What is an investment DAO?
A decentralized autonomous organization (DAO) that raises and invests capital in assets on behalf of its community is an investment DAO. Investment DAOs harness the power of Web3 to democratize the investment process and make it more inclusive.
DAOs can have their units in tokens that are listed on a crypto exchange. Community rules are agreed upon and governance is enforced through smart contracts. Governance (voting) rights can be prorated based on DAO stakes.
A decentralized organization that invests in cryptocurrencies, real estate, non-fungible tokens (NFTs), or any other asset class has several functional differences from traditional investment vehicles. This is particularly true when the underlying investment opportunity is a star crypto company. DAOs that invest in startups differ fundamentally from traditional venture capital (VC).
Before explaining the differences between traditional VC and investment DAOs, let’s understand how traditional venture capital works.
What is traditional venture capital?
A venture capital fund is founded and managed by general partners (GPs). GPs are responsible for seeking investment opportunities, conducting due diligence, and closing investments in a portfolio company.
Venture capital is part of the capital pyramid and acts as a conduit that efficiently raises capital from large institutions, such as pension funds and endowments, and deploys that capital to portfolio companies. These large institutions, family offices and, in some cases, individuals who contribute capital to a venture capital fund are called Limited Partners (LPs).
The role of GPs is to ensure that funds are raised from LPs, high-quality startups are sourced, detailed due diligence is performed, investment committee approval is obtained, and capital is successfully deployed. As startups grow and provide returns to VCs, they pass the returns on to LPs.
Traditional venture capital has been a successful model that has catalyzed the growth of the Internet, social media, and many of the Web2 giants over the last three decades. However, it is not without friction and it is these that the Web3 model promises to address.
Challenges of traditional venture capital
As effective as the venture capital model has been, it still has its problems. It is not very inclusive and decision-making is quite centralized. In addition, institutional investors consider private equity to be a highly illiquid asset class.
Exclusive
The venture capital model is not as inclusive as it could be. Due to the amount of capital involved and the risk profile of the asset class, it is often only viable for sophisticated investors.
It is essential to ensure that investors appreciate the risk-return profile of their investments. Therefore, venture capital may not be the most suitable for all retail investors. However, there are subsets of the retail investor community that are sophisticated enough for this asset class. However, it is often difficult for even the most sophisticated retail investors to become venture capitalists.
This is because proven GPs are often hard to come by for retail investors or because the minimum investment in these funds is several million dollars.
centralized
If LP participation is exclusive, even investment decisions are often made by a small group of people who are part of the venture capital fund’s investment committee. Therefore, most investment decisions are highly centralized.
This can often be a limitation not only in investing globally, but also in being able to identify hyper-local opportunities in the last mile of the world. A centralized team cannot offer much in terms of origination (of investment deals) and deployment capabilities across the globe.
illiquid
The other key problem with traditional venture capital is that it is an illiquid asset class. The capital invested in these funds is usually locked up for years. Only when the venture capital fund has an exit, in the form of a portfolio company acquisition or IPO, do LPs get to see some capital returned.
LPs continue to invest in the venture capital asset class as returns are generally higher than more liquid assets such as bonds and publicly traded equities.
Let’s now look at the Web3 alternative for venture capital: investment DAOs.
Advantages of Investment DAOs
DAOs bring together the ethos of Web3 and the operational fluidity of smart contracts. Investors who believe in a specific investment thesis can come together and raise capital to form a fund. Investors can contribute different sizes to the DAO based on their risk appetite and their governance (voting) rights are prorated based on their contributions.
How do investment DAOs solve the shortcomings of traditional venture capital? Let’s discuss the functional differences.
inclusive access
Investment DAOs allow accredited investors to make contributions of all kinds. By virtue of their input, these investors can vote on key investment decisions. Therefore, the processes of investing in the DAO and deciding on investments in the portfolio are both m
Investment DAOs allow accredited investors to make contributions of all kinds. By virtue of their contributions, these investors can vote on key investment decisions. Therefore, the processes of investing in the DAO and deciding on investments in the portfolio are both more inclusive.
Agreement seeking can be decentralized, as can governance. Imagine that you run a technology-focused fund for coffee farmers around the world. Having members of the community, from Nicaragua to Indonesia, certainly helps to find the best last-mile investment opportunities. This allows investment vehicles to be more specialized, more global and yet very local.
As these DAOs can be tokenized and investors can make smaller contributions. This allows them to choose from a basket of funds to which they can contribute and diversify their risks. Additionally, DAOs are more open to receiving investment from around the world (with exceptions) than traditional venture capital.
liquid investments
In traditional VC, LPs cannot liquidate their positions in the fund before the fund offers an exit. Tokenized investment DAOs solve this problem. Investment DAOs can hold a token that derives its value from the underlying portfolio. At any time, investors holding these tokens can sell them on a cryptocurrency exchange.
By offering this functionality, investment DAOs offer similar returns to traditional VCs, albeit with lower liquidity risk. This makes them a better investment vehicle based on risk-return profile alone.
What’s the catch?
Every opportunity has its risks and vice versa; investment DAOs are no exception. Despite its structural superiority with respect to traditional venture capital companies, there are still aspects that are not clear.
For example, due to the anonymous nature of crypto investments, it is often difficult to identify the sophistication of the investor. This means that it is more difficult to protect investors from taking big risks in a volatile asset. This is a space that regulators are trying to address by regulating how a DAO markets itself to attract investors.
There are also challenges in creating a DAO where the legal language is programmatically set in smart contracts. In traditional markets, these investment vehicles are often put together by large legal teams. Relying on smart contracts to do so effectively poses a legal and technological risk.
However, there are companies like Doola that offer services to bridge the legal gap between Web3 and the real world. Here is a table illustrating the key differences between the two approaches.
Investment DAOs are still a work in progress. However, the model is promising. Once legal and regulatory risks are removed, investment DAOs could be the model adopted by traditional venture capital firms.
Clarification: The information and/or opinions expressed in this article do not necessarily represent the views or editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.