Simon Yi

5 Risks to Decentralizing Too Early

Decentralizing too early may cause more problems than it is worth. Let's dig into the risks of decentralizing before you're ready.

Decentralization itself doesn’t solve all problems. Some problems are solved faster with hierarchical models. With all the hype about DAOs at the time of writing this, there will be more DAO organizations than NFTs. Merely uttering the words crypto will give you millions of dollars in funding that come out of thin air.

Alas, if you truly have a loyal online community — and that community wants to take more ownership in the direction of that community — then decentralized autonomous organization is your Holy Land. Here are a handful of things to consider before handing over the keys to your community.

1. Regulatory risk

Decentralized autonomous organizations are such a new concept that the legal framework to regulate and tax DAOs is still being formed. lDAOs are like C-Corps except there are an infinite number of member managers, vs limited to 99 for C-Corps. DAOs can be treated like LLCs in states like Montana, but the founding members of the LLC would be liable for tax. This is a problem for DAO founders because they do not have control over the company’s treasury at some point in the governance adoption phase.

If this sets off alarms in your head, read more about the legal framework for DAOs from a16z. The TL;DR on this so far is that the US Treasury doesn’t know how to tax DAOs. Find a good international tax lawyer, ideally with cross-border crypto experience.

2. Key Man Risk, aka “Rage Quit” in web3 parlance

Key man risk = when the founding team decides to abandon the project in a fit of rage. This “rug pull” as it’s also called, leaves in limbo the direction of the product And community. How should it govern itself? How should it propose new changes to the current protocol standards?

To start, founders might invest more heavily in best practices for running the product like an open source project:

- invest in good documentation
- develop openly
- offer bounties, grants or other incentives for third-party development

Read more of what a16z has to say about other best practices for DAO’ifying your company

3. Unilateral decision making through a dominance of governance tokens

The whole point of a Decentralized Autonomous Organization is to tap into the wisdom of the crowd. If a DAO issues ERC-20 governance tokens, but a select few wallet addresses hold 51% of the voting power in the governance of the protocol, there is an open risk for these individuals to collude in what’s called a Sybil Attack.

Unilateral decision making through a dominance of voting power begets the need for Quadratic Voting, which is basically a fancy way of saying that the wallet addresses with the least number of tokens hold a proportionately higher voting power PER TOKEN than a whale that has a large percentage of available tokens.

4. Poor engagement from community

Without active community engagement across all of the surface areas of your community (be it Twitter, Telegram, Discord, or Snapshot) there is no way of a DAO moderator to receive the necessary feedback to move forward on initiatives.

Imagine a proposal is published but it does not receive enough votes to push the proposal through. A moderator could adjust the governance protocol to lower the necessary # of votes, but that would basically inch towards a more centralized organization where decisions are dictated by a select few (investors, founding team, executives).

Without community engagement, you’re losing out on the core benefit of decentralizing in the first place: crowdsourcing wisdom and discernment.

5. Decentralizing too early

dApp (short for decentralized application) teams that pursue community ownership first (starting with a wide token distribution) risk engendering a community of speculators, rather than real users. Without a working product, ownership is worthless, and the community won’t stick. Many teams that have done this are unable to back into product/market fit, and as a result have a hard time kickstarting meaningful community participation. Read more about the perils of decentralizing too early here.

Also consider which problems are solved faster or better in decentralized organizations vs more hierarchical organizations. Compare the problem of Twitter spam to the problem of email spam. Since Twitter closed their network to 3rd-party developers, the only company working on Twitter spam has been Twitter itself. By contrast, there were hundreds of companies that tried to fight email spam, financed by billions of dollars in venture capital and corporate funding. Email spam isn’t solved, but it’s a lot better now, because 3rd parties knew that the email protocol was decentralized, so they could build businesses on top of it without worrying about the rules of the game changing later on.

Heed the warnings above — decentralizing too early may cause more problems than it is worth. Even if you decentralize an organization, there are regulatory and tax risks that community organizers & members take on. Consider the risks and weigh them with benefits of decentralizing decision making. Done right, and you’ll be able to progress quickly and in directions that you didn’t previously imagine (eg: FWB). Done poorly, and you’ll be stuck with a group of people who can’t make decisions quickly or delegate task efficiently.

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