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Investment DAOs: what are they and how do they work?

With investment DAOs, buyers team up to fund startups or make investments based on smart contracts that enforce governance rights.

What is an investment DAO?

An investment DAO is a decentralized autonomous organization (DAO) that raises capital and invests it in assets on behalf of its community. By harnessing the power of Web3, investment DAOs are democratising the investment process and making it more inclusive.

A DAO can issue tokens and have them listed on a crypto exchange or, issue NFT’s to proof part ownership of the DAO. Community rules are agreed upon and governance is enforced by smart contracts. Based on the DAO holdings, governance rights (voting) can be apportioned.

Investing in cryptocurrencies, real estate, nonfungible tokens (NFTs) or any other asset class through a decentralised organisation has several important functional differences from traditional investment models. The same pertains particularly when the investment opportunity is a cryptocurrency startup company. Investments by DAOs in startups differ radically from capital raised through venture capital (VC).

Let us first examine the differences between traditional venture capital and investment DAOs.

Traditional VC’s

Venture capital funds are normally founded by and operated by general partners (GPs). General partner’s performs due diligence on investment opportunities, close investments, and source new investment opportunities.

Venture capital efficiently sources and deploys capital from large institutions like pension funds and endowments. Investors who provide capital to a VC fund are called Limited Partners (LP’s) and include large companies or even individuals.

A general partner’s responsibility is to raise funds from LPs, source high-quality startups, conduct due diligence thoroughly, get approvals from the investment committee and deploy capital smoothly. When startups reach profitability, VCs pass the returns to LPs.

Over the past three decades, traditional venture capital has catalysed the growth of the internet, social media, and many of the Web2 giants. Even so, it is not without its setbacks, and this is what the Web3 model promises to address.

Challenges of traditional VC

Although the VC model has been successful, it is not without flaws. There is a lack of inclusivity, and decisions are made centralised. Investments in VC are also viewed by institutional investors as highly illiquid.

Exclusive

Inclusion is not a major characteristic of VC. In many cases, only wealthy, sophisticated investors are able to invest in this asset class since the capital involved is so high.

Investors must understand their investment’s risk-return profile. Therefore, venture capital may not be right for every retail investor. However, some segments of the retail investor community are difinitely sophisticated enough to invest in this asset class. Despite this, even sophisticated retail investors have difficulty becoming LPs of VC funds.

The reason for this is either that proven general partners are hard to reach for retail investors or that the minimum investment into these funds can be multiple million dollars.

Centralised

As an LP, you have exclusive participation in investment decisions that are made by a small group of individuals who sit on the investment committee of the VC fund. As a result, investment decisions are highly centralised.

The lack of access to global capital often hampers not only investments but also the identification of hyperlocal opportunities. Having a centralised team can only provide so much in terms of sourcing of investment deals and deployment capabilities.

Illiquid

Other critical issues with traditional venture capital include its illiquidity. The capital invested in these funds is often locked up for years. Only when a portfolio company is acquired or goes public, do the LPs see their invested capital returned.

The venture capital asset class is still favored by LPs since its returns tend to be higher than those of public equity and debt.

Next, let’s look at the Web3 alternative to venture capital – investment DAOs.

DAO’s

DAOs combine Web3 values with the operational integrity of smart contracts. Investors who agree on a certain investment thesis can pool their resources and form a fund. Depending on their risk appetite, investors can contribute different amounts to the DAO and their governance rights (voting rights) are proportional.

How do investment DAOs overcome the shortcomings of traditional venture capital? First, let us examine the differences in operations.

Specialisation

DAOs allow accredited investors to make contributions of any size. As a result of their contributions, these investors have a say in key investment decisions. Consequently, both the process of investing in the DAO and deciding on investments in the portfolio are more inclusive.

Deal sourcing can also be decentralised. Having community members from particular regions and areas helps source the best last-mile investment opportunities. It allows investments to be more specialised, more global, yet highly local at the same time.

Due to the fact that these DAOs can be tokenised, investors can contribute smaller amounts. As a result, they can choose among a wide range of different funds that they can contribute to and thus diversify their risk. Also, DAOs tend to welcome more overseas investors (with notable exceptions), usually more than venture capital firms traditionally do.

Let’s say a retail investor with £50,000 wants to invest in small groups of Web3 startups. They could find a DAO focused on NFTs, one on decentralised finance and one for layer-2 cryptocurrencies and so on, so their investment ends up spread across all these different DAOs.

Liquidity

It is not possible for LPs to liquidate their positions in traditional venture capital funds before an exit is available to them. Tokenised investment DAOs solve this problem. Tokens can be issued by investment DAOs that derive their value from the underlying portfolio. Investors who own these tokens can sell them on a crypto exchange or an NFT marketplace at any time.

By offering this capability, DAO investments offers returns similar to those of traditional venture capital, but with less liquidity risk.

A popular Cardano NFT Investment DAO – RatsDAO

Risks

Investing in DAOs can however entail a number of risks as well as opportunities. Although they are structurally improved over traditional VCs, some areas still remain unclear.

Due to the anonymity of crypto investments, it is often difficult to tell whether an investor has sophisticated financial knowledge. Because of this, protecting investors against high risks on volatile assets is more challenging. Regulatory agencies are exploring how to regulate the way DAOs market themselves to bring investors on board which should improve them.

Additionally, some challenges arise when a DAO’s legal language is programmed into smart contracts. Traditional markets often require large legal teams to construct such investment vehicles. The use of smart contracts for such a purpose involves legal and technological risks.

There are however firms that bridge the legal gap between Web3 and the real world. Decentralised autonomous organisations are still in the beginning stages. However, the model is promising. As soon as the legal and regulatory challenges are resolved, investment DAOs could replace traditional venture capital firms.

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