What are investment DAOs and how do they work?

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 are leveraging the power of Web3 to democratize the investment process and make it more inclusive.

DAOs may have their units in tokens that are listed on the crypto exchange. Community rules are agreed and governance is enforced through smart contracts. Management (voting) rights can be allocated proportionally based on DAO shares.

Related: Types of DAO and how to create a decentralized autonomous organization

A decentralized organization that invests in cryptocurrencies, real estate, irreplaceable tokens (NFT) or any other asset class has several functional differences from traditional investment instruments. This is especially true when the main investment opportunity is a crypto startup. DAOs investing in start-ups are fundamentally different from traditional venture capital (VC).

Before we look at the differences between traditional VCs and investment DAOs, let’s understand how traditional venture capital works.

What is a traditional VC?

A venture capital fund is established and managed by general partners (GPs). GPs are responsible for finding investment opportunities, conducting due diligence and completing investments in a portfolio company.

Venture capital is part of the capital pyramid and acts as a conduit that effectively raises capital from large institutions such as pension funds and donations and deploys this capital in portfolio companies. These large institutions, family offices and in some cases individuals who provide capital to a VC fund are called limited partners (LPs).

The role of GPs is to ensure that they raise funds from the LP, provide high-quality start-ups, carry out detailed inspections, obtain approvals from the investment committee and successfully raise capital. As startups grow and provide returns to VCs, VCs pass on returns to LPs.

Traditional venture capital is a successful model that has catalyzed the growth of the Internet, social media and many of the Web2 giants over the past three decades. However, this is not without its frictions and it is with them that the Web3 model promises to cope.

Challenges of the traditional VC

As effective as the VC model is, it still has its problems. They are not very inclusive and decision-making is quite centralized. VC is also considered a highly illiquid asset class by institutional investors.

Exceptional

The VC model is not as inclusive as it could be. Due to the amount of capital invested and the risk profile of the asset class, it is often only viable for complex investors.

It is crucial to ensure that investors assess the risk-return profile of their investments. Therefore, venture capital may not be appropriate for all retail investors. Still, there are subgroups in the retail investor community that are complex enough for this asset class. And yet, it is often difficult even for sophisticated retail investors to be LP in venture capital funds.

This is either because proven GPs are often difficult to reach for retail investors, or because the minimum investment in these funds is several million dollars.

Centralized

If participation as an LP is exceptional, even investment decisions are usually made by a small group of people sitting on the VC fund’s investment committee. Therefore, most investment decisions are highly centralized.

This can often be a constraint not only on investing globally, but also on the ability to identify hyperlocal opportunities in the last mile of the world. A centralized team can offer so much in terms of emergence (of investment transactions) and opportunities for implementation around the world.

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The other key problem with traditional VC is that it is a class of illiquid assets. The capital invested in these funds is often locked for years. Only when the VC fund has a way out, in the form of a portfolio company that is acquired or made public, can LPs see the returned capital.

LPs still invest in the venture capital asset class, as returns are usually better than more liquid assets such as bonds and publicly quoted shares.

Let’s now look at the Web3 alternative to venture capital – investment DAO.

Advantages of investment DAO

DAO combines the ethos of Web3 and the operational seamlessness of smart contracts. Investors who believe in a particular investment thesis can come together and pool capital to form a fund. Investors can contribute to DAO in different amounts depending on their risk appetite and their management rights (voting) are allocated proportionally based on their contributions.

Related: What are smart blockchain contracts and how do they work?

How do investment DAOs deal with the shortcomings of traditional venture capital? Let’s discuss the functional differences.

Including access

Investment DAOs allow accredited investors to contribute in all amounts. Thanks to their contribution, these investors can vote for key investment decisions. Therefore, the processes of investing in DAO and deciding to invest in the portfolio are more inclusive.

Transaction extraction can be decentralized, just like management. Imagine running a technology-focused fund for coffee makers around the world. Having members from the community from Nicaragua to Indonesia certainly helps to find the best investment opportunities in the last mile. This allows investment instruments to be more specialized, more global and yet highly local.

Because 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. In addition, DAOs are more open to receiving investment from around the world (with exceptions) than traditional venture capital.

Imagine a $ 100,000 accredited retail investor who wants to expose himself to Web3 subclusters and crypto startups. The investor can find an investment DAO focused on NFT, decentralized financing, Layer 1 cryptocurrencies and so on to allocate their investments to all these different DAOs.

Liquid investments

With traditional venture capital, LPs cannot liquidate their positions in the fund before the fund offers a way out. Tokenized investment DAO solves this problem. Investment DAOs may have a token that derives its value from the underlying portfolio. At any time, investors who own these tokens can sell them on the cryptocurrency exchange.

By offering this functionality, investment DAOs offer a return similar to that of traditional VCs, albeit with less liquidity risk. This makes them a better investment tool based only on the risk-return profile.

What’s the catch?

Each opportunity has its risks and vice versa; DAO investments are no exception. Despite their structural superiority over traditional venture capital, there are still areas that remain unclear.

For example, due to the anonymous nature of crypto investment, it is often difficult to identify the complexity of the investor. This means that it is more difficult to protect investors from taking high risks for a variable asset. This is a space that regulators seek to address by managing how DAO is marketed 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 tools are often made by hand by large legal teams. Relying on smart contracts for this 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 that illustrates the main differences between the two approaches.

Investment DAOs are still in the works. However, the model promises. Once legal and regulatory risks are weighed, investment DAOs can be the model traditional venture capital adopts.