The Roadmap to Unstoppable Decentralized Corporations

In July of 2015 I wrote a blog titled, Will the Next Unicorn be a DAO? In the post, I suggested how blockchain technology could be used to create a commercial organization as valuable as (say) Facebook, but which was not centrally organized and not incorporated anywhere geographically.

A year later, the very first actual blockchain-enabled DAO was launched, and was able to raise $150 Million from over 11,000 people worldwide in it's month-long crowdsale. Several weeks after launch, The DAO was aborted in spectacular fashion through the Ethereum hard-fork.

Since then, the exponential growth of cryptocurrency markets, coupled with the rise of hundred-million dollar Initial Coin Offerings (ICOs), has threatened the VC stranglehold over entrepreneurship and innovation. Indeed, STEEM itself could become the decentralized Facebook killer I had imagined, possibly taking Medium, Reddit, YouTube and Instagram with it....

With all the promise and exuberance however, I feel it's important to remember the centralized corporatocracy will not go quietly. It will leverage its superior capitalization and political influence to try to destroy DAOs and DACs which it deems threatening. And the Achilles heal of STEEM or any DAO in today's economic and political climate is the ease with which they can violate securities laws without intending to.

The rest of this post is a rehash of my original post, focusing on how a DAO could program itself to stay out of the crosshairs and immune to securities regulators, if it so chose.

The Roadmap

In order to function and thrive, a DAO must be “invisible” to government bodies which would seek to threaten its existence. Since the main hurdle is securities law, and since the SEC has pre-emption over the states, the key to DAOs is staying out of the crosshairs of the SEC. The SEC’s mission is in regulating the sale of securities, and protecting investors from securities fraud. But the SEC has no jurisdiction over entities or individuals that do not deal in securities. If you’re selling hotcakes out of a food truck, you’re going to fall under many regulatory agencies’ purview, including FTC, FDA, DMV, various health departments and business administrations. But unless your hotcakes are laced with company stock, you are a non-entity as far as the SEC is concerned.

While most startups are structured as C-Corps, S-Corps or LLCs, these are not the only options. In fact there are much older corporate structures better suited for startups, namely General Partnerships and Workers Cooperatives. Rather than limiting investor control and liability like their newer counterparts, GPs and co-ops blur the distinction between investor and founder. And in so doing the presumption under law is that membership in a General Partnership or a Co-op is not a security. Unless it fails the Howey Test, which tells us a security is:

1. An investment of money (or other item of value)
2. wherein there is an expectation of profits from the investment
3. and the investment is in a common enterprise
4. wherein the profit comes from the efforts of a promoter or third party.

So let’s talk about how to pass the Howey Test while allowing startups to raise capital from investors. Since the Howey Test is to determine whether something is a security, we must reverse the logic of the test to “pass”. For instance, if there’s no reasonable expectation of profit, there’s no security. Similarly, if there is reasonable expectation of profit, but that profit is based on the investor’s own efforts (rather than those of a third party), then it’s not a security either.

As a thought experiment, let’s imagine you tell me you are starting a gold mining club and for $100 you will sell me a membership entitling me to mine for gold on your land and keep whatever gold I find. You warn me that only one in a thousand people who do this full time for a year have found enough gold to make a profit, but the ones who do strike it rich. Here’s a situation where there’s no reasonable expectation of profit. And, any profit I might make is derived only through my own entrepreneurial and managerial efforts. Clearly, membership in your mining club is not a security.

However, we don’t have to be so strict. For instance, if you told me I have a 90% chance of making a profit, then as long as I’m doing my own mining, it’s not a security. Or you could tell me profits are one-in-a-thousand, but instead of mining myself, I'm buying into a pool that does all the work and randomly assigns any proceeds to members based on how much they paid for their membership (i.e. a $200 membership is twice as likely to get gold as a $100 membership). It should be noted that this probably would be considered an “illegal lottery” in most states, but the point here is that it’s not a security.

Since the exercise here is to solve for allowing anyone to invest in a startup, there’s always an expectation of profits. Thus, we need to focus on whether this expectation comes from the entrepreneurial or managerial efforts of others. Before I dive in though, it’s worth remembering that prior to the the Securities Acts of 1933 & 1934 (and the formation of the SEC), stock market fraud was rampant. Grandmothers in Kansas would regularly get fleeced out of their retirement nest egg by stock brokers in New York. So the main thing to remember is the SEC’s raison d’être: to protect investors from getting hurt.

Which means to stay out of the SEC’s crosshairs, we need to prevent investors from getting hurt whenever they are expecting profits from the entrepreneurial or managerial efforts of others. Let’s look at these elements in a bit more detail:

• Financial Risk & Liability – By definition, if your paycheck is not at risk, it’s not entrepreneurial activity, it’s a salaried job. Thus to remain clear, there must be financial risk for both investor and the people doing the work at the startup. And they must both bear the financial liability if there’s a loss.

• Corporate Governance & Control – When the SEC takes action against a company for securities violations, they look for who’s making the decisions (governance) and who’s ultimately in control of the company. If everyone is a decision maker— investors and employees alike — and no individual person can be identified as having more control than others, then there’s no security, regardless of the financial risk and liability.

Programming a Decentralized Autonomous Corporation (DAC)

At this point you may be wondering how many people would want to invest significant sums of money into a startup and have to do a lot of work? Wouldn’t this be antithetical to the first rule of investing, which is to diversify (and thus not put too many resources into one basket)?

In the past, having decentralized governance and control would indeed have required each investor to do significant amounts of “work”. But with the ability to automate and coordinate activity virtually, a DAC need not require more labor from its investors than overseeing a startup investment does today. In fact, investing in DACs has the potential to streamline investor engagement and allow investors to spend less actual time on more startups, leading to greater diversification and thus reduced financial risk.

What follows is a description of one possible DAC structure that accomplishes these goals and remains clear of securities violations (check with your lawyer first, I’m not one). There are many possible alternative structures that will work, some no doubt better and more efficient than the one I am proposing. This is simply to illustrate it’s possible. The structure I will begin with is that of a General Partnership, and for clarity I will refer to the partnership as the Company or the DAC, regardless of whether it is registered as such in any legal jurisdiction.

The structure proposed here is intended to be run on a system like Ethereum, where smart contracts, currency and financial flows are enforced in a decentralized and autonomous fashion.

General Partners (GPs) – Any individual who has a financial stake in the Company (not including Charitable Beneficiaries) must be a General Partner. GPs — and only GPs — may also be Directors, Managers, Workers or Investors (see below). GPs must be individual human beings (not corporations, organizations, animals or technological agents such as software programs). GPs have the following rights and obligations:

• Right to an equal portion of Dividends (see below)
• Right to an equal vote on all voting matters
• Eligibility to work for the Company for fiat dollars and/or tokens (see Working Partners)
• Equal responsibility and liability under the law for the Company’s decisions and actions in all jurisdictions it operates in plus all jurisdictions the GPs reside in
• An obligation to indemnify all other GPs from legal actions and government sanctions arising from their role as a GP
• All GPs are granted a single token representing Company equity upon becoming a GP, and may acquire more tokens via investing or working
• Upon voluntary or forced removal as a GP, all tokens are relinquished back to the Company

Directing Partners (Directors) – Directors serve the sole function of hiring/firing and compensating the Managers. Directors may not contemporaneously be Managers or Workers. Directors are elected by a majority vote of GPs once per quarter. Directors may not receive compensation of any form (except Dividends) while they are Directors. Think of them as jurors; they serve temporarily for the greater good, and they sacrifice accordingly.

Managing Partners (Managers) – While their main function is management of the Company and Workers, the Managers also set the strategic direction of the Company (relative to the Mission), and they hire, fire, and set compensation of the Workers (other than themselves, which is handled by Directors).

Working Partners (Workers) – A Worker is anyone who does work for the Company in exchange for compensation. In the eyes of many legal jurisdictions, there is a distinction between officers, employees, contractors, and advisors, but for the DAC these are all considered Workers.

Investing Partners (Investors) – An Investor is anyone who purchases tokens in the Company from the Company itself. Being an Investor does not affect one’s status as a GP, Director or Manager.

Charitable Beneficiaries (CBs) – Any organization or individual who receives cash donation from the Company without obligation in return. CBs may not be GPs.

Tokens – The Company’s equity/currency, which entitles holders to Royalties and Liquidity. Tokens may only be held by GPs (who are referred to as Stakeholders in such capacity).

Royalties – A percentage of revenues which is allotted for distribution to Stakeholders on a pro-rata basis.

Liquidity – Stakeholders may sell all but one of their tokens to the Company or to other GPs through a transparent/fair marketplace at any time. Upon dissolution of the Company via acquisition, merger or IPO, all assets of the Company will be distributed to Stakeholders pro-rata.

Revenue Waterfall – All revenues to the Company — including from sales, contracts, grants, prizes and investment returns — will be distributed in the following manner:

1. Taxes: all accrued and potential estimated taxes are paid first
2. Royalties to Stakeholders: distributed pro-rata based on % of tokens held
3. Salaries to Workers: as set by Managers (or Directors in case of Managers)
4. Accounts Payable: as standard for any corporation
5. Capital Investment: the Company may invest in assets to grow capital or hedge operational risk, as determined by the Managers
6. Charitable Contributions to CBs: the Company may make charitable contributions as determined by vote of GPs
7. Bonus Pool to GPs: all GPs except acting Directors participate
8. Dividends to GPs: all GPs get an equal share

Company Formation – The Company is formed by a token sale, ratifying the Charter, and which can only be changed later via supermajority vote of all GPs.

Company Charter

• The Mission: why the Company is being formed and what its ultimate goal is
• Royalty Rate: % of undistributed revenues distributed to Stakeholders
• Charitable Contribution Range: minimum and maximum % of undistributed revenues to be donated
• Bonus Pool Size: % of undistributed revenue distributed to GPs
• Initial Directors: an odd number of Directors, along with names of individuals willing to serve the first quarter
• Initial Managers: one or more individuals who will serve at the pleasure of the Directors
• The Initial Token Sale (ITS): the number of tokens to be sold during an initial capital raise and a timeframe during which it will take place. Note that:
  • The first token purchased by any individual comes with GP Membership
  • Proceeds from the ITS are not included as Revenue

Becoming a GP – After the ITS, if there are tokens left over, or new tokens issued, then anyone who is eligible (see above) can purchase their first token, thereby becoming a GP.

Voting – Voting matters will be programmed into the DAC and automatically administered. In addition a majority of tokens may call a referendum at anytime for any reason. Here is a non-exhaustive list of voting matters and their requirements to carry:

• Referendum: simple majority
• Issuance of New Tokens: simple majority
• Quarterly Election of Directors: simple majority
• Modification of Company Charter: supermajority
• Removing GPs: supermajority
• Acquisition / Dissolution / Change of Control / IPO: unanimity

Conclusion

While the above is not meant to be complete, it should give anyone a good headstart. Note that the standard way a company’s operating agreement or articles of incorporation is enforced is through legal contracts as interpreted by officers of the company and attorneys. With DACs, the vast majority is programmed into the blockchain and thus immune from interpretation, tampering or influence. Still there will always be elements that require human oversight and discretion. The exercise above is designed to minimize human involvement, and where necessary to distribute both the effort and control in a way that is both mission-aligned and free from securities violations.