The DAO is the latest Decentralized, Autonomous Organization to make major waves as they raised over $100 million worth of ETH tokens (12% of all ETH). The question remains, is it a good idea to invest in The DAO and have they learned anything from those who have gone before?

In this article I will talk about the experience gained from BitShares, not to promote BitShares as superior, but to highlight the hard lessons that can be learned from BitShares’ failures and how they might apply to The DAO.

Background

Let me take a moment to share my credentials on the subject of DAOs. The first two words of DAO, Decentralized Autonomous, entered the crypto-currency lexicon after a discussion between my father and I back in 2013. I introduced the concept that a blockchain can be viewed as a DAC. It was because of these articles that Vitalik Buterin, one of the founders of The DAO, started exploring the concepts in a three part series .

The last word of DAC was changed from Company (or Corporation) to Organization in order to avoid unnecessary legal entanglements, but the concept remains the same.

Over the past three years I have worked with the BitShares community to implement the worlds first Decentralized Autonomous Organization based upon many of the same principles as The DAO. Money was raised, tokens were allocated, and token holders were given the ability to vote on how to spend community money and set blockchain parameters.

The latest incarnation of BitShares gave members joint control over a $6 million dollar reserve fund. Advanced consensus and voting systems were implemented to address voter apathy. Powers were divided. Participatory budgeting was adopted. The stakeholders have the ability to vote for hard forks that implement new features. BitShares even adopted fee-backed assets to help fund specific features. Every thing in the blockchain was parameterized and those parameters could be changed by elected committee members. BitShares has been and continues to be one of the most comprehensive examples of a self-governing DAC / DAO.

There is only one major technological difference between The DAO and BitShares, with The DAO, the blockchain smart contracts can change without all of the nodes having to upgrade. This difference is relatively trivial and ultimately irrelevant to the potential success or failure of The DAO. The reason this technical difference is irrelevant is because success and failure of a DAO/DAC depends not on the technology used, but entirely on how a community interacts with the technology and each other.

Smart Contracts cannot fix Dumb People

BitShares had all of the tools, the talent, and the money to do great things if only the BTS holders could agree on what should be done, who should be paid, and how much should be spent. So what lessons have we learned from BitShares’ experiment and how is The DAO doing anything meaningfully different to address it?

Poor Voter Participation

One of the first things we learned from BitShares is that the vast majority (90%+) of stakeholders did not participate in voting. This is due to the fact that voting requires time, energy, and skills that most investors lack. How many people have the economic, technical, and entrepreneurial skills to vote responsibly?

In order to boost participation BitShares 2.0 introduced proxy voting which centralized decision making into about a dozen elected proxies. Even with proxy voting, most people ultimately chose their preferred proxy along party/philosophical lines rather than considering individual proposals.

The DAO currently requires a level of voter participation that is much higher than BitShares has ever seen for a worker proposal. Even with proxies the highest level of consensus stakeholders have achieved is just a tad over (20%). This means The DAO is expecting much higher levels of participation of voters without using proxies. Unless the majority of DAO stake is held in a few active hands, this will be very hard to achieve.

Perhaps even more interesting with The DAO, once you vote for something you are no longer allowed to split your ETH out and form a new DAO. This means that you have much to lose by voting and much to gain by not voting. With an initial quorum of 20% it will be very challenging to get enough agreement, especially with the downsides associated with actually voting.

Anti-Spending Movement

It didn’t take long for the BitShares community to realize that funding projects today would cause a short-term fall in the value of BitShares. Unable to bear the short-term paper-loss and psychological impact of a lower market cap, people started electing proxies that would vote against all spending proposals.

With The DAO the same principles are at work. Every time a project is funded, the amount of ETH backing the DAO tokens falls and is replaced with speculative IOU from a contractor. What is worse, when the ETH is sold to fund the projects the value of all ETH falls. Since The DAO keeps its savings in ETH, the actual cost of funding a proposal includes any loss value caused by selling ETH.

Considering many of the investors in the DAO also hold ETH there is a conflict of interest in their voting preferences. Most individuals will see the short-term cost (loss of liquidity) of authorizing spending to be much higher than the long-term benefit. After all, authorizing a $1 million dollar project will cause the DAO to lose 1% of its capital today and would likely move the Etheruem price by more than 1% down as everyone attempts to front-run the sell pressure created by the project. In the long-run the project may add value to Etheruem and the DAO, but the long-run is often years away.

Smart speculators know they can make the most money by not tying up their capital during the no-growth phase. They will sell today and buy back in closer to the completion the project.

Not everyone will agree with the value an approved project will bring to The DAO. So while those who vote to approve it see $1 million dollars being invested to create $10 million of value, many more will see that $1 million dollars being wasted with no chance of return. Who is right? Well odds are in favor of it being wasted as 9 in 10 startups fail.

Fortunately The DAO allows non-voters to split and reclaim their ETH by splitting their funds out.

Death by 1000 Splits

The DAO has tentatively raised $100 million dollars worth of ETH, but so far the investors have taken no real risk. Every single person who has purchased DAO tokens has the ability to reclaim their ETH so long as they never vote. The end result is a massive marketing campaign that totally misrepresents what has been invested and what hasn’t. Considering there is no real risk being taken beyond the risk of holding ETH and that there is the potential for a large gain it is no wonder so many people have participated.

So what happens next? Everyone seeking a zero risk return will abstain from voting. If greater than 80% fall in this category, then nothing will pass. There is a very real possibility that this will happen.

Will there be any proposals in the first place? To prevent proposal spam all new proposals must make a deposit that gets forfeited if a quorum (20%) is not reached. In this case there will be no proposals unless the proposers are already certain they will win. To be certain will require conducting non-binding polls outside The DAO. What happens if people vote in non-binding polls but then refuse to vote for the actual proposal? Free profits for The DAO when the deposit fee is forfeited. This may or may not be an issue depending upon whether the required deposit is small enough to risk losing. Anything less than $100 is probably OK.

Once the first project gets approved a new moral hazard is created. Lets assume it is approved with the minimum 20%. The DAO will receive reward shares in the funded project and those shares will be divided equally among all participants. The non-voters will get the rewards and can then split their funds. The voters on the other hand will be unable to split. They take 100% of the risk and only get 20% of the reward, where as the non-voters get 80% of the reward and minimal risk.

The DAO is complicated and I admit that I am not sure I fully understand how, when, and where ETH can be split relative to payouts and rewards. It may well be that non-voters end up funding 80% of the proposal and can only reclaim a fraction of their original investment after the proposal is funded.

Regardless of which way it is actually implemented, there are more benefits to be gained by not-voting and splitting your ETH out of The DAO than by voting and keeping your ETH in The DAO. Liquidity is valuable.

Ignore the Technology

Fancy technology can obscure our assessment of what is really going on. The DAO solves a single problem: the corrupt trustee or administrator. It replaces voluntary compliance with a corporation’s charter under threat of lawsuit, with automated compliance with software defined rules. This subtle change may be enough to bypass regulatory hurdles facing traditional trustee’s and administrators, but it doesn’t solve most of the problems the regulations were attempting to address.

What The DAO doesn’t solve is all of the other problems inherent with any joint venture. These are people problems, economic problems, and political problems. In some sense, The DAO creates many new problems caused by its ridged rules and expensive machine-enforced process for change.

The DAO doesn’t solve the “group trap” where by losers subsidize winners. It disempowers the individual actor and forces him to submit to group decision making. It doesn’t make raising money cheaper for companies, it just adds blockchain-enforced bureaucratic and political processes.

Ask yourself if you would still invest in The DAO if its rules were written into the charter of a traditional VC firm. Ask yourself it it would not be simpler to keep your ETH and simply vote with your investment dollars for individual blockchain IPO’s where the IPO rules are enforced by the blockchain. Now ask yourself, what value is The DAO providing to your capital in exchange for all of the added restrictions it places on your capital.

A traditional VC firm is run by experts who study potential investments in depth and get paid proportional to their success. People give money to a VC firm because they trust the management of the firm and accept reduced profits because the VC firm is adding value. The DAO is just a committee of non-professional voters who have relatively little ability to do proper due diligence.

Conclusion

My opinion is that The DAO will be DOA (Dead on Arrival). The theory of jointly deciding to fund efforts will face the reality of individual self interest, politics, and economics. There will be rapid defecting (splitting) as people realize there is little to be gained by banding together under the structure of The DAO and much to be lost.

It might not happen at first, but over time the Etheruem community will learn the hard way what the BitShares community has already discovered. Creating social systems to jointly fund development of projects and investments is challenging. Ultimately, technology can only aid in communication, it cannot fix the fundamental incompatibilities between individual self interest and community decision making.