulations, such as the Markets in Crypto-Assets (MiCA) framework, may affect them. MiCA primarily addresses stablecoins and crypto-asset issuers, but its rules could extend to DAO-issued tokens.
• Asia – Singapore and Hong Kong provide favorable regulatory environments for crypto and DAO innovation, while China maintains strict bans on cryptocurrencies.
• Other Regions – Countries like Switzerland (Crypto Valley) and the UAE (Abu Dhabi Global Market) have established regulatory sandboxes to foster DAO innovation. Meanwhile, Australia and Latin America are still developing their regulatory stance on DAOs. Australia is exploring DAO-specific legal frameworks, and some Latin American countries, like El Salvador, have adopted pro-crypto policies that could indirectly benefit DAOs.

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Ultimately, the lack of regulatory standardization means DAOs must navigate a patchwork of legal systems. There’s no “one size fits all”. 

Some crypto users argue that “going under the radar” is the way to go, as freedom drives innovation. On the other hand, others believe that clearer regulation is necessary for mass adoption and greater security in the DAO space. It’s an ongoing debate with no easy answers!

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